Why Have Economic Reforms in Mexico Not Generated Growth?*

Federal Reserve Bank of Minneapolis Research Deparmen Saff Repor 453 November 2010 Why Have Economic Reforms in Mexico No Generaed Growh?* Timohy J. Kehoe Universiy of Minnesoa, Federal Reserve Bank of Minneapolis, and Naional Bureau of Economic Research Kim J. Ruhl Sern School of Business, New York Universiy ABSTRACT Following is opening o rade and foreign invesmen in he mid-1980s, Mexico s economic growh has been modes a bes, paricularly in comparison wih ha of China. Comparing hese counries and reviewing he lieraure, we conclude ha he relaion beween openness and growh is no a simple one. Using sandard rade heory, we find ha Mexico has gained from rade, and by some measures, more so han China. We skech ou a heory in which developing counries can grow faser han he Unied Saes by reforming. As a counry becomes richer, his sor of cach-up becomes more difficul. Absen coninuing reforms, Chinese growh is likely o slow down sharply, perhaps leaving China a a level less han Mexico s real GDP per workingage person. * This work was underaken wih he suppor of he Naional Science Foundaion under gran SES-09-62865. The paper was prepared for a mini-symposium in he Journal of Economic Lieraure on lack of economic growh in Mexico following is economic reforms. The edior, Jane Currie, provided several very helpful suggesions. José Asurias and Sewon Hur provided exraordinary research assisance. We hank Tom Holmes, Ellen McGraan, Ed Presco, and Jaime Serra-Puche for helpful discussions. The daa used in his paper are available a www.econ.umn.edu/~kehoe and a www.kimjruhl.com. The views expressed herein are hose of he auhors and no necessarily hose of he Federal Reserve Bank of Minneapolis or he Federal Reserve Sysem.

1. Inroducion During he decade ha followed is severe economic crisis of 1982 85, he Mexican governmen implemened a series of marke-oriened reforms ha culminaed in he implemenaion of he Norh American Free Trade Agreemen (NAFTA) in 1994. These reforms included fiscal reforms, privaizaion of governmen operaed firms, and opening he economy o rade and foreign invesmen. In spie of hese reforms, Mexico s economic growh since 1985 has been modes, a bes. This growh is especially disappoining if we compare i wih ha of China, anoher large, less developed counry ha sared opening iself o he res of he world afer Mexico. In his paper, we ask why Mexico s reforms did no resul in higher raes of economic growh. We focus on he reforms ha opened Mexico o rade and foreign invesmen. I is worh noing ha one of he auhors was a proponen of hese reforms as a means for achieving higher growh in Mexico (see Timohy J. Kehoe 1992, 1994). Figure 1 presens daa on Mexico s rade in goods and services as a percenage of is GDP, while figure 2 presens daa on inflows of foreign direc invesmen (FDI). Noice ha Mexico s aperura, or opening, resuled in large increases in rade and FDI. (See Kehoe 1995 for he deails of he reforms involved in he aperura.) In paricular, Mexico s rade and inward FDI as shares of is GDP reached levels comparable o hose achieved by China. Figure 3 presens he disappoining daa on economic growh in Mexico. While real GDP per working-age person (15 64 years old) grew by 510 percen (8.2 percen per year) in China over he period 1985 2008, i grew by only 10 percen (0.4 percen per year) in Mexico. 1 Noice ha he verical axis in figure 3 has a log base 2 scale, so ha China s relaively consan growh shows up as being close o linear. [Figures 1, 2, and 3 here] China and Mexico are major exporers and imporers in he world economy. In 1995, China had he larges merchandise rade among counries classified by he Inernaional Moneary Fund as emerging and developing, accouning for 12.7 percen of emerging and developing rade, while Mexico was second, accouning for 7.0 percen. In 2008, China is sill he larges rader a 1 We use real GDP per working-age person, raher han real GDP per capia, because i measures beer an economy s abiliy o produce goods and services, especially in he conex of he neoclassical growh model ha we discuss in secion 4. When we discuss welfare in secion 3, we use real GDP per capia. Anoher measure appropriae for welfare would be real GDP per adul equivalen. All of he daa used in his paper are available a www.econ.umn.edu/~kehoe and a www.kimjruhl.com. 1

22.3 percen, while Mexico has dropped o hird, a 5.4 percen, slighly behind Russia. China and Mexico had some of he larges receips of FDI among emerging and developing economies. In 1995, China was he larges recipien of FDI o emerging and developing economies, accouning for 33.4 percen, while Mexico was second, accouning for 8.5 percen. By 2008, China has remained he larges recipien of FDI o emerging and developing economies, a 14.8 percen, bu Mexico has fallen o sevenh, a 3.2 percen, falling behind Russia, Hungary, Brazil, India, and Saudi Arabia. 2 We begin by reviewing he exising lieraure, asking wheher i provides a convincing answer o he quesion of why Mexico sagnaed afer opening iself o rade while China grew rapidly. Alhough a number of sudies are informaive, we do no find an answer o his quesion. As Clausre Bajona, Mark J. Gibson, Kehoe, and Kim J. Ruhl (2010) argue, sandard rade models do no imply ha opening o rade increases produciviy or real GDP, bu ha i increases welfare. Examining he mechanisms hrough which opening o rade increases welfare, we find evidence ha welfare increased more in Mexico han he real GDP daa indicae and ha he growh gap beween Mexico and China is no as large. Noneheless, a large growh gap remains, and, o accoun for his growh gap, we need o idenify a criical facor ha impeded growh in Mexico bu no in China, or a differen facor ha spurred growh in China bu no in Mexico. Performing a simple growh accouning exercise, we find ha his sor of facor, when insered ino a growh model, would need o explain why oal facor produciviy (TFP) sagnaed in Mexico while i grew rapidly in China. We review a number of possible facors suggesed by he lieraure some associaed wih rade and foreign invesmen policies and ohers associaed wih domesic policies. We conclude by suggesing direcions for fuure research. In paricular, we skech ou a heory suggesed by he research of Sephen L. Parene and Edward C. Presco (1994, 2002) and Kehoe and Presco (2002, 2007). In his heory, echnology in he form of he sock of useable knowledge in he indusrial leader which we idenify as being he Unied Saes over he pas cenury grows a a consan rae. If insiuions and economic policies are consan, his implies a consan rae of growh of real GDP per working-age person. Developing economies like Mexico and China can grow faser han his rae by improving insiuions and reforming policies. The possibiliies for such cach-up growh depend on he disance of he developing 2 FDI inflows are more volaile han merchandise rade, so he lis of leaders changes more frequenly. 2

