Relations between the Canadian and U.S. governments are probably more strained than at any time in living memory. The difficulties are not of the same order of magnitude as those between decidedly competitive or unfriendly neighbors, but they are enough to make uncomfortable a relationship which for at least three decades had been presumed to be, and was in fact, almost ideal. During that period, and indeed generally going back much further, both countries assumed their interests seldom differed significantly in either multilateral diplomacy or in matters related to North America; with this assumption, whatever differences arose were handled with discretion and forbearance.

In recent years this situation has changed progressively. Troublesome issues have arisen, and more important, the general tone of the relationship has declined. As Canadians see it, not only are their interests no longer presumptively the same as those of the United States, but in fact the two countries differ about as often as other pairs of friendly but independent neighbors. Canadians have long felt frustrated at the unequal position of a nation of 20 million people living alongside a neighbor of 200 million; now that frustration, with much else, finds expression in a newly vocal and substantial anti-Americanism among some elements of Canadian society.

A few of the problems are, of course, primarily political in nature.1 But the dominant ones, those above all that touch the Canadian people widely and concretely, are in the economic sphere. After all (though President Nixon managed momentarily to forget it on one occasion in 1971), Canada has been for some time the largest trading partner of the United States, taking 25 percent of U.S. exports, or more than our next three largest single customers combined.2 The other way around, the United States represents about 70 percent of Canadian foreign trade, which means that almost 15 percent of Canada's GNP is sold here. Add the long history of large capital flows between the two, and it is plain why trade and financial issues have always been at the center of U.S.-Canadian relations.

Today, differences over international monetary arrangements and trade restrictions present short-term problems. But overshadowing these are two far graver matters: the role of American investment in Canada and Canada's emerging effort to change the basic structure of her economy. Both of these issues grow out of a strong and growing Canadian desire to become more independent of the United States; the question is whether much greater Canadian economic independence is attainable, or whether instead unsuccessful Canadian efforts in this direction will merely produce resentment of the United States and a continued worsening of U.S.-Canadian relations.

II

In the field of international finance, Canada has pursued an independent line for some time, having experimented with flexible exchange rates from 1950 to 1962 and then, in June 1970, returning to a floating rate. In a sense, Canada was the first rebel against the Bretton Woods system, and this role was a source of concern and friction in Washington as long as the United States remained a firm and ardent defender of fixed exchange rates. For years, academic economists used the Canadian experience of 1950-1962 to deny or at least question the constant argument of American and European officials that flexible rates must be unstable and hence disruptive of normal trade and capital flows. Canada survived and prospered without a parity, leaving American officials (and bankers) in the position of prohibitionists who proclaim the evils of demon rum only to see their tippling neighbor in rude good health.

Canada's gall in returning unilaterally to a float in 1970, with almost no warning and without at least suffering a serious exchange crisis first, was even more annoying to defenders of financial orthodoxy. U.S. officials reportedly put considerable pressure on Canada to return to a parity quickly, but Ottawa resisted successfully. Then, of course, the Bretton Woods system disintegrated in August 1971, and the further crises of 1972 and 1973 have now left almost all major currencies without operative parities. Events have vindicated the Canadian position that fixed exchange rates are crisis-prone and involve unacceptably high costs for those setting domestic economic policies in an open economy. But to professionals in Washington, it is no virtue to be right prematurely: it was bad enough for Canada to be a rebel; it is even worse for the rationale behind the rebellion to triumph.

But exchange rate issues rarely reach the people in a profound political way-and even Canada's onetime critics in Washington have not been deeply scarred by Ottawa's independent monetary line. Considerably more serious has been Canada's reaction to rapidly growing protectionist sentiment in the United States in general and to the temporary import surcharge of August 1971 in particular. For some time Canadians have been concerned about the growing congressional sentiment for protectionism-which has been strongly encouraged by the U.S. labor movement's belated recognition of the extent to which its interests are threatened by the past trend toward relatively free trade-but Ottawa has seen the executive branch in Washington as a bulwark against the new protectionism. To see the President devalue the dollar, suspend gold payments, and impose an import surcharge made August 1971 a "traumatic experience for Canada," in the words of a senior External Affairs official.

Although the surcharge was removed rather quickly, its shock effect remained, and ensuing trade negotiations with the United States were even worse. In these discussions, which were hardly noticed in the United States but received banner headlines in Canada, Secretary Connally took an especially blunt line with a succession of Canadian emissaries, arguing that the recent Canadian trade surplus with the United States was a major factor in the overall American balance-of-payments problem and must be eliminated-regardless of how it came about, how it related to shifts in the capital account, or any other factor. In effect, Canada was told to make unilateral trade concessions so as to adjust the trade balance in America's favor. "A johnconnally" has since become a generic term in Canada for everything that is obnoxious about the United States.

