(Article by Gary Rabbior, President, Canadian Foundation for Economic Education)

Stock markets responded negatively to President Trump’s announcement that the U.S. would place a 25% tariff on imported steel and a 10% tariff on imported aluminum. The market reaction was an indication of the concern of investors and the business community, inside and outside the U.S., that this would lead to a trade war – and the consequences of trade wars have never been positive.

Let’s quickly cover a couple of the basics. A tariff is a tax imposed by the importing country on an imported good or service. The purpose of the tariff is to increase the price of the import to make it less competitive with domestically produced goods and services.

A trade war refers to one country imposing tariffs on the goods and services from another country – e.g. the U.S. imposing a tariff on Canadian steel – and then the other country responding by imposing their own tariffs in return, e.g. Canada putting a tariff on U.S. goods and services coming in to Canada. The war can escalate, with each country putting on more and higher tariffs to retaliate to the actions of the other.

There are usually very few winners from a trade war, and often many losers. Consider, for example, that in the U.S. there are many more people working for industries that use aluminum and steel in what they produce than there are people working to produce aluminum and steel. Those who produce steel and aluminum may think it is a good thing  to tax the steel and aluminum coming in to the U.S. from other countries. But the impact of the tariffs will be to increase the prices of most things that use steel and aluminum in the process of production.

The outcome of this can be fewer sales of items that use steel and aluminum. This leads to less steel and aluminum being used overall, and that can lead to loss of jobs in the metal industries. It also means consumers will have to pay higher prices for the products made using steel and aluminum, whether those products are made in the U.S. or imported.

At the same time as this is occurring, those working in other industries that face tariffs on the goods they export to other countries will also likely see sales decline and there could be job losses in those industries too.

The likely outcome of a trade war then, is: prices rise, the level of trade declines, the level of production declines, job losses increase, incomes are lost and, if the war goes on and escalates, things can get worse and worse. The Depression in the 1930s was worsened by protectionism – that is, countries imposing tariffs to try to protect their domestic producers from imports. A bad economic situation was made worse.

When President Trump announced his intention to impose tariffs, investors and businesses feared that this would set the stage for a trade war, and that is why the stock markets turned sharply negative. While the President was trying to protect U.S. industries that were struggling against global competition – steel and aluminum – his action was really protecting inefficient producers struggling to compete with other countries producing and trading steel and aluminum at lower prices than U.S. producers are able to charge. In trying to protect those industries, the President’s announcement put many other producers at risk – the risk of facing tariffs imposed by other countries retaliating.

Canada, the European Union, and individual European countries such as Germany were quick to respond with indications of retaliation. If the U.S. imposes such tariffs, it could be the beginning of a global trade war –and, like any war today, it won’t end well for anyone.

The last 30-40 years have seen countries around the world – often led by initiatives in the U.S. – create new trade deals and trade agreements to increase global trade to generate the benefits that are available from trade. NAFTA was such an example – a trade agreement involving the U.S., Canada, and Mexico.

Trade can generate many benefits (see the Backgrounder associated with this article). It can help share wealth around the world and help developing countries grow and improve. It is argued that the more countries trade, and become more interdependent, the less likelihood there is of military conflict. If your country is benefitting from selling goods and services to another country, it is less likely you will want to inflict harm and damage on them.

Trade is not without negative consequence though. Because trade rewards those who are most efficient, innovative, creative, etc., it imposes costs on those that are not able to compete. Less efficient and competitive companies may be hurt and they may even close down. Jobs and incomes can be lost in those industries, as is happening in the U.S. steel and aluminum industries.

The challenge for countries that want to reap the benefits of trade is to pursue policies and actions of effective adjustment – that is, finding ways to move resources, including labour, from industries that are not competitive in a trading, global economy to those that are. That is the key to effective trade – being able to respond with education, training, retraining, and labour mobility policies that enable workers to shift from non-competitive industries to those that are competitive.

