The China Shock 2.0

30:49Then you stopped hearing that as much. I think your view is that that has actually become a bigger part of the story again. So let's do this in two parts. What is currency manipulation? Why does it matter? And then where are we on the roller coaster of Chinese currency manipulation? Sometimes currency manipulation is just like a currency whose value we don't like, which is, I think, how the president sometimes used to use it. He hasn't been talking as much about it. But the more accurate way of defining it would be a country that has an undervalued currency. You can quantify that. And so you look for a surplus that's bigger than you would expect given the underlying characteristics of the economy.

31:31Factor one. And factor two is government or quasi-government intervention in the foreign currency market. So it's not just the outcome of differences in monetary policy. There's a government with its finger on the FX market buying currency to hold the currency down. China met both of those definitions unambiguously from 2003 to 2012. There was a political decision not to call them a manipulator. Now, during the latter part of their period, they were letting their currency appreciate. So they're kind of correcting the undervaluation, which is part of the reason why they weren't named. China is now back through rich state banks buying a lot of foreign currency in the market, 50 billion a month, 600 billion a year.

32:18So there's a much clearer case that China is manipulating now than there was in the past. Trump hasn't taken interest in this. The Europeans, though, have. And so I think the what you're seeing is that this shifting from being an American debate to being a global debate. When we were preparing for this conversation, something I found myself thinking about a lot was the question of whether or not it matters if the competition is fair. I'd say for a long time, the narrative that at least we were comfortable with in this was a very procedural narrative about China betraying the principles of free trade.

32:58They are a currency manipulator who is keeping their currency artificially cheap in order to make their exports cheaper, or they're doing all these industrial subsidies, and are you really supposed to do those under the World Trade Organization. And it's a very sort of liberals who believe in the system way of thinking about the problem, that the problem is China's cheating. And I'm not saying cheating can't be a problem, but there's clearly quite a few places now where China is just winning or they've got into a place where they can win. And so I guess my question is, is the problem that some of China's advantages are unfair, right?

33:34They're back to currency manipulation, their currency seems artificially cheap, or is just the problem that from a national interest perspective, from an interdependence and weaponization perspective, that Germany, Europe, the United States, it would be a mistake to just allow their industries to get wiped out. That the questionnaire is not an abstract commitment to free trade. It is what creates a kind of healthy national ecosystem. I increasingly lean towards the, look, we just want these kinds of industries. We don't want full-on dependence. We don't have to rely on arguments about procedural violation of rules, which feel a bit dated in a world where we ourselves are clearly not following the most basic of the rules.

34:29And the rules have a lot of complexity. You're allowed to subsidize under the rules. You're not supposed to subsidize if it's to substitute for imports. Well, if you subsidize a sector and everything in that sector previously was imported, are you import substituting or just subsidizing that sector? is a government-guided fund that puts money into private equity funds and venture funds to invest in chip manufacturing. Is that a subsidy? Yes and no. It may not be a subsidy under the rules. So the rules themselves are contested and not uniformly followed. And to some degree, in certain sectors, I think we care much more about outcomes than about the rules.

35:12That's obvious in sectors of national security importance. So a lot of the rare earths, famous sector, have very, very direct and important military applications. We should probably not, even if China played completely fairly, want to want to be 100 % dependent on China for the supplies of those key materials. And then you kind of have to work further from that. where does the line come about where do you just care about the outcome? And where are you going to rely more on arguments around procedural fairness? And then I think on the flip side, China itself clearly cared about the outcome, not the procedural fairness.

35:58What would you say the Trump administration across its two terms, and I realize they've been different in important ways, has gotten right about China? I mean, if Trump has been disruptive on how America has thought about anything it has been China, and what do you think they've gotten wrong in their either China orientation or their China policy? There is something a little strange about Trump's first term, 2017, 2018, because the U.S. political system reacted to the China shock five to ten years after the first China shock happened. So the timing was maybe strange, but a lot of the policy direction, I would agree, was more or less right.