The U.S. demands were a large order, and not surprisingly the Canadians could and did resist stoutly. With a floating exchange rate, they argued, the level of the Canadian dollar was bound to adjust, both to keep any balance-of-payments problem to small proportions and to make unilateral concessions self-defeating: whatever American exports came in through the concessions would in the end be compensated by exchange-rate changes that would limit other American exports or balance them by increased Canadian exports.3 In short-a point that Mr. Connally and his associates never seemed to grasp in this unhappy period-bilateral deals were no answer to the problem of the dollar and the American balance-of-payments deficit. The American effort to apply a mercantilist approach to its biggest customer (along with others) was bound to fail.

In the end, the revaluation of currencies, especially the yen and the mark, helped the competitive position of Canadian industry, notably auto manufacturing. Nonetheless, American behavior seemed disruptive in Canadian eyes, leaving serious and widespread political scars and a lasting uneasiness about future trade relations with the United States. As Canadians see it, the United States acted in 1971 and 1972 in a way that they might have expected from France or even the United Kingdom, but not from America.

Yet, in its narrow sense, Canadian concern over American trade policy is now less than it was in 1971-72. Canadians hope that the Burke-Hartke Bill has now been laid to rest, although it makes them nervous that President Nixon's trade bill would still give the President discretion to restrict imports unilaterally on a variety of grounds, including unacceptable injury to a domestic industry. If, as now appears likely, the progressive devaluation of the American dollar brings marked improvement in the American balance of payments, protectionism in Washington (at either end of Pennsylvania Avenue) should recede somewhat. If at the same time the world monetary structure moves toward more flexibility, as also now seems likely, then the rifts on both trade and money between Canada and the United States may fade in the next year or so.

III

The issues of American investment and the structure of the Canadian economy are more serious and lasting. Both have been aggravated by the differences on trade and monetary policy. But their roots lie far deeper, resulting primarily from a rapidly growing feeling in Canada that the country ought to be far more independent of the United States, in every attainable way, than was ever thought desirable or even possible in the past.

For the blunt fact is that even friendly and reasonable coöperative arrangements with the United States are now seen by many Canadians as a certain route to American domination and hence as something to be avoided unless they are overwhelmingly to Canada's benefit. The attitudes through which Ottawa and Washington coöperated on a variety of issues in the past were often known collectively as "continentalism." This term and this view of the relationship are politically dead in Canada.

Thus, in a major statement in the fall of 1972, Minister for External Affairs Mitchell Sharp in effect announced that a basic goal of the Trudeau administration henceforth will be to reduce Canada's dependence on the United States. In a long and carefully reasoned article (International Perspectives, Autumn 1972), Mr. Sharp analyzed three options for future Canadian relations with the United States: (1) the maintenance of the status quo with no implied changes in major policies, (2) a conscious policy of furthering integration with the United States, and (3) an attempt to devise a wide range of policies which would reduce Canada's dependence on and vulnerability to the United States. The article concluded that what has become known as Option Three is to be the basis of Canadian policy. While this statement is not in itself a fundamental shift in Ottawa's attitudes, it acknowledges and intensifies the trend of the last few years.

There are a number of reasons for the desire among many Canadians to be as independent of the United States as possible. One is a rapidly growing Canadian self-awareness and nationalism. Whereas in the past Canadians often perceived themselves as residents of a rather small, underpopulated, rural and unprosperous country next to a political, economic and cultural giant, in recent years Canada's population and economy have grown somewhat more rapidly than those of the United States. With a population of over 20 million and a GNP of over $100 billion, Canada has a new sense of what might be called "critical mass" among the industrialized countries. Economic comparisons with the United States used to be commonly based on a ratio of 1:15. Now the statistical ratio is 1:12, and Canada's resource base and rapidly growing population mean that the Canadian economy ought to continue to grow significantly more rapidly than the American for the next decade or so. As these changing circumstances sink in, there is a rejection of the previous self-image and a desire to end that image once and for all.

Secondly, many Canadians have always felt that "continentalism," or the "continental partnership," was one-sided and that the United States received the vast majority of its benefits. As the junior partner, many Canadians have felt taken for granted and sometimes merely taken. Whether Canada was actually unfairly treated in the past is far from certain, but feelings are facts and the sense of being taken for granted surely has a substantial basis. Canadians are understandably tired of being viewed by Americans as rather dull, staid and unfailingly dependable neighbors-and completely fed up at being told by American visitors that we do not view them as foreigners because they are "just like us."

Finally, the last ten years of U.S. history have drastically changed the Canadian image of the United States. Vietnam, the urban crime wave, racial problems, Watergate and other unhappy developments have led many Canadians to wish that they could put considerable distance between themselves and the United States. When in the past Canadians resented the role of the United States in their economy and culture, these feelings were offset by admiration and even envy-for the rapid growth of the U.S. economy, for its apparently responsible and vital role in world affairs, for the dynamism of its cultural and political life. The last ten years have reduced if not destroyed these attitudes and made it considerably easier for the old resentments to come to the surface, occasionally as noisy outbursts of anti-Americanism. The nationalism described above, with its element of anti-Americanism, is most concentrated in urban Ontario, particularly in the media and academic communities. Those groups tend to be opinion leaders, however, so it is reasonable to expect their views to become more common throughout Canada.