If countries are not successful in enabling this transition of resources, economic hardship can occur for those affected. In the U.S., responding to such perceived hardship for those working in the steel and aluminum industries, the President has announced tariffs in the belief that this can ease that hardship. The reality is that such policies will likely end up making the situation worse for those industries at the same time as it creates hardship for many other industries and workers.

A trade war, in the modern, interdependent global economy is not good for anyone – and the stock market reaction is a way of sending that message to the President.

Backgrounder: the importance of trade to Canada

Trade is a very popular topic in the news these days. There is uncertainty around the NAFTA agreement, which is being reviewed currently by teams from Canada, the U.S. and Mexico. There is a chance the U.S. may look to withdraw, at least according to statements from President Trump. There is also Canada’s announcement of its participation in the Trans Pacific Partnership – or TPP.

The concept of free trade is open to debate, as are the winners and losers, and benefits and costs, of various trade agreements. There is also justifiable concern over who does benefit, and who lose s, from more global trade and new trade agreements. It is generally accepted by all who are involved in trade and trade negotiations that, inevitably, there are winners and losers. The challenge has always been how to adjust to the consequences of changes in trade. Can those who are vulnerable to the negative impact of trade and possible job loss be retrained or assisted in some ways to be able to move to those areas that benefit, grow, and create jobs, either with new skills or by being assisted to move to areas of the country benefitting from trade.

Much has been said in the U.S. about the negative impact of NAFTA and how U.S. jobs have been lost. In reality, there are many areas and industries that have done very well by NAFTA in the States. And contrary to the claim that things have been unfair for the U.S., Canada ran about a $6 billion trade deficit with the U.S. in 2016. The greater challenge for the U.S., rather than looking to a resurgence of industries like coal, is to look to retrain, educate, and support workers to be able to move into areas of job growth.

So the new story of NAFTA, and the success, or not, of the TPP for Canada is still to be written. But regardless, the reality is that Canada is a trading nation, and trade is very important to Canada’s economy. Relative to many countries, Canada trades a high proportion of its GDP – that’s what makes us a so-called trading nation. The jobs and incomes of many Canadians depend on our trade success. Given that, let’s look at why trade is important to a country like Canada and why it is important for us to work out effective agreements with our major trading partners.

The total output of goods and services in an economy is measured by the gross domestic product (GDP). The more an economy produces, the more wealth and employment it creates and the more income it generates for its citizens. Goods and ser­vices are largely produced in response to demand: if people want them and are prepared to pay for them, a producer is usually willing to produce them.

The demand for goods and services in Canada comes primarily from two sources – buyers inside Canada and buyers outside of Canada.

When our producers sell goods and services to buyers in other countries, production in Canada increases, income is generated and jobs are created. As well, investment to expand our production facilities is encouraged. Expanded facilities allow us to serve larger markets.

If a significant proportion of trade to foreign countries is lost, income and jobs are lost.

Compared with other developed industrial countries, Canada is quite dependent on trade. Nearly 30 per cent of all the goods and services we produce are for export – that is, for sale to other countries. The United States, meanwhile, exports only about 10 per cent of its output. It is estimated that approximately 25 per cent of Canadian jobs depend in some way on producing goods and services that are sold through international trade.

Furthermore, Canadians want and need goods and services that are produced in other countries – goods and services that cannot be produced here or that are produced better or more cheaply elsewhere. The more Canada is able to sell to the rest of the world, the more income we earn from those sales, enabling us to buy goods and services produced in other countries.

So the more success we have at exporting, the more we are able to import. The more we export, the more we can afford those things we need and want from other countries. That is, trade leads to wealth creation in Canada – it increases incomes, creates jobs and enhances our ability to acquire things that we want from other countries.

Other benefits of trade

It would be foolish to devote our resources to efforts to selling goods and services to other nations if we didn’t think we could produce output that would compete favourably and sell in other countries. If our resources could be put to better use to produce goods for sale at home, it would be wrong to use them to produce output for export to other countries. Trade enables Canada to concentrate on what it can do best, and other countries to concentrate on what they do best. Nations engage in trade to provide what they have produced to other countries and to acquire needed goods and services from other countries. Trade, therefore, increases the efficiency of production and resource allocation throughout the world.