economy from he fronier, he level of real GDP per working-age person in he Unied Saes. In Mexico which, in spie of is slower growh, is sill closer o he Unied Saes in erms of real GDP per working-age person han is China his cach-up growh is more difficul. Our heory suggess ha he facors ha currenly impede growh in Mexico, such as inefficien financial insiuions, and insufficien rule of law, and rigidiies in he labor marke, do no ye do so in China because China has no ye reached a sufficien level of economic developmen. We hypohesize ha, as China grows, hese facors will become more imporan and, absen significan reforms, growh in China will slow down sharply, as i has in Mexico. 2. Lieraure review We now survey he exising lieraure relaed o our quesion of why Mexico sagnaed afer opening iself o rade and foreign invesmen while China grew rapidly. Since his lieraure is large, we focus on hose sudies paricularly relevan o he heory ha we skech ou in secion 5. 2.1. Cross-counry growh regressions In conras wih he approach of his paper, which compares he experience of Mexico afer i opened iself o foreign rade and invesmen wih ha of China, here is a large lieraure ha includes measures of openness in cross-counry growh regressions. The lieraure on he empirical relaionship beween rade policy regimes and economic performance goes back o he 1970s. Sebasian Edwards (1989) provides a comprehensive summary of he early work. I is worh noing ha Edwards criicizes much of he previous lieraure, and in paricular he World Bank (1987), for employing univariae measures of policies ha divide counries ino open or closed, noing ha such divisions are ofen highly subjecive and run he risk of simply verifying he policy preferences of he researchers doing he sudy. We focus on he seminal work of Jeffrey Sachs and Andrew Warner (1995), who consruc a univariae measure of openness ha classifies a counry as closed if i had any one of five characerisics: (1) a high average ariff rae, (2) nonariff barriers on a large fracion of impors, (3) a socialis economic sysem, (4) a sae monopoly over major expors, or (5) a high blackmarke premium during eiher he 1970s or he 1980s. Sachs and Warner find ha counries ha are open, in ha hey have none of hese characerisics, have on average 2.4 percen per year higher growh in real GDP per capia han hose ha were closed. Of paricular relevance o he 3

comparison beween Mexico and China is Sachs and Warner s classificaion of Mexico as closed up unil 1986 bu open hereafer and heir classificaion of China as being closed. They classify China as a socialis economy and noe ha, alhough China has progressively liberalized since 1978, is rading sysem was sill rife wih quaniaive resricions a leas as of 1994. Updaing he Sachs-Warner classificaion, Romain Wacziarg and Karen Horn Welch (2008) classify Mexico as open bu China as sill closed because of is socialis regime and is black marke premium. Francisco Rodríguez and Dani Rodrik (2000) criicize Sachs and Warner, poining ou ha he power of he openness variable in heir regressions derives mosly from he sae-monopolyof-expors and he black-marke-premium crieria. These crieria, Rodríguez and Rodrik argue, are no measures of rade policy per se and, overall, he Sachs-Warner openness variable serves as a proxy for a very broad range of insiuional and policy variables. Warner (2003) responds o his criicism by showing ha he average ariff on impors of capial and inermediae goods has a significanly negaive effec on growh and ha he sae-monopoly-of-expors and he black-marke-premium crieria can be dropped as long as he conrols for iniial GDP per capia. I should be noed ha, in Warner s daa se, Mexico has lower han average ariffs on capial and inermediae goods and China has higher han average ariffs. As Rodríguez (2007) poins ou, he message of Warner (2003) is much more nuanced han ha of Sachs and Warner (1995) and, in paricular, openness seems o have a more posiive effec on poorer counries han on middle income counries. Anoher aemp o respond o Rodríguez and Rodrik s (2000) criicism of Sachs and Warner (1995) is ha of David Dollar and Aar Kraay (2004), who examine he impac of firs differences in openness o rade on growh. They idenify globalizers as counries ha significanly increased heir raios of rade o GDP beween he lae 1970s and he lae 1990s. Dollar and Kraay find ha globalizers experienced large increases in heir growh of real GDP per capia, while non-globalizers saw heir growh raes decline. According o he Dollar-Kraay crierion, boh Mexico and China are globalizers. Three general aspecs of he lieraure are worh noing: Firs, here is a posiive and robus relaionship beween a counry s rade as a share of GDP and is growh rae, as esablished in he work of such researchers as Jeffrey A. Frankel and David Romer (1999), Francisco Alcalá and Anonio Ciccone (2004), and Dollar and Kraay 4

(2004). As a number of researchers, including Rodríguez and Rodrik (2000) and Rodríguez (2007), have poined ou, however, he rade share is no a direc measure of policy and he causal relaion beween he rade share and growh is problemaical. Howard L. M. Nye, Sanjay Reddy, and Kevin Wakins (2002), for example, argue ha Dollar and Kraay s aemp o relae heir resuls involving changes in rade shares o changes in ariffs is highly sensiive o he years chosen for ariff changes and he years chosen for growh raes and ha Dollar and Kraay s resuls are no robus. Second and relaedly, he relaionship beween measures of policies relaed o openness and growh does no seem o be robus: A number of researchers including Ann Harrison (1996) and Edwards (1998) in addiion o hose whose work we have already discussed find a large and significanly posiive relaionship beween policies relaed o openness and growh. Oher researchers like Ha Yan Lee, Luca A. Ricci, and Robero Rigobon (2004) find a posiive, bu small, relaionship. Sill ohers including Rodrik, Arvind Subramanian, and Francesco Trebbi (2004) in addiion o hose whose work we have already discussed do no find a significan relaionship beween policies relaed o openness and economic growh. Oher researchers find more nuanced resuls: In addiion o, and in conras wih, he work of Warner (2003), Seve Dowrick and Jane Golley (2004) and David N. DeJong and Marla Ripoll (2006) find ha openness has a significanly posiive impac on growh only for developed counries, while Hali Yanikkaya (2003) acually finds ha openness has a negaive effec on economic growh for less developed counries. Third, many of he researchers who sudy he relaionship beween openness and growh do so wihou being closely guided by a heoreical model. Oher researchers, paricularly hose working in he 1990s, are guided by he heoreical work on endogenous growh by researchers such as Luis A. Rivera-Baiz and Paul M. Romer (1991). In his sor of model, here are ypically scale effecs from posiive exernaliies in producion. Tha is, everyhing else being equal, larger counries should grow more rapidly. Inernaional rade can allow a small counry o benefi from hese posiive exernaliies. This sor of heory indicaes ha well-specified growh regressions need o conrol for an appropriae measure of counry size when sudying he impac of openness. Typically, in hese heories, a smaller counry benefis more from opening o inernaional rade han does a larger counry. Once again, he empirical resuls are mixed: Frankel and Romer (1999) and Alcalá and Ciccone (2004) find a posiive relaionship beween 5

