Trump's Tariffs and Canada's Response
There's been more heat than light in much of the commentary on Trump's tariffs and Canada's response. This post tries to untangle some of the economics and the political economy around the tariff war.
On February 1st, as previously telegraphed, US President Donald J. Trump, via an executive order, imposed a 25 percent across-the-board tariff against Canada, except for energy products, where the tariff was set at 10 percent. He also imposed a 25 percent tariff on Mexico and an additional 10 percent tariff on China. In a post on his social media site, Trump referred to “the major threat of illegal aliens and deadly drugs killing our Citizens, including fentanyl.” Later, Trump reiterated his claim that the United States “subsidizes” Canada, referring, presumably, to the US trade deficit with its northern neighbor.
(I’ve noted previously that a country’s aggregate current account deficit is a macroeconomic phenomenon, rather than principally a “real” trade phenomenon, and there’s no necessary reason why a country’s bilateral trade balance with any one particular trading partner should be balanced, in surplus, or in deficit.)
Trump thus laid our several possible rationales for his tariffs, a subject discussed in previous posts (please scroll back to last autumn, when he first mooted tariffs against Canada and Mexico). In addition to the illegal entry of migrants and drugs into the US, he’s previously said that a tariff wall could bring manufacturing and jobs back to America. Do these claims have any economic rationale?
As argued in the previous posts I mention, it is true, as a matter of economic theory, that a “large” country — which in international trade is defined as a country whose exports and imports have an impact on world prices — may benefit from appropriately selected tariffs. The appropriate tariff, known in economic jargon as the “optimum,” reflects the improvement in a large country’s terms of trade (the ratio of export to import prices), which brings gain above the free trade situation of zero tariffs. Of course, this theoretical result, by itself, cannot tell us if Trump’s 25 percent tariff is below, at, or above the optimum level for the thousands of categories of goods that are affected.
What of Canada’s retaliatory tariffs, announced by Prime Minister Justin Trudeau late on the evening of February 1st? Canada is hitting back with its own 25 percent tariffs in a phased retaliation. Again, as a matter of textbook international trade economics — so, perhaps, somewhat remote from the real world of trade policy formation — it is self-harming when a “small” country (one that doesn’t have much if any influence on world prices) imposes tariffs on its trading partners — even if intended as retaliation against tariffs by that partner. Canadian consumers will bear the brunt of the tariffs, not American producers, given the relative size of the two economies and Canada’s far greater dependence on trade than the US.
(The retaliatory tariffs, and the ongoing depreciation of the Canadian dollar, are going to put the Bank of Canada in an almost impossible bind. The self-inflicted harm of Canada’s tariffs will cause a jump in the price level, and a falling dollar will stoke inflation, which the central bank has just about managed to get down close to target. Tamping down an incipient fresh burst of inflation, or elevated prices, will require pausing, or even reversing, interest rate cuts. Yet, that could worsen any recession caused by the escalating trade war. It is an unenviable balancing act for the bank to navigate.)
Yet, this textbook theorem misses at least two elements, as I noted earlier on X. First, tariffs may be used strategically in a dynamic negotiation process with a partner who has imposed tariffs. Even the doyen of modern Anglo-American economics, and a great acolyte of free trade, Adam Smith, understood that tariffs could be used to pry open foreign markets and could have some utility. Additionally, the political pressure to retaliate against hostile tariffs is irresistible.
Thus, even though retaliatory tariffs will doubly harm Canadians, Trudeau (or anyone else) couldn’t possibly have not imposed them. Can you imagine a leader addressing their people, saying that “economic theory tells me that retaliation harms us, so we’ll just turn the other cheek”? Ausgeschlossen!
Meanwhile, other fallacious reasoning on the impacts of the tariffs on the US abound. Thus, a Democratic Congressman posted on X that Trump’s 25 percent tariff will raise the price of a large range of commodities by 25 percent. This might be correct for a small economy, but, for a large economy such as the US, the terms of trade improvement caused by the tariffs will reduce the import price of these commodities, thus reducing the impact on US consumers. In addition, if the tariffs cause an appreciation of the US dollar relative to the Canadian dollar and Mexican peso — already in train since Trump’s announcement — then this currency appreciation could offset a further portion of the impact on consumers.
Fallacies abound. It’s asserted in countless news story that “economists” (I’m not sure who they are) assert that tariffs will lead to higher inflation in the US. This is faulty economics. An across-the-board tariff will result in a one-time jump in the price level — which is entirely different from ongoing inflation. Many economists who ought to know better seem entirely oblivious (or deliberately obfuscate) something that I teach my first year economics students.
On balance, therefore, it seems pretty clear that the tit-for-tat, dollar-for-dollar tariffs imposed by the US and then by Canada and Mexico are going to cause much greater harm to America’s northern and southern neighbors than it does to their own economy. And, to the extent that they succeed in goading those two neighbors to fall in line with Trump’s wishes on what’s going down at the northern and southern borders, the tariff gun may hit its intended target, even in the presence of (self-harming) retaliation.
What of Trump’s claim that tariffs will bring manufacturing and jobs back to America? A newly published report, posted to X, which speaks to a range of business leaders in Canada, suggests that this may, indeed, be the case. Several of the individuals interviewed in this report indicate that they may move their businesses to the US, as the tariff wall will make it impossible to service the majority of their customers, who are in the US. As I noted in a post last fall, this motivation for tariffs, known as “tariff-jumping” in the academic literature, may have some merit on its side, as the early (tariff-ridden) histories of both the US and Canada itself testify.
Most major firms in Canada are subsidiaries of US parent companies, and they set up shop in Canada precisely to jump the tariff wall that existed in the late 19th and well into the 20th centuries. In everything from breakfast cereal to toothpaste to automobiles, all the top brands in Canada are American. That was due, in no small measure, to Canada’s previous policy of tariffs.
Having said all of this, the tariff war is of great concern. Since the NAFTA, which came into force in 1993, and the renegotiated USMCA of 2020, supply chains in sectors such as automobiles have been tightly integrated across the “three amigos.” A tariff war may lead to a costly unwinding of this tight economic integration, and there could be pain for Americans, as Trump himself has acknowledged. The economic efficiencies of a large and integrated North American market may, therefore, be undone. This may succeed in restoring manufacturing (and the attendant employment gains for blue collar workers) to America — but at great cost to its neighbors and some cost to itself.
That brings me to my last point for this post. While Trump may extract economic gain for his country through a tariff war with Canada and Mexico, he will do so by all but tearing up a trade agreement, the USMCA, that he himself negotiated in his first term in office. This can only do great damage to what international relations scholars call the liberal, or rules-based, international order. (See Gideon Rachman on this, writing recently in the Financial Times.)
While this order has been bent to serve the interests of the global hegemon — the US — on many occasions in the post-Second World War period — think just of American intervention to help topple legitimately elected governments they didn’t like in various parts of the world — in the case of international trade, it actually did succeed extremely well in bringing down trade barriers across the world, to the benefit both of the US itself and other rich countries of the West (now usually called the “North”) and the countries of the developing world (now usually called the “global South,” a somewhat problematic term which conflates very different types of societies, but which, for better or worse, has become common currency).
What does this all add up to? I am more sanguine than most of the mainstream commenting class that Trump’s tariffs may well be beneficial for the US. But, they are going to upend a system that has governed the international political economy for almost eighty years, since the end of the Second World War, and seriously damage the economies of some of America’s key trading partners, notably, Canada and Mexico, for a start.
If you’re not an American, then, as the old saying goes, brace for impact.