How free trade came to Canada: lessons in policy analysis

Charles J. McMillan

The US-Canada Free trade Agreement (FTA), and its extension, the North American Free Trade Agreement (NAFTA), is passing an anniversary of sorts, celebrated by free trade proponents as a second- best option to a new multilateral agreement, and chided by opponents as the steady slide to economic depend- ence on the vast American marketplace. Canada and the United States, the two countries then sharing the largest trade flows in the world, broke new ground on several fronts — in agriculture, in investment, in tariff reduc- tion, in services and in dispute settlement. At the time, the US-Canada agreement coincided with an enormous build-up in global protectionist pressures and, paradoxi- cally, with the first case of a significant US bilateral trade agreement, given the difficulties of negotiating a new round of multilateral trade negotiations, the so-called Doha Round.

Any prospective agreement with the US on any topic, let alone something as central as trade, places the prospects for other countries to examine the US position. For Canada itself, despite the numerous economic studies promoting free trade, including the bête noire of Canadian nationalists, Professor Harry Johnston, in his 1962 opus, The Canadian Quandary, the 1971 study, Looking Outward by the Economic Council, and of course, the lead recommendations of the Macdonald Royal Commission in 1985, there was little sign that either Ottawa or the provinces were prepared to make any bold policy leaps. Indeed, with the single exception of Peter Lougheed in Alberta, none of the premiers saw free trade as a policy winner, and for the most part, most provin- cial governments were prepared to hide behind the implicit framework of tariff protection acceptable to the leading manufacturing jurisdiction, Ontario. Despite occasional rantings of policy analysts and a few Canadian CEOs, such as Walter Light of Northern Telecom, free trade was simply not on the national agenda.

In the US, trade talks are only one side of a larger economic agenda. By 1975, the US was starting to feel the first signs of dramatic post-war shifts in the global economy. Richard Nixon faced the first  dramatic shift, the devaluation of dollar and leaving the gold standard by abandoning the post-war Bretton Woods framework established in 1944. President Ronald Reagan started an inexorable trend to a “managed trade” framework governing such key sectors as textiles, automobiles and semi-conductors, where the key economic relationship was governed by the two biggest economies, the US and Japan. The two countries were mirrors of each other, rising surpluses and deficits, a creditor and debtor status, where their joint policies affected the global economy in such areas as exchange rates, capital flows and third world debt. Severe imbalances, in part influenced by OPEC, required new policy coordination and led to annual meetings of leaders, the G4, then the G5 and later the G7, including Canada. Just as the Reagan administration had to face severe Japanese industrial competition in traditional manu- facturing (e.g., autos, cameras, motorcycles, radio and TV), and new sectors like consumer electronic, and industrial machinery equipment, robots), big business US saw an FTA with Canada as issue, secondary to trade pacts with Japan and Europe.

A new government in Ottawa, elected in a sweeping election victory on September 4, 1984, and a new Prime Minister with no specific prom- ises or direct interest in bilateral free trade with the US, became leading pro- ponents of an FTA in the next election, in November 1988. It remains a para- dox that neither the Americans nor the Canadian population were push- ing for this agreement, and it wasn’t the primary goal of either political leader in 1984. Indeed, the forces pushing the US administration were quite different than the policy drivers in Canada, and conventional ideology, economic or nationalist, weren’t directly central. So why did the agree- ment succeed? As Harold MacMillan, the British prime minister would say, “Events, dear boy, events.”

In the run-up to Ronald Reagan’s sweeping election victory in 1984, two issues dominated the American economy. The first was the deep recession in 1982, when interest rates climbed to double digits, and Paul Volker, the Fed chairman, declared war on inflation. The second issue was the growing problem of American competitiveness, in partic- ular the growing inroads of Japanese producers in the American market across a range of sectors: automo- biles, consumer electronics, semi- conductors and steel. Across the industrial world, policy-makers rec- ognized the fragility of the growing integration of the market economies. The symptoms of the problems were (and remain) deeply embedded with the problems themselves, namely, the value of the stock market, the devaluation of the world’s most important currency, the debt crisis of the Third World and the intractable problems of monetary instability, i.e., major currency fluctuations and huge gyrations in capital flows. In the 1980s, the United States and Japan were the two major players shaping the biggest economic crisis of the post-war era.