populaion size and economic growh. Albero Alesina, Enrico Spolaore, and Wacziarg (2000) and Spolaore and Wacziarg (2005) find he same relaionship and also find a negaive (alhough saisically insignifican) coefficien for he ineracion erm of populaion size wih heir measure of openess. On he oher hand, Chris Milner and Tony Wesaway (1993), Harrison (1996), and Xavier Sala-i-Marin (1997) find no significan link beween measures of populaion size and growh. David A. Backus, Parick J. Kehoe, and Kehoe (1992) similarly find ha growh and size of GDP are largely uncorrelaed, bu hey do find evidence of significan scale effecs in manufacuring, and evidence ha hese effecs are larger and more significan when hey conrol for a measure of openness suggesed by he heory of Rivera-Baiz and Romer (1991). 2.2. Sudies of Mexico s sagnaion We are by no means he firs researchers o sudy why Mexico has sagnaed in spie of is reforms. In his secion we review he research ha idenifies facors believed o impede growh in Mexico. For each of hese facors we ask: Does China share his characerisic? And, if so, why has i no impeded growh in China? In many cases we find ha he facors associaed wih slow growh in Mexico are also presen in China, so we are lef o ask: Why do hese facors impac growh differenly in he wo counries? The mos popular se of heories for Mexico s sagnaion focuses on is inefficien financial sysem and lack of conrac enforcemen. Raphael Bergoeing, Raimundo Soo, Kehoe, and Kehoe (2002, 2007), for example, compare he growh experiences of Mexico and Chile following heir economic crises in he early 1980s. While Mexico sagnaed, Chile grew rapidly. Afer examining fiscal reforms, privaizaion, and reforms of policies relaed o rade and foreign invesmen policy in Mexico and Chile, hese researchers conclude ha he crucial difference beween policies in Mexico and Chile are hose relaed o he financial sysem and o bankrupcy proceedings. They skech ou a model of firms wih heerogeneous produciviy and argue ha an inefficien financial sysem can misallocae labor and capial, leading o a low measure of TFP. Furhermore, inefficien bankrupcy proceedings can keep inefficien firms alive and impede he enry of new, more efficien firms, slowing down he growh of TFP. Anne Krueger and Aaron Tornell (1999) and Tornell, Frank Wesermann, and Lorenza Marinez (2003) sudy he recovery of he Mexican economy following he financial crisis of 6

1994 1995. They find ha, while he raded goods secor grew rapidly, he nonraded secor recovered sluggishly. They argue ha his occurred because domesic bank lending dried up afer he crisis, and raded goods firms were able o obain financing from abroad while nonraded goods firms were no. One of he reasons ha lending dried up was ha poor conrac enforcemen such as he inefficien bankrupcy procedures idenified by Bergoeing e al. (2002, 2007) generaed a large quaniy of nonperforming loans. Tornell, Wesermann, and Marinez (2003) develop a model in which rapid GDP growh canno be susained over a long period if i is driven only by growh in he raded goods secor, because firms producing raded goods need nonraded inpus. The problem wih idenifying a poorly funcioning financial sysem and lack of conrac enforcemen as he facors ha differeniae Mexico from China is ha China also has a poorly funcioning financial sysem and lack of conrac enforcemen. Thomas G. Rawski (1994) and Franklin Allen, Jun Qian, and Meijun Qian (2005) esablish ha China has been able o achieve phenomenal economic growh wih a poorly funcioning financial sysem and legal sysem and wihou any significan reforms o hese sysems. Sudying he Chinese experience, Alessandra Guariglia and Sandra Ponce (2008) go so far as o quesion wheher an efficien financial sysem is necessary for growh a all. Oher researchers idenify oher possible impedimens o growh in Mexico. Gueorgui Kambourov (2009), for example, argues ha a rigid labor marke kep Mexico from benefiing as much from opening o rade as Chile did. Nora Lusig (2001) idenifies an insiuional vacuum in he agriculural secor afer governmen inervenion here was reduced as leaving many producers wih less access o credi and echnical assisance. Juan Carlos Moreno-Brid, Jesus Sanamaria, and Juan Carlos Rivas Valdivia (2005) idenify a sharp fall in public invesmen. I is worh noing ha Lusig and Moreno-Brid e al. also idenify problems in he financial sysem as being significan barriers o growh in Mexico. The conclusion ha we draw from hese sudies is ha facors like an inefficien financial secor, lack of conrac enforcemen, and rigidiies in he labor marke kep Mexico from benefiing from is reforms o policies involving foreign rade and invesmen. China also has hese same problems, bu we will argue ha hese did no impede growh as hey did in Mexico because China is a a lower level of developmen. Perhaps China s growh is even par of Mexico s problem. M. Ayhan Kose, Guy Meredih, and Chrisopher Towe (2005), for example, 7