On the U.S. side, most Americans, including those familiar with international affairs, are insufficiently aware of the extent to which the U.S.-Canadian relationship has changed, and might be more generally described as only dimly aware of Canada in any sense, both because it is so close and because it appears to be so utterly unexotic. In Washington, however, there is a feeling of annoyance toward Canada among some officials responsible for international economic policy, above all in the Treasury. To these officials, Canada seems to have been trying to have it both ways, to play the independent role of a sizable economic power when it suits her, but at the same time to come running for help and special consideration as a small neighbor when that is more advantageous. The prime examples of the latter are Canada's repeated (and until 1971 successful) appeals for exemption from American balance-of-payments measures, and the special auto pact of 1965-of which more hereafter.

Too often Canadian officials have described their country as "a mouse living next to an elephant," suggesting that the U.S. elephant ought to take great pains to avoid injuring the tiny Canadian mouse. Yet in the past it has been precisely this argument that has often lain behind instances of "continentalism." Now that this term has become anathema to Canadians, the elephant/mouse analogy ought to be retired as well. In any event, the mouse is now far too large and the elephant's life too hard for it to retain any appeal in Washington.

IV

In the framework of these Canadian feelings, the most important single economic issue is the dominant role of U.S. investors in the Canadian economy. About 57 percent of Canadian manufacturing is owned or controlled by foreigners, with 45 percent coming from the United States. Most major U.S. manufacturing firms have subsidiaries in Canada, and many important Canadian industries are little but extensions of U.S. industries. Outside of manufacturing, the role of U.S. investors is sometimes even more important. Foreign investors control about 75 percent of Canada's booming oil and gas industry, with about 60 percent coming from the United States. In the case of mining and smelting the figures are 65 percent and 56 percent.4

U.S. investors in Canada have become dominant in part by concentrating their efforts in rapidly growing sectors of the economy and by avoiding relatively stagnant industries such as utilities, textiles, shoes and basic steel. Not surprisingly, U.S. manufacturers attracted to Canada are disproportionately those with a great deal of intangible capital in the form of unique technical knowledge or brand loyalties and merchandising abilities. The advantage of intangible as opposed to real capital is that its use in a Canadian subsidiary does not reduce its availability to the U.S. parent. A relatively high Canadian tariff on finished-products has also encouraged many such U.S. firms to manufacture in Canada rather than export from U.S. plants. Another major source of U.S. direct investment funds has been vertically integrated firms seeking sources of raw materials which Canada has in abundance.5

There can be little question that, from an economic standpoint, foreign and especially American investment has had major economic advantages for Canada. First, foreign capital provides a sizable addition to Canadian GNP and hence to flows of income to Canadians. Although the net profits of these enterprises ultimately return to U.S. owners, large corporate tax payments remain behind. In addition, this capital not only provides jobs that might not otherwise be available, it also raises the wage rates paid throughout the Canadian labor market. Elementary price theory demonstrates that the productivity of labor, and hence the competitive wage rate, rises with the ratio of capital to labor. Put simply, the more capital each employee has to work with, the more productive that employee will be and the higher will be his likely wage rate. This is why workers of a given skill level typically earn more in highly automated industries than do those in industries using more labor-intensive methods. Since U.S. investors have provided a significant proportion of the Canadian capital stock, they have raised the Canadian wage rate. One econometric study of the role of foreign capital in Canada has concluded that the loss of this capital would reduce real wage rates by 17 percent.6 This relationship is reasonably obvious, but is ignored by some Canadian students of the foreign investment issue.

An additional benefit of foreign investors is that they often bring technology and hence potential productivity which would otherwise be unavailable in Canada. It is unlikely, for example, that Canada would have a significant computer industry if IBM were not there. The same probably applies to a number of other technologically oriented industries such as chemicals and consumer electronics. The foreign investor both brings technology for his own use and encourages (or compels) a climate in an industry in which domestic competitors become technologically more advanced. This occurs in part because technology escapes from the innovating firm to its competitors despite efforts to maintain secrecy.7

Finally, the foreign firm increases competitiveness and consequently encourages greater efficiency and lower prices throughout the affected industry.8 Given the relatively high Canadian tariff and the lack of a meaningful anti-combines (anti-trust) effort in Canada, an absence of U.S. firms would often leave domestic enterprises in a position to exploit highly uncompetitive situations. The potential effects on the efficiency and price structure of the Canadian economy are obvious.

Yet the other side of the coin is deeply real and important to Canadian nationalists. To overstate their case slightly, some Canadians feel like tenants in their own country. They are unhappy that so many decisions concerning the Canadian economy are made in New York, and they suspect that those corporate decisions are somehow biased toward the interests of the United States and against Canada. It seems more plausible that they are actually biased toward profit maximization, which has little or nothing to do with the particular national interests of either country. At least, extensive research by a number of scholars has found no hard evidence that U.S. firms are in fact poor corporate citizens or that their decisions are biased against Canadian interests.9 Whatever the reality, strong suspicions remain.

