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UNCLAS SECTION 01 OF 03 OTTAWA 000268 SIPDIS SENSITIVE STATE FOR WHA/CAN - BREESE AND HOLST WHITE HOUSE/NSC - SHIRZAD STATE PASS USTR FOR CHANDLER USDOC FOR 4320/OFFICE OF NAFTA/GWORD/TFOX; 3134/OIO/WESTERN HEMISPHERE TREASURY FOR IMI GENEVA FOR USTR E.O. 12958: N/A TAGS: ETRD, EINV, CA, North American initiative SUBJECT: PLACING A NEW NORTH AMERICAN INITIATIVE IN ITS ECONOMIC POLICY CONTEXT REF: (A) 04 Ottawa 3431 (Regulatory agenda) (B) 04 Ottawa 066 (Canadian trade policy) SUMMARY/INTRODUCTION -------------------- 1. THIS MESSAGE IS SENSITIVE BUT UNCLASSIFIED. NOT FOR DISTRIBUTION OUTSIDE USG CHANNELS. 2. (SBU) An incremental and pragmatic package of tasks for a new North American Initiative (NAI) will likely gain the most support among Canadian policymakers. Our research leads us to conclude that such a package should tackle both "security" and "prosperity" goals. This fits the recommendations of Canadian economists who have assessed the options for continental integration. While in principle many of them support more ambitious integration goals, like a customs union/single market and/or single currency, most believe the incremental approach is most appropriate at this time, and all agree that it helps pave the way to these goals if and when North Americans choose to pursue them. 3. (SBU) The economic payoff of the prospective North American initiative - in terms of higher incomes and greater competitiveness - is available, but its size and timing are unpredictable, so it should not be oversold. Still, a respectable economic case has been made for such an initiative, and this message spells it out. We believe that, given growing Canadian concern about "border risk" and its effects on investment, a focus on the "security" side could also produce the most substantial economic/trade benefits. END SUMMARY/INTRODUCTION CANADIAN ECONOMIC PERSPECTIVE ----------------------------- 4. (SBU) Canadian economists in business, academia and government have given extensive thought to the possible options for further North American integration. Nearly all of this work assumes that each of the three countries is pursuing standard economic policy goals - growth, productivity and competitiveness (rather than more specific concerns raised by Mexican analysts such as migration management, regional development, or environmental protection). Since 9/11, Canadian economists working in this area have generally endorsed a comprehensive initiative with the United States on security, trade, and immigration. Following is our summary of the professional consensus: PROCESS: At this time, an "incremental" approach to integration is probably better than a "big deal" approach. However, governments should focus on choosing their objectives, and not on choosing a process. BORDER VS. PERIMETER: Even with zero tariffs, our land borders have strong commercial effects. Some of these effects are positive (such as law enforcement and data gathering), so our governments may always want to keep some kind of land border in place. Canada and the United States already share a security perimeter to some degree; it is just a question of how strong we want to make it. BORDER RISK: The risk that business will be obstructed at the border by discretionary U.S. actions, such as measures to defend against terrorism or infectious disease, in addition to growing congestion, have become major risks to the economy, inhibiting investment in Canada. For small businesses, the complexities of navigating the border are apparently even more intimidating than the actual costs. Reducing this risk is Canada's top motive for pursuing further integration. LABOR MARKETS: Many Canadian economists point to labor markets - both within and among countries - as the factor market where more liberalization would deliver the greatest economic benefits for all three countries. They advocate freeing up professional licensing laws, and developing a quick, simple, low-cost work permit system, at least for U.S. and Canadian citizens. REGULATION: Canadian economists agree that Canadian regulations (if not their standards, then their complexity) are needlessly restricting foreign investment and impeding food, communications and other industries. (Inter-provincial differences are important here, since Canada's federal government does not have the benefit of a U.S.-style "interstate commerce" clause). While much of the problem is domestic in nature, an international initiative could help to catalyze change. CUSTOMS UNION: A common external tariff, or a customs union which eliminated NAFTA's rules of origin (ROO), is economically desirable. NAFTA's ROO are so restrictive that importers often prefer to pay the tariff rather than try to prove North American origin. However, economists differ on the size of the benefits available and on whether these would justify the effort of negotiation. One study estimated that a full customs union which eliminated ROO would only raise national income by about one percent. CURRENCY UNION: Canadian economists are split on whether a return to a fixed exchange rate, or adopting the U.S. dollar, would benefit Canada in current circumstances. (Canada last tied its dollar to the U.S. dollar from 1962 to 1970). The central bank governor has taken the position that "monetary union is an issue that should be considered once we have made more progress towards establishing a single market." NORTH AMERICAN INTEGRATION: WHAT WE KNOW ----------------------------------------- 5. (SBU) Past integration (not just NAFTA but also many bilateral and unilateral steps) has increased trade, economic growth, and productivity. Studies suggest that border efficiency and transportation improvements (such as the lower cost and increased use of air freight) have been a huge part of this picture. Indeed, they may have been more important to our growing prosperity over the past decade than NAFTA's tariff reductions. Freight and passenger aviation are critically important to our continent's competitiveness, and businesses are very sensitive to the timing, security, and reliability of deliveries - hence the "border risk" which so concerns Canadian policymakers. 6. (SBU) A stronger continental "security perimeter" can strengthen economic performance, mainly by improving efficiency at land borders and airports. It could also facilitate future steps toward trilateral economic integration, such as a common external tariff or a customs union, if and when our three countries chose to pursue them. Paradoxically, the security and law enforcement aspects of the envisioned initiative could hold as much - or more - potential for broad economic benefits than the economic dimension. WHERE'S THE UPSIDE? ------------------- 7. (SBU) Some international economic initiatives (such as FTAs) produce across-the-board measures that generate broad benefits for a country's industries and consumers on a known time-line. This was true of NAFTA but it is less likely to be true of the economic aspects of the NAI. Non-tariff barriers such as standards and regulations generally must be tackled one- by-one. This is a piecemeal process and the ratio of payoff to effort is likely to be lower than with across- the-board measures. Governments naturally focus on resolving the problems which their firms or citizens bring to their attention. While this approach has merits, it tends to deliver the payoffs toward particular interests. If there are hidden costs, there might be little impact on national performance. As we move toward a list of barriers to tackle, it will remain important to balance those interests. For example, some Canadian economists have suggested that NAFTA fell short of expectations with respect to increasing consumer choice in Canada; that may be a theme we should stress as efforts to promote further integration take shape. 8. (SBU) In contrast, cooperative measures on the "security" side, a critical focus of current bilateral efforts, can deliver substantial, early, and widespread economic benefits. Security and law enforcement within North America have evolved rapidly since 9/11, leading to many less-than-perfect processes for handling legitimate international traffic. Collaboration to improve these processes could yield efficiency improvements which would automatically be spread widely across the economy, leading to general gains in trade, productivity, and incomes. A NOTE OF CAUTION ----------------- 9. (SBU) There is little basis on which to estimate the size of the "upside" gains from an integration initiative concentrating on non-tariff barriers of the kind contained in NAI. For this reason, we cannot make claims about how large the benefits might be on a national or continental scale. When advocating NAI, it would be better to highlight specific gains to individual firms, industries or travelers, and especially consumers. CELLUCCI