idenify increased compeiion from China in is expor markes, as well as problems in he legal sysem and rigidiies in he labor and elecommunicaions markes, as barriers o growh in Mexico. 2.3. Sudies of China s fas growh A number of researchers have idenified rapid TFP growh as he driving force behind Chinese economic growh. Loren Brand and Xiaodong Zhu (2009) find ha abou half of Chinese TFP growh was due o produciviy differences beween enering and exiing firms during 1998-2005. Chang-Tai Hsieh and Peer J. Klenow (2009) idenify reallocaion of resources from inefficien firms o efficien firms as a significan deerminan of his TFP growh. We ask: Why have hese facors no been a work in Mexico? Policies relaed o foreign rade and invesmen played significan roles in he reallocaion of resources ha led o TFP growh. Bajona and Tianshu Chu (2010) argue ha China s 2001 accession proocol o he World Trade Organizaion forced he Chinese governmen (or gave reformers inside he governmen he poliical clou) o drasically cu subsidies o he saeowned secor and show ha his generaed a reallocaion from inefficien sae-owned firms o efficien privae firms. Zuliu F. Hu and Mohsin S. Khan (1997) argue ha reforms ha led o FDI araced efficien foreign firms o inves in China. Zheng Song, Kjeil Soresleen, and Fabrizio Ziliboi (forhcoming) build a model o accoun for China s recen growh experience, which is characerized by subsanial reallocaion wihin he manufacuring secor in an economy wih large financial imperfecions. I would be emping o hypohesize ha he mechanisms ha generaed TFP growh in manufacuring in China were no presen in Mexico, bu his does no seem o be he case. In paricular, using firm level daa for Mexico, Erneso López-Córdova (2003) finds ha rade and foreign invesmen reforms resuled in large increases in produciviy in he manufacuring secor in Mexico, especially in he machinery and equipmen, compuing equipmen, and precision insrumens indusries. This suggess ha problem in Mexico is lack of produciviy growh, no in manufacuring, bu in he res of he economy. I furher suggess ha we should look a lack of compeiion in oher secors in Mexico such as peroleum exracion, elecriciy, elecommunicaions, and ransporaion for he facors inhibiing produciviy growh. 8

We could also hypohesize ha China has been able o grow because i has a srong cenral governmen ha has been able o overcome some of he problems associaed wih poorly funcioning markes, while Mexico has no been able o do his. This hypohesis is worh exploring, bu i is worh poining ou wo reasons for doubing i: Firs, Mexico became a democracy only in he mid-1990s; previously i had a one-pary sysem ha was in many ways as srong and cenralized as ha in China. Furhermore, he Mexican governmen conrolled he banking sysem from 1982 hrough 1991, and Bergoeing e al. (2002, 2007) idenify he inefficien allocaion of credi during his period as a major facor in Mexico s poor economic performance. Second, Bajona and Chu (2010) argue ha unil China joined he WTO, he banking sysem here served mosly o funnel savings ino invesmen in inefficien sae-owned enerprises. Allocaion of credi by he governmen seems o have been he major problem in he financial sysems in boh Mexico and in China, no a remedy for oher problems. 3. Gains from rade and real GDP The empirical evidence on he link beween rade and growh is inconclusive. Wha do heoreical models of inernaional rade predic should happen when a counry liberalizes rade? Perhaps surprisingly, he workhorse models of rade such as he Ricardian models of Rudiger Dornbusch, Sanley Fischer, and Paul A. Samuelson (1977) and Jonahan Eaon and Samuel S. Korum (2002), or he imperfec compeiion models of Paul Krugman (1980) and Marc J. Meliz (2003) do no yield a clear relaionship beween rade and real GDP. In hese models, real GDP can increase, can remain unchanged, and can even decrease afer ariffs are reduced! This resul follows from he way in which changes in he erms of rade are incorporaed ino real GDP. Bajona e al. (2010) show ha he change in real GDP from a change in ariffs can be decomposed ino wo pars: he change in real GDP a facor prices and he change in real ariff revenues, (1) GDP(, p ( )) GDP F (, p ( )) T (, p ( )), where p is he erms of rade, and is an ad valorem ariff. If decreasing ariffs changes he counry s erms of rade, real GDP a facor prices will weakly decrease. The lower ariffs also generae an increase in impors, and he ariff revenue associaed wih hose impors, compued a he base period (higher) ariff rae, increases. The change in real GDP is he ne effec. If real ariff revenues increase enough o offse he decline in real GDP a facor prices, real GDP 9

increases; if he change in ariff revenues is small, real GDP decreases. The effec of he erms of rade on real GDP in a counry wihou ariffs is addressed in Ulrich Kohli (2004), and in models wih ariffs, in Kehoe and Ruhl (2008) and Rober C. Feensra, Benjamin R. Mandel, Marshall B. Reinsdorf, and Mahew J. Slaugher (2009). The ambiguous impac of rade liberalizaion on real GDP does no imply an ambiguous impac of liberalizaion on welfare: All of he models considered by Bajona e al. predic ha rade reform increases welfare. Accuraely measuring he gains from rade for Mexico and China is an inherenly model specific exercise. Cosas Arkolakis, Arnaud Cosino, and Andrés Rodríguez-Clare (2010), for example, show ha, for a class of models, he change in real income in a counry is a funcion of he impor peneraion raio and a parameer relaed o he elasiciy of subsiuion beween impors and domesic goods. Changes in impor peneraion raios are similar in Mexico over 1990 2000 and China over 1998 2008, suggesing ha, as fracions of real GDP erms, he gains from rade in China and Mexico are similar, alhough in absolue erms, Mexico s gains are much larger han China s. Raher han go ino model specific deails here, we consider wo oher measures: an adjusmen o real GDP o accoun for erms of rade effecs and a measure ha accouns for he gains from he greaer varieies available hrough rade. These measures indicae ha Mexico has gained more from rade han has China. I is worh noing ha his comparison assumes, for he momen, ha China s higher GDP growh was no iself a gain from rade. We could resae our comparison as saying he gains from rade idenified by sandard models have been higher in Mexico han in China. 3.1. Gains from he erms of rade Trade liberalizaion and, more broadly, globalizaion brings abou changes in he erms of rade. Changes in he erms of rade impac welfare in he counry bu will generally no ranslae ino changes in real GDP, as discussed above. Kohli (2004) argues ha he invariance of real GDP o changes in he erms of rade makes real GDP a poor measure of counry progress; Kehoe and Ruhl (2008) and Feensra e al. (2009) sudy he impac (or lack hereof) of he erms of rade on measures of produciviy. These auhors sugges several alernaives o real GDP; here we use he real gross domesic income (GDI) of a counry, as defined by he Unied Naions Sysem of Naional Accouns, o capure he impac of changes in he erms of rade on welfare and produciviy. 10

