Timothy Kehoe, Kim Ruhl 19 November 2011
In 1985, Mexico opened itself to trade and investment. In recent years, China has followed the same path with much more impressive results. But this column argues that the slow growth and crises that Mexico experienced after the initial boom should act as a warning to those optimistic about China.
Does opening to international trade and foreign investment generate economic growth? A large empirical literature employs regressions with a country’s growth rate as the dependent variable and some measure of openness among the independent variables. Although some researchers find that growth is positively correlated with the share of trade in GDP, Rodríguez and Rodrik (2001) point out that the trade share is not a direct measure of policy. When the dependent variable is a measure of policy, the results are ambiguous and highly sensitive to the exact specification of the regression. Some researchers find large and significantly positive effects of openness on growth; others find no significant effects; still others find that openness is related to growth for countries at some level of development but not for other countries. Edwards (1989) surveys the early literature and in our paper Kehoe and Ruhl (2010), we survey more recent research.
Here we compare Mexico and China, large, less-developed countries that pursued openness policies. Following its 1982–85 crisis, the Mexican government implemented a series of reforms that culminated in the North American Free Trade Agreement in 1994. Starting in the 1990s, China implemented a series of reforms that culminated in accession to the World Trade Organization in 2001. Figure 1 shows that the evolution of the trade shares of Mexico 1990–2000 and of China 1998–2008 have been remarkably similar. Nonetheless, growth in real GDP per working-age person in Mexico averaged only 1.0% per year 1990–2000, while that in China averaged 8.3 % per year 1998–2008. (We use working-age population because it is the appropriate measure of the potential labour force. It may not be appropriate for welfare measurement.)
Figure 1. (exports+imports)/GDP Source: Kehoe and Ruhl (2010); all data available at http://www.econ.umn.edu/~tkehoe/data.html
Should we have expected similar growth in China and Mexico following their reforms? The evidence from the empirical literature on trade and growth is mixed. Perhaps more surprisingly, theoretical predictions regarding trade and growth are also ambiguous. The workhorse models of trade – Heckscher-Ohlin models, Ricardian models, and models with imperfect competition – do not yield a clear relationship between openness and real GDP. As Bajona et al (2011) show, in these models, real GDP can increase, can remain unchanged, and can even decrease after tariffs are reduced. The ambiguity in measured real GDP does not imply an ambiguous change in welfare, however. Openness increases welfare, and we show that welfare has increased in both Mexico and China.
If not trade policy, what?
Researchers commonly conclude that Mexico’s slow growth, despite its reforms, is a consequence of its inefficient financial system and lack of contract enforcement. Bergoeing et al (2002) compare the growth trajectories of Chile and Mexico following the financial crises they both suffered in the 1980s; Chile recovered rapidly while Mexico stagnated. They conclude that the crucial differences between policies in Mexico and Chile are those related to the banking system and to bankruptcy proceedings. Krueger and Tornell (1999) also find that the lack of credit, particularly in the nontradable goods sector, was responsible for the poor growth in Mexico.
Identifying an inefficient financial system and lack of contract enforcement as the factors that slow Mexican growth leaves us with a puzzle – China also suffers from these problems. China has been able to grow with a poorly