A more tangible grievance, at least until very recently, has been the extraterritorial application of U.S. laws and regulations to Canadian subsidiaries of U.S. firms, especially U.S. laws against sales to certain Communist countries. Although it is not clear that large or firm orders ever existed for deliveries to China and Cuba by such U.S.-owned companies, the mere threat of American sanctions was an affront to Canadian sovereignty. Now this has changed, at least with respect to China. The United States will sell almost anything to just about anyone with money to spend (if the Albanians and Cubans had any real cash, American relations with them would probably be considerably better), so the Trading With The Enemy Act has become largely a dead letter. But the U.S. government ought to be particularly careful to avoid either the reality or the appearance of interference with Canadian firms which happen to be U.S.-owned.

Still another argument against U.S. firms in Canada is that they encourage a truncated development of the economy by concentrating basic production in Canada, rather than research and development and other technologically sophisticated activities. Although there is no convincing evidence that U.S. firms carry on less research and development work than their domestically owned competitors, neither group does much of it, and the lack of a major research and development community in Canada (as in some other medium-sized countries) does tend to stunt some scientific areas. Pure economics may suggest that it does not matter a great deal where the research work is done if the results are made available to Canada at reasonable cost. Research and development are not ends in themselves, and new technology spreads rapidly through multinational firms irrespective of where the incentive work is done. Emotionally, however, it is understandable that Canadians want to encourage their own scientific community as an end in itself, and see the role of U.S. firms in the economy as a barrier to that goal.

Finally, some Canadians feel that the profits being sent back to U.S. owners of Canadian subsidiaries are excessive and leave Canada without any real benefits from the investments. Here it should be noted that the definition of an "excessive" profit is inherently subjective, and often appears to mean only a rate of return which happens to be earned by a foreigner. The actual rates of return on U.S. direct investments in Canada averaged 8.0 percent in the late 1960s, down from 10.7 percent in the early 1950s;10 these figures hardly seem outrageous in an era of 9 percent prime rates and 8.5 percent bond yields.

Such are the roots of Canadian concern over U.S. investment. Again, this concern has a clear regional flavor within Canada, being concentrated largely in urban and wealthy Ontario. The poorer and less-developed regions of Canada, such as the Maritime provinces and rural Quebec, are eager for capital and jobs from any source. The attitudes of the Ontario intellectual and media establishment have thus far found only limited support elsewhere in Canada and are particularly suspect in poor areas. However, the national broadcasting system, the largest Canadian newspaper, and the magazine with the largest circulation all support economic nationalism with some energy.

In summary, although the economic benefits to Canada of U.S. investment appear to be sizable, the emotional and political disadvantages of having such a high percentage of their economy owned by foreigners have led more and more Canadians to believe that the net benefits of foreign investment may be small or non-existent. Relative costs and benefits of foreign capital are impossible to measure with any precision, but it would probably be hard for most Canadians to imagine the state of their economy (and of their personal incomes) without the capital and technology which have flowed into the country from the United States and elsewhere. It seems unlikely that any but the most ardent Canadian nationalists would actually prefer an economy without the incomes derived from this capital. Canada would have full "independence" in such a situation, but might have relatively little else.

V

Yet if Canada has needed and benefited from net capital inflows in the past, it does not follow that similar future inflows are needed or that the direction of the flow could not be reversed within a few years. With Canadians determined to make a change, let us first look at what they might decide to do, and then consider whether an objective economic analysis might point to different policy directions-seeking the same results but by a sounder route.

For years there have been Canadian studies of the foreign investment issue, notably the Gordon Report of some years ago and the Gray Report of 1972. The consensus of these studies is that Canada must "do something" to reduce the threat of U.S. domination of the economy, but the unanswered question is "what?" Broadly speaking, the alternatives for Canada are to attempt to understand and then reverse the fundamental market forces which have encouraged massive capital inflows, or to use a variety of regulations and controls to reverse these capital flows while leaving the underlying market forces unchanged.

Many Canadians, especially fervent nationalists, currently favor the regulatory approach, and there is some evidence that the government is moving slowly in that direction. Thus far, however, it has merely adopted a policy of screening foreign takeovers of Canadian firms and the creation of new enterprises by existing foreign firms, to see to it that such investments do not occur unless a "significant benefit" to Canada exists. By forcing potential investors to show that their projects will increase employment and exports, spread research and development, or contribute to other Canadian goals, the screening process will operate to control behavior in ways not applicable to domestic firms. The screening of take-overs also discriminates against Canadian owners of businesses who want to sell at the best possible prices, and who will now typically be restricted to a far smaller pool of potential buyers. More important, however, this approach is a classic example of too little too late. U.S. investors are already dominant in much of the Canadian economy, and restricting entry by those few sizable U.S. firms which are not currently operating in Canada or restricting the creation of new enterprises by existing firms is not going to change that situation appreciably.