Real GDI reas he domesic componens of expendiure in he same way ha real GDP does he componens are deflaed by heir respecive price indices bu i differs in he deflaion of he rade balance. To compue real GDI, we deflae he rade balance by he impor price deflaor: Expors are valued in erms of he amoun of impors hey could purchase, C I G X M. (2) GDI C I G M P P P P In figure 4 we plo he percenage deviaion of real GDI from real GDP for Mexico and China. We refer o his measure as he erms of rade premium: he gain, relaive o real GDP, ha accrues o a counry because of changes in he erms of rade. In Mexico, he average erms of rade premium is 0.17 percen per year, bu he crisis in 1994 1995 was accompanied by a sharp deerioraion in he erms of rade; he impac of he financial crisis was worse han real GDP indicaed, and he recovery more robus. In China, he erms of rade have seadily deerioraed and he resuling adjusmen o GDP is sriking: Chinese real GDP oversaes he growh in real gross domesic income by almos 8 percenage poins over he decade considered. The inuiion for his resuls is simple: The policies ha keep he relaive price of impors in China high make Chinese consumers worse off han he real GDP daa indicae. [Figure 4 here] 3.2. Gains from new varieies The new rade models based on differeniaed varieies and increasing reurns o scale (for example, Krugman 1980 and Meliz 2003) imply ha rade liberalizaion no only changes he prices of goods ha were already available for consumpion, bu also changes he composiion of varieies ha are available for consumpion. Kehoe and Ruhl (2003) show ha, following rade liberalizaion, newly raded goods can significanly change he composiion of rade beween counries. Capuring he impac of changing varieies is difficul wih sandard measuremens because i is difficul o accoun for a good when is iniial price is no observed. The seminal conribuion in Feensra (1994) is a resul ha, for consan elasiciy of subsiuion (CES) preferences, he impac of new varieies on prices can be measured despie he absence of iniial prices for some goods. We apply he echnique developed in Feensra (1994) o compue he gains from he imporaion of new varieies for China and Mexico. In wha follows, we consruc a measure of 11

he bias in impor prices ha exiss when he changing composiion of varieies is ignored in price indices. This bias allows us o compue he gains from he greaer varieies ha can be consumed wih rade in China and Mexico. Our approach follows Chrisian Broda and David E. Weinsein (2006), which measures he gains from new varieies in he Unied Saes. We classify impors ino goods, which are collecions of varieies. Goods and varieies ener uiliy hrough a nesed CES uiliy funcion. The se of all impored goods is G, and for each g G, he se of all varieies available a ime is I g. Noe ha we have assumed he se of goods is consan over ime, while he se of varieies can change. The sub-uiliy of impored good g a ime is an aggregaion of varieies, (3) where g g 1 g 1 g g gi gi i Ig M d x, x gi is he consumpion of variey i of good g and d gi is a variey specific demand shifer. All of he varieies of a good have he same elasiciy of subsiuion, 1, bu his elasiciy may differ by good. Goods are aggregaed ino a composie impor good in a second CES aggregaor, and, finally, he composie impor good and a composie domesic good are combined in he uiliy funcion. We would like o price he composie impor good. Feensra (1994) shows ha, given he vecors of prices and quaniies, p g and x g, he exac price index is g (4) g g 1 M M g g ( p, p 1, x, x g g g g 1, Ig ) Pg ( p g, p g 1, x g, x g 1, Ig ) g G g G. g 1 The index M Pg is he CES ideal price index, for good g, compued over he varieies presen in boh periods, I g Ig Ig 1, as derived in Kazuo Sao (1976) and Yrjö O. Varia (1976). g is he ideal log change weigh, and g is he share of he common varieies in oal expendiure on good g, (5) g i Ig c Ig p p gi gi x x gi gi. 12

This is an imporan resul: i allows us o compue he change in he price index even hough we do no have prices for all varieies in all periods. Furher deails are available in Feensra (1994) and Broda and Weinsein (2006). The second produc on he righ hand side of equaion (4) is he conribuion of new varieies o he price index wha Broda and Weinsein name he aggregae impor bias. The lambda raio, g g 1, measures he exen o which he changing varieies impac expendiure on he common se of goods. If he new varieies have small expendiure shares, he lambda raio is close o one, and he bias is small. The lambda raio is weighed by a erm ha involves boh he good s elasiciy of subsiuion and he good s weigh in oal impor expendiure. Goods wih fewer subsiuable varieies, or goods wih larger weighs, have larger impacs on he bias. To compue he aggregae impor bias, we define a good o be a hree-digi caegory of he Harmonized Sysem (HS). We define a variey o be a six-digi HS code counry pair. A good, for example, would be 090, Coffee, ea, mae, and seed spices, while a variey would be 090111-Colombia, Coffee, no roased, no decaffeinaed from Colombia, which is a differen variey han 090111-Cosa Rica. We have 164 goods. In China, he median number of varieies per good was 300.5 in 1998 and grew o 406.0 in 2008. In Mexico, he median number of varieies per good rose from 150.5 in 1990 o 230.5 in 2000. We use he counry-specific elasiciies esimaed in Broda, Joshua Greenfield, and Weinsein (2006) in our calculaions for China and Mexico. The mean and median elasiciies are repored in able 1. Table 1 also summarizes he lambda raios in he wo counries. The disribuions of he lambda raios are similar; he median lambda raios are near 0.95 and he 95h percenile raio is abou 1.03. The bias in he aggregae impor price index, over he 11-year period, is 0.94 for Mexico: he price of a uni of he composie impor in Mexico has fallen by 6 percen over he period because of he increase in impored varieies. The composie impor price in China fell by abou 5 percen. [Table 1 here] We can pu hese numbers ino perspecive by calculaing he amoun of exra income a consumer would need in order o achieve he same increase in uiliy over he period wihou he new varieies. This equivalen variaion is compued as he inverse of he aggregae impor price bias, weighed by he share of impors in oal expendiure. We repor he impor weighs 13

