Scenarios for the U.S.-Canada Economic Relationship
The United States and Canada have enjoyed a long and fruitful relationship that dates back more than 150 years and has grown to encompass deep economic, cultural, and political ties. Side by side, our countries prevailed in both world wars and the Cold War, and with the triumph of the West at the dawn of the 1990s, unprecedented steps were taken to thin our common border and integrate our economies. The 21st century was to be one of economic liberalism, and the U.S.-Canada relationship was to exemplify all that free markets and free trade have to offer.
Earlier steps toward economic integration were always understood to be part of a one-way trip, but that assumption is now being challenged. In the United States, President Trump has maintained his popularity in part by tapping into a deeply rooted suspicion of free trade held by parts of the electorate. That wariness is not entirely unfair, as the benefits and costs of globalization have not been shared equally. Unfortunately, the U.S. administration has also embraced the unorthodox notion that trade is often zero-sum in nature, and that running a trade deficit means you’re losing (or even being preyed upon).
The argument for free trade does not need to be re-litigated here in any depth. Trade permits greater specialization and unleashes economies of scale, and thereby lowers production costs and lifts living standards. It is a positive sum undertaking. It would be counterproductive to erect trade barriers between states, provinces, cities, or neighbourhoods; they are equally illogical between friendly and like-minded nations. Large and persistent trade deficits can sometimes reflect underlying economic imbalances and therefore bear monitoring, but to focus only on the balance of trade is to miss the point.
Exactly where U.S. trade policy will land, and how trading partners will respond, is still highly uncertain. Over the past nine months, the administration has increased tariffs against virtually all trading partners and the levies continue to evolve week by week. In a welcome move toward stability, the U.S. has negotiated tentative agreements with some of its largest overseas trading partners—however, the deals have yet to be ratified and have been largely one-sided, which casts doubt on their durability. The outlook is further clouded now that many U.S. tariffs are in limbo before the courts.
Canada, after initially finding itself squarely in the administration’s crosshairs, has avoided across-the-board tariffs for the time being. However, the situation remains fluid and North American trading arrangements will return to the fore with the joint review of the USMCA/CUSMA, which must be held by July 2026 (we’ll use “USMCA” in this report). The review process will give all sides an opportunity to air grievances, demand changes, and posture. A constructive outcome would help assure businesses and investors that the North American economic project remains intact; a bad one could upend continental trade and the economy.
This report identifies several possible paths forward for the U.S.-Canada trading relationship and considers their potential economic impact on both sides of the border. We find that even in an optimistic case, the damage already done to cross-border goodwill and confidence will impede business investment and growth for some time. At the other end of the spectrum, a large increase in tariffs would virtually assure a significant economic downturn in Canada, and, while the impact in the U.S. would be less dire, it would add to other headwinds. Regional and industry effects would vary widely, with some sectors faring relatively well and others coming under existential pressure. However, neither markets nor policymakers would stand idly by. Exchange rate adjustments, easier monetary policy, potential fiscal stimulus, and (in Canada) trade policy reorientation would help to soften the blow.
Before diving into the scenarios, we survey the history of the U.S.-Canada economic relationship, take stock of recent events, and put the upcoming USMCA review into context. To close, we peer above the current fray and consider areas for greater cooperation in the future.
A Brief History of Trade Across 49°
The U.S. and Canada have long had a special economic partnership, albeit with some ups and downs over time. Economic ties stretch back to the formative years of our countries. In the mid-19th century, with the War of 1812 a distant memory and the western border ironed out a decade earlier, the U.S. and British North America (as Canada was then known) negotiated the Reciprocity Treaty of 1854, which lowered tariffs on natural resource products. The agreement lasted little more than a decade, but reciprocity (i.e., free trade) continued to be pursued in fits and starts by advocates on both sides. Unfortunately, it would take the better part of a century to regain traction.
In the early 1900s, the U.S. increasingly opened itself to international trade as it stepped into its new role as the world’s largest economy. By the turn of the century, U.S. trade already amounted to more than 10% of GDP (Figure 1). However, it flowed primarily across the Atlantic, and Europe became a crucial outlet for rapidly growing U.S. industrial output, accounting for three-quarters of U.S. exports and more than half of imports. Canada, with its much smaller economy, accounted for just over 5% of U.S. trade. With much to gain, the possibility of bilateral free trade became a central issue in the 1911 Canadian federal election, but lost the day due to concern about potential U.S. dominance. Two decades later, the Great Depression brought sharply higher tariffs on both sides of the border, with Congress enacting the infamous Smoot-Hawley Act and Canada retaliating in kind (Figure 2).
The economic relationship warmed as the world exited the Depression, fought World War II, and entered the post-War era. Commercial trade between the U.S. and Europe had collapsed during the war and remained weak in its aftermath, despite efforts to rebuild the continent. Meanwhile, the North American economy roared ahead, physically undamaged and in the midst of an unprecedented baby boom. With the U.S. consumer now the world’s most important engine of growth, trade became a less important part of the country’s economic fabric. However, Canada was able to secure a larger piece of that pie. Less wary of its southern neighbour, its share of U.S. trade jumped to more than 20% of the total.