36:43I think it was right to broadly say that the WTO rules, which were thought to be constraining China, had become a constraint on ourselves. China was really good at finding ways of achieving outcomes by living on the edge of the rules, the targeted first wave of tariffs were actually in sectors where it was reasonable, generally speaking, to have tariffs. And you're talking here in the first term. First term, yeah. So like in the first term, the tariffs were basically on China. In the second term, the tariffs were basically on everyone. And I am much more comfortable with putting tariffs on China, particularly now because, you know, China's economy has shifted dramatically and become much more export oriented, much more of a competitive threat now than it was then.

37:34So I think Trump one got that bit right. Like Bob Lighthizer, the United States trade representative under, in Trump's first term, was sort of the first step of moving us from the WTO consensus to a world of reciprocal interdependence, supply chain vulnerability, supply chain warfare, a world where everything is using a more militarized vocabulary, even around economic exchange. And so there was an element in the first term of unilateralism, which obviously becomes unilateralism on steroids over time. So maybe before then we get to Trump too, it's worth talking about Biden because, you know, there's a lot of democratic criticism of the way Trump talks about China to some degree of Trump's tariffs on China, but the Biden team comes in.

38:21they largely keep the tariffs in some cases expand them into new areas they begin doing more to limit the export of what they consider to be strategically important technologies like advanced chips to china they put on higher tariffs on evs and they do a lot of industrial policy that actually looks sort of like the way you're describing chinese industrial policy so the inflation reduction act is trying to build a domestic supply chain for things like solar panels and wind turbines and things like that. Now, they're more okay with it being in friendly countries too, but there's a lot of bi-American standards on all of this.

38:59And they begin talking a lot in terms of strategic technological competition. AI is a big thing for them in the AI competition with China. How do you think about the way the Biden administration approached this and both kind of tweaked but didn't upend the Trump won approach? it probably didn't go far enough. It wasn't just clean energy, although that was certainly a big focus. It also included semiconductors. And in semiconductors at the time, the concern was dependence on Taiwan, which was vulnerable to pressure from China, put the U.S. in a difficult position if China were ever to put an embargo or attack Taiwan.

39:41And at a certain point, the U.S. just made a decision that we did not want China to have the ability to make the world's best chips. Too many risks associated with that. I think that was the right decision, but it unambiguously was viewed by China as a directly hostile act. And I think if someone had done that to us, we would have viewed it as a directly hostile act. So it put us into a world, unambiguous world of rivalry and competition and in a position where we don't, there is no way China is not going to try to engineer us out of their chip supply chains. That's become a national priority.

40:19And so we are trying to reduce our vulnerabilities to Chinese economic coercion at the same time. But it didn't really go far enough in critical minerals, rare earths. I mean, there was plenty of talk about it, but there wasn't enough action, not enough on active pharmaceutical ingredients, where either the medicine or the key chemical precursors are almost 100 % sourced from China. So I think, you know, it was a step in a necessary direction. It was controversial because industrial strategy, industrial policy, you know, for a long time, the thought was that was something other countries did. It wasn't something that America did.

40:59And it wasn't something we're necessarily very good at. And in some cases, like rare earths and the magnets, like active ingredients, it means finding ways to incentivize production in sectors where you know you can't compete with China on cost.

41:29Thank you.

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42:42So that then brings us to Trump too. So how would you rate what they have done and where it has hit the right balance and where it's been off? So in general, I like Bob Lighthizer's trade policy, i.e. Trump's first term, better than I like Donald Trump's trade policy, i.e. Trump's second term. Lighthizer was careful to only threaten things that the U.S. economy could sustain. So, you know, the tariff level was set at 25%, which, yeah, people didn't like paying it, but you could afford to pay it. He didn't cover all of trade. So there was always a little more trade you could bring into that tariff.

43:24Trump had a theory of the case in his second term, which worked for most of the world, but didn't work for China. And the theory of the case is, well, trade's rigged against us. We need to raise our tariffs and you need to lower your tariffs, lower your barriers to U.S. exports to put trade on a more fair footing. You shouldn't, in other words, retaliate for our tariffs. China retaliated. China said this is coercive. Plus, China knew they were going to be in the crosshairs. She did a good job of getting ready. He'd spent four years plotting this out. So China retaliates. We counter-retaliate. China retaliates some more.

