Out of Equilibrium: Why EU-Canada Free Trade Won’t Work in the REAL World
The Canadian and EU governments are working toward a free trade agreement that would comprehensively liberalize trade in goods and services, government procurement, foreign investment, and other important economic interactions between the two parties.Â
Canada enters these negotiations with a notable disadvantage in terms of both quantitative trade flows, and the qualitative composition of trade.Â Canada currently incurs large bilateral trade deficits with the EU ($15 billion in goods, and close to $4 billion in services).Â About half of Canada’s total EU trade deficit results from our especially skewed trade with Germany – a country which has successfully pursued export-led growth and generated the second largest trade surplus in the world.Â A disproportionate share (half) of Canada’s exports to the EU consist of raw or barely processed resources; almost all of Canada’s imports from the EU, on the other hand, consist of more sophisticated and technology intensive products.Â The recent appreciation of the loonie against the euro (up 18% since the two sides first committed to free trade talks) vastly overwhelms any cost advantage Canadian exports could hope to attain in European markets through tariff elimination.Â Aggregate trade imbalances, and the skewed sectoral composition of trade, imply that Canada already loses some 70,000 jobs (51,000 in goods, and another 19,000 in services) as a result of bilateral trade with the EU.
The EU and Ottawa commissioned a joint economic study which predicted mutual economic gains from a free trade agreement, worth approximately $12 billion per year to Canada by 2014.Â However, that report incorporates bizarre and far-fetched assumptions regarding the self-adjusting nature of all markets, and the manner in which free trade would be implemented and experienced.Â More specifically, the joint report made the following assumptions, with no actual empirical evidence presented to support them:
- full employment is maintained throughout
- full income-expenditure equilibrium is maintained throughout (hence there are no changes in debt or in aggregate trade balances)
- the only limit to national output is the available supply of productive factors; macroeconomic issues (such as aggregate demand, unemployment, currency swings, etc.) are ignored
- the landed cost of all processed goods traded between Canada and the EU will fall 2 percent (in addition to any tariff reductions) because of the free trade agreement
- services will become as extensively traded between Canada and the EU, as they are within Europe
- national savings and investment rates will increase in both parties, expanding productive capacity and total output
- there is no capital mobility between countries
The findings of this study amount to an assertion that free trade will produce mutual economic gains, not a demonstration that this will be the case.Â If you live in a neoclassical economics textbook, perhaps this approach makes sense.Â But if you live in the real world, it clearly doesn’t.Â Yet despite its aggressively optimistic modelling methodology, even the government’s own report shows that Canadian imports (of both goods and services) from the EU will increase by twice as much as Canadian exports to the EU, substantially widening the existing bilateral trade deficit.
How could Canada possibly experience a significant GDP and national income gain, through this visible deterioration in what is already a disadvantageous trading relationship?Â Only thanks to the idealized assumptions built into the model (namely that widening trade deficits with the EU will be offset by trade flows with other countries, that any displaced workers will find equally or more productive work in other sectors, and that Canadians will save and invest more despite the deterioration in trade performance), could Canada thus hope to “snatch victory from defeat”: attaining aggregate economic gains despite a marked deterioration in trade balances.
The real-world experience of the other free trade agreements already implemented by Canada does not support the hope that a free trade agreement with the EU would make that unbalanced relationship more beneficial for Canada.Â The five free trade agreements which have been fully implemented by Canada (with the U.S., Mexico, Israel, Chile, and Costa Rica) resulted in an average (across the five FTAs) annual growth in exports of 4.77 percent, but an average annual growth in imports of 8.67 percent.Â In fact, exports grew less rapidly with FTA partners than with non-FTA partners, but imports grew quicker with FTA partners than with non-FTA partners.Â Trade balances worsened with all but one of Canada’s FTA partners.Â There is no historical basis to conclude that free trade agreements are good for either Canadian exports, or for Canadian trade balances.Â In the real world, free trade agreements (not surprisingly) tend to make existing trade imbalances even worse: this is true throughout economics, where deregulation generally tends to exacerbate the imbalances and unevenness of market outcomes.Â Despite this observed failure, pursuing free trade agreements seems to be the default, one-note policy response from Ottawa to Canada’s worsening global trade performance – which is currently delivering us the biggest current account deficits in our history.
The full CCPA paper Out of Equilibrium presents some alternative simulations of the likely trade and employment impacts of EU-Canada free trade – unconstrained by traditional neoclassical assumptions regarding full employment, balanced trade, international capital immobility, and so on.Â Three scenarios are presented: one in which tariffs are mutually eliminated; one in which EU-Canada trade expands in line with the historical experience of Canada’s previous FTAs; and one in which tariff elimination is combined with the appreciation of Canada’s currency (versus the euro) which has been experienced in fact since the two parties launched free trade negotiations.Â In every case, the bilateral trade balance worsens significantly (and in the third scenario, it worsens dramatically – since the higher Canadian dollar reduces Canadian exports, even as imports from the EU are surging).Â Based on average employment intensity across 23 goods-producing industries, the simulations suggest an incremental loss of between 28,000 jobs (in the first scenario) and 150,000 jobs (in the third).Â Direct losses in Canadian GDP range between 0.56 percent in the first scenario, and almost 3 percent in the third.Â Those losses would be even higher in the presence of multiplier effects experienced in non-tradeable sectors, and/or the same sorts of savings/investment spillovers as were assumed (in a positive context) by the EU-Canada joint economic report.
Enhancing Canadian exports, and diversifying export markets away from the U.S., are important economic policy goals for Canada.Â It is clear, however, that merely signing another free trade agreement – even with a partner as important as the EU – holds no prospect of achieving either goal.Â A free trade agreement with the EU will exacerbate Canada’s existing large bilateral deficit, at the expense of output and employment in many important sectors of the economy.Â Those real costs cannot be assumed away on the basis of faith in idealized, self-adjusting equilibrium mechanisms which do not exist in the actual world.
Canadian policy-makers would be better advised to tackle the more pragmatic, and in many ways more challenging, tasks associated with constructing globally successful and innovative industries and firms: addressing Canada’s technological and productivity deficiencies, assisting Canadian-based firms in becoming more globally oriented, mobilizing investment in capital and technology (rather than simply assuming, as does the EU-Canada economic report, that investment grows automatically), managing exchange rate fluctuations, and using trade policy and other measures to ensure that our purchases from successful exporters (like the EU) are balanced by our sales to them.Â Ironically, these are exactly the sorts of hands-on industrial development strategies which European countries have historically pursued, and which have made the EU in general (and Germany in particular) a global export powerhouse.Â We should learn carefully from Europe (and other successful export jurisdictions, like East Asia and Brazil) about what is really required to build successful, innovative export industries, instead of continuing to naively hope that more free trade agreements will solve all that ails our trade performance.
This is the executive summary of a 44-page report on EU-Canada free trade released this week by the Canadian Centre for Policy Alternatives.Â Visit www.policyalternatives.ca to download the full report.