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US / Mexico Border, Drug Trafficing and the US Economy

Politics / US Politics Feb 01, 2008 - 12:08 AM GMT

By: John_Mauldin

Politics Protecting the border is a big part of the presidential political debates. This week in a special edition of Outside the Box, my friends at Stratfor give us yet one more reason why we should be concerned when we look south. The topic not only concerns security, but our economy. The drug trade is becoming a problem. This is a short but very disturbing letter, but you should read it.

Stratfor continues to provide insightful and pertinent research on economic and geopolitical events and their respective ramifications. Stratfor continues to generously provide significant savings to readers of Outside the Box, for further information please click here . For those like me who seek objective analysis of world affairs, Stratfor is a daily necessity.

John Mauldin, Editor
Outside the Box

The Geopolitics of Dope
January 29, 2008
By George Friedman

Over recent months, the level of violence along the U.S.-Mexican border has begun to rise substantially, with some of it spilling into the United States. Last week, the Mexican government began military operations on its side of the border against Mexican gangs engaged in smuggling drugs into the United States. The action apparently pushed some of the gang members north into the United States in a bid for sanctuary. Low-level violence is endemic to the border region. But while not without precedent, movement of organized, armed cadres into the United States on this scale goes beyond what has become accepted practice. The dynamics in the borderland are shifting and must be understood in a broader, geopolitical context.

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The U.S. border with Mexico has been intermittently turbulent since the U.S. occupation of northern Mexico. The annexation of Texas following its anti-Mexican revolution and the Mexican-American War created a borderland, an area in which the political border is clearly delineated but the cultural and economic borders are less clear and more dynamic. This is the case with many borders, including the U.S.-Canadian one, but the Mexican border has gone through periods of turbulence in the past and is going through one right now.

There always have been uncontrolled economic transactions and movements along the border. Both sides understood that the cost of controlling and monitoring these transactions outstripped the benefit. Long before NAFTA came into existence, social and economic movement in both directions - but particularly from Mexico to the United States - were fairly uncontrolled. Borderland transactions in particular, local transactions in proximity to the border region (retail shopping, agricultural transfers and so on), were uncontrolled. So was smuggling. Trade in stolen U.S. cars and parts shipped into Mexico, labor from Mexico shipped into the United States, etc., were seen as tolerable costs for an open border.

A low-friction border, one that easily could be traversed at low cost - without extended waits - was important to both sides. In 2006, the United States imported $198 billion in goods from Mexico and exported $134 billion to Mexico. This makes Mexico the third-largest trading partner of the United States and also makes it one of the more balanced major trade relationships the United States has. Loss of Mexican markets would hurt the U.S. economy substantially. The U.S. advantage in selling to Mexico is low-cost transport. Lose that through time delays at the border and the Mexican market becomes competitive for other countries. About 13 percent of all U.S. exports are bought by Mexico.

Not disrupting this trade and not raising its cost has been a fundamental principle of U.S.-Mexican relations, one long predating NAFTA. Leaving aside the contentious issue of whether illegal immigration hurts or helps the United States, the steps required to control that immigration would impede bilateral trade. The United States therefore has been loath to impose effective measures, since any measures that would be effective against population movement also would impose friction on trade.

The United States has been willing to tolerate levels of criminality along the border. The only time when the United States shifted its position was when organized groups in Mexico both established themselves north of the political border and engaged in significant violence. Thus, in 1916, when the Mexican revolutionary Pancho Villa began operations north of the border, the U.S. Army moved into Mexico to try to destroy his base of operations. This has been the line that, when crossed, motivated the United States to take action, regardless of the economic cost. The current upsurge in violence is now pushing that line.

The United States has built-in demand for a range of illegal drugs, including heroin, cocaine, methamphetamines and marijuana. Regardless of decades of efforts, the United States has not been able to eradicate or even qualitatively reduce this demand. As an advanced industrial country, the United States has a great deal of money available to satisfy the demand for illegal drugs. This makes the supply of narcotics to a large market attractive. In fact, it almost doesn't matter how large demand is. Regardless of how it varies, the economics are such that even a fraction of the current market will attract sellers.

Even after processing, the cost of the product is quite low. What makes it an attractive product is the differential between the cost of production and the price it commands. In less-developed countries, supplying the American narcotics market creates huge income differentials. From the standpoint of a poor peasant, the differential between growing a product illegal in the United States compared with a legal product is enormous. From the standpoint of the processor, shippers and distributors, every step in the value chain creates tremendous incentives to engage in this activity over others.

There are several factors governing price. The addictive nature of the product creates an inelastic demand curve in a market with high discretionary income. People will buy at whatever the price and somehow will find the money for the purchase. Illegality suppresses competition and drives cartelization. Processing, smuggling and distributing the drugs requires a complex supply chain. Businesses not prepared to engage in high-risk illegal activities are frozen out of the market. The cost of market entry is high, since the end-to-end system (from the fields to the users) both is a relationship business (strangers are not welcome) and requires substantial expertise, particularly in covert logistics. Finally, there is a built-in cost for protecting the supply chain once created.

Because they are involved in an illegal business, drug dealers cannot take recourse to the courts or police to protect their assets. Protecting the supply chain and excluding competition are opposite sides of the same coin. Protecting assets is major cost of running a drug ring. It suppresses competition, both by killing it and by raising the cost of entry into the market. The illegality of the business requires that it be large enough to manage the supply chain and absorb the cost of protecting it. It gives high incentives to eliminate potential competitors and new entrants into the market. In the end, it creates a monopoly or small oligopoly in the business, where the comparative advantage ultimately devolves into the effectiveness of the supply chain and the efficiency of the private police force protecting it.