As this fact becomes apparent to Canadians, there is a chance that political pressures will develop for far more restrictive and discriminatory measures. Heavy taxes on dividend repatriation, corporate profits taxes which vary directly with the percentage of external corporate ownership, restrictions on the growth of foreign-owned firms (as were applied in the abrasive Mercantile Bank case of the mid-1960s) and a variety of more subtle techniques might be proposed to reduce the value of Canadian operations to U.S. owners and hence to "encourage" their sale at whatever prices were available. If Canadian frustrations over the role of U.S. firms in the economy reach a level at which the government is encouraged to adopt such an approach, the implications for U.S.-Canadian relations would be very unfortunate.

This unhappy result can be avoided if Canada will instead devise nondiscriminatory market-oriented policies to deal with the problem of adequate capital. This means first understanding the fundamental causes of Canada's past dependence on foreign funds, and then acting to deal with these causes. Such a program might be difficult and politically unattractive, but it would produce a more independent Canada without violating the legitimate interests of previous U.S. investors and hence necessarily involving the U.S. government.

There have been a number of reasons for the attractiveness of Canada to U.S. investors, including the previously mentioned opportunity to use intangible capital in another market and a Canadian tariff system which encourages U.S. firms to assemble products in Canada to take advantage of the lower tariff on parts and components. The major force in the capital flow, however, has been the combination of two factors: highly capital-intensive natural resource industries and limited Canadian savings available for domestic private investment. There is, for example, no labor-intensive way of using the hydroelectric potential of Churchill Falls or James Bay, or of moving natural gas from the Mackenzie Delta to markets in the south. Natural resource endowments which require a capital-intensive approach and the long distances over which communications and transportation systems have had to be developed have virtually guaranteed that the development of the Canadian economy would be significantly more capital-intensive than would be the case for a smaller, more densely populated country which lacked such endowments.

Given this inherent bias toward capital intensity in Canadian development, the Canadian savings rate has been inadequate-not necessarily low in absolute terms or by comparison with other economies of the same total size, but unquestionably low relative to Canada's needs for capital when the economy is fully employed. Thus, interest and profit rates have had to be high to attract foreign capital and to allocate scarce domestic capital resources.

To some extent, these features have been up to now inherent in the Canadian economic situation. Yet they have also been aggravated by major public policies that could be changed. The Canadian government sector has tended to maintain a decidedly expansionary fiscal stance even in periods of strong demand pressures and low unemployment, in that tax receipts have typically been insufficient to avoid sizable deficits at such times. Thus, the government sector both uses a large proportion of the economy's resources and makes heavy demands on the capital markets; in recent years borrowing by the various provinces has been particularly heavy. Put another way, fiscal policy remained relatively expansionary, thus putting the responsibility to counter inflation onto monetary controls. This helped to produce the high rates of return on capital which have attracted U.S. investors and lenders.

The answer to this problem is then fairly clear. Canada ought to consider a shift toward a more restrictive fiscal policy (higher taxes and/or lower government expenditures), along with a more expansionary monetary policy in periods of high employment. This would result in lower public deficits (or even a positive rate of public saving) and a sizable increase in the availability of domestic funds for Canadian private investments. It would also mean lower interest rates (and hence higher price/earnings ratios on equity shares of corporations) and would reduce or end the attractiveness of Canada f6r American investors and lenders. Lower rates of return on capital in Canada might even encourage U.S. firms to sell equity interests in their subsidiaries to Canadian residents. Alternatively, Canadian funds might be channeled by mutual funds into sizable minority holdings in the U.S. parent companies and these holdings could be used to secure Canadian representation on the boards of such firms.

The recent announcement by the Canadian Development Corporation (government-created and -funded but operationally independent) of an intention to purchase a controlling interest in the Texasgulf Corporation represents one route to Canadian ownership. Political and financial limitations on this type of government action suggest, however, that it is unlikely to represent more than a token effort. A more basic answer ought to include a shift in Canadian policies which would make capital funds available through a variety of private channels.

This solution is inherently difficult for Canada. Higher taxes and lower government expenditures are certain to be unpopular. It is a solution, however, which deals with the fundamental causes of Canada's problems rather than with symptoms.

Moreover, at this moment of dramatic international readjustment, such an approach might be both more hopeful and less painful than ever before. For Canadians could get a good deal of help in repatriating part of the ownership of their economy from the striking trend in the United States toward an expansionary fiscal policy and an offsetting tight monetary stance. That is, the United States has been moving toward the previous Canadian fiscal/monetary mix, and this may produce a reversal in the tide of capital flows with only modest efforts on the part of Ottawa. Although the borrowing needs of the American states are reportedly declining, the U.S. federal budget appears to be completely out of control. Large deficits have been run in recent years despite general prosperity and serious inflation, and the Fiscal 1973 deficit of about $14 billion in the midst of the worst inflation in the peacetime history of the economy would be considered an outrage by any sophomore economics student. The result has been that monetary policy has been the only restraining force in the economy, and the United States has had a sharp upward trend in interest rates for almost a decade, with yields which are now at historic highs and cannot be expected to decline significantly for some time.

