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. 

Canada enters these negotiations with a notable disadvantage in terms of both quantitative trade flows, and the qualitative composition of trade.  Canada currently incurs large bilateral trade deficits with the EU ($15 billion in goods, and close to $4 billion in services).  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.  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.  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.  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.  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.  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.  If you live in a neoclassical economics textbook, perhaps this approach makes sense.  But if you live in the real world, it clearly doesn’t.  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?  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.  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.  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.  Trade balances worsened with all but one of Canada’s FTA partners.  There is no historical basis to conclude that free trade agreements are good for either Canadian exports, or for Canadian trade balances.  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.  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.  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.  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).  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).  Direct losses in Canadian GDP range between 0.56 percent in the first scenario, and almost 3 percent in the third.  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.  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.  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.  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.  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.  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.  Visit www.policyalternatives.ca to download the full report.

9 comments

  • Until Canada has high quality manufactured products to export, these free trade deals will only widen the trade deficit bound to lead to a fundamental structural problem. Canada does not have the same luxury to print money like America does. They have the fortune of $US as the accepted international reserve currency. For how long will this keep them afloat, though? Rest of the world is asking questions

    http://www.atimes.com/atimes/Global_Economy/LJ27Dj04.html

  • You have done a great job Jim, and gotten good coverage as well. I will be interested to see if anybody tries to refute your analysis. I am sure the Finance Dept. has assigned some people to look at your work. And those business associations and lobbies running the policy side of government at least since 1982 must be interested as well.
    Unhappily for them the truth will become know eventually, despite their assertions.

  • The politics of opposing a deal with the EU are different from the politics of opposing a deal with some unpopular 3rd world regime. People are going to ask if the unions aren’t opposed to ALL trade agreements if even agreements with countries with relatively good worker and environmental protections are opposed. This could in turn make it that much harder for union voices to be given popular consideration in future trade policy debates.

  • Well, in many ways the financial shenanigans of the banksters only exposed underlying economic weaknesses caused by too much unmanaged trade. It might be time to talk about whether masses of trade is really the panacea everyone always claims.

    Some trade is useful. It would probably be kind of expensive for Canada to grow our own pineapples. There are important minerals that aren’t found in Canada in useful concentrations as far as we know.
    But is Canada (or any other country) really better off if we fail to manufacture our own goods locally? Is Canada (or any other country) really better off if we fail to produce much of our own food? Is killing our environment to export huge quantities of raw materials so we can then import smaller amounts of finished product we might have made ourselves really such a great thing?

    I think there can be too much trade, and there can be bad patterns of trade, and there can certainly be an overemphasis on trade. Overemphasis on trade is very likely to set in when you have a government looking for relevance but ideologically opposed to doing the things it might to help the country’s economy directly.

  • Good points plg

    Let’s not kid ourselves, a majority of trade out there is not in misguided countires growing cold weather pineapples.

    Th e majority of trade is based upon costs, and over the last 20 years and especially the past 10 years there was and is a massive reallocation of the global about force, based upon costs, guided by standards. Any body that argues against that has their ideological economic blinders on and have been reading too much.

    If you develop the walmart economy, you will keep attacking your middle class numbers and you will erode the income distribution. That again is simple economics of demand.

    Suddenly you end upmwith a hollowing out on many fronts and the whole structure comes crashing down. Especially when you have a wealthy elite that loses interest in social compromise and spend the,last many years building their own legal money printing press. The dynamics have turned so ugly and unbalanced, and themtrajectoriesmare what bother me the most. Sadly most economists do not see politics the way they should. Potentially the current death of economics is a great historical episode. In fact Imhavemnever favored book burning, but I do say i would supply the hot dogs and marshmallows if somebody wanted to help.

    The profession has never been a science and at best a bad art for the elites.

    Pt

  • That should read reallocation of the global labour force.

  • Those numbers and sentences don’t sound very good to us… But as many others countries we have to accept the fact that many trades will stay on the place with cheaper labour cost and relevant transport expenses. Canada should start to think about creating “green jobs”. There are many opportunities in developing alternative energy sources. We have big potential in science and we have sources for experiments. Very interesting is studies how to heat up houses with biomass. We should continue in new environmentally friendly projects.

  • Does the EU-Canada Trade deal contain provisions on copy-rights and patents? If so, you should call it a Trade deal rather than a “Free Trade deal” as it expands (internationalizes) protectionist barriers that favour certain companies.

    http://www.truth-out.org/article/free-trade-why-free-matters

  • Sorry for jumping on this thread so late, but I see a major issue concerning CETA that does not seem to have been noticed/acknowledged thus far. Rather than going through the worthwhile exercise of analyzing the potential (likely) negative consequences of free-trade between Canada and the EU in terms of trade (im)balances and CETA detracting from much-needed internal reform to make some Canadian industries more internationally competitive, I think we first need to ask what can/will actually come of these negotiations. I personally don’t see very much coming out of the CETA negotiations, and hence see little need to worry about the negative consequences of any potential deal.

    When we look at the major potential areas of trade opening between both economies, I believe that there is little likelihood that any major progress will be made on the liberalization front. It must be recognized that, as a result of the GATT and WTO (and Most-Favoured Nation Principle), a great deal of trade barriers between Canada and the EU have been significantly reduced (particularly in manufacturing sectors). Remaining sectors of importance for Canada revolve around non-tariff barriers, particularly in agriculture (through Sanitary and Phytosanitary measures), and other regulations in safety and the environment. In terms of agriculture, the mutually-incompatible interests of agricultural exporters and protectionists in Canada, with the wheat industry being primarily export-oriented and the poultry and dairy sectors benefiting from supply management serving as examples , it is unlikely that Canada will be able to extract enough concessions from the Europeans (and their beloved Common Agricultural Policy) to align Canadian agricultural interests (or at least give enough incentive for the export-oriented side to overpower the other) and truly liberalize agriculture. In terms of regulation, given our trade dependence on the US, and the fact that the US and EU have been wrapped up in a battle for regulatory supremacy for years, it is unlikely, if not suicidal, for Canada to enter into a process of regulatory-harmonization with the EU. Canada will not engage in a process that could undermine the current gains from continental integration.

    On Europe’s side, opening up Canadian public procurement practices by enforcing the WTO’s national treatment principle is a pipe-dream. Canadian provinces continue to favour local producers in government projects for political reasons. For example, despite the fact that Germany may have higher quality turbines to generate hydroelectricity, and that the provinces have a seat at (or at least right behind) the negotiating table, it is doubtful that Quebec or Saskatchewan would risk the likely political effects of hydro liberalization, just as the Canadian government will never open up access to Canada’s 5 schedule A (full-service) banks.

    Although I think all of you are fundamentally right in questioning the discourse projected by the Harper government concerning the deal, take ‘Hart’ (whose arguments largely form the basis for my assertions here), CETA won’t significantly deviate from the character of existing deals with the EU: big on talk, little on substance.

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