The 51st State Playbook

A Canadian user's guide to the new president

It’s hard to overstate how much of the Canadian economy relies on trade with the United States, with the country accounting for over 75% of our exports. And so it’s no surprise that Donald Trump’s tariff threats are causing a great amount of stress for investors north of the border. It’s hard to imagine a more unpopular person in Canada than The Donald, and I’m absolutely going to infuriate a good chunk of my readers with this article (apologies for the triggering title, I thought it was funny). So the usual disclaimers apply even more than usual. This is just my opinion, and probably a very unpopular one at that.

Kneejerk nationalism and “buy Canadian” campaigns are the instinctive reactions, but neither will solve the fundamental problem. If Canada is facing a crisis right now, it’s a crisis largely of our own making, having watched our productivity decline for decades, and yet still failing to address the core issues impacting our global competitiveness. The world has changed in some fundamental and lasting ways, and this will require us to abandon fundamental beliefs that no longer serve us.

Back to Trump. A friend introduced me to this paper by Stephen Miran (Trump’s nominee for Chairman of the Council of Economic Advisors) back in November. I’ve referred to it many times while trying to figure out what’s going to happen in the coming months and years, and how it might change the investment landscape. This week the paper hit the mainstream, and I’m seeing it referenced daily in the financial press.

Based on my interpretation of Miran’s paper, below are my thoughts on what the new world of trade means for us, from a Canadian vantage point.

My conclusion: tariffs are coming. Threats of 25% across the board on day 1 are not likely to come true, but rather get ready for a slow and steady rollout. I think we will see some tariffs come into force on March 1, because after the postponement on February 1, Trump needs to show that he means business. Miran’s paper tells us unequivocally that these are not empty threats.

Everyone seems to acknowledge that tariffs are bad for business, but the American plan is to offset the burden being placed on exporters through a program of aggressive deregulation and tax cuts. They are uniquely positioned to execute this playbook.

A master troll at work.

The paper is a pretty dense 40 pages, so I picked out the highlights.

The role of tariffs

Tariffs provide revenue, and if offset by currency adjustments, present minimal inflationary or otherwise adverse side effects, consistent with the experience in 2018-2019. While currency offset can inhibit adjustments to trade flows, it suggests that tariffs are ultimately financed by the tariffed nation, whose real purchasing power and wealth decline, and that the revenue raised improves burden sharing for reserve asset provision.

Tariffs aren't only about trade, but also about the "return of national security threats."

If you have no supply chains with which to produce weapons and defense systems, you have no national security. As President Trump argued, “if you don’t have steel, you don’t have a country.”

Indeed, while there is widespread consensus that free trade is an economic ideal¹ (based on Adam’s Smiths theory of comparative advantage), the strongest case for tariffs comes from a national security perspective.

Why raise revenue through tariffs? Because they're so low.

The distortionary costs of taxation are convex, i.e. tax hikes are much more costly when starting from already-high rates. A one-point hike from 35% to 36% marginal tax rates is much more damaging to the economy than a one point hike from 2% to 3%. Costs are convex because the higher tax rates move, the more intensely households and firms adjust their behavior to avoid the tax burden.

Because marginal rates are already much higher on labor and capital income than they are on imports, the economic consequences of an increase in tariff rates might well be less problematic than an increase in income or corporate rates.

What of the US dollar?

The theory underpinning much of this paper is based on currency movements, and the unique position of the USD as a global reserve currency.

Because America provides reserve assets to the world, there is demand for U.S. dollars (USD) and U.S. Treasury securities (USTs) that is not rooted in balancing trade or in optimizing risk-adjusted returns.

This is described as a "Triffin world," after the economist Robert Triffin.

In Triffin world, reserve assets are a form of global money supply, and demand for them is a function of global trade and savings, not the domestic trade balance or return characteristics of the reserve nation.

The usual currency adjustments in response to trade surpluses or deficits don't apply to the US. Rather,

As the United States shrinks relative to global GDP, the current account or fiscal deficit it must run to fund global trade and savings pools grows larger as a share of the domestic economy.

Further down the road, a "Mar-a-Lago" accord will be likely to bring the USD back down to ease currency pressures:

recall that President Trump views tariffs as generating negotiating leverage for making deals. It is easier to imagine that after a series of punitive tariffs, trading partners like Europe and China become more receptive to some manner of currency accord in exchange for a reduction of tariffs.