44:00We retaliate again, and we push tariffs up to 145%. You might think that gives us more leverage. We've completely cut off trade. It turned out to be the opposite. Our economy couldn't sustain 145 % tariffs on pretty much everything coming from China. So the administration was in a position where they needed to negotiate a rollback in the tariffs. You know, there's a rare earth component as well. But China, where China was holding back rare earths, which was crippled our manufacturing. Yeah, so that was real. But it's, I think even if China had not done that, even without the supply chain restrictions, the administration knew it needed to roll back the 145 % tariffs.

44:41The example that I like to give is that in the summer of Trump's first year with 100-ish plus tariffs, all the retailers who import artificial Christmas trees, which like all come from China, think Christmas tree ornaments, think holidays. Well, those are things that are actually typically imported during the summer. Now, if you're paying 150 % tariff, you're going to have to triple whatever your retail price or something crazy. And the Christmas tree importers weren't sure, because they're building up inventory ahead of a future sale, that American consumers would be willing to pay that higher price.

45:19So they just stopped importing. And, you know, when there's a hole and there are other places where companies were having to pay that price for a part, and that would render their ability to export utterly uncompetitive. So it was just, it was too broad, too high, too fast. It was disrupting the U.S. economy. That was a mistake. And I think Lighthizer in his first term got it closer to right. Don't ever escalate to the point where you're put on tariffs that you aren't willing to maintain. The other side will realize that you are looking for a face-saving way to pull things back. That was, I would say, mistake one.

45:58Mistake two was the breadth of the tariffs, not targeted reasonably by countries. Just everyone got hit with the Liberation Day tariffs, in some cases, very, very, very high tariffs. That alienated a bunch of countries that themselves were worried about trade with China. So it kind of took away the possibility of building a broader coalition against China. So that's the first problem with these very, very broad tariffs. Second problem with the very, very broad tariffs was that they ended up being done in kind of irrational, to my mind, ways. We were tariffing at really high levels Canadian aluminum.

46:42Canadian aluminum is, you know, not that this administration cares, but it's made in a kind of green way, trapped hydropower in Quebec. It has been part of our aluminum industry since World War II, you know, when the bombers were built with Canadian aluminum. There is no national security threat. It is essential to our market. The primary aluminum market doesn't clear in the U.S. without Canadian imports, which meant that just prices shot up. And then the final problem was like, hey, aluminum is electricity distilled, incredibly energy intensive and electricity intensive. So it is competing with data centers for power.

47:21And so even with the really high tariffs, we weren't investing more in new aluminum. So it was pure self-harm. Fully on board with limiting imports of aluminum from China, having a more self-contained North American market. But this was kind of silly. Getting into a trade war with Brazil, when Brazil is one of the few countries where we have a trade surplus, didn't make sense in Trump's own terms. And then we ended up, weirdly, because, you know, electronics got excluded, chips got excluded because, you know, you can't penalize data center constructions, right or wrong. The richest companies basically found ways out.

47:59So the highest tariffs at the end of the day were on low-end household goods coming from Southeast Asia. So it became sort of more of a Walmart tariff and not a strategic tariff. I think all of these were just kind of mistakes of design. We ended up with a tariff policy that wasn't in the second year of the second term, not at all focused on China. China, basically, they got the same deal as everyone else, which is a huge win for them. Most important developments, China showed it can punch back. People worried for years about them unwinding purchases of U.S. treasuries. They didn't do that. I mean, the sense that if it's escalated, they had more dependencies that they could weaponize, I think, has been very salient.

48:39there are multiple places where China has leverage. Ironically, the treasury market turned out not to be one of them. It's not just that they didn't threaten it. It's been one of the harder places to weaponize, partially because China isn't buying. I mean, some people think they're selling. That's not true. They just have moved to other custodians. It gets real technical. But at the end of the day, we actually have a counter if China sells treasuries. The Fed can always buy more treasuries, QE, than China can sell. We showed that in 2020. We actually showed that in 08 and 09 when China was selling agencies, Feddy, Franny, mortgage-backed securities, and the Fed started buying them.

