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It was a clever solution to an emerging problem for Canadian dairy farmers. Perhaps a little too clever.

Milk protein ingredients, mainly from the United States, started flooding the Canadian market about a decade ago, displacing domestic milk in the making of dairy products such as cheese and yogurt. The trade was lucrative because protein – in highly concentrated liquid or powder form – is not subject to the 200- to 300-per-cent tariffs that apply to virtually all other dairy imports. Imports ballooned to 54 million kilograms in 2016 from less than four million in 2008, creating an import market worth nearly $200-million a year.

Determined to stem the flow, Canadian dairy farmers lobbied for the creation of a new and lower wholesale price for milk ingredients. The idea was to create an incentive for dairies to buy more Canadian milk and make those ingredients here instead.

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The plan worked brilliantly for farmers. U.S. protein imports fell by half after the new price was introduced in early 2017 – just as U.S. President Donald Trump announced he wanted to renegotiate the North American free-trade agreement.

Canadian farmers knew the price move would upset their counterparts across the border. But they could not have anticipated that Canada’s dairy policies would become a punching bag for Mr. Trump.

This arcane pricing scheme – known as Class 7 – has emerged as a surprise stumbling block in the stalled NAFTA talks.

U.S. officials are livid. They see the price change as a breach of an unwritten rule that Canada should not let its highly-protected supply management system interfere with global dairy markets.

“So I tell our Canadians ‘Do not lay frustrations with NAFTA at the feet of our president,’” Ted McKinney, the U.S. Agriculture Department’s undersecretary for trade, bluntly told reporters recently. “You started Class 7 milk. You then decided to dump dried milk powder on the world market at half to two-thirds of world price.”

Mr. McKinney also suggested that the Trump administration is less interested in destroying Canada’s supply management regime, than reining in our shifting pricing policies.

“If you’re going to have a managed milk supply, manage it,” he complained. “That doesn’t mean you have the freedom to create these new classes every time you have a need and then take all your excess and dump it on the world market. Not fair. Not fair.”

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Some key actors in Canada are sympathetic. Last week, Quebec Premier Philippe Couillard told Bloomberg that Canada should get rid of Class 7 if the controversy is holding up a NAFTA deal. “If that’s the main issue, let us see how we can approach that separate from supply management,” said Mr. Couillard, whose province is home to half the country’s dairy farms.

The chief executive officer of one of Canada’s largest dairy processors, Montreal-based Saputo Inc., is also critical of the price scheme. “You can’t hold onto your milk supply-managed system and have a class of milk competing with world markets at the same time,” Lino Saputo told Reuters last month.

Several other countries have complained about the Canadian milk pricing scheme at the World Trade Organization, including Australia, New Zealand and India. Trade challenges are likely inevitable.

The controversy over the milk ingredient price may seem obscure. But it highlights an existential problem facing Canada’s dairy industry. Farmers are caught in a squeeze between growing encroachment into their protected home market and their own inability to export because the relatively high fixed domestic prices are considered subsidies under global trade rules.

Over time, it has become harder to shield the sector from outside price influences. Technology has allowed milk ingredients to be easily shipped around the world. And with each new trade agreement, Canada cedes a little bit more of its domestic market.

The more foreign dairy products enter the Canadian market, the harder it is for farmers to keep prices comfortably above the much lower world price. And lower prices destabilize the precarious economics of Canadian dairy farms, which typically carry heavy debt loads because so much of their capital is invested in quota allowances to produce milk.

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Why the Trump administration would get so hung up on Canada’s dairy industry, and Class 7 milk in particular, is a bit of head scratcher. Dairy trade is a tiny blip in a $450-billion a year flow of goods between the two countries.

But coupled with Canada’s prohibitive tariffs, it was an easy and obvious target. And Canada can’t claim the moral high ground.

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