bout de papier, Vol. 4, No. 4 (1986) — Winter 1986 // Hiver 1986, pp. 9–11
Generally, academic economists are very supportive of free trade because it will increase per capita income. Contrary to the generally held public view of the matter, tariffs cannot increase employment or demand for goods.
Tariffs and other forms of trade barriers increase prices, reduce real income of consumers and therefore reduce demand for goods in all industries. If, for example, because of the tariff or other trade barriers, we must pay more for our clothing or beer, we have that much less left to buy other goods and this, or course, reduces demand for output generally.
It is true, of course, that much of what we import are intermediate goods used in the production of other goods. These are not sold directly to consumers, but the effect on per capita income and demand for goods is the same. Tariffs and other trade barriers increase the cost of intermediate goods and therefore the cost of goods consumers buy. For example, tariffs and other forms of trade barriers increase the cost of the woven and knitted goods used to produce clothing. The prices charged for clothing are increased thereby and the consumer has that much less left to purchase other goods. This process reduces per capital income and therefore cannot increase demand for goods or employment.
Success in the market is the best evidence of economic efficiency. Those firms that survive the market process are the ones that lead the nation step by step to higher levels of national income. Tariffs, taxes and subsidies are put in place by well meaning politicians, usually to support declining industries, but often also to support domestic oligopoly. In either case, prices rise and incomes fall. It is the process which leads us step by step toward ever declining levels of national income. Neither demand for goods nor employment can be increased.
It is said that the sequence of tariff negotiations carried on since the Second World War have led the world forward toward higher levels of per capita income and this is true. It was an equally important achievement of these negotiations, however, that they prevented the world from slipping backward step by step toward protection and lower levels of per capita income.
Tariffs and other trade barriers are the worst form of market intervention.
Canadian empirical research since the Second World War indicates that free trade with the United States would increase G.N.P. by seven to 10.5 per cent. Let me take a moment to explain why this is so. Partly it is because free trade eliminates distortion in relative prices. When consumers are given prices that correctly reflect costs, they maximize their consumption in a way that minimizes the cost of the nation’s resources and labour. This is the so-called classical argument for free trade, but empirical measurement has indicated that gains from free trade of this sort are not large.
The greatest part of the increase in G.N.P. would come about through a rise in productivity achieved through economies of scale at the level of the producing firm. Canadian production currently falls short of the American level because individual plants are not sufficiently specialized. Because of the smaller market here, Canadian production runs are necessarily shorter and the variety produced in each plant must be greater. Removal of the United States tariff and other trade barriers is seen as the remedy. If the entire North American market is open to them, Canadian firms can lengthen their production runs. They can reduce costs by producing a larger number of fewer varieties.
This is why the tariff and other forms of trade restraint have a greater effect on per capita income in Canada than do other forms of taxation. A free trade arrangement with the United States will expand our potential market tenfold.
The adjustment process will be very similar to that which took place when the European Common Market was formed. Products of a similar kind were both exported and imported in greater volume. Individual firms became more specialized and expanded their exports. Imports increased, but total sales did not fall because a greater proportion of output was exported. The adjustment took place within firms and, accordingly, the amount of dislocation of labour and the amount of re-tooling was minimized.
What I have been describing are the hard core economic aspects of the free trade issue. These conclusions are rarely disputed even by those who are otherwise opposed to trade liberalization. Those who do oppose it are apprehensive for other reasons: they are fearful @ that the manufacturing sector will decline in size, ® or that strategic parts of the manufacturing sector will decline, @ or that the adjustment to free trade will bring an intolerable level of short-run unemployment, ® or that Canada will in some sense become more dependent on the United States than it presently is.
The size of the manufacturing sector is a matter that has concerned Canadians throughout their history. We do not want to be hewers of wood and drawers of water. But we have always been a little schizophrenic about it. Wages are high in the mining industry and production is located in the areas where employment is most difficult to generate. People who live in the north are very protective about the forestry industry just as are the people of Newfoundland about fishing and the associated lifestyle. The resource industry accounts for a substantial share of our foreign exchange earnings and this is as it should be. We are exchanging that which is abundant here for goods which are scarce. Canada’s resource sector will be relatively large whether or not there is free trade.
This fact also influences our manufacturing establishment. Canadian manufacturing industries are concentrated at the lower level of processing which takes resources through their initial phases. This kind of manufacturing differs from so called “end stage” processing by which is meant production of goods near the final form required by consumers. We think of wool and cotton as a lower level of processing, cloth as an intermediate stage and clothing as the end stage. Canada’s manufacturing is concentrated toward the earlier stages because our resource abundance gives us a cost advantage compared to other nations — it doesn’t mean that Canada is underdeveloped or backward.
But what about the absolute size of Canada’s manufacturing sector. Is it likely to decline in free trade?
