Canada's unwanted trade war and implications for macroeconomic policy

This is the latest in my Canada's Struggling Economy series.

It used to be that Canada, like most other so-called advanced economies, faced one or two major economic and other policy challenges at one time (e.g., population aging, chronic budget deficits and rising indebtedness, etc.), and that was already daunting. Now we face an entire menu of inter-related challenges and crises, all converging at once: negative productivity growth, weak economic growth, declining real GDP per capita, a severe housing shortage, a cost-of-living crisis, and a surge in population without a corresponding increase in our capacity to absorb such large numbers.

These domestic challenges and crises, many of which have been (at least partially) self-induced, come on top of those that are menacing all nations. These include global warming and wider ecological destruction, the spectre of a new Cold War, and the emergence of a tiny global techno-financial elite whose interests don't seem to align with the great majority of people everywhere. And, if this were not enough, the West as a whole is also facing a crisis of democracy and governance - again, at least partially (if not mostly), self-induced.

On top of all this, Canada faces the wrath of a warped economic narrative coming from incoming President Trump. The core of this mostly false narrative has changed from its original incarnation following Trump's re-election in early November. Initially, Trump announced his intention to punish Canada with an across-the-board tariff of 25 per cent on our exports to the U.S. because of weak border security and the resulting inflow (into the U.S. from Canada) of so-called illegal aliens and illicit narcotics. The core of Trump's narrative now is that the U.S. subsidizes Canada in the amount of $100 billion per year because of Canada's trade surplus with the United States. It doesn't matter that the actual trade surplus in 2024 was approximately $50 billion. And, while it's great that so many well-meaning professionals here on LinkedIn and elsewhere have provided an accurate account of Canada's economic relationship with the U.S., facts don't seem to matter.

So, the question is what to do if President Trump makes real on his threat, which seems likely. As I argued in my previous article in this series (Trump's tariff threats - bracing for impact | LinkedIn), the imposition of an across-the-board tariff of 25 per cent on Canadian exports to the U.S. would be devastating for our economy. Ontario Premiere Doug Ford noted earlier this week that 500,000 jobs could be destroyed in his province alone. With Canada's economy currently growing at only 1 per cent, and four-fifths of our exports going to the U.S., Trump's tariffs would push Canada deep into recession (in the absence of offsetting policy measures). And, if Canada retaliated with counter-tariffs and other measures, as Prime Minister Trudeau promised on January 17th, this would reignite high inflation. So, inflation would accelerate just as it has been brought down by two years of high interest rates and the resulting stagnation of the economy, which itself came in the wake of COVID. Consequently, the baseline scenario for Canada is stagflation (inflation and recession together), with the possibility of large-scale unemployment.

This raises the question of whether retaliating with counter-tariffs would be in Canada's best economic interest. It also raises another question: if the stagflation scenario were to unfold, would the Bank of Canada fight the rise in inflation with higher interest rates? If they didn't, there might be more inflation for longer. If they did, that would deepen the recession.

To clarify some of the different scenarios facing Canada, consider the table below. In the event that President Trump imposes the 25 per cent across-the-board tariff and Canada does not retaliate with counter-tariffs on U.S. imports, then we would only face the powerful recessionary headwinds from shrinking exports to the US. In this case, the Bank of Canada could keep interest rates low to stimulate demand and put a floor under GDP. This is scenario 1. A, entitled "recession". There would be no need for the Bank of Canada to raise interest rates in this case (which is scenario 1. B, or "deeper recession").

However, in the event Canada retaliates with its own tariffs, there would be both profound recessionary headwinds from U.S. tariffs and a big inflationary impulse, as (equivalent?) tariffs on U.S. imports lead to an increase in prices right across the country. The magnitude of this inflation would depend on the nature of our tariffs. Such a trade war would also very likely lead to a further depreciation of the Canadian dollar against both the U.S. dollar and other major currencies (Euro, Yen, China's RMB, etc.). This would make imports from the U.S. and the rest of the world more expensive, further boosting inflation and the cost of living. This is scenario 2. A, entitled "Recession and higher, for longer inflation".

But in such a scenario as 2. A, the Bank of Canada would not likely remain passive and keep interest rates low. The Bank of Canada, following standard Neoclassical macroeconomic doctrine, would very likely meet inflation with higher interest rates. This would magnify the recessionary headwinds coming from U.S. tariffs. That is, the recession would be even deeper.

In short, we face either a deep recession (scenario 1 A), or some form of stagflation - i.e. deep or deeper recession, plus inflation (these are scenarios 2 A or 2 B). Any of these three scenarios could in turn ignite a vicious cycle of declining GDP (and GDP per capita), shrinking private consumption, savings, and investment, declining tax revenues and widening budget deficits, higher indebtedness, and further declines in output.

Thus, stagflation is the baseline scenario facing Canada, unless there is a powerful counterforce that could soften these profound headwinds set to hit our economy. What could that counterforce be? In the immediate term, which is our time horizon, there's only fiscal policy. With a federal budget deficit at 2 per cent of GDP and net federal debt at 14 per cent of GDP, there is substantial room to put a fiscal floor under the economy in the immediate term (see table below, which is Table 4 from the Government of Canada's Fiscal and Economic Statetment released on December 16th, 2024). It should be noted that total federal debt currently stands at 42 per cent of GDP, and that the comparisons with other G7 countries below do not include provincial debt, which push Canada's consolidated (general) government debt above 100 per cent (in 2024).

Over the medium-to-longer-term, there is also ample space to use the Government of Canada's spending and tax powers to rebuild Canada's manufacturing sector, which - 40 years ago - accounted for over 20 per cent of GDP compared to the 9 per cent today, the lowest among major "advanced economies". And we know from the data that countries with relatively large manufacturing sectors are more economically diverse, more productive, have a higher GDP per capita, and pay comparatively higher wages.

The problem, however, is two-fold. The first problem is that, because the federal government has become so bloated and even more sprawling under nine years of Trudeau rule (especially since COVID), there are growing calls from both main parties for either austerity measures or fiscal restraint. But in the face of the deep stagflationary pressures that are headed fast through the pipeline at Canada, such a stance will either have to be dropped or modified to move as much of federal spending as possible towards growth- and employment-friendly spending (and as soon as possible).

The second problem is ideological inertia. According to orthodox Neoliberal / Neoconservative economic doctrine, governments can't pick winners (I'm not being gross here; that's the actual term that mainstream economists use). I have three responses to that. First, they don't have to. Government policymakers just have to design an overarching national strategy and use the state's tax and spending powers to tilt our economy towards greater domestic production and demand. Second, private companies and markets, while great at inventing, producing and distributing products, cannot provide a national economic strategy. Only the state can do this. Third, given that most small businesses and start-ups fail within 5-10 years, it seems that both the state and private sectors have a difficult time picking winners.

Future articles in this series will explore both the potential for growth-friendly fiscal policies in the immediate term, and wider national-scale industrial policies over the medium-to-longer-term - with the aim of rebuilding Canada's prosperity in a new age of global fragmentation and great power politics.