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No. 3: North American Economic Integration: 25 Years Backward and Forward

by Gary C. Hufbauer and Jeffrey J. Schott, Institute for International Economics, Washington (DC), under contract with Industry Canada, 1998


Summary

This report offers a retrospective and prospective view of the process of economic integration in North America. It begins with a history of the past 25 years of bilateral economic relations, and then speculates on how U.S.–Canada economic relations are likely to evolve over the next 25 years.

Twenty-five Years Backward

This section examines the roots of the "silent" integration of the past generation. On the basis of this analysis, in the second part we draw some insights about the future course of bilateral economic relations.

Bilateral Trade and Investment

Canada is among the most trade-dependent of the OECD countries, while the United States is one of the least. Each country is the other's best customer, but the United States has no foreign rivals in the Canadian market while Canada is first among equal trading partners in the U.S. market. In simple terms, the U.S. market is more important to Canada than the Canadian market is to the United States.

Over the period from 1970 to 1995, bilateral trade in goods and services has grown faster than GDP, increasing at an average annual rate of about 11 percent. Machinery and transportation equipment dominate two-way trade, accounting for roughly 40 to 45 percent of total bilateral trade. In contrast, bilateral flows of direct investment have been less robust and direct U.S. investment in Canada has slowed markedly since 1990. Firms seem to be expanding output at their most efficient sites and phasing out smaller facilities formerly necessitated by trade barriers.

These aggregate trends mask the significant growth of a series of regional market clusters along the border. In recent years, trade between the U.S. states bordering Canada and their Canadian counterparts has grown substantially faster than national bilateral trade.

Macro-economic Policy Issues

Canada and the United States share many economic values but differ markedly in the role of government in the national economy. While central government spending as a percentage of GDP is roughly the same in both countries, Canadian provinces outspend American states by about two to one. Canada's external debt exceeds 100 percent of GDP (compared to under 20 percent for the United States), and its budget deficit as a percentage of GDP is roughly twice that of the United States. As a result, Canadian policy makers are caught in a vise between the huge expense of social programs and the substantial political support for their continuance.

Since 1970, Canada and the United States have also diverged in terms of the percentage of GDP claimed by income and profit taxes: the share has increased in Canada and decreased in the United States. In 1993, the figures diverged by a full three percentage points of GDP. Canadian taxes on goods and services have consistently been about double those in the United States.

The Canadian economy tends to move in tandem with the U.S. economy but not in lock step. The degree of correspondence is highest in the money markets, where there is an extremely close correlation between U.S. and Canadian long-term (10–year) interest rates. Except for the early 1990s, there has also been a close correlation between inflation rates. In contrast, the exchange rate continues to fluctuate extensively.

Perhaps the biggest difference concerns labour. Until the late 1980s, Canadian unemployment followed the U.S. pattern with a lag of about a year. Since then, however, it has increased markedly while the U.S. rate has gently declined. The divergence is probably due to the fact that, in the early 1990s, the recession came later and was much deeper in Canada than in the United States. Because Canadian labour markets are less flexible than the U.S. markets, Canadian wages continued to increase in step with U.S. wages. Under the circumstances, Canada's drive for zero inflation would have required much lower wage gains to avert an increase in unemployment.

Trade and Investment Frictions

Among the impediments to integration of the North American economies are unilateral trade actions that can distort trade and investment flows and undercut business strategies seeking to rationalize production across the region. In this paper, we review three types of measures: anti-dumping or countervailing duties, U.S. Section 301 actions and economic sanctions.

Anti-dumping or countervailing duties have been imposed relatively rarely given the overall volume of bilateral trade, but they have drawn considerable attention in Canada because a few U.S. cases covered big-ticket sectors, such as softwood lumber. The United States has initiated more than 70 cases over the past three decades but the incidence has declined sharply in recent years. The new dispute settlement procedures of the Canada-United States Free Trade Agreement (FTA) deserve credit for mitigating the tensions created by these cases.

Could future regional and/or multilateral negotiations curb abuses of the anti-dumping regime? Past attempts do not offer optimism; indeed, recent GATT accords added to the dense regulatory guidelines for administrative agencies. We are wary of new efforts in this area; it may be better to let anti-dumping practices wither on the vine rather than try to prune them back. Past pruning has led to new grafts that have strengthened anti-dumping rules.

Countervailing duties will remain a problem as long as governments remain fixated on subsidizing economic sectors to redistribute income and promote employment. Both countries have tried unsuccessfully to rein in subsidy practices at the sub-federal level, where states and provinces compete with each other to attract new investments to their jurisdictions. Regional and multilateral negotiations have also failed to discipline these domestic subsidy practices. The only effective policy for curbing subsidies is likely to be budget constraint or taxpayer revolt.

