Fraser Forum

Turmoil in Washington may have immediate consequences for Canada

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This week, Gary Cohn, President Trump’s top economic advisor, resigned, allegedly because he disagreed with the president’s plan for tariffs on imported steel and aluminum.

After the tariffs announcement, several Republican politicians and senior advisors (including Cohn) sought to persuade the president to abandon his plan. Unsurprisingly, the criticism from within his own party and from some of his advisors merely strengthened Trump’s conviction to impose the tariffs. Indeed, the day before the announcement of Cohn’s resignation, the president vowed to not back-off on his plan. Then he announced Thursday that he’ll exempt Canada and Mexico from steel and aluminum tariffs, but said he may change his mind depending on how the ongoing NAFTA talks pan out.

In this era of fast-breaking news from Washington, Cohn’s resignation may not immediately interest Canadians, but it should. It means that Trump’s mercantilist trade advisors are now fully ascendant in the White House hierarchy. They include trade representative Robert Lighthizer, Commerce Secretary Wilbur Ross and senior trade advisor Peter Navarro. Neither man is favourably disposed towards free trade. And all share the belief that America’s trade partners engage in unfair practices that generally make trade a losing proposition for the United States. Cohn stood as a defender of free trade against this triumvirate, and his departure is a serious matter for bilateral relations going forward.

One obvious implication of Cohn’s resignation is that a successful renegotiation of NAFTA has become less likely. A second implication, which is perhaps of more immediate concern, is that competent policy advisors seemingly find it difficult to work with President Trump. There’s a growing and widespread perception that the U.S. administration is in chaos with important policy decisions being made on an ad hoc basis depending on the president’s mood and who is in favour or disfavour with him.

Again, why should Canadians care?

Because there’s substantial evidence that political uncertainty discourages physical capital investment. Investors move away from risky long-term assets to assets with more predictable returns and shorter time horizons, most notably government bonds. Since the U.S. government debt market is relatively large and liquid, it acts as a “safe haven” for international investors in periods of political uncertainty. This means that the international demand for U.S. dollars increases to finance purchases of U.S. government securities. The corollary is that the U.S. dollar appreciated against foreign currencies, including the Canadian dollar.

As recently as Feb. 2, the Canada-U.S. exchange rate was US$1.0000 = C$1.2380. On March 7, the exchange rate was US$1.0000 = C$1.2977. This represents almost a 5 per cent decline in the value of the Canadian dollar on an annualized basis. Since the U.S. accounts for about two-thirds of Canada’s imports, the appreciation of the U.S. dollar will have a significant impact on Canada’s rate of inflation.

If the depreciation of the Canadian dollar continues, as seems likely—especially if the prospects for a successful conclusion to NAFTA become more distant—the Bank of Canada will face a wicked dilemma: allow domestic inflation to rise beyond the target rate or increase interest rates to protect the value of the Canadian dollar. Neither is a good outcome for the Canadian economy.

Sadly, Canadians will pay a price for U.S. political chaos.