and he equivalen variaion in able 1. The consumer in Mexico needs an exra 1.42 percen of his or her 1990 income and in China, 1.01 percen of his or her 1998 income o be indifferen o he new varieies of impors accumulaed over he nex en years. In able 2 we summarize he impac of rade on real income growh. Column 2 repors he annual growh rae of he erms of rade premium ha we calculaed in he previous secion. For China, his implies ha real GDP oversaes he growh in real income by 0.76 percen per year due o he deerioraion of he erms of rade. Accouning for boh he gain in varieies and he adjusmen for he erms of rade, he growh rae of real income per capia in China is 8.33 percen, compared wih he 8.99 percen growh in real GDP. In Mexico, he gains from rade imply ha real income has grown abou 0.30 percen per year faser han real GDP. As repored in he World Bank, in Mexico, real GDP per capia a purchasing power pariy (PPP) is 10,121 2005 U.S. dollars in 1990 and 2,325 dollars for China in 1998. The absolue gain from hese wo adjusmens is 319 dollars per capia for Mexico in 2000, and a loss of 148 dollars per capia for China in 2008. [Table 2 here.] Our measuremens sugges ha Mexico, despie slow growh in GDP, has reaped subsanial benefis from liberalizaion. We should be clear, however, ha our measuremens are only capuring he improvemen in welfare ha comes from consuming less expensive goods or from consuming new varieies of goods as a resul of lower rade barriers. The gains from rade measured here do no accoun for oher channels hrough which rade can impac welfare, such as echnology ha may be embodied in impored capial goods or spillovers from he operaions of mulinaional firms. We discuss hese possibiliies below. 4. Neoclassical growh model and power of produciviy We now argue ha a successful heory of why Mexico sagnaed even as i opened iself o rade and foreign invesmen while China grew rapidly needs o focus on why produciviy sagnaed in Mexico while i grew rapidly in China. To do so, we employ he growh accouning developed by Kehoe and Presco (2002, 2007). Kehoe and Presco use he neoclassical growh model o guide heir view of economic daa. The model feaures an aggregae Cobb-Douglas producion funcion, (6) Y AK L, 14

where Y is oupu, A is TFP, K is capial, and L is labor inpu. If he working-age populaion grows a a consan rae, N N0, and TFP grows a a consan rae, A A 1 0, hen he economy has a balanced growh pah in which all quaniies per working-age person grow a he rae 1 excep for hours worked per working-age person, which is consan. In our growh accouning for Mexico and China, we assume ha hours worked per worker is consan, which allows us o use he number of workers as a measure o he labor inpu. We do his because we do no have daa on hours worked for China. Alhough we have such daa for Mexico, we do no use hem o be consisen. (The resuls change very lile, however, if we use Mexican hours daa.) Kehoe and Presco (2002, 2007) rewrie he producion funcion (6) as 1/(1 ) (7) Y / N A K / Y /(1 ) L / N. They noe ha, along a balanced growh pah, when A grows a a consan rae, he capialoupu raio K / Y and he paricipaion rae L / N are consan. Kehoe and Presco show ha U.S. daa over he period 1960 2000 are close o a balanced growh pah. Here we show ha Chinese daa over he period 1985 2008 are close o a balanced growh pah, albei a a very high rae of growh. Figure 5 decomposes he growh in oupu, Y / N, measured as real GDP per working-age person in China ino a produciviy facor, A 1/(1 ) K / Y, a capial facor, /(1 ), and a labor facor L / N. Once again he scale on he verical axis is log base 2. Noice ha he Chinese growh is close o balanced in ha he growh in Y / N is close o ha in A 1/(1 ), and K / Y /(1 ) and L / N are close o consan. To be sure, here are deviaions from balanced growh behavior. In he mid-1990s, growh in oupu Y / N acceleraes, and much of his acceleraion is due o growh in he capial facor /(1 ) K / Y and, especially, he labor facor L / N. [Figures 5 and 6 here] Figure 6 presens he growh accouning for Mexico. The poor performance in erms of real GDP growh is driven by an even worse performance in erms of TFP growh. Since 1995, however, here has been some GDP growh, and ha growh has been driven by TFP growh. 15

Beween 1995 and 2000, real GDP per working-age person grew by 3.2 percen per year, while overall, beween 1995 and 2008, i grew by 1.7 percen per year. In our growh accouning, growh in human capial shows up as growh in TFP. Flucuaions in facor uilizaion also show up as flucuaions in TFP, alhough his is probably more imporan in sudying business cycle momens, like he 1994 1995 financial crisis in Mexico, han i is in sudying growh over a decade or longer. The Kehoe-Presco growh accouning in equaion (7), in conras o ha of Rober M. Solow (1957) and Edward F. Denison (1962), akes ino accoun he feaure of he neoclassical growh model ha, in a balanced growh pah, as echnological growh occurs, consumers will save so as o keep he capial-oupu raio consan. Researchers like José De Gregorio and Jong-Wha Lee (2004) and Barry Bosworh and Susan M. Collins (2008), who use a growh accouning ha looks a increases in oupu per worker as a funcion of variables ha include capial per worker, ypically find increases in TFP and increases in capial roughly equally imporan in accouning for growh. Our growh accouning which impues o he produciviy facor he increase in capial necessary o keep he capial-oupu raio consan and impues o he capial facor only he increases in he capialoupu raio, ha is, capial deepening finds ha capial is much less imporan and ha increases in produciviy are ypically he driving force of economic growh. Undersanding ha i is he growh in TFP ha is essenial for accouning for why some counries grow faser han ohers allows us o reassess some of he research ha employs growh regressions. Of he research ha we have discussed, Backus e al. (1992), Edwards (1998), and Alcalá and Ciccone (2004) direcly address he need o accoun for TFP growh, making some measure of produciviy growh, no growh in real GDP per capia, he dependen variable in heir regressions. Many oher auhors, going back o he lae 1950s, have realized ha undersanding TFP growh is essenial for undersanding economic growh. Of paricular relevance for he heoreical framework ha we skech ou in he nex secion are William W. Lewis (2004) and Parene and Presco (2002). Lewis (2004) uses case sudies of differen counries o show ha produciviy in oher secors, besides jus manufacuring, is essenial for deermining relaive income levels across counries. He also uses anecdoal evidence o argue ha i is governmen policies ha discourage he adopion of he bes available echnologies from he res of he world ha keep counries relaively poor. Parene and Presco (2002) develop a model in which i is 16

