We’ve dealt with historic trade shocks, but the perfect storm we face requires a hard look at 4Gs: gravity, geopolitics, geoeconomics and governance.
Over its relatively short history, Canada has been hit with numerous trade shocks that shaped the direction of Canada’s trade, its economic policy, and indeed its very structure. These include the following:
- Britain’s adoption of free trade in 1846, which ended Canada’s preferential access to the colonial mothership and precipitated an economic crisis that led Canada to seek a free trade deal with the United States (the Elgin-Marcy Reciprocity Treaty of 1854, negotiated on Canada’s behalf by Britain);
- The abrogation of this treaty by the United States in 1866, which accelerated the push for Confederation in 1867 and pushed Canada toward a national economic policy;
- The US Smoot-Hawley tariff of 1930, which led the United Kingdom to adopt a new tariff and enter into free trade agreements with its colonies, including Canada through the Ottawa Agreements of 1933;
- The US Nixon Measures of 1971, followed by the United Kingdom’s accession to the European Community (EC) in 1972, which sent the Pierre Trudeau Government off in its failed effort to secure its “Third Option” – a free trade agreement with the EC; and
- The unleashing of US protectionism through trade policy reforms in the 1970s and 1980s, which introduced the unilateral Section 301 measures (in the Trade Act of 1974) and activated the widespread use of anti-dumping and countervailing duty actions, all of which prompted Canada to push for a free trade deal with the United States that curbed the use of those tools.
While there were further fender benders in the ensuing years – post 9/11 border thickening and the new Buy American provisions introduced during the Great Financial Crisis of 2008, each of which prompted new initiatives to preserve Canada’s access to the US market – the subsequent era of more or less free trade was one of general trade calm for Canada. Unfortunately, it proved to be the calm before the perfect storm: for then came Donald Trump, trade wars, the digital transformation, and now the pandemic crisis, which has only temporarily eclipsed the existential threat of climate change.
Global trade is being transformed and Canada is again being buffeted by events over which we have little control. There are four factors that shape Canada’s response: gravity, geopolitics, geoeconomics, and governance. This is Canada’s 4G trade policy challenge.
The scale of trade relations is dominated by distance between and the size of the trading partners – economic gravity. This places Canada deep in the US gravity well, makes trade relations with the United States almost as important as domestic policy, and (as the history recounted above has shown) exposes Canada disproportionately to collateral damage when the United States changes its global trade policy. Thus, notwithstanding perhaps the best-balanced trading relationship on the planet in the pre-Trump period, Canada was targeted for “rebalancing” by the incoming Trump Administration and forced to renegotiate the North American Free Trade Agreement (NAFTA) on less-advantageous terms.
The resulting Canada-United States-Mexico Agreement (CUSMA) represents a discount on NAFTA (“NAFTA 0.8” as it has been sometimes dubbed) on several grounds.
First, while it introduces some marginal trade liberalization, its primary effect is to intensify trade diversion, which requires firms in the three countries to use production inputs such as steel or sewing thread sourced from North America even though these inputs are produced more efficiently elsewhere. This has a negative impact on Canada’s economic potential and welfare.
Second, it fails to insulate Canada from future applications of the Section 232 “national security” tariffs (introduced by the Trade Expansion Act of 1962), the new “go to” protectionist tool in the United States and one with uncertain future application in the new “reshoring” environment created by the pandemic crisis (a spate of new Section 232 investigations have been launched).
Third, it channels what might be termed the “Trump Uncertainty Principle,” which states in effect that the future of the Agreement rests on whether America “wins” – if Canada “wins,” the rules will be rewritten pursuant to the renegotiations mandated by the new sunset clause.
As in the past, when its trade market access was threatened, Canada has looked towards greater trade diversification as a remedy. It is doing so again and hardly disguising the fact: the minister responsible for trade now has the formal title of the Minister of International Trade Diversification. But here, Canada runs squarely into other G’s: geopolitics and geoeconomics.
With the CUSMA, the Comprehensive Economic and Trade Agreement (CETA) and the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP) in place, the only truly significant market with which Canada does not have a full-fledged trade agreement is China. And there, Canada has major problems, because the United States has pulled out all stops in a comprehensive campaign to isolate China technologically and economically. Canada has been roped into this conflict in at least four major ways:
- The CUSMA Article 32.10, which makes entry into a free trade agreement with a “non-market economy” grounds for abrogation. The potential cost to Canada of abrogation is set to rise with the US announcement of its intent to renegotiate its most favoured nation (MFN) tariff commitments under the World Trade Organization (WTO) Agreement.
- The additional administrative costs incurred to document that Canadian goods shipped to the United States are not manufactured using Chinese production inputs in order to ensure they are not slapped with punitive tariffs.