As a result of the Kennedy and Tokyo Round of negotiations, there have been substantial reductions in world and Canadian tariffs. Most Canadian industries have adjusted without difficulty. The Canadian industries least able to cope under these more competitive conditions are the same ones which were in difficulty long before the period of tariff reductions began. Their plight is by no means uniquely a Canadian problem. The same industries are in distress in almost all industrialized nations. They are the ones characterized by low wages and labour intensive production.
In this type of production, Third world nations with dense populations have the comparative advantage in production. It is sometimes the only means they have to earn the foreign exchange needed to buy goods produced in the industrialized nations of the world. Given the need for agricultural goods and for goods needed to develop their industries and infrastructure, it is almost certain that every dollar’s worth of export earnings will be immediately spent in the industrial world. The output and employment lost in our labour intensive industries will be re-employed in the higher wage, capital intensive industries.
There is no doubt that the problems these industries are experiencing will be greater with free trade and there is no doubt that output and employment will decline in these industries. Empirical studies indicate, however, that total manufacturing output and employment will increase in the firms located in Canada.
But will the same set of industries continue to locate in Canada after free trade? This is really a question for regional economics and we should therefore rephrase the question slightly and ask whether or not the same industries will locate in one of the Canadian or one of the American industrial regions because, with free trade, the nation of location is no longer of such importance. The regional location of any firm depends on a host of factors:
• the availability of specialized suppliers,
• the availability of specialized labour
• infrastructure,
• transport costs,
• land rents,
• taxes,
• living costs… The list could go on and on. The average wage is not important. A correct assessment would be based on the wages paid in the skills required by a particular firm. Each firm has a different set of requirements and will choose the most suitable location accordingly. The advantages that have brought Canadian industries to their present regional locations will not disappear if we move to free trade. In the public forum we represent industrial regions as far more unstable than they really are. The relative sizes of North American regions will change if the regions have different growth rates — none needs to actually decline. Market forces resist change. In regions that grow the fastest, wages, rents and other costs rise and there are corresponding declines in those regions where growth is proceeding more slowly. We have been fortunate in Canada that our major cities have not suffered from the racial unrest and core destruction that has occurred in the United States. They provide attractive locations for business and the head offices of businesses.
In one respect, however, free trade will make matters worse for us. When it is in place, there is an incentive for foreign firms to establish branch plants in Canada to avoid payment of the tariff. With free trade this incentive will be gone. However, free trade will also remove a substantial disadvantage of Canadian location. With free trade, any firm located in one of the Canadian regions will no longer have to pay the American tariff.
But will the industries locating in Canada be the ones we want – the high technology types which commit substantial sums to research and development?
Reearch and development are part of the firm’s fixed cost. The amount of funds that can be committed to research and development depends on the size of the potential market. The greater the potential market, the lower are average fixed costs and the greater the amount that can be committed to research and development. With the United States market added, Canadian located firms can justify adding larger sums to their research and development budgets.
All of these considerations lead me to expect that employment opportunities will increase under free trade and that the adjustment costs will not be great. Tariff reductions under the Kennedy and Tokyo rounds have had little impact on Canadian manufacturing and, since the adjustment to free trade will occur largely within the firm, the amount of labour relocation and retooling should be minimal.
But if we take this step will we have lost the freedom to make our own economic policy? As far as monetary or fiscal policy is concerned, little would be changed. As far as commercial policy is concerned, much depends on the form of the free trade agreement. If it is a multilateral free trade arrangement, it would almost certainly fall under the auspices of GATT and, conceivably, our freedom to manoeuver would be little changed. A free trade union with the United States would leave us free to decide the level of tariff that would apply to Third nations. With a North American Common Market, Canada and the United States would need to agree on a single schedule of tariff rates. This would be the most restrictive form of free trade.
It isn’t always true that the smaller nation has the least bargaining clout. It is true that, if a North American Common Market is established, in some sense we would be held to ransom. The United States could threaten to end the agreement and put the Canadian economy back through the process of economic adjustment. On the other hand, it is argued that Canada is an important supplier of resources and energy to the United States and would become a more important supplier under free trade.
The extensive American investment in Canadian industries gives us an ally in the American political arena. These are factors which increase our bargaining position. If the Congress of the United States is pressured into renewed protection for one of its industrial sectors, it is likely that Canada, as part of the free trade area, would be exempt. This has been the pattern in the past.
On the other hand, Canada has very little influence when tariff rates are negotiated through the GATT mechanism. Most reductions are negotiated on a bilateral basis. The large nations negotiate with each other. Under the so-called “most favoured nation principle”, the results of bilateral negotiations are applied to all nations. Canada benefits from the agreements, but it cannot have much influence on the process itself except through the influence of larger nations such as the United States. We are likely to have more influence in GATT negotiations it we are in a tree trade arrangement with the United States than if we are simply standing aside waiting for the main agenda to be announced
This takes us into the political realm, where opinions of economists vary.
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Originally published in bout de papier, Vol. 4, No. 4 (1986) — Winter 1986 // Hiver 1986, pp. 9–11. Read the rest of this issue →