49:22It's not maybe ideal, but we have an alternative. For the rare earth magnets that go into weapon systems, comes, unless we have stockpiles, we don't have alternatives. So it's actually a more potent form of leverage. One of the charts as I was preparing for this that struck me is that if you look at America's trade deficit, the world doesn't look that different than at the beginning of Trump's term. So in terms of what we've been trying to achieve with our various trade wars or trade policies, have we achieved anything? I mean, in Trump's own sort of conception of the world, manufacturing, trade imbalances, is there progress that they can point to?

50:07Not much. We haven't grown our exports to China with the deals. Our exports are actually down relative to where they were, certainly down as a share of U.S. GDP from before the trade war. We have not stopped Chinese industrial policy. We have not generated a structural change in China's economy. We haven't changed the fact that China has, you know, agricultural hostages that it takes whenever we threaten, you know, you want to sell soybeans to us, you want to sell beef to us. You got to be, you know, not tariff us. We have leverage over you. We haven't changed that. And we haven't changed China's broad trajectory.

50:46China is a bigger exporter globally, runs a bigger global trade, not just by small amounts, by enormous amounts, a more unbalanced economy now than it was when the trade war got started. We haven't changed our trade deficit in aggregate. We have shifted final assembly for the U.S. market away from China to Vietnam, to Taiwan, to Mexico. But the components are still coming from China. So I think, you know, the main thing you can say that Trump's second term trade policy unambiguously has achieved is it's alienated a lot of allies. It has not at all been targeted. It alienated the courts because not a lot of thought was put into conforming to reasonable expectations of what the law allowed.

51:38And it generated a bit of revenue. And there's an oddness to the first part about allies to me, because given everything that were talking about with the second China shock being very focused on Europe among others, you really could have imagined something that was more of a united set of goals between us and Europe. We all want to protect our auto industries. We all don't want to be dependent on Chinese chips or China taking over Taiwan. And then we have a huge chip problem. I guess the question is, what do you think our goals should be here? What do you think the set of outcomes we are trying to generate should be?

52:20And can they be generated or is there an inevitability to all this given China's size, given its manufacturing capacity? People sometimes talk about where we're going as having an almost, yeah, an inevitability to it. I'm curious if you buy that. I do not believe in the inevitability. But I do believe the changes to avoid growing dependence on China from inputs of manufacturers and final goods are quite significant. Look, I was part of the Biden administration at the beginning. I'm implicated in some of those decisions. And in the early days of the Biden administration, the overarching goal of the trade policy was to avoid a trade war with Europe, which was sort of where Trump was heading had he won reelection that year.

53:21And convince Europe that whatever our traditional sources of friction, we had a common interest in thinking through how to handle China and taking real action against China. bring our policies into harmony by bringing European tariffs closer to U.S. tariffs, not by bringing U.S. tariffs on China down. At the time, the Europeans were not interested. Europe said, the problem is that you guys aren't following the WTO rules, the rules are important, you've got to go back to the rules. Nothing Europe loves like a procedural argument. People love procedural. We actually love procedural arguments too.

54:02But the Europeans loved the notion that they were the rule-abiding, rule-creating, order-enforcing power in the system. That has shifted. And I think the Trump administration missed the shift, didn't explore the possibility of shift, nor was it interested. Because, you know, I think Trump came in and he said many times that Europe's almost as bad as China. allies, not allies, not how he thinks of the world. Xi, great leader. We should be doing deals with Xi. Bunch of European leaders, not great leaders. You know, they've allowed themselves to have their hands tied by the European Union. Real leaders like Xi, like Trump, don't allow their hands to be tied by supranational institutions.

54:54Just kind of disdain. And so he missed an opportunity to explore Or if Europe was willing to join the U.S. in some kind of economic alliance, North America plus Europe and North Atlantic alliance, you know, they wouldn't it wouldn't be called against China. but it would effectively be an alliance to create a bigger market outside of China with some sense common barriers to China that would have allied scale, would be big enough that it would easily support a competitive EV industry that didn't rely on Chinese parts, a competitive magnets industry that didn't rely on China, so forth and so on. So I think, you know, where should we have gone?