The US and Japan were in fact at a watershed. Yet at a time when joint cooperation and policy coordination are essen- tial preconditions for monetary and trade stability, Japan and the US had allowed their bilat- eral relationship to change. As a leading economist noted:

Japan is already challenging the United States with a major new drive toward cre- ativity and leadership in advanced technology... Japanese bureaucrats and politicians will be sorely tempted to seek new avenues for national advancement. American officials will find it  harder than ever to ward off self- defeating protectionist measures. The media will have a field day publishing the charges and coun- tercharges of angry politicians. Public opinion in both nations could take an ugly turn. Traditional diplomacy will fail.

The growing integration between Japanese industry and American industry and the resulting manage- ment and technology linkages across the Pacific, to Japan and Southeast Asia, and eventually to China, point to a dramatically different environment for multilateral or binational trade agreements. For two decades, Japan’s balance of payments remained rough- ly in equilibrium, and the merchan- dise trade surplus was approximately $35 billion. By 1983, riding a crest of phenomenal productivity and invest- ment growth, Japan’s trade surplus in one year equalled that of the previous two decades. In 1987, the trade surplus approached $101 billion — the largest in recorded economic history. In the US-Japan context, in the 15 years prior to 1986, two-way merchandise trade increased to $115 billion, from about $54 billion — a growth of $61 billion. Japan’s exports to the US accounted for $53 billion of this $61 billion, and US exports to Japan accounted for only $8 billion, or less than 13 percent. Of this low amount, almost half, or $3.5 billion, came not from car exports, not from sophisticated electronics, but from gold, sold for re-export from Japan.

Growing competitive problems at large, and the hollowing out of the manufacturing centre in the Mid- west of the US, in key states like Michigan, Ohio and Illinois, placed severe political pressure for protection by both state governments and mem- bers of Congress, and Ronald Reagan responded with a series of “managed trade agreements” limiting Japanese imports to set levels.

For Canada, these US developments in the early 1980s were particu- larly ominous. Canada’s dependence on the American market, and the cen- trality of North American integration in such keys sectors as cars, energy and pulp and paper, forced governments at all levels to worry about the new trade environment of the US. But events were also changing in Canada, but from different quarters.

Canada’s own competitiveness had seriously deteriorated; unemploy- ment was at historic highs; govern- ment deficits and national debt were virtually out of control. In early 1986, as the Canadian government decided to enter into trade talks for a compre- hensive free trade agreement with the United States, a succession of problems flowing politically from “managed trade” started to emerge with force. Japanese-American bilateral disputes added to the tension, especially in such sectors as steel, agriculture, semi- conductors and automobiles.

However, there were also particular US-Canada sectoral disputes such as carbon steel and softwood lumber. These disputes greatly added to the stress of the “managed trade” approach, especially in light of the application of US trade remedy laws, which had the perverse effect of defin- ing unilaterally what constitutes unfair trading practices. It was in this politi- cally charged climate that Canada and the US undertook to negotiate the bilateral free trade agreement in 1986 between the two countries. It is the most important bilateral initiative since 1945, since the two countries share such a huge trade relationship. The essence of the deal has been amply reviewed elsewhere; it suffices to high- light certain features, namely reduc- tion of tariffs over a ten-year period, free trade over time in energy, certain agricultural products and services; lib- eralized investment and government procurement; and new mechanisms for dispute settlement, especially a bi- national review panel for appeals.

From a multilateral perspective, the US-Canada trade agreement offered a number of policy signals, some ominous for future US views on world trade policy:

  1. Is the trade agreement the latest, but most concrete, evidence of American retreat into a Fortress North American policy, reinforced with potential bilateral agreements with Mexico and Canada? (These agreements followed earlier trade arrangements by the US, namely a bilateral deal with Israel in 1985 and the Caribbean Basin economic initiative.)

  2. Is the trade agreement a clear policy alternative to the traditional multilateral approach of trade lib- eralization, wherein the US nego- tiates a series of bilateral agreements with like-minded countries? In fact, Treasury Secre- tary James Baker spelled out this approach quite boldly: “If possi- ble, we hope...liberalization will occur in the Uruguay Round. If not, we might be willing to explore a ‘market liberalization approach, through minilateral arrangements or a series of bilater- al agreements...Other nations are forced to recognize that the Unit- ed States will devise ways to expand trade — with or without them.”

  3. Is the US-Canada FTA the launch of a new US approach to initiate a broader policy framework between the United States and other countries, forgoing the tra- ditional multinational trade agree- ments starting since 1945, the GATT agreements? Would the US prefer these bilateral deals, with Japan, with the European Com- munity, as the basis of trade mat- ters, but on the broader agenda of military, political and technologi- cal issues between the world’s largest market economies?

