How not to totally lose a trade war

With a newly elected left-wing Mexican president, a tariff war in full swing, and hopes fading for the ongoing NAFTA negotiations, it’s time to remind ourselves of economic and strategic issues related to free trade.

Retaliation against President Donald Trump’s tariffs is ultimately a failing strategy, especially for small countries like Canada. We might feel better defending ourselves with reciprocal tariffs, but the result is shooting ourselves in the foot.

First, let’s remember that while Canada might be the world’s 10th-largest economy, we still only account for less than two per cent of world GDP. We have little influence on world prices for anything except the one or two commodities where we control major market share, such as potash or uranium.

That means any tariff we impose hurts us without hurting others. Higher import prices increase costs to Canadian businesses and consumers. But foreign producers still enjoy the same net price, since any loss in Canadian sales is easily made up with sales to the large global market.

This point was recently made in an amusing Wall Street Journal article showing American reactions to Canada’s newly enacted tariffs on licorice, lawn mowers, inflatable boats, playing cards and assorted other consumer products. The United States Playing Card Co. reacted to Canada’s tariffs by asking “Is that the best you can do?” — since Canadian sales were only a small share of its overall demand.

Other American producers are a bit more concerned, such as Hershey Co., which already faces struggling global demand and whose Canadian customers make up 10 per cent of its sales. But overall, even in chocolate as with so much else, we are still pretty small in relation to the U.S. market.

Large countries get to play by different rules. As a net importer with a 20 per cent share of the global market, the U.S. could optimally impose a tariff that would force down imported prices, thereby reducing prices paid to producers in other countries. The tariff would therefore increase national income as tariff revenues and cheaper imported prices offset any economic consumer losses from displacing cheap imports. Unlike small countries, it is optimal for a large country to impose tariffs on a unilateral basis.

Trade intervention can also be good for a large exporter like China. To grab market share, China has heavily subsidized products like rare-earth metals, steel and aluminum. It can now exploit its market power by taxing exports.

Small countries like Canada are best off pursuing unilateral free trade, not by retaliating. Just because another country might wish to mess up its economy with taxes and subsidies doesn’t mean we should mess up our own.

The Trump administration has been schizophrenic in trade policy. While saying its tariffs are designed to promote reciprocal free trade, it bargains for more protective policies for the auto industry in NAFTA negotiations. This is not free trade.

Neither is Canada a pure free-trader. We impose limits on foreign ownership in

SMALL COUNTRIES LIKE CANADA ARE BEST OFF PURSUING UNILATERAL FREE TRADE, NOT BY RETALIATING.

banking and telecommunications. We protect dairy, egg and poultry producers, who are now each worth an average of $5 million in wealth. And we restrain log exports, lowering production costs for our forest product producers.

Negotiations could improve free trade for Canada and the U.S. Game theory provides two useful insights.

First, the “threat” point at which a country is better off without NAFTA. About a quarter of our GDP is exported to the U.S. versus American exports to Canada which make up about two per cent of U.S. GDP. Thus, NAFTA is far more important to us, leaving us with little credible leverage.

Further, Canada has developed few alternatives for our major global exports: One-third are in energy and vehicles and parts, both of which are overwhelmingly sold to the U.S. (95 per cent and 83 per cent respectively). In particular, regulations have prohibited the development of alternative markets for oil and natural gas exports, and auto-trade pacts have historically joined the U.S. and Canada at the hip.

Second, the long-run game. Co-operative agreements can be enforced by tit-for-tat strategies, such as responding to tariffs with tariffs. However, for Canada, this is a losing strategy. The Trump administration knows we would suffer much more in a trade war than the U.S. would. Putting on auto tariffs and killing off Keystone XL would be far more devastating than any retaliatory tariff policy we could pursue. Retaliation can’t work.

One option is to offer to remove trade irritants on a tit-for-tat basis. The Canadian government has wisely cultivated many influential friends in the U.S. to support NAFTA. However, more is needed. Prime Minister Justin Trudeau, as the current chair of the G7 group, could take up Trump’s suggestion to eliminate tariffs among G7 countries. Or he can offer to remove some Canadian trade irritants to get a deal done.

Canada, being a small trading partner with little bargaining leverage, can’t easily master The Art of the Deal. If NAFTA collapses and we retaliate with tariffs, we become the biggest loser of all. The federal government’s primary focus must make sure that never happens.