- The exclusion of Huawei from the buildout of Canada’s 5G telecommunications infrastructure.
- The arrest of Huawei executive Meng Wanzhou pursuant to a US extradition request.
Canada had a China-sized hole in its trade policy before this conflict; with these measures and China’s tit-for-tat responses, that hole has become much bigger. Canada should at this point observe the first law of holes: when in one, stop digging. Apart from that, geopolitics drives Canada’s trade diversification efforts in other directions.
Canadian trade policy in the postwar era was developed in the context of what was globally a mature, highly competitive industrial economy. In this rapidly globalizing world, market competition and a liberalized trading system were generally sufficient to prevent the emergence of dominant firms that could use market power to extract above-normal profits (“rents” in economic jargon). By the same token, there was little inducement for countries to pursue strategic trade and investment policies (“rent-seeking”) to capture particular markets – and little reward for such attempts at strategic behaviour that were made.
This point is nicely illustrated by China’s failed use of its dominant position in supply of rare-earth minerals as leverage over Japan in a territorial dispute. China’s export ban prompted Japan to move expeditiously to diversify its supply chain – which in turn prompted China to quickly abandon its export ban. China’s attempt at economic coercion was a classic example of geoeconomics – and the result explains how open, internationally competitive markets undermine such behaviour.
The multilateral trade system that Canada has championed and embraced emerged in this era. In retrospect, it may be observed, this rules-based system was uniquely suited to the competitive market conditions that characterized the era. This point is best illustrated by counter-examples – in sectors such as civil aviation and computer memory chips, which featured market conditions that were conducive to the emergence of dominant suppliers, strategic behaviour was the norm. Civil aviation featured protracted trade conflict – Boeing versus Airbus and Bombardier versus Embraer. In the 1980s conflict over semiconductors, the United States unleashed the full spectrum of its economic weaponry on Japan, including a revision of trade rules (the Tokyo Round of the General Agreement on Tariffs and Trade was mainly focused on introducing new measures to discipline Japan’s economic policies); a currency revaluation (the Plaza Accord of 1985); and a unilateral attempt to reset Japan’s industrial policy framework through the Structural Impediments Initiative of 1989.
The lessons from this history are that, when there are large rents to be captured, rules-based orders tend to break down and geoeconomic behaviour takes over. That is the situation Canada faces today globally. The modern, innovation-intensive, knowledge-based, and data-driven economy is prone to the emergence of firms that dominate their industries – the US “FAANG” companies (Facebook, Apple, Amazon, Netflix, and Google) and China’s “BAT” companies (Baidu, Alibaba and Tencent) are the quintessential examples. But even aside from these prominent Internet-based companies, market concentration is growing and profit share of income is increasing.
Simply put, the economic conditions today feature powerful inducements for strategic behaviour – and we are seeing it in action. The battle to dominate 5G telecommunications networks, the moves to capture rents from the Internet economy through digital taxes, the launch of massively funded industrial policies, and even the more subtle contest to establish standards that favour national champions are all expressions of this strategic behaviour. It is hardly surprising in this context that the WTO has been sidelined. Geoeconomic powerplays are now shaping the world and Canada must be prepared to make its own strategic investments. To date, Canada has been much too timid.
In an age of platform economics, in which private firms like Amazon, Alibaba, Facebook, and Tencent provide Internet-based marketplaces and agoras that match buyers and sellers and host social interaction, the nation-state can be seen as the ultimate platform; in this sense, getting governance right is key. Canada’s track record on good governance gives it a potential leg up in the competition to host the data-driven economy. The regulatory challenge is, however, immense. At the domestic level, the body of regulation developed for the material economy needs to be suitably transposed for the digital economy. At the same time, a plethora of issues needs to be re-examined and renegotiated at the international level: competition policy for a world of superstar firms; cybersecurity and sovereignty in a world of virtual borders; industrial policy disciplines in a world featuring strategic behaviour; revised intellectual property rules for the age of machine learning and creation; and regulation of data in a world of ubiquitous surveillance and datafication. Eventually, a WTO 2.0 will be needed.
Rethinking trade diversification
As Canada frames its trade policy for the post-pandemic, digitally transformed economy, it faces significant constraints from two G’s: gravity and geopolitics. It also must rise to a major challenge calling for strategic investment from another G, geoeconomics. This third G has already prompted the major jurisdictions – the United States, the EU and China – to commit to major investments to “own the podium” in the critical new technologies. And it needs to seize the opportunity implicit in a fourth G – governance – that will make Canada a leading platform, populated by companies that will naturally diversify Canada’s trade globally. Trade diversification 2.0 for Canada requires platforms and firms, not regions.