Episode 4: NAFTA and the Giant Sucking Sound

Jim Grenn: The Arkansas Razorbacks basketball team cruised into 1994 NCAA tournament as a #1 seed on their side of the bracket.  They played a fast, aggressive style … almost chaotic at times.  No team in the country scored more points than Arkansas did in 1993/94.    Led by Nolan Richardson, the first African American basketball coach hired by a major university in the south, the Razorbacks pressured their frustrated opponents all the way down the court. 

His coaching style was affectionately referred to by fans as ‘40 minutes of hell’. 

The style attracted some pretty influential fans.  Bud Walton, of the Wal-Mart family made the largest private donation in college history in 1991 to construct a state of the art 19,000 seat basketball area.

Walton hadn’t gone to the University of Arkansas, he just liked the way they played the game.

The President of the United States, and Arkansas grad Bill Clinton was also a fan.  The President even found time to attend the 1994 national championship game against Duke. 

Richardson embraced Clinton at half court shortly after the buzzer sounded in the Championship game.  

The victory was just another feather in the cap for the state of Arkansas.  In the spring of 1994, the state of Arkansas was responsible for the President, the National Champs, and one of the country’s most influential global companies: Wal-Mart.  Without whom, we wouldn’t have free trade in North America.  This deal almost bankrupted Mexico, though.  Again. 

This is Domino – an examination a historical event that had a ripple effect on the global economy.

Hi, this is Jim Grenn and I’m your host.  Today we are going to examine the passage and impact of free trade by looking specifically at NAFTA.  The North American Free Trade deal signed in 1993 and the surprising role that Wal-Mart played in the process.

Brady Raanes:  In 1991, Wal-Mart made a bold decision to expand to Mexico. 

Jim Grenn: that’s Brady Raanes.  He’ll fill in a lot of details for us.

Brady Raanes: They were one of the early adopters of globalization and they saw their neighbors to the south as an easy avenue for growth.   Rather than start from the ground up, Wal-Mart entered into a 50-50 partnership with Cifra, Mexico’s largest retailer.  Cifra understood the culture, and had the operational expertise to handle the logistics in Mexico.  Wal-Mart had the name brand and the unique size and scale to drive down prices for consumers.  Their first venture together was a Sam’s Club in Mexico City. 

Kent Oliver:  There is even a book written about this globalization and free trade movement coming out of the NW Arkansas-based retailer, called To Serve God and Wal-Mart: The Making of Christian Free Enterprise:

Jim Grenn: That’s Kent Oliver, He’ll paint us a big picture of everything going on.

Kent Oliver:  Let me read a little expert “The opening day of the world’s largest Wal-Mart was appropriate to the historical moment. Mariachi musicians and scantily clad spokesmodels were just the beginning, reported an Associated Press account that was widely carried in the United States. “Someone in a penguin costume does the cha-cha across the slippery tile floor of the 244,000-square-foot Wal-Mart Supercenter while amused customers watch.”

Brady Raanes: At about this same time, there was a debate raging in Washington about free-trade.  There was a bill known as NAFTA, the North American Free Trade Agreement that was becoming a hot topic in the presidential debates.

Jim Grenn:  Brady, we still hear a lot about NAFTA today.  Explain just what exactly it originally proposed.

Brady Raanes:  So, NAFTA was this proposed bill that would allow the US, Mexico and Canada to buy and sell goods between each other with no tariffs or trade barriers… and that sounds great, but many worried that jobs would leave the US for Mexico and create high unemployment in the states.

Kent Oliver:  The 1992 election had three pretty unique candidates, Bill Clinton was the democratic nominee, George Bush was the incumbent Republican and a little fiery guy from Texarkana of all places named Ross Perot was the independent.  Perot was by far the most vocal opponent of NAFTA.  Perot’s main gripe was that jobs would flow to Mexico because of cheap labor and the US economy would suffer pretty severe unemployment while Mexico’s economy would boom.

Jim Grenn: That seems logical.  The average income is much lower in Mexico so it would reason that companies may begin to outsource their factory jobs to Mexico.

Brady Raanes: Yeah, that’s true, and Perot uses some great imagery to make his point.  As you can imagine a lot of Americans agreed with him.  Bill Clinton on the other hand was somewhat in favor of the deal.  I mean, he wasn’t singing its praises but he was a big fan of globalization in general and generally pushed for open borders.  Partially because he had seen how much success Wal-Mart, from his home state was having.

Kent Oliver: So, The Walton family had long been friends and supporters of the Clinton family.  In 1986, Bill Clinton’s wife, Hillary became the first female board member in the company’s history.  She remained on the board until 1992 when her husband made his run for the presidency.

