The North American Free Trade Agreement (NAFTA) was meant to encourage trade among the United States, Canada and Mexico. One obvious way it did that was getting rid of tariffs the countries had imposed on one another’s exports. But it also regulated treatment of cross-border investments.
This past week, U.S. Trade Representative Robert Lighthizer took aim at Investor State Dispute Settlement (ISDS), a key provision that serves to protect multinational companies that invest abroad.
At issue is what happens if, for example, an American company investing in Mexico faces outright expropriation (e.g., seizing a factory) or new regulation that de facto renders the American company’s investment worthless. What recourse would the American company have in such a case?
As a rule, the countries that inspire the most fear about expropriation are also the countries whose court systems inspire the least confidence. The ISDS provision in NAFTA and similar agreements provides an alternative to domestic courts. The American investor could press a claim against Mexico in front of an arbitration panel. If the investor won, Mexico would have to pay damages.
The pillars of the Lighthizer critique of investment protection were:
- Explicit: Protecting American companies against the risks of investing abroad is effectively providing them with an unfair subsidy.
- Implicit: Why should the administration want to encourage investment abroad when the priority is America first?
Here was how Lighthizer put it:
It’s always odd to me when the business people come around and say, ‘Oh, we just want our investments protected.’ … I mean, don’t we all? I would love to have my investments guaranteed. But unfortunately, it doesn’t work that way in the market. … I’ve had people come in and say, literally, to me: ‘Oh, but you can’t do this: you can’t change ISDS. … You can’t do that because we wouldn’t have made the investment otherwise.’ I’m thinking, ‘Well, then why is it a good policy of the United States government to encourage investment in Mexico?’ … The bottom line is, business says: ‘We want to make decisions and have markets decide. But! We would like to have political risk insurance paid for by the United States’ government.’ And to me that’s absurd. You either are in the market, or you’re not in the market.
His argument appears to be a rejection of any collective action to improve the business environment. In fact, free trade agreements are often a vehicle whereby countries such as Mexico try to reduce the riskiness of investment there. The ability to offer guarantees, such as through ISDS, lets countries credibly break free of a history of poor economic policies (see here for how this worked for Peru).
One might ask: But shouldn’t countries like Mexico or Peru have to give up something if they want help attracting investment this way? In fact, they do. As part of NAFTA, Mexico dropped its tariffs a lot more than the United States did. Before NAFTA, the average U.S. tariffs on Mexico were around 3%; the average Mexican tariffs on the United States were roughly 15%.
Lighthizer seems to be saying: If you want to invest in Mexico, pay the risk insurance! Logically, he might follow up: If you want to export to Mexico, pay their tariffs!
Of course, he doesn’t say the latter because the administration views investment in Mexico as bad but exports to Mexico as good and tariffs impede those exports. There is a reason that trade and investment go together. In a NAFTA letter to the administration in early August, a long list of U.S. organizations argued for the importance of investor protections. They wrote:
Foreign investment is often the best way for American manufacturers, service providers and agricultural producers to reach foreign consumers. Such investment allows them to set up their own distribution networks to deliver products and services directly, tailor products to the local consumer and win sales more efficiently and successfully. Highly regulated service providers have to invest and establish themselves in foreign countries to be able to sell their products.
This conceptual linkage between trade and investment is supported by data. The United States tracks trade between “related parties” – a parent company and its affiliate. This measures how important the investment relationship is to trade.
In 2016, more than 42% of U.S. goods exports to Mexico were between related parties. This excludes services, which likely pushes the average down. In the highest-value category, “Transportation Equipment” – which includes cars – related-party exports made up over 63% of U.S. exports to Mexico. Those numbers suggest investment is often a prerequisite for export success.
While there are sophisticated arguments to be made for and against ISDS, Lighthizer’s critique reveals a misunderstanding of both trade and trade agreements. That’s a big reason NAFTA is in trouble.