Prime Minister Yosuhiro Nakasone’s January 1986 visits to Washington and Ottawa made clear that the Japanese objected to a “Fortress North American” policy framework, where discriminatory measures would be taken against third countries, especially Japan. Clearly, the Japanese knew the underlying bilateral issues facing Canada and the US, including the fact that so much of this two-way trade represents trade flows across subsidiaries of companies locat- ed on both sides of the border, i.e., within the framework of multination- al subsidiaries, and special arrange- ments in other areas, such as the US-Canada Auto Pact, NORAD and the defence-sharing agreement.

The US-Canada trade deal tried to meet three tests. First, this bilateral deal advances multilateral negotia- tions at the GATT (which later became the WTO). In fact, the US-Canada agreements broke new ground on tariff barriers, investment, agriculture and services, and these areas may serve as a model at the GATT talks. Second, bilat- eral initiatives can be trade-creating, rather than trade-destructive, because it advances international trade ration- alization. In the North American con- text, domestic subsidiaries on both sides of the border, rather than closing, as apocalyptic views have argued, will lead to product specialization and new market niches. Third, because exchange rates will be the primary factor determining investment flows, rather than trade barriers, further Japanese and North American integra- tion will increase trade as each country adjusts its industrial structure based on real comparative advantage.

The starting points are obviously different. Canada, like most European countries, is trade dependent, up to 30 percent of GNP. Canada, alone among the G7 countries, relies heavily on unprocessed raw materials and a limit- ed range of services. With the excep- tion of automobiles, Canada has a relatively weak manufacturing sector, especially on such criteria as R&D per- formance, export marketing and financial capitalization. Canada’s domestic economy experiences high foreign ownership, strong inter- provincial trade barriers and a small- scale industrial base outside the Toronto-Montreal corridor. For high- tech sectors, where economies of scale in production runs are central, Canada was the only G7 country without secure access to a market of 100 mil- lion consumers. Further, Canada’s micro problems in the 1980s were an accumulation of neglect over the pre- vious two decades. And politically, the forces challenging the US-Canada deal were uncompromising, not only from Canadian nationalists, but from provincial governments like Ontario. As Allan Gotlieb, Canada’s ambassador to the US at the time, neatly put it, “In the US, there are those who believe that unilateralism is strength; in Canada, there are those who believe that bilateralism is surrender.”

But are the antecedent conditions, i.e., those political and personality factors necessary for momentous change, present in the FTA agreement? Those conditions are instructive on this score. Much has been made of the Reagan-Mulroney personal relationship. It began during the June 1984 Washington visit by the then Opposition Leader Brian Mulroney, only a week after John Turner, himself a strong pro-American lawyer and former senior cabinet minister, succeeded the enigmatic Pierre Elliot Trudeau to the leadership of the Liberal Party. Mulroney had campaigned for the leadership of his own party through- out the spring of 1983 on a strong pro- US platform, and for changes on policy issues largely inimical to American companies — namely, Trudeau’s policies on energy, foreign investment, NATO, intellectual prop- erty, Crown corporations and interna- tional trade. Personally, Mulroney was initially lukewarm on comprehensive free trade, but spoke openly and criti- cally on bilateral trade restrictions in sectors like steel, lumber, energy and agriculture.

Shortly after Mulroney was elected on September 4, 1984, with the largest parliamentary majority in Canadian history, Mulroney accepted the President’s invitation for bilateral talks in Washington. At those meetings, President Reagan reiterated his 1980 initiative for a Canada-US-Mexico free trade zone, linking the peoples throughout North America to a new liberalized trade regime, however vague the details. At this point, exhausted by the long 58-day national campaign, and preoccupied by the need to form a new government and cabinet, Mulroney pushed only for a new bilateral process — an annual meeting of president and prime minis- ter, and a quarterly meeting of Canadian and US foreign ministers.

The new Conservative govern- ment, in keeping with its campaign commitments, recalled Parliament on November 5, 1984, with a Throne Speech — an omnibus policy state- ment of legislative intentions, much like a State of the Union address — and announced major new initiatives, including policies for competitiveness and liberalized trade. In a major and more detailed statement, the Mulroney government set out its national economic agenda — an eco- nomic framework based on market lib- eralization, downsizing of government, improved tax incentives and social policy reform. As part of the agenda pronouncements, the govern- ment launched a massive consulta- tions exercise — a process to consult

Canadians directly on a whole series of economic reforms. The industry sec- tors were all-encompassing: housing, energy, forestry, small business, tourism, mining, fisheries. The policy areas covered a wide spectrum — tax reform, welfare policy, regional devel- opment, export financing, science and technology, and international trade. However, already facing American pro- tectionist sentiments, trade policy became a central priority of the Canadian corporate community.