This unhappy situation is making it very difficult for U.S. firms to raise long-term funds domestically, and they are likely to be encouraged to bring capital home from abroad. A rather modest shift in the Canadian mix of fiscal and monetary policy, enough to produce somewhat more buoyant Canadian capital markets, could easily encourage a number of U.S. firms to sell off their Canadian operations to raise funds for domestic investment needs.

Finally, steps could be taken to deal with a secondary reason for the large flows of long-term capital to Canada, namely the fact that Canadian capital markets do a rather imperfect job of intermediating between short-term lenders and long-term borrowers. Canadian savers apparently prefer relatively short-term and highly liquid assets, while the investment requirements of the economy stress long-term funds with a considerable element of risk. Canadian banks and other financial institutions have failed to bridge this gap fully, and the result has been a yield curve (or difference between short-term and long-term yield rates) which is considerably steeper than that prevailing in the United States, thus encouraging rather than discouraging a tendency to export short-term funds and import long-term debt and equity capital.11 Although it is not obvious how to shift Canadian savers' preferences toward longer term assets quickly, it ought to be possible to use the government's regulatory powers over banks and other financial institutions to affect their lending and investing patterns in a way which would flatten the yield curve somewhat. Alternatively, the various levels of Canadian government might shift their borrowing activities toward the shorter maturities, which would also tend to reduce the differential between long- and short-term yields.

VI

The final area of difficulty in U.S.-Canadian relations is of more recent vintage than the concern over American investment, though its roots are similar. Many Canadians have now come to argue that the government ought to devise an "industrial strategy" which would encourage secondary manufacturing in Canada and discourage the production and export of raw materials. Although the Canadian government has not yet adopted a general policy in this area, there are a number of indications of a halting and uncoördinated movement in this direction. First, a number of recent speeches by Canadian officials have stressed the great importance of a rapidly growing manufacturing sector, and have indicated an intention in Ottawa of encouraging such a result. Canada's strategy for the upcoming GATT negotiations, moreover, will apparently be aimed particularly at increasing export markets for manufactures rather than primary products. On the subject of primary product exports, Canada has recently put controls on oil exports, similar to those which have existed on natural gas for some time. In addition, recent tax reform measures will significantly reduce, but not eliminate, the depletion allowance system for the petroleum industry.

Eric Kierens, a strong and somewhat unorthodox Canadian nationalist, has argued for far more serious measures to discourage raw material exports than the Trudeau administration has been willing to accept thus far. Kierens resigned from the Trudeau cabinet over this issue and later wrote the Prime Minister a public letter presenting arguments against Canada's reliance on raw material production. Since Kierens supported the slightly leftist New Democrats in the 1972 election and the New Democrats currently hold the balance of power in a greatly weakened Trudeau government, his views may currently be taken somewhat more seriously in Ottawa.

It should be noted that as long as Canada maintains a truly flexible exchange rate, policies which discourage raw material exports automatically encourage manufacturing output, and vice versa. Significant reductions in Canadian exports of gas and oil, for example, would cause a depreciation of the Canadian dollar, which would improve the competitive position of Canadian manufacturers who compete with foreign products. This linkage is widely understood among Canadian proponents of an industrial strategy, and is particularly noticeable in Kierens' arguments.

There are a number of reasons for a Canadian desire to redirect the economy toward manufacturing and away from primary output, one of which is a fear of depleting irreplaceable mineral resources. Although it is not obvious that Canada actually faces shortages of oil, gas, or other important minerals, there is a widespread feeling that Canada ought not to export resources which may be needed at home in a few decades. The Canadian Minister of Energy, Mines and Resources, Donald Macdonald, recently put the case in a nutshell: "Sure, we're going to keep on being friendly, and we'll be as helpful as we can with their energy problems, but if anybody's lights are going to have to be turned out, why should it be ours?"

Second, there has been a longstanding bias among economists, politicians and others against farming and raw material production as the basis for a national economy. For some reason secondary manufacturing is widely associated with a strong and progressive national image, while farming and primary production are identified with national backwardness. Few countries apparently want to be "hewers of wood and drawers of water," even when the prices of "wood" and "water" are increasing rapidly. Why what goes on in grimy mill towns such as Gary, Indiana, is somehow more progressive and admirable than farming or producing lumber is far from clear, but this attitude is neither new nor restricted to Canadians.

The Canadian desire to encourage manufacturing also results in part from a desire to produce more jobs for a rapidly growing labor force. Many Canadians feel that primary production employs relatively few people and that manufacturing must be more labor-intensive; hence, a reduction in raw materials production which is offset by an equal increase in manufacturing output ought to increase employment.