Decades of rapid globalization followed, spurred in part by the ever-present tensions of the Cold War. For the U.S. and Canada, close cooperation on security in the north made tighter economic ties feel natural and the two countries began to put major bilateral deals to paper (Figure 3). Trade expanded elsewhere, too. A reimagined Japan underwent its economic miracle and embraced globalization wholeheartedly. The East Asian tigers did the same. Western Europe experimented first with economic and then political union, later to be joined by a host of former Soviet Bloc members. With the U.S. at the economic centre of it all, trade more than tripled as a share of its economy by the turn of the millennium. Canada, with its newly minted trade deals, was able to ride that wave.
The first major bilateral trade agreement between the U.S. and Canada was the Auto Pact, signed in 1965, which integrated vehicle production between the two countries. After a devastating recession in the early 1980s, the Canadian government sought ways to strengthen the economy and all signs pointed south. Negotiations on a comprehensive free trade deal began in 1986, and the two sides announced the Canada-U.S. Free Trade Agreement (CUSFTA) little over a year later. However, the possibility of free trade remained controversial across much of Canada and the deal was ratified only after a highly contentious federal election in 1988. The push for an expanded deal including Mexico began in the early 1990s. The idea of a trilateral deal proved politically divisive in the U.S., but the three amigos eventually signed the North American Free Trade Agreement (NAFTA), which took effect in 1994.
The early 2000s were in some ways a high-water mark for economic liberalism and U.S.-Canada trade. Since then, U.S. merchandise trade has declined slightly as a share of the economy, though services trade has done somewhat better. Canada has also had a tougher go in the U.S. market. Its share of U.S. trade has declined by around one-quarter amid inroads by China, Mexico, and others. In part, these developments are flip sides of the same coin. As emerging-market producers became more competitive, the resulting pressure on the U.S. manufacturing sector affected its demand for natural resources and other Canadian inputs. Both countries have to some extent pivoted toward the Pacific.
The decline of U.S. manufacturing employment, and the resulting social impact, were key factors behind President Trump’s rise to power in 2016. In reality, the long-term slide in manufacturing employment has been more rooted in technological advancement than overseas competition; since the turn of the century, real manufacturing output has been little changed despite the sector shedding around 5 million jobs. Still, overseas competitors have not always played fair. China’s ascent was partly driven by welcome market reforms beginning in the 1980s, but it also engaged in blatant mercantilism in its pursuit of export-led growth, and it has never been alone in its use of such tactics. With this backdrop, it was easy to blame foreign trade for many of America’s woes.
The U.S.-Canada relationship was bruised, but not broken, during the first Trump administration. At the time, the President denounced NAFTA as “one of the worst trade deals ever” and warned that he would withdraw from the pact. In 2018, he imposed tariffs on imports of Canadian steel and aluminum on national security grounds. Nevertheless, the two sides (and Mexico) eventually came to the table and negotiated a successor deal, the U.S.-Mexico-Canada agreement (USMCA), which entered into force in 2020.
USMCA negotiations were at times acrimonious, but produced a fairly balanced deal that retained free trade as a core principle. For its efforts, the U.S. obtained tighter country-of-origin rules in the auto space, stricter intellectual property protections, higher de minimis limits, and greater access to the Canadian dairy and poultry markets. In exchange, Canada was able to retain aspects of NAFTA that it viewed as critical, including the dispute resolution mechanism for countervailing and anti-dumping duties, protections for cultural industries, and its supply management system. The USMCA handed the Trump administration an important symbolic victory and was heralded by the President as “truly historic”, but if you squint, it ended up looking a lot like NAFTA. Most ominously, the U.S. sought and obtained a review and sunset mechanism, which is now returning to the fore.
It’s difficult to overstate the degree of economic integration between the U.S. and Canada (Figure 4), even as trade has gravitated East over the past two decades. Of course, the relationship remains far from symmetrical. Canada famously relies on the U.S. as a destination for about 75% of its merchandise exports, equivalent to 19% of GDP in 2024. Factoring in exports of services like travel, transportation, and commercial services puts total exports to the United States at 23% of Canadian GDP. In the other direction, Canada is the largest single-country market for U.S. merchandise exports, but the immensity of the U.S. economy and its greater diversification leaves northbound shipments at a comparatively modest 1.2% of U.S. GDP. Even counting services, exports to Canada amount to only 1.5% of U.S. GDP. It goes without saying that Canada has far more at stake in any cross-border economic dispute, though many U.S. states and industries have plenty of skin in the game.
Nor are economic linkages confined to trade; cross border investment is also significant. At the end of 2024, U.S. investors had Canadian asset holdings equivalent to US$2.5 trillion, or around 9% of GDP, with concentrations in direct investment, debt securities (including Government of Canada bonds), and deposits (Figure 5). In the other direction, Canadian investors held an estimated US$2.7 trillion in U.S. assets, equivalent to almost 120% of GDP and concentrated in similar types of holdings. Moreover, these numbers represent only book value estimates; the data on market value holdings is limited but suggest that cross-border investment could be perhaps twice as large at current prices. Canada’s relatively larger net investment position in the U.S., which amounts to roughly US$170 billion, is the flip side of the moderate bilateral trade imbalance between the two countries over the past few decades. Although Canada has exported more goods to the U.S. than the other way around, the U.S. has sold more financial assets to Canada.
To read the full special report as it published by BMO Economics, click here.