A concept important to an understanding of some of the benefits of trade is economies of scale. A business sells goods and/or services to cover its costs and to earn a profit. The price the business charges for its output is related to how much of its output it can sell.

Let’s take an unrealistic, but illustrative, example:

Suppose you go into the business of producing hockey sticks. You set up a factory, buy equipment, hire labour and so on. You will incur a certain level of fixed costs – costs that you have to pay whether you sell one hockey stick or I 00,000. Suppose your fixed costs are $50,000. And suppose you have the ability to produce 10,000 hockey sticks.

Suppose you sell only 50 hockey sticks. You have to spread your fixed costs over the 50 sticks you sold, which means it costs you $1,000 to make each hockey stick. Pretty expensive hockey sticks.

Now, suppose that you sell 10,000 hockey sticks. Now each hockey stick costs you about $5 to produce.

The more hockey sticks you sell, the more the average cost of making each stick declines. This is called a lower unit cost.

If the more you are able to produce and sell, the less it costs you to produce each unit, then you are achieving economies of scale.

This has a number of benefits. Obviously, it lowers unit cost and can increase profit for the producer. It can also benefit the consumer by helping to lower the selling price of each unit. In addition, the more that Canadian producers are able to lower their unit costs, the more productive they are in relation to other world producers – in other words, the more internationally competitive they are.

To understand why this is important for trade, you have to recognize that Canada has a relatively small domestic market – approximately 36 million people. Many industrialized countries serve much larger domestic markets than Canada and so are able to sell much more and thereby achieve economies of scale. Canadian producers often have to increase the size of their markets by selling outside the country to achieve economies of scale. By selling more, they lower their unit costs and become more profitable.

Economies of scale are more important to some industries than others. In the oil and gas industry, for example, many of the greatest costs are upfront investments in developing the capacity to produce – finding the oil or gas, extracting it, building pipelines, etc. Once the oil and gas are flowing, it is relatively inexpensive to keep them flowing and the big issue for those companies is how much they can sell. The more gas or oil they are able to sell, the more income they have to spread over those enormous extraction costs and to invest in more exploration and development.

The same is true for agriculture, mining, forestry and so on. Generally, the higher the costs of setting up a business and getting it producing, the more important achieving economies of scale is to that industry.

Given that Canada has a relatively small domestic market and that many of its industries are resource-based, with high fixed costs, the ability of Canadian companies to achieve economies of scale through trade is very important. If they couldn’t sell exports, many Canadian companies would have higher unit costs, be less competitive and have to charge domestic consumers higher prices.

Summary: the benefits of trade

The following is a summary of the benefits that can be achieved through successful trade. These include ones that we have discussed in some detail, plus a few additional ones for your reference.

  1. Trade offers access to more markets, which creates the opportunity to sell more goods and services and therefore increases the output, jobs, and incomes generated by Canadian businesses,
  2. As employment rises in the country and there is more competition for labour, wages will tend to rise, thereby helping to increase the incomes of Canadians.
  3. As Canadian companies are successful and able to sell more in the global economy, they can undertake longer production runs and achieve economies of scale. This enables Canadian companies to become more competitive and also helps to lower prices.
  4. The competition generated through trade pushes companies to be innovative and create new, more efficient production methods.
  5. The competition can help to improve the quality of output too, as Canadian companies strive to offer the world, and Canadians, a better product than the com
  6. The higher incomes that can be earned, and the pressures to be competitive, can spur investment in Canada, which will help to achieve economic growth and to expand and modernize our productive resources.
  7. The more successful we are in selling our goods and services to other nations, the more income we earn to buy desired imported goods and services.
  8. Through trade with our trading partners we can acquire goods and services that aren’t available in
  9. Our trade with other nations can help other nations to grow and prosper, which is a good thing in itself, but it also means that they can become even better potential markets for Canadian goods and
  10. Finally, the more we trade and the better we become at trade, the more opportunities will be generated for us throughout the world, which will likely have the impact of improving our general relations throughout the world.

Canadian Foundation for Economic Education
March 2018