Over the next year, a series of events set the stage for launching the bilateral trade talks. They are instructive for understanding the political dynamics of how the free trade negotiations actually got started and what they imply for other bilater- al negotiations. When the new Prime Minister spoke in New York on December 10, 1984, to the Economic Club, a group of elite American indus- trialists and bankers, hosted by David Rockefeller, the policy context for free trade had started to change dramati- cally. For one thing, the new Prime Minister began to realize the sheer depth of US protectionist sentiment in Congress, as witnessed by the spate of bills then being introduced before both the House and the Senate. Moreover, the lobbying efforts of Canadian business groups — on lum- ber, agriculture, steel and fisheries — exposed the “finger in the dyke” nature of the exercise. The Americans were in no mood for trade rhetoric — least of all from their largest trading partner. The PM’s New York speech, that “Canada is open for business,” gave a strong pro-free trade signal on both sides of the border. Ironically, a concrete statement on free trade was deleted from the text of the speech.

Mulroney’s public views on free trade were heavily influenced by Ontario’s traditional protectionist stance, often cloaked in the guise of Canada’s national interest. The new prime minister himself had opposed free trade during the leadership cam- paign in 1983, not so much on its eco- nomic merits as on its political perils. After all, it was a Conservative govern- ment under Robert Borden that had defeated the 1911 Laurier initiative on free trade with the United States. Ontario’s Premier, William Davis, was a strong Mulroney ally during the 1984 federal election campaign, but announced his resignation in the spring of 1985.

Davis left a de facto political leader- ship vacuum in Canada’s anti- free-trade movement. Alberta’s strong pro-free-trade Premier, Peter Lougheed, quickly seized the initiative. Indeed, at the February 1985 meeting between Mulroney and the ten provincial pre- miers held in Saskatchewan — only one month prior to the Reagan- Mulroney Shamrock Summit in Quebec City — Lougheed led the forces calling for a dramatic new initiative on bilateral trade. The new Ontario Premier, Frank Miller, was largely mute on the question and the pendulum quickly shifted in federal government circles — intellectually and politically, ven more so when David Peterson’s Liberals defeated the Conservatives in the 1985 Ontario election.

Social policy reform in Canada had become the biggest political cause célèbre for the new government. Centring as it did on the famous Mulroney by-election statement in Central Nova,the Nova Scotia seat he borrowed from Elmer MacKay, that Canadian medicare was “a sacred trust,” the defiant mood of social activists, reinforced by a senior citizen- ry with strong memories of double- digit inflation, challenged the new government’s attempt at policy reform, which focused on a scheme for de-indexing seniors’ pensions. The ardour for dramatic reform in social policy soon died, especially after a ran- corous Question Period in December 1984. The free trade issue, by default, moved to the forefront of the govern- ment’s reform agenda.

But other events were also at work — another product of Mulroney’s good luck. In 1982, the Trudeau government had appointed a blue ribbon Royal Commission on Canada’s economic future. Trudeau selected Donald S. Macdonald as chairman. Macdonald had been close to Trudeau — as finance minister, energy minister, per- sonal friend and go-between to the Canadian business community.

But as a Liberal politician, Don Macdonald had strong credentials as a staunch nationalist, a defender of Canadian interests. His report was released in September 1985, but Mulroney could have shut down the commission when he won his election in 1984. Its major recommendation was the advocacy of a comprehensive US-Canada free trade agreement. By coincidence, the report’s release to the public occurred the same week that Mulroney flew to Washington for his meeting with President Reagan.

It was in this larger context that the most radical policy agenda item sur- faced — free trade with the United States. The Macdonald Commission, widely report- ed and praised in the Canadian media, paralleled the policy initiatives launched in the November 1984 Throne Speech and Economic Statement, despite their separate ori- gins. By the early spring of 1985, Mulroney and his cab- inet had begun to rethink and refocus Canada’s trade policy. Important initiatives in areas such as export promotion, trade enhancement in the Pacific Rim, and export financing had been introduced. But the central role of US-Canada trade policy — and the Canadian options of functional trade, bilateral sectoral trade or comprehensive free trade — had become the basis of the government- industry consultations exercise launched in January 1985.