The economics of this argument are open to question. It is far from clear that the production and processing of raw materials in fact produce fewer jobs than an equal amount of manufacturing. Unpublished studies done at the University of Toronto (with Imperial Oil support) suggest that where processing is allowed for, there is no reason to prefer manufacturing over primary production for employment purposes. More basically, the maintenance of an adequate level of employment is usually the responsibility of those managing fiscal and monetary policies. Canada's unemployment problems result in part from less than ideal demand-management policies and from a particular concentration of unemployment in the Maritimes and rural Quebec. Regional development policies would appear to be more relevant to the latter problem than the industrial strategy approach. Whatever the realities of the employment problem, however, many Canadians have concluded that it results at least in part from the dominant role of primary product industries that are presumed to be low in employment.

The final and perhaps most important argument for a Canadian industrial strategy is the previously discussed goal of reducing Canada's dependence on the United States. Canada's massive endowments of land, forests and mineral resources have combined with the law of comparative advantage to produce an economy which is complementary to the U.S. economy. Canada typically has a comparative advantage in raw materials, the United States in most manufactured products, and market forces have produced a huge flow of trade based on this pattern. The result is an extremely prosperous Canadian economy (particularly now that raw materials prices are increasing sharply), but also one that is closely integrated with and hence dependent on the United States.

The problem is that the market forces which produced the existing structure of the Canadian economy are also those which can be expected to maximize Canadian output and incomes. The usual presumption among economists is that market forces determine the industrial structure of an economy, and that if left undisturbed by government intervention the market will produce the mix of industries which most efficiently uses the country's particular resources. Foreign trade is important in this process because it allows an economy to specialize in producing those goods for which it is best suited and hence avoid wasting resources in industries in which it has a comparative disadvantage.

If a Canadian industrial strategy is pursued and if the economy is distorted significantly from a structure based on comparative advantage, the costs to Canadians in terms of reduced economic growth and lower real incomes may be large. While it is possible that many Canadians would be prepared to accept costs to reach their political goal, it is not clear that those pressing this strategy have made serious efforts to discover how high the costs might be. In particular, one hears little reference to the fact that an aggressive industrial strategy would primarily benefit urban Ontario and a few other small industrial regions, and that it would probably injure the western provinces which are heavily dependent on raw materials production and farming.

At first glance the determination of a Canadian industrial strategy would appear to be a purely internal matter and not the source of difficulties with the United States. However, the pattern of comparative advantage that provides major efficiency and income gains for Canada produces similar benefits for the United States, and this means that it is not in U.S. interests for the pattern to be significantly disturbed. The United States is in particular need of oil and gas imports at present, and discussions in Canada about discouraging the growth of the petroleum industry or further restricting exports to the United States are obviously not popular in Washington. If the Canadian restrictions on gas and oil exports are the result of actual reserve shortages, they can hardly be opposed in Washington. If they become part of an industrial strategy designed to fundamentally shift the pattern of U.S.-Canadian trade in order to restructure the Canadian economy, however, Washington would surely complain.

Similarly, Canada's desire to use foreign trade as a direct means of forcing the development of secondary manufacturing presents problems to the extent that Canada intends to replace manufactured goods coming from the United States with domestic output, or to export growing amounts of manufactures to the United States in competition with domestic products. If such a pattern grew out of natural market forces and changing patterns of comparative advantage, Washington might not be overjoyed, but there would be no reason to oppose Canadian policies. To the extent, however, that this pattern is encouraged by Canadian government policies which are designed to distort the economy and Canada's trade away from market-determined patterns, the United States is likely to be unhappy.

Two controversies in the past year have shown the depth of the problem. One concerns the history and present status of the U.S.-Canada auto pact of 1965, in which a tariff-free structure was created for large areas of automotive manufacturing on both sides of the border. Under side agreements entered into with the pact, U.S. manufacturers made substantial added investment in Canada, and auto production there has grown very greatly in the years since (as, of course, has production in the United States itself). Now the American side is concerned with the elimination of one area of remaining Canadian tariffs, while the Canadian side wishes to treat these added investments of the U.S. companies in Canada as in effect a guarantee for the future.

These issues need not be grave, as market forces would probably cause the American manufacturers to go on making a great many cars in Canada in almost any event. What has made the matter serious, however, is that the pact did operate to shift the balance of trade in automotive products as a whole heavily in Canada's direction, so that this category alone (not all covered by the pact, be it noted) accounted for a shift of over $1 billion a year when the overall trade balance became an acute issue in the late 1960s. To American officials, again especially in the Treasury, and to some Congressmen, this seems a prime case of favoritism to the "mouse." The experience has cast a shadow over future arrangements that could have similar effects.

In the other case, it is Canada that currently feels a grievance. Canada has a regional development program which is intended to encourage the location of new factories in high unemployment areas such as the Maritime Provinces, and this program was used to provide a subsidy to the Michelin tire company for the construction of a large tire factory in Nova Scotia. The resulting plant is far too large to operate solely for the Canadian market, and was obviously intended from the start to export heavily to the United States in competition with unsubsidized U.S. firms such as Goodyear and Firestone. Canada claims that this is merely a regional development subsidy and that its main effect is to shift employment from the rest of Canada to Nova Scotia. The U.S. view is that a clear export subsidy exists and that Michelin would therefore have an unfair advantage competing in the U.S. market. As a result the Department of the Treasury in 1972 imposed a countervailing tariff on tires from the Nova Scotia factory.

