So Donald Trump and Xi Jinping are meeting in Beijing this
week. And if the footage is anything
like prior summits, will be treated to two men in suits
walking very slowly through a building, shaking hands at a
slightly uncomfortable distance and staring at each other like
two people who've been set up on a blind date by a mutual friend
who has since left the country. Now to recap how we got here,
because it has been quite a journey.
Last year. Tariffs between the the United
States and China hit levels that hadn't been seen since the
1930's. the US put tariffs of up to 145% on Chinese goods.
China retaliated with tariffs of 125% on American goods.
And then, just to keep things interesting, restricted exports
of rarer minerals which are used in basically everything from
vacuum cleaners to fighter jets, but mostly vacuum cleaners.
This went on for a while, and then both sides appeared to
quietly realize that they were running out of things to put
tariffs on. So they agreed to a 90 day
truce, which is the one currently in effect and which
expires in November. Now, expectations for this
summit are, to put it generously, modest.
The press have taken to calling it the Beans and Bowing Summit,
which tells you something about the level of ambition.
Both leaders arrive at this summit under considerable
domestic stress, but for very different reasons.
China is dealing with a property sector that has been falling for
years and shows no real signs of stopping, youth unemployment
that the government briefly dealt with by not publishing the
numbers anymore, and a demographic decline that no
amount of government encouragement seems to be
fixing. the US president is dealing with the inflationary
consequences of his own policies, falling approval
ratings, and a military situation in the Middle East
that's not going particularly well.
So this is the backdrop, 2 economies under strain, a
temporary truce that expires in a few months, and the summit
that will be mostly remembered for the photographs.
But the thing that almost nobody on the news will explain,
because it requires about 10 minutes of patience and some
basic accounting, is that the problem these two leaders are
trying to solve is not really a political problem at all.
It's an accounting problem. And the reason it never gets
fixed is not that politicians are unwilling to fix it, it's
that most of them don't appear to understand what's actually
causing it. And that's what this video is
about. To understand the current trade
dispute, we need to look at what trade is actually supposed to
be. About 6 months ago, Robin
Harding wrote a piece in the Financial Times about a trip he
took to China where he posed the same question again and again to
the economists, technologists and business leaders he met
with. His question was simple.
Trade is an exchange where you provide something of value to me
and in return ioffer something of value to you.
So what exactly does China want to buy from the rest of the
world? A few of the economists he spoke
to who had perhaps pondered the issue already jumped ahead to a
different point altogether. Their answer to the question of
what China would like to buy from the rest of the world was
you should let Chinese companies set up factories in Europe.
Which is not really an answer to the question, but it does tell
you quite a lot about how they see the problem.
Now, to a certain type of politician, this might sound
like a triumph of national strategy, until you remember how
trade actually works. The basic idea, going all the
way back to David Ricardo, is that trade is supposed to be
mutually beneficial. The entire purpose of selling
your goods abroad is to acquire foreign currency so that you can
buy the foreign goods that you need.
If you accumulate foreign exchange that you never intend
to spend, you're not running a brilliant economic strategy.
You're just collecting pieces of paper.
And if your goal is to systematically put the rest of
the world's manufacturing out of business, you eventually run
into a problem. Your customers won't have any
money left to buy all of the goods that you're hoping to sell
them. This makes no sense.
It's the equivalent of the town's Baker aggressively
pricing the butcher, the Brewer and the candle maker into
bankruptcy, and then looking around a few years later
wondering why nobody in town can afford bread.
During the first China shock in the early 2000s, China's exports
surged, but so did their imports.
They were buying up the sophisticated equipment needed
to build their factories. Today, as Samira Keynes pointed
out in the FT, China's import volumes are comparatively
anaemic. They are selling, but they're
not buying, Which raises a fairly obvious question.
If the strategy eventually makes everyone poorer, including
yourself, would you do it? To understand why a country
would do this, it helps to look at the work of Michael Pettis, a
finance professor at Peking University and a senior fellow
at the Carnegie Endowment. Pettis has been writing about
this for years, and his core argument is the trade surpluses
and deficits are not really caused by trade policy.
They're the automatic consequence of domestic savings
and investment decisions. Here's what he means by that.
When a government suppresses household income through low
interest rates on savings and undervalued currency, weak labor
protections, and other policies that effectively transfer wealth
from ordinary people to the state and to manufacturers, it
forces up the National Savings rate.
Households earn less than they produce, so they can't consume
enough to absorb everything the economy makes.