governmen policies and insiuions like monopolies ha impede new echnology adopion ha keep produciviy, and herefore income per capia, low. 5. Direcions for fuure research and a proposed heoreical framework I is very possible ha here are oher aspecs of openness besides hose emphasized by sandard rade models ha generae growh. Researchers like Naalia Ramondo and Andrés Rodríguez-Clare (2009) and Ellen R. McGraan and Presco (2009) have sressed he role of FDI in ransferring echnology from one counry o anoher. Researchers like Thomas J. Holmes and James A. Schmiz, Jr. (2001), Schmiz (2005), Gibson (2007), and James A. Cosanini and Meliz (2008) have sressed he role of inernaional rade in giving firms he incenives o pay he coss of adoping new echnology. Given our quesion of why Mexico sagnaes while China grows, we need o ask of all of hese papers why he mechanisms ha hey sudy worked in China bu no in Mexico. A poenial answer is ha mos of Mexico s rade and FDI inflows are wih he Unied Saes. I may be ha he predominance of inrafirm rade beween Mexico and he Unied Saes reduces he incenives oward compeiion and innovaion ha would arise from rade and foreign invesmen reforms. Furhermore, Mexican manufacuring seems o be complemenary wih U.S. manufacuring, while Chinese manufacuring is a subsiue for boh Mexican and U.S. manufacuring. The emergence of China may have reduced he incenives oward innovaion in boh he Unied Saes and Mexico. These are possibiliies worh sudying, bu i may be, as he work of researchers like López-Córdova (2003) suggess, ha i is no he manufacuring secor or a leas hose subsecors mos involved in rade ha is responsible for Mexico s sagnaion, bu oher secors. We propose a heoreical framework for sudying hese sors of hypoheses as well as for reconciling some of he conradicory evidence on openness and growh in he empirical lieraure. We follow Kehoe and Presco (2007) in using he economic performance of he Unied Saes over he pas cenury as he saring poin for our heory. Figure 7 presens he daa on real GDP per working-age person in he Unied Saes, 1900 2008. Noice how close hese daa are o a consan growh pah wih 2 percen growh per year. The average growh rae during his period was 1.99 percen per year. There are small business cycle flucuaions around he consan growh pah, and here is he major deviaion during he Grea Depression of 1929 17

39 and he subsequen World War II buildup. The Unied Saes has been he indusrial leader, he riches major counry in he world, since he early wenieh cenury, when i ook over his role from he Unied Kingdom. We follow Kehoe and Presco in hypohesizing ha he near consan growh in he Unied Saes since hen is driven by a near consan growh rae in he sock of knowledge useful in producion. I should be sressed ha his sock of knowledge is no measured TFP. Measured TFP depends on he sock of knowledge bu also depends on he efficiency wih which facors of producion are allocaed across firms and secors in he economy. [Figure 7 here] The daa in figure 7 are fascinaing and invie speculaion and heorizing. I is difficul, for example, o reconcile hem wih he once popular endogenous growh heories of auhors like Romer (1986). As we have menioned, he Unied Kingdom was he indusrial leader during he nineeenh cenury, and i is possible ha he European Union or even China migh assume ha role laer in he weny-firs cenury. I is also possible ha he echnological progress may be slowly acceleraing: According o Angus Maddison (1995), he average growh in he Unied Kingdom of real GDP per capia 1820 1900 was 1.2 percen per year. While all of his is ineresing, i is largely irrelevan o our quesion involving growh in Mexico and China, counries ha are far behind he indusrial leader. [Figure 8 here] We hypohesize ha he sock of knowledge, which has increased very smoohly over he pas cenury or more, can be adoped, perhaps a some cos by counries ha are behind he indusrial leader. This would give rise o rend growh of close o 2 percen per year, a leas afer capial and labor have had ime o adjus. The absolue level ha a specific counry is a compared o he indusrial leader depends on is insiuions and economic policies. Changes in hese insiuions and economic policies can cause depressions or booms. Evenually, however, if insiuions and policies sabilize, and afer capial and labor have adjused, he counry reurns o rend growh. Figure 8 presens daa on real GDP per working-age person in Mexico, 1900 2008 (excep for 1910 1920 during he Mexican Revoluion). Afer a period of slow growh involving he Revoluion and he Grea Depression of he 1930s and is afermah, Mexico began o grow rapidly during he early 1950s. Beween 1953 and 1981, Mexican real GDP per working-age person grew by 3.8 percen per year. From 1981 hrough 1995, Mexico suffered he 18

