In the last few days, the new US administration has accused many of its international trading partners of benefiting from an undervalued currency. Comments have been made about Mexico, Germany, Japan and China. The administration’s view seems to be that any country that runs a large trade surplus against the US has been able to accomplish this only as a result of the unfair competitive advantage their cheaper currency has given them. Since trade is relatively balanced between Canada and the US, we have so far been spared from any tweets proclaiming our currency is too cheap. This may be disheartening for our Governor.
To make American economic growth great again, Peter Navarro and Wilbur Ross have focused in on trade in Trump’s economic plan. They make the case that by simply eliminating the trade deficit drag on GDP from importing foreign goods, this will translate into faster growth, more jobs and a decrease in public debt. To them, it’s obvious as the value of imports gets deducted from total GDP. Replace those nasty subsidized foreign imports with American-made goods and the trade problem vanishes. Rid yourself of the negative and all you have left is the positives. Brilliant. Now, to achieve this, renegotiate all the “bad” trade deals signed before, add a few well-placed trade tariffs, include a border adjustment tax in corporate tax reform and keep jaw-boning foreign exchange markets, reminding them that the dollar is overvalued.
It all seems pretty straight forward. Will it work? There is considerable debate amongst economists whether or not it will. The debate centres on whether the benefit of an increase in aggregate income from the domestic jobs created to replace the missing imports will more than offset the increased costs of higher priced goods. The conclusion, not surprisingly, from the economics profession is “it depends”. Michael Pettis’s recent piece, entitled “Is Peter Navarro Wrong?”, explains the conditions that would result in a positive outcome from protectionist measures and those conditions that would result in the opposite.
Sadly, there seems to be no debate on the impact on Canada of US protectionism. Either a border adjustment tax or the imposition of tariffs are seen as clearly negative. Dan Ciuriak and Jingling Xiao, in a working paper published by the CD Howe Institute, looked at the impact on Canada if a 10% tariff by the US on all imports was imposed, modelling it after what President Nixon did in the early 70s. The paper is very detailed in examining the effects, coming to the conclusion that a tariff imposition would reduce the economic welfare of Canada by $33 billion. Importantly, they also point out that this cost only goes higher if we retaliated by imposing a tariff on the US, as other countries would move in to replace our exports.
So the US administration could make a plausible case using economic theory that US GDP would respond positively to the introduction of measures to increase the cost of imports, especially if combined with other tax reforms and increased infrastructure spending.
However, as Pettis points out in his blog, the assumption that trade flows take primacy over capital account flows is dangerous. Reducing the US trade deficit lessens the flow of US dollars to the rest of the world, importantly decreasing the amount of US dollar funds that can be recycled back into the American economy. Thus, the administration’s plan appears to be contradictory. At the same time that they want to force a contraction in the trade deficit, they are increasing the need for dollar funding by encouraging investment through tax reform and infrastructure spending by the private and public sectors. Potentially starving the economy of the funds it may need to achieve the desired level of investment will offset many of the positive effects of their proposed measures.
So argument can be made from both sides of the protectionist debate for the US economy. The world is too complex to forecast with precision. However, either way, one can argue that the US dollar will strengthen, even in the face of stiff “tweets”. If protectionist measures are adopted, any beneficial boost to output will result in a stronger US dollar. A less positive outcome may also strengthen the dollar, due to the result of higher interest rates caused by a shortage of US dollars to fund any desired expansion. Heads or tails, the argument is there for a stronger US dollar.
The same cannot be said about the Canadian dollar. Whether the US economy gains or loses from any protectionists measures matters little to the size of the hit the Canadian economy will take. The Governor has recently stated that the currency is too strong now given the current size of the economy’s output gap, let alone post any protectionist measures by the US. Right now, he would probably love to see the currency weaken and have the “problem” of reading a tweet from the administration claiming the Canadian dollar was undervalued.
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