Understandably, this action has aroused anger in Canada. It is hard for an outsider to judge the complex factual question whether the special benefits accorded to Michelin simply offset the higher costs of manufacturing in Nova Scotia rather than Ontario, or are greater and thus a subsidy. Canada's effort to aid the depressed Maritimes is surely wholly in order, but the fact that almost any manufacturing enterprise will depend substantially on the American market means that regional development efforts cannot be separated from delicate trade issues involving Washington. Future attempts by the Canadian government to encourage secondary manufacturing, by whatever method, are almost certain to cause similar problems. The United States and Canada both have unemployment among the unskilled and semi-skilled, and Washington is not likely to accept Canadian policies which would shift manufacturing employment of such people to the north. This kind of policy might have been accepted or at least endured when Canada was a small economy with an even smaller manufacturing sector, and when the United States was confident about its strong competitive economy. Neither of these circumstances exists at present.

In sum, if Canada persists in the desire to reduce the relative share of raw material exports and increase that of manufacturing, its actions will run head on into the overwhelming interdependence of the Canadian and American economies. There are almost sure to be further painful episodes and disagreements before a new balance emerges.

VII

Since the problems in the U.S.-Canadian economic relationship are fairly basic and hence not amenable to quick diplomatic or other solutions, it is useful to ask in conclusion how the two countries can minimize the difficulties of what must remain a sensitive period.

To the south, Americans ought to recognize Canada's goal of greater independence from this country, and avoid actions or statements which imply a relationship which no longer exists. The two are distinctly separate societies, economies and political entities, and remarks about the "13th Federal Reserve District" or about "continental" arrangements both annoy Canadians and encourage their less kind views of us. The situation in which Canada was a loyal and polite junior partner in North America was undoubtedly pleasant for the United States, but it is over, and relations between the two countries would be improved if Americans more often spoke and acted with that fact clearly in mind.

On the northern side of the border, it would be helpful if there were an increased realization that Canada's difficulties in becoming more independent are not primarily America's fault. To blame the United States for Canada's problems is undoubtedly emotionally satisfying, but fails to solve the problems and even threatens to worsen bilateral ties that matter a great deal. We did not force Canada to accept U.S. capital; Canada instead often complained loudly whenever attempts were made in Washington to reduce the flow of U.S. funds to the north. Nor did Americans compel Canada to sell raw materials and semi-finished products here; the history of the trade relationship is instead one of considerable Canadian efforts to gain increased access to these markets, often to the considerable pain of competing U.S. producers. Both causes and solutions to Canada's problems lie primarily to the north.

In a broader context, the problems of the Canadian economy can be seen as part of larger changes in world economic patterns. Canada has become heavily dependent on the United States, in part as a result of the decline of the United Kingdom as an alternative. The U.K.'s entry into the European Community represents the final end of whatever parental role London played for Canada, and undoubtedly leaves Ottawa feeling a bit lonely. An apparently inward-looking Europe probably holds little promise for Canada as a source of markets or capital, and developing trade relations with Japan are almost certain to repeat the pattern in which Canada exports raw materials in exchange for secondary manufactures. Given the increasing lack of attractive alternatives, it would be surprising if Canada did not feel a little trapped.

Yet Canadians should realize that Americans too feel trapped and troubled, and indeed face basically similar problems with both Europe and Japan. Perhaps, then, one should conclude on the note that both countries are in the same boat-and that it will not help to hit each other with the oars.

Footnotes

1 See John Sloan Dickey, "Canada Independent," Foreign Affairs, July 1972, for a discussion of underlying Canadian feelings and central political issues.

2 According to the U.S. Department of Commerce, 1972 U.S. exports to Canada totaled $12.4 billion, compared to $4.9 billion to Japan, $2.8 billion to West Germany, and $2.7 billion to the United Kingdom.

3 In 1970-71, the Canadian currency was not in fact wholly flexible, as the float was then being controlled by the Bank of Canada by dollar purchases to prevent the rate from rising too fast. Thus, Canada did maintain a balance-of-payments surplus at this time. Since 1972, the Canadian dollar has been allowed to find its own level without significant intervention.

7 See Harry G. Johnson, "The Efficiency and Welfare Implications of the International Corporation" in Charles P. Kindleberger, ed., The International Corporation, Cambridge: MIT Press, 1970.

9 Safarian, op. cit., p. 423.

10 Safarian, op. cit., p. 421.

11 Two speeches by Andrew Brimmer, a member of the Board of Governors of the Federal Reserve System, deal with this subject. See "United States-Canadian Balance of Payments: Prospects and Opportunities," given in Montreal on September 28, 1970, and "Structural Changes in the Canadian-American Balance of Payments," in Canadian-U.S. Financial Relations, Federal Reserve Bank of Boston, 1972. On the narrow issue of the yield curve, see also the comments of the present author in the same volume.

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