Jim Grenn: Interesting, so the Clinton’s could see first hand the impact that Wal-Mart’s expansion could have on their bottom line.

Brady Raanes:  That’s right.

Jim Grenn: So obviously, we know that Clinton wins.  Does this end the NAFTA debate?

Kent Oliver:  Well, it didn’t cement the victory for NAFTA.  It helped it have a home field advantage of sorts, but in order for NAFTA to become official, the agreement would need congressional approval.  But congress was fairly split.  In order to pass it, however, congress needed public opinion to sway back in its favor.

Jim Grenn: and what was the public’s opinion at this point. 

Kent Oliver: Recall 19% of the popular vote in that election went to Perot and even many of those that didn’t vote for him were still stuck on his Giant Sucking Sound.  Therefore, many felt that the passage would create massive job loss

Brady Raanes: Back in Arkansas, Wal-Mart was all for it – they urged their suppliers and manufacturers to write their representatives and encouraged them to get involved in the fight to approve NAFTA. The company organized meetings with Secretary of the Treasury Lloyd Bentsen and U.S. trade representatives.  Wal-Mart quickly embraced its role in shifting the public view.

Kent Oliver: And Mexico was on board as well.  Mexican president Carlos Salinas spoke highly of the idea.  In his eyes, the deal had a high likelihood of accelerating growth in the Mexican economy.  The debt crisis of the 80’s loomed large for Mexico.  At this point they’re looking for anything that would help integrate it back into the global economy after years of struggles.  The agreement, he felt, would stand as a sign that Mexico was back on stable footing. 

Jim Grenn: Who were the big names against it?

Brady Raanes: One key naysayer was Republican Congressman Tim Hutchinson.  Hutchinson was particularly noteworthy because of who he represented.  Hutchinson was from Arkansas.  More notably, he was from Bentonville, Arkansas, the home town for Wal-Mart’s headquarters.  Hutchinson had become the poster boy for the anti-NATFA side.  He happily sang the same tune as Ross Perot, warning of the inevitable job losses from the agreement.

Jim Grenn: Interesting.

Brady Raanes:  No kidding. 

Kent Oliver: So, a date was set for a final congressional vote on NAFTA and there is a lot of doubt surrounding the outcome.  Tim Hutchinson is doing a great job of rallying the opposition.  But Wal-Mart had an idea.  They decided to take a few selected Congressman on a field trip to Mexico to see Wal-Mart’s stores first hand.  So, Hutchinson and others flew to Ixtapalapa, Mexico to visit the largest Wal-Mart in the world at the time.  Everyday 35,000 shoppers strolled through the Wal-Mart isles in Mexico.  Over half of the products on the shelf were American made; Fruit of the Loom socks and tee-shirts, baby toys and soap, all from the US.  Once Hutchinson saw the demand for high quality American goods, he quickly became a convert and returned the states with a new outlook.

Brady Raanes: The Mexicans were consuming vast amounts of American goods, and if the United States wouldn’t provide the goods, surely Asia or Europe would.  Hutchinson’s change of heart was a dramatic win for Wal-Mart and other NAFTA supporters.   A handful of other congressional representatives flipped their support in favor of NAFTA as well. 

Kent Oliver: The tide of public opinion had suddenly shifted.  The press seemingly became fairly one-sided as well.  Reports in the New York Times told stories of Mexican women on their “pilgrimage” to “this country’s newest shrine: Wal-Mart,” where customers happily bought (and I’m quoting here) “such exotic made-in-the-U.S. wonders as Rollerblades, microwave popcorn and upholstered cat perches.” A columnist for the Boston Globe even warned that Failure to ratify the North American Free Trade Agreement could trigger a global economic collapse

Jim Grenn:  Seems a bit extreme.

Kent Oliver:  Yeah, I’d say.  But anyway, NAFTA passes on December 8, 1993 and is signed into law on New Years day a few weeks later.

Jim Grenn:  So, to recap a bit. There is this big debate that a free trade agreement in North America will lead to a labor imbalance.  American jobs will go overseas and lead to higher unemployment.  Mexico is ok with it, but Congress is concerned until they travel to Mexico to see a Wal-Mart store in action.  Wal-Mart became the crowning symbol of what NAFTA could lead to… and NAFTA is signed into law.

