From the Fraser Institute

By Jock Finlayson

We didn’t want it but it has crashed onto our shores anyway. U.S. President Donald Trump has unleashed his long-mooted assault on Canada, deploying tariffs as his chosen weapon of “economic coercion.” The Executive Order justifying 25 per cent across-the-board tariffs on southbound Canadian exports (10 per cent on exports of energy and critical minerals) cites American concerns over cross-border drug shipments. Yet that can hardly be the real reason for Trump’s unprecedented action. Canada is at most a tiny part of America’s festering problem of widespread illegal drug use. The notion that these punitive tariffs are mainly about compelling Canada to clamp down on fentanyl production is far-fetched.

It is obvious that this most unconventional of American presidents has other aims in mind. One may be to impose steep tariffs on all or most imports entering his country as a means to raise money for the cash-strapped U.S. treasury. A second may be to suck industrial production and capital out of Canada and other trading partners, to support the MAGA movement’s objective of rebuilding American manufacturing. In his remarks delivered (virtually) to the good and the great assembled at the World Economic Forum’s shindig in Davos in January, President Trump put much emphasis on this latter point. Or perhaps what the new U.S. administration most wants is to convince Canada (and other trading partners) to align with American policies to de-couple from and slow the economic and military ascent of China.

If some or all of these are indeed Mr. Trump’s most important goals, it will be difficult for Canada to negotiate our way out of the bilateral trade war. As hard as it may be to imagine, Trump’s tariffs–with the possibility of even higher levies and various other trade restrictions still to come–could be the new “normal” for Canada, at least for the duration of his presidency. For the moment, the trilateral Canada-U.S.-Mexico trade agreement is either dead or at best barely clinging to life.

As the tariff war gets underway, it is useful to look at the composition of Canada-U.S. trade. Most of it involves cross-border trade in “intermediate inputs,” not finished goods or final products (see the accompanying table). More than three-fifths of Canada’s U.S.-bound exports consist of energy, building materials, agri-food products, other raw materials, and other items used to produce final goods. Similarly, over half of all U.S. goods shipped to Canada are also made up of intermediate inputs. Capital goods (e.g., machinery and equipment) represent 16 to 23 per cent of bilateral merchandise trade. Final goods constitute between a fifth and a quarter of the total. This underscores the highly integrated nature of North American supply chains–and the significant disruptions that two-way tariffs will cause for many industries operating on both sides of the border.

*e.g., machinery and equipment
Source: Canadian Chamber of Commerce, Data Lab.

Looking ahead, it’s clear our economy is about to suffer, as Canadian industries, workers and communities absorb the biggest external shock in a century (apart from during the initial phases of the COVID pandemic). To see why, recall that the U.S. buys more than three-quarters of Canada’s international exports, with the value of our U.S.-destined shipments amounting to about one-fifth of Canada’s GDP.

According to projections published by the Bank of Canada, 25 per cent U.S. tariffs coupled with Canadian retaliatory tariffs will reduce the level of Canadian real GDP by at least 3 per cent over 2025-26–this represents a permanent output loss, meaning it is national income we will never recoup. Business fixed non-residential investment falls by 12 per cent, with exports dropping by nine per cent. Unemployment rises significantly and job creation downshifts. Consumer spending also weakens–in part because retaliatory Canadian tariffs raise the cost of many consumer goods, thus leading to a temporary bump in Canadian inflation. All of these estimates are measured relative to a counterfactual baseline scenario of no U.S. and Canadian tariffs. The U.S. economy will also take a hit from President Trump’s tariffs, notably through higher inflation, increased business uncertainty, and the costs of rejigging the supply chains of American companies that rely significantly on raw materials, other inputs and consumer goods supplied by Canada and Mexico.

How should Canada respond to the American tariffs? An initial priority is to determine if there is a pathway to a negotiated settlement–not a simple task, as the Americans have yet to specify what it would take to make peace. A second option is to hit back. Canada has already announced a schedule for retaliatory tariffs, covering some $155 billion of goods imported from the United States; all of these are slated to be in place by the end of March. While the political impulse and pressure to respond in kind is understandable, retaliation will magnify the economic damage to Canada from the U.S. tariffs. Finding a way to end the conflict–if that is possible–is far superior to a series of tit-for-tat bilateral tariffs.

Some politicians and media commentators have talked up “trade diversification” as an option for Canada. Reduced reliance on the U.S. would likely deliver benefits in the long-term, but it won’t help us in 2025/26. Despite entering into 15 trade agreements with 51 nations (other than the U.S.), Canada has seen virtually no export market diversification in the last two decades. There has been modest diversification on the import side of the trade ledger, mainly due to the growing importance of China and other Asian emerging markets as suppliers of final goods and some intermediate inputs. But the U.S. remains the source of more than half of Canada’s imports of goods and services combined. Moreover, “gravity models” of international trade confirm that Canada’s dense, extensive web of trade and other commercial ties with the United States makes perfect economic sense given the advantages of geographic proximity, a common language, and similar business practices between the two countries.

The Trump administration’s self-chosen trade war is a watershed moment for Canadian foreign and commercial policy. The shock from this U.S. action will persist, even if the tariffs are in place for only a few months. Treating an ally as an enemy is an abnormal practice in the history of Western diplomacy. But with Donald Trump at the helm, the past is no longer a reliable guide to understanding or forecasting American policy.