President Trump Stirs Trade Policy Pot with NAFTA 'Sunset Clause'

Recently U.S. Trade Representative Robert Lighthizer proposed adding a "sunset clause" to the North American Free Trade Agreement (NAFTA), in keeping with President Trump's repeated claims that the agreement is a bad deal for America. If approved, the clause would automatically end NAFTA five years after it is renewed unless all three members — the United States, Mexico, and Canada — support keeping it in place.

Even those skeptical of free trade should consider this a bad idea. Businesses won't know what trade policy to expect, and the uncertainty would reduce trade and investment with our neighbors, making Americans worse off.

Businesses don't like uncertainty over the future course of the economy or policy. It makes them less likely to expand their operations, hire more workers, and do the things that generally make American living standards rise. By making the NAFTA agreement temporary, international economic policy among the three members becomes far harder to predict.

And when trade policy uncertainty is high in the United States, it becomes especially difficult for Mexican or Canadian businesses to export to or invest in America because it is more difficult for them to assess the expected profits from doing so. Meanwhile, American businesses must then fear potential trade policy retaliation by Mexico and Canada, creating the same problems here at home.

Because there are nonrecoverable marketing and setup costs associated with selling or investing abroad, when policy uncertainty is high, foreign and U.S. entrepreneurs tend to hold off on international deals. Businesses have to know the rules of the game before they market their products or invest abroad. Agreements like NAFTA and the World Trade Organization (WTO) help to establish those rules, lowering their investment risks.

There is plenty of evidence to support this claim. Joining the WTO or a regional free trade agreement like NAFTA dramatically increases trade. Studies of the Australian and Chinese trade experiences show that exports expanded significantly following their accession into the WTO as a result of greater clarity about their trading partners' tariffs.

One key study by Scott Baier and Jeffrey Bergstrand examined 96 bilateral trading partners and found that trade flows doubled in the 10 years following the signing of a trade agreement. Consumers in the destination countries paid significantly lower prices for a greater variety of goods, making them better off.

My own forthcoming Mercatus Center at George Mason University research examines the impact of economic and trade policy uncertainty in the United States since the 1980s. I find higher economic policy uncertainty reduces both foreign direct investment as well as imports and exports. The decline in foreign direct investment inflows into the United States is consistent with other research examining the impact of political uncertainty on investment.

The evidence shows large investment declines around elections in a large group of developed and emerging economies. Higher economic policy uncertainty also increases exchange rate volatility, which also reduces trade flows and international investment. The decline in foreign direct investment lowers capital formation and the growth in U.S. wages.

On the other hand, international agreements like NAFTA and the WTO do a number of things that reduce economic policy uncertainty, facilitating trade and investment:

First, they establish the basic rules of the game. Exporters can be more confident that tariff rates won't change in unpredictable ways. Foreign investors can be more certain of the expected returns on their investments.

Second, when a trade dispute does arise, these agreements contain a process to objectively settle the dispute.

The bottom line is that international trade agreements establish the rules that influence international commerce. By making the international rules more certain, these agreements help expand trade and investment, raising income at home and abroad.

The United States has played a central role in freeing global trade and investment since World War II. The Peterson Institute for International Economics estimates that U.S. income per person is about $7,000 higher as a result. These gains are even larger for low- and moderate-income Americas, who consume a larger proportion of imported goods.

The President needs to recognize these gains. Adding a "sunset clause" to NAFTA agreement could ultimately reduce American prosperity.