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NAFTA's demise puts Canada in the 'penalty box,' study shows

July 25, 2019

Research has long indicated that the elimination of the North American Free Trade Agreement (NAFTA), or simply the withdrawal of the U.S. from NAFTA, would reduce standards of living in Canada, Mexico and the U.S.

A new study from the University of Notre Dame shows the move would indeed economically hurt all three countries, but with a surprising twist -- Canada would suffer the most.

Typically, the smallest economy -- in the case of NAFTA, Mexico -- loses the most in per capita income because smaller economies tend to rely more on international trade, but not here, according to the study, "Putting Canada in the Penalty Box: Trade and Welfare Effects of Eliminating NAFTA," forthcoming in The World Economy by Jeffrey Bergstrand, professor of finance in Notre Dame's Mendoza College of Business.

"When a free trade agreement is eliminated, tariffs between the former members rise," Bergstrand explains. "With NAFTA, as each country's tariffs rise, it makes goods in non-member countries cheaper to buy and export. And it makes goods at home relatively less expensive. However, the fall in members' trade does reduce demand in each country and lowers wage rates in all the countries, which we found. It also -- due to higher tariffs among the former members -- raises prices in all the countries, which we also found. This is what lowers standards of living."

The study's determination that Canada's standard of living fell the most is due to the economic and geographic structure of the Canadian economy.

"As some of Canada's trade with the U.S. and Mexico is diverted to its own economy, that new intra-national or domestic economic activity in Canada is much more expensive," Bergstrand says. "Canada's population is much more dispersed, which increases the costs of trading within the Canadian borders. Canada's population is one-tenth that of the U.S., but its geographic area is three times its size. Canada's area is five times that of Mexico, and one may argue that Canada's economic activity is heavily concentrated in adjacent provinces of Ontario and Quebec; however, half of Mexico's GDP is generated among three cities that are all within 450 miles of one another. Also, Mexico has one common language for transactions, while Canada is prominently bilingual, which historically raises costs of doing business."

Bergstrand used a standard New Quantitative Trade Model of international trade, paying particular attention to capturing carefully and completely the international trade costs between nations as well as the intra-national trade costs within each country. Such models have been increasingly employed since 2016 to analyze Brexit (the withdrawal of the United Kingdom from the European Union).

"Canada's per capita income loss of 2.11 percent is nearly two times that of Mexico's loss of 1.15 percent and nearly eight times the United States' loss of 0.27 percent," Bergstrand says, "illustrating the important influence of trade costs -- both international and intra-national -- in contributing to the gains or losses from an economic integration agreement's formation or elimination."

NAFTA is at risk if the U.S. withdraws, which President Donald Trump has threatened to do if his new trade deal -- the United States-Mexico-Canada Agreement -- is not passed by Congress.

Last year, Bergstrand testified before the International Trade Commission on the documented benefits of free trade agreements, including boosts to trade and economic welfare.

Bergstrand is a research associate of CESifo, an international network of researchers based in Europe. His research has been published in more than 50 articles and book chapters. He has served as a visiting scholar at the European Commission in Brussels, the Ifo Institute/University of Munich, ETH University in Zurich and several other institutions.

Co-authors of the study include Scott Baier at Clemson University and John Bruno at Cornerstone Research (also a Notre Dame graduate).

University of Notre Dame

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