Brady Raanes:  You got it.  Now, you mentioned that Mexico was on board with it.  That’s true – in fact Mexico was pretty pumped about it.  Mexico, more so than Canada and US, had cheap labor to offer and it seems liked a natural fit that lower skilled jobs would quickly be outsourced resulting in the construction of factories and plants.  Many believed that the inflows would likely send interest rates down in Mexico and set off an economic boom.  Mexican borrowers were so convinced of the outcome that adjustable rate mortgages became the loan of choice in hopes that their interest rates would adjust lower.  Opportunistic investors and Mexican banks began buying interest rate swaps to profit from the inevitable outcome.

Kent Oliver: Then something unexpected happened.  The two-sided free trade agreement become incredibly one-sided.  It turned out that American consumers liked the free chips and salsa, but didn’t have any appetite for Mexican goods, while Mexican consumers happily scooped up all the goods and services that American companies could provide.  K-Mart entered Mexico, as did Sears, and Domino’s Pizza.  The American goods were made better.  They lasted longer, they didn’t break, and they cost about the same.  There was no comparison. Mexican consumers began to choose the American goods over their own locally made products.  As demand fell for Mexican made goods, factories in Mexico began to close.  The demand for the peso also fell.  Unfortunately, the Mexican peso was pegged to the dollar at a fixed exchange rate. 

Brady Raanes: Rather than allow their currency to change in price against the dollar, the Mexican government effectively “fixed” their currency at a set exchange rate.  If an American tourist traveled to Mexico with $100 US dollars to spend, they knew in advance exactly how many pesos they could convert that to.  This was not only convenient for tourism, but extremely helpful for any international trade taking place between the two economies.  Without a fixed exchange rate, companies would have to navigate the changing currencies values with each transaction.  But as Kent mentioned, when Mexican’s started buying more US stuff, the demand for the dollar rose and the demand for peso fell.

Jim Grenn: But if the currencies are pegged then what difference does it make?  I mean, how would rising demand for one or the other mess up a currency peg?

Brady Raanes:  Great question.  Well, pegged currencies are only pegged because the government intervenes in the currency market and buys or sells their own currency to keep a fixed value.  I mean, imagine it this way… Let’s pretend that some company, like Microsoft announced that their stock price was forever going to be between $98-$102 per share.  But the stock still trades publicly... so the prices are constantly changing.  Microsoft would have to buy or sell their own shares whenever demand rose or fell.  If they had great earnings and the stock started to rise they would begin quickly issuing more shares to balance out the new demand and keep the price constant.  Does that make sense? 

Jim Grenn: I see, and of course, that couldn’t happen in the normal in the stock market because it would be price manipulation, but I suppose a country can do whatever it wants to its currency value

Brady Raanes: Exactly, countries are in charge of their own currency, so they can print more as needed or buy and sell more on the open market to keep the value of the currency in a pretty tight range or pegged to another currency value.

Kent Oliver: So anyway, Mexican consumers start scooping up American goods and the value of the peso begins to plummet.  In order to maintain the peg, Mexico has no choice but to start selling dollars and begin buying pesos on the open market to try and keep the value constant as Brady just described.    

Brady Raanes: The Mexican government continued to buy pesos and sell dollars to offset the imbalance in demand and maintain the peg.  But they couldn’t just print more US dollars.  Mexico was limited to the dollars they held in reserves.  By late 1994, just a year after NAFTA was passed, Mexico’s $29 billion reserve had dwindled to only $6 billion. 

Jim Grenn:  Wow – so Mexico starts trading the US dollars they have in reserves for their own currency, the Mexican peso, and the demand is so strong that they blow through more than $20 billion US dollars to prop up the value.

Kent Oliver: Pretty crazy right.  See Mexico was kinda stuck.  They couldn’t print US dollars – they could only print pesos.  So, in theory, they could keep printing pesos and exchanging them for dollars, but if they did that they would be devaluing the peso with all the newly printed money.  As their supply of dollars dwindled it became apparent that they wouldn’t be able to maintain the pegged currency.

Brady Raanes: Yeah, Mexico really had no choice… they had to break the peg.

Kent Oliver: In December of 1994, just a year after NAFTA passed, Mexico announces that the peso will be allowed to float freely…. And the peso plummets…  Within a matter of months, the value of the peso had fallen by more than half.  Again, the price of everyday products surged for Mexican consumers. 

Brady Raanes: I found this quote in the New York Times from December of 1994 that I love.  The President of the Association for Mexican Bankers said “The best thing I can say about 1994 is that it is almost over” 

Kent Oliver:  But 1995 wasn’t any better.  Hyperinflation ripped through Mexico, reaching 52% by year end.  The unemployment rate doubled. 

Brady Raanes: The Mexican government again teetered on the verge of bankruptcy.

Jim Green: It seems like Mexico just couldn’t catch a break, just like Latin America’s lost decade in the 80s. 