To the surprise of the International Trade Minister, James Kelleher, his department and indeed the entire cab- inet, the consultations exercise pro- duced an overwhelming consensus in the Canadian business community to push for a bilateral trade agreement — the cause, lest it be misunderstood, of the Liberal defeat on trade reciprocity in 1911. This time, the Canadian pri- vate sector and many supporters among labour, academe, and some provinces, moulded a constituency for a free trade agreement with the US. The Prime Minister seized the initia- tive and announced the launch of the US-Canada free trade initiative on September 26, 1985.

Canada’s detailed preparations for the actual negotiations — including the monitoring work of a special cabinet committee, 15 separate sector trade advisory groups and an umbrella advisory committee of private sector personnel — all strengthened the gov- ernment’s hand for specific negotiat- ing issues. Joe Clark was placed in charge of the special cabinet commit- tee, which could draw on external and internal advice, including from the main negotiator, Simon Reisman. At the start, the aim was to reduce the political pressures for exemptions by placing all issues on the bargaining table, including cultural issues and investment subsidies. The negotiators on both sides of the table soon recog- nized what the political masters were only too quick to underscore: threat- ened industries, after all, are not only job-intensive, they are vote-intensive.

In a perfect world, for small coun- tries like Canada negotiating bilateral free trade agreements with the biggest economy in the world, all instruments of government need a central focus. Unfortunately, in the practical world, other factors are at work. The Mulroney government faced these practical issues on a daily basis.

The huge majority and the largest cabinet in Canadian history led to a succession of scandals, and six minis- ters resigned in the first four years. The government initiated a new constitu- tional accord, the Meech Lake agree- ment, which on its own caused political discord among significant stakeholders. Constant budget deficits, amounting to $30 billion a year, and rising national debt angered conserva- tive deficit hawks. Media foreplay by the trade negotiators, and some unfor- tunate media comments by Simon Reisman, angered many senior cabinet ministers. And many members of the Conservative caucus, worried by what a trade agreement might mean for industries in their local riding, placed significant time burdens on the Prime Minister and the PMO.

Three time lines were in fact well underway, and each had only some over-lapping personnel to coordinate Canadian responses within the govern- ment. The first, of course, was the nego- tiating time period, where both Reagan and Mulroney were totally committed. For Ronald Reagan, who wanted a signif- icant defence agreement with Mikhail Gorbachev and the Soviet government before his term expired, a failure to sign a deal with Canada was not a preferred option. And Mulroney needed a deal for the pending 1988 election. The second time line was the 1988 election, and Mulroney’s desire to win an unprece- dented, successive two-term majority government, forgoing the disastrous 1962 election when John Diefenbaker not only lost his majority but most of French Canada, including Quebec. The third time line was to implement an enormous policy agenda, and supportive policy to trade adjustments in such areas as science and technology, regional eco- nomic agencies, small business and training, while keeping Conservative caucus MPs supporting the FTA.

In the end, the 1988 election was a pivotal turning point for the Canadian economy. Mulroney won 170 seats out of an enlarged House of Commons, and carried all of Alberta’s 26 seats, and most of Quebec, 63 of 75. Predictably, the six cabinet ministers who lost their seats came from regions which thought they would be eco- nomically vulnerable to trade competi- tion and loss of local jobs. Ironically, however, close analysis of these regions show that other factors were at work. A main factor was that an FTA would lead to the potential abandon- ment of Canada’s medicare program and that pushed traditional supporters to vote against the Conservatives.

Virtually all the shibboleths against free trade turned out to be illu- sory. Despite plant closures, as firms rationalized their production runs, expanded production to meet new markets and introduced powerful new technologies, trade expansion, job cre- ation and trade growth reached unprecedented lev- els, doubling every eight years. Canada’s biggest provincial economy, Ontario, overtook Michigan as the biggest auto and truck producer.

It is the largest information and communication technologies (ICT) sec- tor in Canada, and the world’s third biggest, rivalled only by New York and Silicon Valley in California. Canada’s smallest province, Prince Edward Island, where all Conservative members lost their seats in 1988, has unprece- dented export growth, high-tech job creation and new business formations in aerospace and biotechnology, thanks to supportive policies like the fixed link (the Confederation Bridge), new airport facilities and R&D science policies.

More to the point, now that the FTA and NAFTA are firmly in place, it is difficult to find significant political leaders who opposed the FTA policy in 1988 still in agreement with that posi- tion today. Brian Mulroney might take comfort in the words of Winston Churchill: “To improve is to change; to be perfect is to change often.”