Published on: February 5, 2025
As Donald Trump recently postponed for a month the imposition of 25% tariffs on Mexican and Canadian imports, Canada finds itself at the centre of a trade fight that will have significant impacts on its economy, regardless of the outcome.
Setting the Record Straight
The President claims that trading partners have abused the US economy by creating trade deficits that force the United States to subsidize its trade with other nations. Under a subsidy, a government contributes to the private sector by providing it with public money. However, we are talking here about economic transactions between private businesses without the slightest State intervention, which completely refutes the subsidy argument.
Trump’s unfounded rhetoric also contradicts the commercial theory of comparative advantage. In practice, imports can serve the mutual interest of an importer and a foreign producer on a microeconomic basis, as it is the best available option for minimizing input costs.
On a macroeconomic basis, when the sum of all these international transactions creates a deficit, exchange rate adjustments, commonly referred to as “market forces”, occur. Attempting to adjust regional production by bringing more factories back to the US through tariffs is nothing more than a fiscal strategy that distorts natural market forces between economies.
Dual Standards
The postponement of tariffs does not lift the threat of their application, and there is no question that further negotiations will be necessary to create a more stable trading environment in the medium term. It should also be noted that Canada is a small, open economy with an export-to-GDP ratio of 32%, of which 22 percentage points are directly attributable to the United States.
The US economy, on the other hand, is a large, closed economy with a low ratio of imports to GDP (14%), in which the Canadian market share is a mere 13%. This means that tariffs of 25% on Canadian exports, even excluding oil which would be subject to a 10% tax, would have a significant impact on Canada’s real GDP growth.
Crystal-Clear Figures
The calculations published last week in the Bank of Canada’s Monetary Policy Report, which include different scenarios based on a different set of assumptions, point to a straightforward conclusion. Tariffs of 25% would lead to a recession in Canada over the course of the year, with a marginal impact on real GDP growth of -2.5% on our side of the border. Moreover, the loss of production resulting from a recession would add considerably to the unemployment rate, as export-based industries would shed jobs.
The extent of inflation would depend on how quickly it hits consumers, i.e., whether businesses start to feel the effects of the crisis on their margins. In the worst-case scenario, the Bank of Canada predicts that inflation will rise by a further 0.8 percentage points this year.
Conclusion
In this context, Canada is facing a binary economic scenario. The introduction of such tariffs would lead to a recession in Canada, which would likely prompt the Bank of Canada to make further aggressive cuts to its policy rate, as overcapacity would offset the direct inflationary impact of the tariffs.
On the other hand, the removal of these significant tariffs would virtually mean a return to normality, without eliminating the uncertainty that lies ahead. Canadian business investment could come under pressure, exacerbating our productivity lag with the United States.