That means that drug organizations evolve in several predictable ways. They have huge amounts of money flowing in from the U.S. market by selling relatively low-cost products at monopolistic prices into markets with inelastic demand curves. Second, they have unique expertise in covert logistics, expertise that can be transferred to the movement of other goods. Third, they develop substantial security capabilities, which can grow over time into full-blown paramilitary forces to protect the supply chain. Fourth, they are huge capital pools, investing in the domestic economy and manipulating the political system.

Cartels can challenge - and supplant - governments. Between huge amounts of money available to bribe officials, and covert armies better equipped, trained and motivated than national police and military forces, the cartels can become the government - if in fact they didn't originate in the government. Getting the government to deploy armed forces against the cartel can become a contradiction in terms. In their most extreme form, cartels are the government.

Drug cartels have two weaknesses. First, they can be shattered in conflicts with challengers within the oligopoly or by splits within the cartels. Second, their supply chains can be broken from the outside. U.S. policy has historically been to attack the supply chains from the fields to the street distributors. Drug cartels have proven extremely robust and resilient in modifying the supply chains under pressure. When conflict occurs within and among cartels and systematic attacks against the supply chain take place, however, specific cartels can be broken - although the long-term result is the emergence of a new cartel system.

In the 1980s, the United States manipulated various Colombian cartels into internal conflict. More important, the United States attacked the Colombian supply chain in the Caribbean as it moved from Colombia through Panama along various air and sea routes to the United States. The weakness of the Colombian cartel was its exposed supply chain from South America to the United States. U.S. military operations raised the cost so high that the route became uneconomic.

The main route to American markets shifted from the Caribbean to the U.S.-Mexican border. It began as an alliance between sophisticated Colombian cartels and still-primitive Mexican gangs, but the balance of power inevitably shifted over time. Owning the supply link into the United States, the Mexicans increased their wealth and power until they absorbed more and more of the entire supply chain. Eventually, the Colombians were minimized and the Mexicans became the decisive power.

The Americans fought the battle against the Colombians primarily in the Caribbean and southern Florida. The battle against the Mexican drug lords must be fought in the U.S.-Mexican borderland. And while the fight against the Colombians did not involve major disruptions to other economic patterns, the fight against the Mexican cartels involves potentially huge disruptions. In addition, the battle is going to be fought in a region that is already tense because of the immigration issue, and at least partly on U.S. soil.

The cartel's supply chain is embedded in the huge legal bilateral trade between the United States and Mexico. Remember that Mexico exports $198 billion to the United States and - according to the Mexican Economy Ministry - $1.6 billion to Japan and $1.7 billion to China, its next biggest markets. Mexico is just behind Canada as a U.S. trading partner and is a huge market running both ways. Disrupting the drug trade cannot be done without disrupting this other trade. With that much trade going on, you are not going to find the drugs. It isn't going to happen.

Police action, or action within each country's legal procedures and protections, will not succeed. The cartels' ability to evade, corrupt and absorb the losses is simply too great. Another solution is to allow easy access to the drug market for other producers, flooding the market, reducing the cost and eliminating the economic incentive and technical advantage of the cartel. That would mean legalizing drugs. That is simply not going to happen in the United States. It is a political impossibility.

This leaves the option of treating the issue as a military rather than police action. That would mean attacking the cartels as if they were a military force rather than a criminal group. It would mean that procedural rules would not be in place, and that the cartels would be treated as an enemy army. Leaving aside the complexities of U.S.-Mexican relations, cartels flourish by being hard to distinguish from the general population. This strategy not only would turn the cartels into a guerrilla force, it would treat northern Mexico as hostile occupied territory. Don't even think of that possibility, absent a draft under which college-age Americans from upper-middle-class families would be sent to patrol Mexico - and be killed and wounded. The United States does not need a Gaza Strip on its southern border, so this won't happen.

The current efforts by the Mexican government might impede the various gangs, but they won't break the cartel system. The supply chain along the border is simply too diffuse and too plastic. It shifts too easily under pressure. The border can't be sealed, and the level of economic activity shields smuggling too well. Farmers in Mexico can't be persuaded to stop growing illegal drugs for the same reason that Bolivians and Afghans can't. Market demand is too high and alternatives too bleak. The Mexican supply chain is too robust - and too profitable - to break easily.

The likely course is a multigenerational pattern of instability along the border. More important, there will be a substantial transfer of wealth from the United States to Mexico in return for an intrinsically low-cost consumable product - drugs. This will be one of the sources of capital that will build the Mexican economy, which today is 14th largest in the world. The accumulation of drug money is and will continue finding its way into the Mexican economy, creating a pool of investment capital. The children and grandchildren of the Zetas will be running banks, running for president, building art museums and telling amusing anecdotes about how grandpa made his money running blow into Nuevo Laredo.

It will also destabilize the U.S. Southwest while grandpa makes his pile. As is frequently the case, it is a problem for which there are no good solutions, or for which the solution is one without real support.

Your wondering how we shut the drug trade down analyst,

By John Mauldin

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Copyright 2008 John Mauldin. All Rights Reserved
John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staff at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above. Mauldin can be reached at 800-829-7273.


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