One of the outcomes outlined by Miran is "a structural increase in implied volatility in currency markets." I think this explains the current rally in gold, even as the USD climbs.

What about inflation?

Is Miran worried about tariffs leading to inflation? Based on the experience with Chinese tariffs from 2018-19, nope.

the Chinese renminbi depreciated against the dollar over this period by 13.7%, so that the after-tariff USD import price rose by 4.1%. In other words, the currency move offset more than three-fourths of the tariff, explaining the negligible upward pressure on inflation. Measured from currency peak to trough (who knows exactly when the market begins to price in news?), the move in the currency was 15%, suggesting even more offset.

So, it's expected that appreciation in the USD will offset the majority of the tariff effect for domestic producers. The negative impact on exporters can be at least partially addressed through aggressive deregulation.

Thus there is a tradeoff: if currencies perfectly adjust, the U.S. government collects revenue in a noninflationary way paid by foreigners via reduced purchasing power, but exports may become encumbered.

Policymakers can in part alleviate any drag on exports by an aggressive deregulatory agenda, which helps make U.S. production more competitive.

So what’s the playbook?

The paper includes a clue about how the tariffs will be implemented:

President Trump, and those likely to staff his economic policy team, have a history of caring deeply about financial markets and citing the stock market as evidence of economic strength and the popularity of his policies. A second Trump Administration is likely therefore take steps to ensure large structural changes to the international tax code occur in ways that are minimally disruptive to markets and the economy.

The paper suggests graduated implementation as one of these ways, which is why I expect to see only targeted tariffs against Canada and Mexico come March 1.

We all know that Trump uses the stock market as a scorecard, and I’m sure that at least partially explains why indices remain near record highs, even as tariffs are being implemented.

President Trump has shown repeated concern for the health of financial markets throughout his Administration. That concern is fundamental to his view of economic policy and the success of his presidency. I therefore expect that policy will proceed in a gradual way that attempts to minimize any unwanted market consequences of efforts to improve burden sharing for provision of reserve assets and the defense umbrella.

If retaliatory tariffs are implemented, the US has the economic strength to win any trade war:

Retaliatory tariffs impose additional costs on America and run the risk of tit-for-tat escalations in excess of optimal tariffs that lead to a breakdown in global trade. Retaliatory tariffs by other nations can nullify the welfare benefits of tariffs for the U.S. Thus, preventing retaliation will be of great importance.

Because the United States is a large source of consumer demand for the world with robust capital markets, it can withstand tit-for-tat escalation more easily than other nations and is likelier to win a game of chicken.

This is bad news for Canada, and for Canadians who believe that they can win a trade war based on patriotic sloganeering and choosing the right brand of ketchup. Worse, with an election coming up this year, God help the politician who tells the truth… that we indeed can’t win a trade war against the US and should get to work negotiating concessions rather than needlessly prolong the inevitable Canadian recession.

The ultimate end game

A much stronger demarcation between friend, foe and neutral trading partner. Friends are inside the security and economic umbrella, but there is more burden sharing.

I’m quite optimistic longer term, because Canada is a natural friend of the US - geographically and culturally. It's a mutually beneficial relationship, and ultimately it would take mismanagement of epic proportions for us to land outside of the friend circle. But it will require a pragmatic approach from our leaders, not just rah-rah nationalism and the promise to "fight back." Ultimately, we should expect Canadian defense spending to rise significantly, and there is a real risk that protected industries (dairy, telecom, banking, etc) could be exposed to US competition. Bad for entrenched oligopolic interests, but great for consumers.

This isn’t the disaster that many Canadians believe it is. In fact, we are already finally seriously discussing a reduction of provincial trade barriers and overregulation that have stifled business growth for far too long. Hopefully the next step will be to take a more pragmatic approach to a highly politicized anti-business “climate change” agenda that makes little sense for a resource-rich country that accounts for less than 1.5% of global carbon emissions.

Call me an optimist. It is my hope and belief that one day we will be thanking President Trump for ending the era of Canadian complacency.

1. I have a long enough memory to recall the political left in Canada railing against free trade back when NAFTA was first negotiated in the 1980s, and I find it amusing that today they are very upset about the prospect of returning to a pre-free trade world.