grea depression analyzed by Bergoeing e al. (2002, 2007), conracing by 1.7 percen per year. From 1995 o 2008, Mexico reurned o close o rend growh, growing by 1.7 percen per year. [Figure 9 here] To compare China wih Mexico in erms of absolue level of income, we use he PPP real GDP daa published by he World Bank (2008). Figure 9 depics he daa. China has been growing more rapidly han Mexico bu is sill subsanially poorer in 2008. Specifically, China s GDP per working-age person in 2008 is 7,986 2005 U.S. dollars, which is only 38.5 percen of Mexico s 20,755 dollars, and is GDP per capia in 2008 of 5,712 dollars is only 42.5 percen of Mexico s 13,434 dollars. In erms of our heoreical framework, Mexico is no experiencing he rapid cach-up growh ha China is experiencing now because i already had his sor of cach-up during he period 1953 1981. In he heory ha we propose, i is easier o grow faser han he indusrial leader when an economy is far behind. An economy like China or Mexico in 1953 1981 can grow rapidly even wih an inefficien financial sysem, lack of rule of law, and rigidiies in he labor marke. As he counry ges closer o he indusrial leader, however, rapid growh sops and he counry levels off a he rend growh rae of GDP per working-age person of 2 percen per year or a lile less. This seems o have occurred in Wesern Europe in he early 1970s, in Japan in he early 1990s, and in Chile in he lae 1990s, o menion a few cases. How far shor of he indusrial leader he counry levels off depends on is insiuions and economic policies. Chile, for example, afer specacular growh following is grea depression in he early 1980s, has had a level of real GDP per working-age person and a growh rae similar o hose in Mexico since abou 1998. Unless China coninues o reform, we can expec economic growh here o slow down sharply a some poin. I is an open quesion wheher or no his slowdown will occur when China is sill behind Mexico in erms of real GDP per working-age person. 3 Many open quesions remain o be resolved for our heory o be useful in accouning for he economic developmen of counries like Mexico and China: How can we modify he sors of growh regressions o capure he periods of rapid growh followed by slowdowns prediced by 3 Our heory suggess ha i may be more fruiful o compare Mexico o economies a a similar level of economic developmen. Brazil is a frequenly cied example. I is a counry ha has abou 70 percen of he real GDP per working-age person of Mexico in 2008 bu ha has experienced higher raes of growh han Mexico since 2000. Over he period 1995 2008, however, he growh rae of GDP per working age person in Brazil has been 1.1 percen per year, less han Mexico s 1.7 percen per year. I has ye o be seen ha Brazil is performing significanly beer han Mexico. 19

he heory? Is openness o rade and foreign invesmen even necessary for rapid growh when a counry is very far behind he indusrial leader? India s recen experience suggess no. Specific quesions abou he experience of Mexico remain o be resolved as well: Why was he period of rapid growh, 1995 2000, following he enacmen of NAFTA so shor? Or, pu anoher way, why was he recovery following he 1982 95 grea depression so modes? I may be ha Mexico s slower growh since 2000 is he produc of he conracion of he U.S. manufacuring secor and of compeiion wih China. Perhaps mos imporanly, wha sors of reforms does Mexico need o enac o resume rapid cach-up growh? We hypohesize ha hese are reforms ha eliminae he barriers o growh of an inefficien financial sysem, lack of rule of law, and rigidiies in he labor marke. In erms of more specific reforms, promoing compeiion in nonmanufacuring secors like peroleum exracion, elecriciy, elecommunicaions, and ransporaion could spur produciviy growh. 20

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Table 1 Calculaion of Broda-Greenfield-Weinsein (2006) welfare gains from variey Mexico 1990-2000 China 1998-2008 Mean Elasiciy 6.704 5.634 Median Elasiciy 3.070 3.488 5h percenile lambda raio 0.832 0.789 Median lambda raio 0.956 0.954 95h percenile lambda raio 1.028 1.031 Impor price bias 0.939 0.947 Impor log-change weigh 0.224 0.185 Equivalen variaion (percen) 1.417 1.013 Sources: Broda, Greenfield, and Weinsein (2006) and auhors calculaions. Table 2 Real GDP growh versus real income growh in Mexico and China Annual growh rae (percen) Real GDP per capia Terms of rade premium Gain from variey Real income per capia China 1998-2008 8.989 0.761 0.101 8.329 Mexico 1990-2000 1.782 0.169 0.142 2.093 Sources: World Bank World Developmen Indicaors and auhors calculaions. 27

Figure 1 Trade in Mexico and China 80 70 60 Mexico percen GDP 50 40 30 China 20 10 0 1985 1990 1995 2000 2005 Source: IMF Inernaional Financial Saisics. Figure 2 FDI inflows o Mexico and China 6 5 4 China percen GDP 3 2 Mexico 1 0 1985 1990 1995 2000 2005 Sources: UNCTAD World Invesmen Repor 2009 and IMF Inernaional Financial Saisics. 28

Figure 3 Real GDP per working-age person in Mexico and China 3.00 800 2.00 400 index (1985 = 100) 1.00 200 0.00 100 China Mexico -1.00 50 1985 1990 1995 2000 2005 Sources: IMF Inernaional Financial Saisics and World Bank World Developmen Indicaors. Figure 4 Terms of rade premium in Mexico and China 4 percen real GDP (T 0 = 0) 2 0-2 -4-6 Mexico (T 0 = 1990) China (T 0 = 1998) -8 0 2 4 6 8 10 year since T 0 Sources: World Bank World Developmen Indicaors and auhors calculaions. 29

Figure 5 Growh accouning for China 3.000 800 index (1985 = 100) 2.000 400 1.000 200 0.000 100 oupu produciviy capial labor -1.000 50 1985 1990 1995 2000 2005 Sources: Conference Board Toal Economy Daabase, IMF Inernaional Financial Saisics, World Bank World Developmen Indicaors, and auhors calculaions. Figure 6 Growh accouning for Mexico 0.32 125 index (1985 = 100) 0.00 100 oupu labor capial produciviy -0.32 80 1985 1990 1995 2000 2005 Sources: Conference Board Toal Economy Daabase, IMF Inernaional Financial Saisics, World Bank World Developmen Indicaors, and auhors calculaions. 30

Figure 7 Real GDP per working-age person in he Unied Saes 3.00 800 index (1900 = 100) 2.00 400 1.00 200 0.00 100 2 percen growh rend real GDP -1.00 50 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 Sources: Maddison (2010), U.S. Bureau of he Census Saisical Absrac of he Unied Saes, and U.S.Bureau of Economic Analysis (2010). Figure 8 Real GDP per working-age person in Mexico 800 3 index (1900 = 100) 400 2 200 1 1000 2 percen growh rend real GDP -1 50 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 Sources: Maddison (2010), Insiuo Nacional de Esadísica y Geografía (2009), IMF Inernaional Financial Saisics, and World Bank World Developmen Indicaors. 31

Figure 9 Purchasing power pariy GDP in Mexico and China 25,000 2005 U.S. dollars per person 20,000 15,000 10,000 5,000 Mexico GDP per working-age person Mexico GDP per capia China GDP per working-age person China GDP per capia 0 1985 1990 1995 2000 2005 Source: World Bank World Developmen Indicaors. 32