This is what economists call financial repression, and it's
the mechanism by which countries like China and before Japan and
Germany subsidized their industrial growth at the expense
of their own consumers. Now all of that excess saving
has to go somewhere. It goes into investment, and
building infrastructure that you actually need does generate real
economic growth. But once your investment exceeds
your productive needs, once you build enough high speed rail and
enough apartment blocks, continuing to invest doesn't
create economic value, it destroys it.
The money is spent. The GDP figures look impressive,
but the underlying projects generate less value than they
cost to build. The difference shows up as dead.
President Xi has reportedly spent a good portion of his
career studying Japan's last decades.
Apparently, he found them inspiring.
In the 1980s, Japan suppressed consumption to fund investment
LED growth, built spectacular infrastructure, achieved
extraordinary technological advances, and was widely
expected to overtake the United States.
Then the debt caught up with them, and they spent the next 30
years dealing with the consequences.
Pettis argues that the only way out of this is to shift from
investment LED growth to consumption LED growth.
You have to stop subsidizing factories and start giving money
to households so that your own citizens can actually afford to
buy the things your economy produces.
But politicians generally hate doing this, because shifting
well to households means that the state has to give up control
over where capital gets allocated.
So rather than making that difficult choice, they keep
subsidizing production. The domestic consumers can't
absorb the output, and the excess has to go somewhere.
It goes abroad as a trade surplus, not because anyone
planned it that way, but because the accounting leaves no other
option. So if China is producing vastly
more than it can consume and doesn't want to buy anything
from the rest of the world, who is absorbing all of this excess
output? Well, let's look at who else is
at the table. Europe is running a trade
deficit with China of roughly €1 billion per day, which is a
number that sounds made-up but isn't, and is driven by a
massive imbalance in manufactured goods, particularly
electric vehicles and electronics.
The EU is simultaneously trying to deregulate it's own economy.
A recent survey found that German firms alone had hired an
additional 325,000 people over three years whose entire job was
to take regulatory boxes. Europe is also preparing
legislation that wood forest Chinese companies to hire
European workers, buy European components, and transfer their
technology as the price of market access.
This is, of course, exactly what China did to Western
multinationals a generation ago, and Chinese officials have
apparently noticed the similarity.
They're not finding the imitation flattering, but Europe
is not absorbing all of this. Happily.
The EU trade commissioners compared Europe dependency on
Chinese minerals to its former reliance on Russian energy and
has warned that without action, Europe risks losing whole
sectors of industry within a couple of years.
The IMF estimates that selling goods across EU borders costs
firms the equivalent of a 44% tariff on goods and a 110%
tariff on services. These are not tariffs imposed by
a foreign adversary, these are tariffs the EU has imposed on
itself through paperwork. The EU has essentially conducted
a trade war against it's own economy and impressively appears
to be winning. So Europe is already
uncompetitive and it's now being flooded with cheap Chinese goods
on top of that. This is not a combination that
ends well for European manufacturing.
That leaves the United States. the US has the deepest, most
liquid, and historically best governed financial markets in
the world. When surplus countries like
China and Germany suppress domestic consumption and
generate excess savings, those savings have to go somewhere.
And roughly half of the world's excess savings end up in
American financial markets, not because Americans invited them,
but because there's nowhere else for that volume of capital to
go. Now here's where the accounting
gets important. When foreign capital flows into
the United States, the US must, by definition, run a
corresponding trade deficit. This is not a choice.
It's a balance of payments identity.
The foreign money is being used to buy bonds and financial
assets, not goods. The US becomes the consumer of
last resort for the global economy, not because it wants
to, but because the accounting leaves no alternative.
As Pettis puts it, the US doesn't fund its trade deficit.
Surplus countries force it to run one.
Now, you might think that all of this foreign capital pouring
into America would be good for the economy, and that it would
fund new factories and lower interest rates.
And that might be true if American businesses were
desperate for capital. But they're not.
US corporations are sitting on trillions of dollars in cash.
They don't lack access to funding.
They lack customers who can afford to buy more of what they
already produce. So the foreign capital doesn't
flow into productive investment. Instead, the economy has to
absorb it some other way. As Pettis points out, there are
really only three options. The excess capital can push up
unemployment as cheaper imports put American factories out of
business. It can push up household debt as
consumers borrow to maintain their spending.
Or it can push up the fiscal debt deficit as the government
borrows to keep the economy from contracting.
Since no politician wants the first option, the US has
historically chosen some combination of the 2nd and 3rd.
And here's the part that almost nobody in Washington seems to
understand. Running a massive fiscal deficit
doesn't fix the problem. It feeds the monster.