Section 301 cases have not been a major concern, with the notable exception of cultural industries. Section 301 refers to Section 301 of the Trade Act of 1974. This statute authorizes the President to retaliate against "unfair" foreign trade practices. Unilateral Section 301 actions are still possible if contested policies are not covered by World Trade Organization rules. Canada's insistence on exempting cultural industries from regional and WTO obligations thus makes it easier to use Section 301 to contest trade practices in this area. This could be a growth area for North American trade lawyers.

Economic sanctions: Until the recent U.S. Helms-Burton Act, the United States and Canada differed infrequently on the use of sanctions in support of foreign policy objectives, and sanctions have not impeded regional trade and investment flows to a significant degree. However, the trend toward invoking sanctions through legislation rather than executive order (as in the Cuba, Iran and Iraq sanctions) is worrisome. If this trend gathers strength, the United States could find itself increasingly embroiled in rancorous disputes with Canada and other countries over the imposition of U.S. sanctions.

Bilateral Economic Initiatives

U.S.–Canadian bilateral economic initiatives over the past generation reflect an emerging understanding that negotiated approaches to conflict resolution are more constructive than unilateral actions. We review briefly the landmark agreements of the period: the Auto Pact, the FTA and the NAFTA.

The Auto Pact spawned a huge network of cross-border trade and spurred investment in the Canadian auto sector. In a conceptual sense, it also proved to be the forerunner of the Free Trade Agreement since the Auto Pact was the first significant departure by the United States from its postwar strategy of pursuing trade liberalization on a multilateral basis.

The FTA strengthened bilateral trade relations and created new rights and obligations regarding investment, services and dispute settlement; these have provided models for subsequent trade talks both regionally and multilaterally. Bilateral trade in financial services has grown at an annual rate of 21 percent since the FTA was implemented, while trade in closely related computer and information services has grown by almost 30 percent. In turn, the FTA largely provided the institutional underpinning for further liberalization achieved in the NAFTA.

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Twenty-five Years Forward

Economic Integration: the Example of Germany and the Benelux Countries

This section examines the economic convergence between Germany and the Benelux countries over the past three decades as a way to derive insights into future convergence between Canada and the United States. Integration in Northern Europe was particularly far-reaching because of shared borders and close linguistic ties (French and English are common second languages). By 1960, the Benelux states and West Germany had reached a degree of formal integration that Canada and the United States did not achieve until 1990.

On the basis of this European experience, we draw several conclusions:

First, the importance of trade in North America is likely to grow relative to GDP. While rising trade ratios are the natural consequence of globalization, in the 1960s and 1970s trade-to-GDP ratios rose faster in Europe than elsewhere; we attribute the extra growth to integration efforts.

European integration generated a 50-percent increase in intra-regional trade (above levels that would probably have been achieved otherwise). Because barriers to North American trade started at a lower level, we would not expect trade growth comparable to that achieved in Europe, but increases of 20 to 30 percent seem quite possible.

By the same token, it seems probable that trade-to-GDP ratios for Canada and the United States will also rise. In 1993, the ratio of trade in goods and business services to GDP was 60 percent for Canada and 22 percent for the United States. These numbers could well rise to 80 and 35 percent respectively over the next two decades.

The development may be expressed in another way: the rising ratio of trade to GDP means that U.S. and Canadian import markets should grow at least one percentage point faster per year than real GDP.

Second, for several key macro-economic variables, North America has already achieved as much convergence as Northern Europe. The two areas where greater convergence might occur are the exchange and unemployment rates. If exchange rate stability increases in future, it will probably reflect fundamental forces (particularly synchronized inflation rates) rather than a policy decision by the Bank of Canada. In contrast, the force of open markets for goods and services will probably create more flexible labour practices throughout Canada and a closer match with U.S. unemployment levels.

Third, integration does not require convergence of tax policies. In Europe, after far-reaching integration, national tax structures actually diverged more than they had in 1965. In brief, the smaller partners were able to carry on with a more extensive social agenda than the largest partner. We expect current disparities between U.S. and Canadian tax structures to endure for some time, and see no reason why economic convergence by itself should force Canada to the mode of lower taxes and reduced public spending preferred by the United States.

Implications for Competitiveness

The European experience suggests that there is considerable scope for further economic convergence between the United States and Canada in the next generation. This scenario suggests four lessons for Canadian firms and government policy:

  • Corporations must follow the high-quality, low-cost leader or go out of business. Firms must have a lean staff and keep costs to the minimum.
  • Firms should be very sensitive to workforce availability and habits in making decisions on new locations.
  • Governments may well find that targeted subsidies are effective in attracting individual firms. Given budget constraints, however, officials will have to juggle priorities between general programs (such as better schools) and targeted programs (such as road links to specific industrial sites).
  • Government officials should place greater emphasis on goods and services taxes that can be adjusted at the border, and on income tax systems that are fairly uniform so as to avoid driving away highly skilled people or especially profitable but mobile industries.

