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Lessons from the U.S.-Canada Free Trade Agreement

David R. Francis

"The tariff cuts boosted labor productivity (how much output is produced per hour of work) by a compounded annual rate of 2.1 percent for the most affected industries and by 0.6 percent for manufacturing as a whole."

There is good news and bad news in regard to the Canada-U.S. Free Trade Agreement (FTA). The good news is that the deal, especially controversial in Canada, has raised productivity in Canadian industry since it was implemented on January 1, 1989, benefiting both consumers and stakeholders in efficient plants. The bad news is that there were also substantial short-run adjustment costs for workers who lost their jobs and for stakeholders in plants that were closed because of new import competition or the opportunity to produce more cheaply in the south.

"One cannot understand current debates about freer trade without understanding this conflict" between the costs and gains that flow from trade liberalization, notes Daniel Trefler in The Long and Short of the Canada-US Free Trade Agreement (NBER Working Paper No. 8293). "This paper," he writes, "does not provide the silver bullet that makes the case either for or against free trade." The central tenet of international economics is that free trade improves economic welfare. "Yet the fact of the matter is that we have one heck of time communicating this to the larger public, a public gripped by Free Trade Fatigue." The FTA, he writes, provides a unique window on the effects of trade liberalization because it was an unusually clean trade policy exercise, not bundled into a larger package of national economic measures or market reforms.

His paper looks at the impact of the FTA on a large number of performance indicators in the Canadian manufacturing sector from 1989 to 1996. In the one-third of industries that experienced the largest tariff cuts in that period, ranging between 5 and 33 percent and averaging 10 percent, employment shrunk by 15 percent, output fell 11 percent, and the number of plants declined 8 percent. These industries include the makers of garments, footwear, upholstered furniture, coffins and caskets, fur goods, and adhesives. For manufacturing as a whole, the comparable numbers are 5, 3, and 4 percent, respectively, Trefler finds. "These numbers capture the large adjustment costs associated with reallocating resources out of protected, inefficient, low-end manufacturing," he notes.

Since 1996, manufacturing employment and output have largely rebounded in Canada. This suggests that some of the lost jobs and output were reallocated to high-end manufacturing. On the positive side, the tariff cuts boosted labor productivity (how much output is produced per hour of work) by a compounded annual rate of 2.1 percent for the most affected industries and by 0.6 percent for manufacturing as a whole, Trefler calculates. The tariff cuts raised "total factor productivity," a measure that takes account of capital input as well as labor input, by a compounded annual rate of 1 percent for the most affected industries and by 0.2 percent for manufacturing as a whole. Trefler figures this is attributable to a mix of plant turnover (closings, openings, takeovers) and rising technical efficiency within plants. It is not because of plants being bigger, or a shift in market share toward firms with already high productivity. In low-end manufactures, productivity rose sharply.

Surprisingly, Trefler writes, the tariff cuts raised annual earnings slightly. Production workers' wages rose by 0.8 percent per year in the most affected industries and by 0.3 percent per year for manufacturing as a whole. The tariff cuts did not effect earnings of higher-paid non-production workers or weekly hours of production workers. Thus, the FTA reduced inequality in incomes, albeit minimally.

Between 1989 and 1996, U.S. exports to Canada of products of the most affected industries increased 70 percent. The tariff cuts, reducing the barriers to goods from the United States, account for three quarters of that increase. Also, the tariff cuts explain about a third of the increased share of imports from the United States in total Canadian imports from all countries, from 85 percent to 90 percent. Trefler concludes, "Most of the effects of the FTA tariff cuts are smaller than one would imagine given the heat generated by the debate."

Canadian Economy

With a population of 30 million and a GDP forecast to exceed $830 billion in 1997, Canada is one of the world's largest economies. A member of the G7 group of leading industrial countries, Canada enjoys an enviable standard of living, an excellent infrastructure, a highly educated and skilled labour force as well as a well-deserved reputation as a successful trading nation.

State of the economy

The Canadian economy is strong. Since 1994, Canada's economic performance has been characterized by growth, low inflation, stable unit labour costs, improved cost competitiveness, record exports, and a healthy level of business investment.

Among the G-7 countries—the most developed economies in the world—Canada ranks highly in per capita purchasing power. The country's level of exports has never been higher. This is due to improvements in cost competitiveness and strong productivity growth. As well, Canada continues to maintain one of the lowest inflation rates in the world.

Looking ahead, both the Organization for Economic Co-operation and Development and the International Monetary Fund predict that Canada will be among the fastest-growing industrial economies in both 1997 and 1998.

Domestic economy

Domestic business confidence is greater today than at any time since 1979. With a positive economic forecast and good prospects for consumer spending, overall demand in the Canadian consumer and industrial markets should continue to be strong.

Canadians currently spend close to $500 billion each year on consumer goods and services, with services now accounting for more than half of Canadian household expenditures. Consumer spending has also risen rapidly on items related to information technologies.

Average family income continues to increase and growth in disposable income continues to pick up as Canada's economy strengthens, labour market conditions continue to improve, and governments move to trim tax rates-a process that has already started in some provinces.

Investment climate

Canada's solid economic fundamentals, strong business investment, increasing competitiveness, and integration into the North American market provide the basis for the country's near-and long-term growth potential.

A sound and innovative domestic financial sector, combined with investment from foreign sources, provide the capital necessary for more research and development, technological upgrading, and infrastructure development. The environment for conducting research and development remains highly attractive through some of the most generous tax incentives among all industrial countries. The labour force is highly educated, skilled and committed, and works for competitive wages. Turnover and absenteeism rates are low.

Government policies are creating a more favourable climate for domestic and foreign investors, including a low-inflation environment. Consumer prices have risen by less than 2 percent annually since 1991, a trend that is expected to continue. The fiscal environment has improved considerably in recent years. The federal government has balanced its budget and the ratio of debt-to-gross domestic product has started to decline. Several provincial governments have also balanced their budgets or moved into a surplus position.

Because of its economic potential, Canada has continued to attract a large volume of direct investment from foreign sources. The stock of foreign direct investment in Canada has been increasing steadily in recent years indicating continued investor confidence in Canada's long-term prospects.

Financial services

Canada has always been known for the sophistication of its financial markets. One of the main reasons for this is the strength of the financial services sector.

The Canadian financial services sector is made up of a variety of institutional players and markets, all of which provide numerous, and in many cases, competing products and services to domestic and foreign customers. It is stable, sophisticated and internationally competitive. The sector employs over half a million people, or about 3.5 percent of working Canadians, and contributes about 8 percent of Canada's gross domestic product.

With assets in excess of $1 trillion, chartered banks form the heart of Canada's financial services sector. They have approximately 8,000 branches throughout the country and an active presence in about 60 foreign countries. The country's six largest banks rank among the top 100 banks worldwide.

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