The bigger the deficit, the more Treasury bonds you issue.
The more bonds that you issue, the more attractive your debt
markets look to surplus countries with excess savings to
park. The more capital flows in, the
stronger the dollar gets, the less competitive American
exports become, and the wider the trade deficit grows.
And of course, all of that government spending is
stimulative, which means it's inflationary, which pushes up
interest rates, which makes the debt even more expensive to
service, which requires yet more borrowing.
It's a feedback loop, and it's one that no amount of summitry
in Beijing is going to break. Now, being the consumer of last
resort has not been entirely unpleasant. the US economy is
remarkably productive. Labor productivity has been
growing at about 2% a year over the last five years, the fastest
rate in two decades. Cheap domestic energy means
Americans pay about half what Europeans pay for electricity.
The US economy is flexible, dynamic, and has been absorbing
these imbalances for decades without anything obviously
breaking. But the bill has been
accumulating. A few days ago the FT reported
that the US government sold 30 year debt at a 5% yield for the
first time since 2007. Financing the growing national
debt is getting meaningfully more expensive.
In a video a couple of weeks ago on inflation, I discussed how
the US Treasury under Scott Percent has been funding long
term obligations with short term borrowing, a strategy that the
economist Stephen Moran Annuriel Dubini described as activist
Treasury issuance and compared to stealth quantitative easing.
Besent, as it happens, criticized Janet Yellen for
doing exactly the same thing before he took office and then
adopted the strategy himself, which is the Treasury Secretary
equivalent of mocking someone's cooking and quietly asking for
the recipe. This is essentially a massive
bet that long term interest rates are going to come down.
Which seems like a rather aggressive gamble when you
consider that the US government is simultaneously pursuing
tariffs, running a massive fiscal deficit, reducing the
labour supply through deportations, pressuring the
Federal Reserve to cut rates, and fighting a war in the Middle
East that has driven up the price of fuel and fertilizer.
It's not entirely obvious why long term interest rates would
fall while the government is actively engineering inflation.
Betting that rates will come down while you borrow a trillion
dollars a quarter to fund a trade war is a strategy that
relies heavily on optimism. None of this is a new problem.
As Martin Wolf pointed out in the FT this week, clashes over
how to adjust these imbalances have reoccurred roughly every
two decades. The 1920's, the 1960's, the
1980s, two, 1008 and now the 1920s version ended with a
global depression and the World War.
The 1980s version was resolved through the Plaza Accord, where
the major economies agreed to coordinate their exchange rates.
The 2008 version was resolved by, well, a global financial
crisis. So the two available options
appear to be international cooperation and economic
catastrophe. And historically, we've tended
to go with the second one. Economists have understood the
structural problem since at least the 1940s.
As Darren McFadden outlined in the FT last week, when the
global financial architecture was being designed at Bretton
Woods, Keynes proposed a system built around a neutral
international currency that he called Bancorp.
The key innovation was that it would penalize countries for
running either persistent surpluses or persistent
deficits, forcing both sides to achieve.
Just as the economist Robert Triffin later pointed out, any
country that supplies the world's reserve currency is
essentially trapped. It must run persistent deficits
to meet global demand for safe assets.
Keynes saw this coming and designed a system to prevent it.
the United States rejected that proposal at the time. the US was
the world's largest creditor then and it's dominant
manufacturer. It was basically the China of
that era, and it had no interest in signing up to a system that
would penalize it's surplus. In doing so, it consolidated the
dollar as the anchor of the International Monetary system,
which is the very thing that now forces it to run the deficits
it's complaining about. So that worked out well.
Wolf also makes a point that surplus countries tend to
overlook. They are not in a strong a
position as they think. Japan ran enormous surpluses in
the 1980s, and the pressure to boost domestic demand led to a
property bubble that, when it burst, produced 3 decades of
stagnation. China ran huge surpluses after
2008, and the pressure to reinvest them domestically
produced a property bubble. Germany ran persistent surpluses
within the euro zone, and when the deficit countries hit
crisis, Germany had to choose between financing them or
watching the euro collapse. They chose to finance them, but
they did want everyone to know that they were not happy about
it. The pattern is fairly
consistent. Surplus countries build their
economies around selling to others, and when the music
stops, they discovered that they needed those deficit countries
more than they thought. So what happens when the global
consumer of last resort, the United States, is running a 5%
cost of capital and starts looking for ways to stop
absorbing everyone else's excess production?
Well, historically it ends in either one of two ways.