The Trade Policy Outlook and its Implications for North American Economic Integration

This final section offers our vision of future U.S. trade policy and how it could directly and indirectly affect U.S.-Canadian economic relations. We argue that U.S. policy is likely to follow the script of the past two decades and continue to be based on a mixture of domestic legislative actions, regional trade initiatives and multilateral negotiations in the WTO. We describe the likely evolution of ongoing integration initiatives in the Western Hemisphere and the Asia-Pacific regions, as well as new efforts in the WTO.

The United States and Canada are committed to eliminating barriers to trade with the major trading nations of Asia-Pacific and Latin America. If barriers really are removed, free trade and investment in both regions will yield a rich harvest of reforms in the dynamic economies of East Asia and South America, but only modest changes will be required in North American policies affecting most manufacturing sectors (with the important exception of apparel). Agricultural reform will be a sticking point in both regions, as it has been in the United States-Canada context. These commitments hold three main implications for the North American economies:

  • increased adjustment pressure on the apparel sector;
  • additional competition in meat and dairy products from Argentina, Australia and New Zealand, and in sugar from Brazil and potentially Cuba; and
  • increased export opportunities in the markets of regional partners, as a result of trade-spurred growth.

Western Hemisphere: We are optimistic about the prospects for a Free Trade Area of the Americas (FTAA), for several reasons. First, economic reforms continue throughout the hemisphere, strengthening the foundations for economic growth over the medium and long term. Second, the Summit of the Americas process is working. Third, the process of integration has continued advancing in various sub-regional pacts.

What is the most likely course of development for the FTAA? We believe that a FTAA will evolve from a pragmatic, ad hoc approach that combines the continuation of sub-regional integration efforts (including the expansion of the NAFTA region) with hemisphere-wide efforts to harmonize national and/or sub-regional trading rules that could potentially erect obstacles to the FTAA. The NAFTA will play an important role in future hemispheric integration since the NAFTA area accounts for more than 85 percent of the hemisphere's output. Stronger ties between the expanding NAFTA and MERCOSUR areas will also be critical.

Negotiations on Chilean accession to the NAFTA should proceed quickly in 1998, once U.S. fast-track negotiating authority is renewed. The main challenge will be to devise solutions for the WTO-plus features of the NAFTA (e.g., investment, intellectual property, services and labour/environment side agreements).

Asia-Pacific: The United States and Canada have committed to achieving free trade and investment in the Asia Pacific Economic Co-operation (APEC) region by the year 2010. How this will be done is still unclear since the Asian-style negotiating process adopted by APEC creates uncertainty about the depth and timing of national trade reforms. While APEC members seem committed to eliminating border trade restrictions, they have not clarified how deep into domestic policies they will extend their commitments, although discussions have covered a broad range of issues, including investment and competition policy.

Nonetheless, it is difficult to imagine APEC reforms going beyond the comprehensive free trade obligations covered by the NAFTA. U.S.–Canadian norms are thus likely to represent the high water mark for APEC efforts. The one area where APEC could forge ahead is in competition policy, where regional and multilateral efforts in other forums are in their infancy.

In simple terms, we do not expect APEC's government-to-government negotiations to serve as a catalyst for North American integration. Instead, the lure of expanding Asian markets and the challenge of competing in those markets will provide a more powerful impetus for North American industry to restructure.

WTO: If regional free trade initiatives are sustained, they are likely to become linked in new WTO negotiations under the banner of global free trade.

The main question for these prospective WTO talks is whether negotiations in this forum can lead to the same deep integration (i.e., convergence or mutual recognition of domestic regulatory policies) achieved in EUrope and now evolving in North America. The difference is that the WTO talks will balance EU norms with those of other regions. In some areas the U.S.–Canadian norm may not be the most stringent and North American policies could be strengthened to meet EU norms.

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Conclusion

Over the next 25 years, the economic integration of North America will advance markedly:

  • The border between Canada and the United States will be no more intrusive than the German–Dutch border today. Border trade measures will be a relic of the past; declining resort to anti-dumping duties and other border measures will be replaced by regulatory competition and investment subsidies.
  • Trade will play an even larger role in both economies, and two-way trade flows will continue to expand sharply.
  • Trade with Asia will take a much larger share of U.S. and Canadian exports and imports, spurring further development of west coast ports.
  • Regardless of developments in Quebec, we will continue to see the devolution of power from federal governments to states and provinces. In both countries, provinces and states will play a larger role in shaping the direction of future integration. This trend will constrain growth of the federal tax base and will thus continue to squeeze budgets for social services.
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