The optimal response to Trump’s tariffs: unilateral free trade

Next week Canada will learn its Trump tariff fate. As the Canadian elite and its chattering class hand-wring over Trump’s tariff threats, politicians have arrived at a consensus that we must respond with our own tariffs and trade restrictions. Canada has no control over what Americans do, but we don’t have to compound the problem by doubling down on a defunct mercantilist view of trade.

Tariffs are import taxes. In effect, tariffs prevent ships from arriving at our ports filled with goods that our citizens want to buy at prices they find favourable. Tariffs restrict the freedom of the people to transact at the best deal they can find. It’s poor policy, but if a foreign country wishes to impose import taxes on their citizens, that’s their business. However, it makes zero sense for us to respond to their tariffs by preventing their ships from arriving at our ports. How is the best response to a foreign country’s restriction on their people’s market freedom to restrict our own people?

The silliness of the situation arises because most people and most politicians have a ridiculous mercantilist understanding of trade – that somehow trade is a zero-sum game. Trade between two voluntary parties makes them both better off, otherwise they would not have traded. Think of a friendly foreign country as a machine with strange inner workings. If Canada pours in just the right amount of wheat, oil, minerals, lumber, etc., the machine spits out cars, computers, and other things we like. More than that, we value the stuff we get from the machine more than the stuff we put into it. None of this trade is organized by government. Individual citizens create the trade networks from their own buying and selling and it makes us better off.

We don’t need free trade agreements. Edmonton and Calgary don’t have a free trade agreement; Canada doesn’t need one with the United States either. Free trade agreements are actually anti-free trade because their purpose is to delineate which domestic industries remain protected by tariffs. Canadian politicians arguing for retaliatory tariffs are not defending the interests of Canadian prosperity.

If we want to put Canada first, then allow Canadians to buy from and sell to Americans, without interference, whenever we want. Who knows, maybe President Trump will want the same deal for Americans.

Update

It appears that Trump’s real goal is to eliminate the trade deficit that the US has with Canada. It’s a bit of a strange idea. All the trade deficit means is that Americans buy more stuff from Canadians than Canadians buy from Americans. If you think about it, you have a huge trade deficit with every single business or store that you buy from. On the other hand, you have an enormous trade surplus with your employer. No one pulls their hair out because they have a trade deficit with the grocery store.

OK fine, Trump wants Canadians to buy more stuff from Americans than Americans buy from Canadians – hence his 25% tariffs. Tariffs are a form of taxation. But will Trump’s tariffs accomplish his goal? And in the end who bears the tax incidence of the tariffs? It’s not clear because the exchange rate shock absorbs the effect – changes in trade also change the demand for each country’s respective currency. Broadly there are three scenarios:

1) The effect of the tariffs and the realignment of trade perfectly balance such that the exchange rate does not change. In that case, Americans pay more for Canadian imports and so their demand will drop. Canadians continue to buy just as much from the US (if we don’t apply tariffs) because Canadians see the same price for American products as before the tariffs. The entire tax incidence of the tariffs falls on Americans and the trade deficit with Canada shrinks. Americans bear the cost of the tariffs, the US-Canada trade deficit is much smaller or eliminated, and apparently Trump is very happy. Weird, but whatever.

2) The tariffs cause the Canadian dollar to depreciate somewhere between 0% and 25%. In that case, Canadians buy less from Americans as American products become more expensive. However, Americans continue to pay more for Canadian imports, but not as much as in the first scenario because the stronger US dollar softens the blow for them. What happens to the US trade deficit is unclear – maybe it goes down a bit, maybe up a bit, but probably it doesn’t change much. Americans and Canadians share the tax incidence of the tariffs. Trump grumbles that his tariffs aren’t doing enough.

3) The Canadian dollar depreciates by the full amount of the tariff, 25%. In this case, Americans continue to buy just as much from Canadians as before the tariffs (again if we don’t add tariffs ourselves) because the exchange rate perfectly offsets the tariffs. Canadians see much higher prices for American products so we import less. In this case, the US trade deficit with Canada INCREASES, but the entire tax incidence of the tariffs falls on Canadians. Even though Canadians bear the cost of the tariffs, Trump finds the result unacceptable – what wild tales he’ll spin, who knows.

The anchor to the problem is the accounting identity: Net Exports = Savings – Investment. Since US savings and investment are not likely to change, the US trade deficit with Canada is also unlikely to change. Probably something like case 2 is in our future.

Again, the best thing for Canada to do is nothing. If we must do something, eliminate all tariffs with everyone in the world – including the US. It’s hard for Canadians to claim moral principle over Trump when we have all kinds of protective tariffs on dairy, and other agriculture products. If you think we are justified with our existing tariffs, then you have to accept that Trump is justified with his protectionist arguments; he’s just making them on a larger scale.

Unilateral free trade is the only sensible answer to American tariffs. We have an opportunity to increase our own prosperity, regardless of what Trump does or doesn’t do.