Either the major economies sit down and negotiate a cohort
coordinated adjustment, which requires a level of
international cooperation that is, to put it politely, not
obviously forthcoming at the moment, or the adjustment
happens through crisis. If the US stops buying, American
consumers will face higher prices and fewer cheap goods.
That would be unpleasant but for the surplus economies, countries
that have built their entire economic model on the assumption
that foreigners will endlessly borrow money to buy what their
factories produce. It will be significantly worse.
A consumer can find a more expensive substitute or do it
less. A factory with no customers has
a much bigger problem. This brings us back to the
handshakes in Beijing this week. Expectations for this summit
are, to put it generously, modest.
Both sides appear to be looking for just enough progress to
justify the photographs. the US wants China to commit to buying
those beans and bow wings. To oversee these purchases, the
two sides are expected to announce a Board of Trade, a
committee of senior officials from both countries, whose job
will be to make sure the. With China actually follows
through this time. This is necessary because China
made similar purchase commitments in the phase one
trade deal in 2020 and then didn't follow through.
So the solution to China not honouring its commitments is a
new committee to monitor whether China honours its commitments.
I'm sure that this time it'll be different.
Now the Board of Trade will sit alongside the already existing
Board of Peace, which was established earlier this year to
promote peace building, which Trump will chair for life.
So we now have a Board of Peace and a Board of Trade, and all we
really need next is a board of good intentions and we'll have
the complete set. There's also the small matter
that Trump arrives in Beijing having largely been disarmed by
his own courts. In February, the Supreme Court
struck down his IEPA tariffs, the ones he had been raising and
lowering on a near daily basis last year.
He immediately pivoted to a different legal authority,
Section 122 of the Trade Act, which allows temporary tariffs
to address balance of payments crises.
Last week, a Federal Trade court ruled those ones illegal, too,
on the grounds that the US is not actually experiencing the
kind of balance of payments crisis the law was designed for.
The administration is appealing, but the tariffs expire in July.
Regardless, a third set of tariffs under Section three, O
1, is being prepared, but those investigations won't be complete
until the summer. So the US president is sitting
across from Xi Jinping at a in negotiating table, and his most
prominent negotiating tool has been taken away from him by his
own judiciary twice. His domestic position isn't
helping either. Approvals ratings are at 34%,
the lowest of his second term. And with midterm elections in
November, Republican members of Congress are not exactly lining
up to support inflationary trade policies in an election year.
Several were reported to quietly celebrated when the Supreme
Court struck down the tariffs. Xi Jinping will be aware of all
of this. When you're negotiating
counterparts own party is relieved that your signature
policy has been overturned by the courts, it does somewhat
reduce the credibility of the threat to bring it back.
Both sides are really just trying to buy time. the US wants
breathing room to build domestic rare earth processing capacity
because China currently controls those supply chains and use them
as devastating leverage during the tariff war.
China wants time to develop it's semiconductor industry and
reduce its dependence on western technology.
And XI has his own grievances to raise too.
China imports roughly 40% of its oil through the Strait of or
move. So the American military
situation in the Middle East is not just AUS political problem,
it's costing China money and she will want to make sure Trump
knows it. As Eli Ratner, who served as the
US Assistant Secretary of Defense for Indo Pacific Affairs
until last year, pointed out in the FT, the US has made this
mistake before. The pattern is consistent.
When Washington backs off, Beijing doesn't reciprocate it
consolidate it's gains. When the Obama administration
declined to challenge China's island building in the South
China Sea, artificial reefs became military installations.
When Trump paused tariffs in his first term in exchange for the
phase one trade deal, China missed it's purchase commitments
and the structural reforms were deferred to a phase two that
never came. Ratner argues that the time
being bought isn't being used to strengthen America its position,
particularly given that the war in Iran has drained military
readiness for any potential crisis in the Pacific.
And all of this will happen while the much larger
geopolitical issue, the future of Taiwan, hovers in the
background. A senior Taiwanese official told
Bloomberg last month that what they fear most is being put on
the menu at a Trump XI summit. China would very much like
rhetorical concessions on Taiwan in exchange for those beans and
bowings. Whether they get them is another
question. So the two leaders will shake
hands, make announcements and fly home.
The photographs will look very serious, but the underlying
problem, the one we've spent this entire video explaining,
will not have changed. Trade imbalances are not caused
by lack of summits. They're caused by domestic
policy choices that need either side appears willing to change.
China will continue to suppress household consumption, the US
will continue to absorb the resulting surplus, and the
accounting will continue to do what accounting does, regardless
of what anyone announces at a podium in Beijing.
Thanks for tuning into this week's podcast.
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Have a great week and talk to you again soon.
Bye.