Brady Raanes:  Yep.  This one wasn’t really debt-driven and it wasn’t regional.  It was pretty exclusive to Mexico.  But the result was the same.  Another rescue package was put together by the IMF, the US Treasury, the Federal Reserve, the Bank for International Settlement and Goldman Sachs totaling $50 billion to keep the government afloat.

Jim Grenn: Another IMF bailout.  For those who don’t know, Brady, give us a little refresher on the IMF. 

Brady Raanes: Sure, so the IMF stands for the International Monetary Fund – an organization created in the Bretton Woods agreement.  You may recall from previous episodes – the IMF is essentially the credit union of the world.  They make loans from rich countries to poor countries, but the IMF didn’t impose all of the same austerity measures that crippled the economy in the 1980s so the recovery was a little easier.

Jim Grenn: …and there were no earthquakes.

Brady Raanes: Good point, unlike the 1980s there were no earthquakes.

Kent Oliver: It’s also worth noting that there are unique differences between currency crises and debt crises.

Brady Raanes: Oh, good point.

Jim Grenn:  Can you elaborate?

Kent Oliver: Well, with a debt crisis the initial thinking is that you have two choices – you either have to hoard cash and cut spending in order to have cash to pay your debt or… you have to grow your way out of it with even more debt and stimulus – which usually just leads to a deeper crisis.  But with a currency crisis, you just raise interest rates in hopes of increasing the value of your currency. 

Brady Raanes:  That’s right, once a currency is floating it kind of becomes a balancing act – the weak peso makes Mexican travel and investment more appealing to foreigners – so they travel more and spend more and the demand tends to increase – which strengthens the value of the peso. 

Kent Oliver: Yeah, typically, a government will also opt to increase interest rates at the same time to avoid currency flight from within the country.  So… in 1995, the Mexican government hiked rates to as high as 50%.

Jim Grenn: That kind of puts Paul Volcker’s rate hikes in the 1970s to shame.

Kent Oliver:  No doubt… and remember all those adjustable mortgages that had been so popular?  It caused millions of Mexicans to lose their homes.  Mexican companies fell even farther behind their American competitors as their debt load soared against higher interest rates and a weaker peso.  Mexican banks suffered deep losses from their “can’t lose” bets on interest rates.

Jim Grenn:  Not to state the obvious, but it really feels like US policy has messed up Mexico quite a bit in recent years. 

Brady Raanes:  Yeah, I mean, your right.  Somewhat ironically, I think it was really welcomed both times.  In the 1970s Mexico was really happen to welcome US banks into the country in hopes of increasing development in the 1993 Mexico was all to happy for NAFTA to pass in hopes that it would mean more jobs for Mexicans.  It’s kind of strange how much you just can’t predict that kind of thing.    

Jim Grenn:  Safe to say the economy is a complex system.  There are just so many moving parts – you think that pulling one lever will lead to one outcome and sometimes it leads to something totally different.  

Kent Oliver:  Good point, well, in this case – as the peso tanked American companies began to see opportunities and went on a spending spree for Mexican assets at pennies on the dollar. The main winner was Wal-Mart.  By the end of 1995 there were more than 22 Sam's Clubs, and 11 Wal-Mart stores throughout Mexico.

Brady Raanes: The cracks in the Mexican banking system also made banks easy takeover targets.  Eight years after the crisis, 80% of the banking system in Mexico was controlled by foreign ownership.

Jim Grenn:  That’s staggering. 

Brady Raanes: The jobs everyone expected to flow into Mexico never really came.  The Mexican peso that tanked in 1995 is still floating today although it has recovered from its fallout in the mid-1990s but the Mexican economy never really boomed as everyone expected after NAFTA.  At the time of this recording the exchange rate is roughly 19 pesos per dollar.  But drama still simmers around the NAFTA deal. 

Kent Oliver: Discussions around NAFTA continue to play a vital role in trade policies today.  It remains the largest trade agreement in the world and it has been credited with more than quadrupling trade and providing a significant boost to economic growth… although clearly at the expense and exploitation of some in the process.  In many ways putting a full court press on Mexico…

Jim Grenn: We began this episode talking about basketball and Arkansas coach Nolan Richardson.  Well, in 2007, Richardson agreed to coach the Mexican national team and brought his 40 minutes of Hell south of the border.  The team didn’t qualify for the Olympics but they did pull an impressive upset in the qualifying round against a superior Puerto Rico team. Nolan Richardson smiled and high fived his Mexican players as he walked off the court.  All those years later, and Mexico still had a taste for high quality American imports.