55:45I think we should have moved in that direction. There are ways to do better coordination of industrial policies too, but basically like extend our security alliances into economic alliances. Uh, try to compete with China. Don't give up. Don't accept that every EV in the world is going to be made in China, which is a realistic outcome right now, uh, with fully, you know, China can expand its EV production capacity. and has enough spare capacity to meet all global demand. So the entire EV industry could be Chinese production. You know, China is supplying 10 % of the European auto market. There's a future where it could supply 70.

56:27If that's not an outcome you think is acceptable, you kind of have to work backwards from that because that is now a realistic possibility. What do you think about the notion of a China Shock 3 that you're beginning to see on the horizon, which is we've been talking about how China Shock 1 was kind of low-end, middle-end manufacturing. Number two has been high-end batteries and cars and things like that. But the thing that America has had that has insulated it, that has made our stock market such a booming part of the global financial system is, as we talked about, sort of software, finance, and more recently, of course, AI.

57:04And we are still have real leadership in AI, But it's amazing how strong the Chinese open source models are, how close they are. They're a lot cheaper. They're cheaper to run. And China is able to, I mean, China does not have the chips we have, but they are able to pump energy into it. They're not going to have the data center slowdown that we're going to have, right? You're not going to have, you know, local data center protests that are stopping China from building enough data centers. So it's not crazy given how much more difficult it is to create the infrastructure for AI here that China will pull ahead in the coming years.

57:43so i do think that's that is uh a possibility if you think a china shock 3.0 is sort of services but services that not as in haircuts but as you know software ai the models uh there is a world uh where china and the u.s compete directly in a way that they didn't compete in the big platforms, you know. China protected its search market because it wanted political control, but that sort of meant that China's search engine is never really that competitive globally, which left the lion's share of the globe, you know, using U.S. platforms, using U.S. software, using U.S. cloud. Huge businesses, incredibly profitable businesses, the businesses that have propelled the U.S.

58:38stock market to its stratospheric heights that have made U.S. stocks, two-thirds of the global stock market index. So an enormously important part of the U.S. economy and an even more important part of the stock market. Look, AI is up for grabs. We don't know if the U.S. models will, that people are willing to pay as much as the people who are spending tons of money to build all the data centers and buy all the NVIDIA chips are willing to invest. That's an open question. It is quite possible that it will prove to be a competitive market and no one will make the super profits that sort of Google or Alphabet, Microsoft, Apple generated out of the digital world we now live in.

59:18And that AI will either be dominated by China or prove to be competitive and there won't be the kind of profits that people expect. And so it will be disruptive and disruptive to the parts of the U.S. economy that have generated the most high end jobs and certainly the most profits. So to assume that we're going to have a lead in high-end digital services forever and that China is not going to compete, I think that's, I wouldn't agree with that. Is what we want or what we should want for China to be exporting less, for them to have less of an overcapacity, as it gets called, or is what we want for China to be more open to imports, right?

59:59this sort of bit around the fight over whether or not we should export chips to China. The Biden administration really clamped down on that. Trump opened up a bit, somewhat under the push from Jensen Huang of NVIDIA. And NVIDIA's argument, and the argument that I heard from Trump people around this was, look, we actually want China somewhat dependent on NVIDIA's chips. We have all these dependencies on China. The idea that they're somewhat dependent on us is not a bad thing. Now, even once we sort of open that back up, China's not been excited about Nvidia chips. They have made strides on their own.

1:00:33And yes, they would like the very best stuff, and there's some things we're still holding back. But I felt like in there you saw this kind of emergent fight, which is, do we want to be more separated or actually is a problem that there's been more openness in one direction than the other? It's like, that's the the thing we should be targeting. How do you think about that? I have complex, conflicted, and probably incoherent thoughts. But the goal from China, and I think it's independent whether you give them this chip or that chip today, they may or may not achieve it. The goal is to replicate the full chip ecosystem, to be able to make the machines as well as make the chips and be at the frontier.

1:01:18So the risk is that you would become dependent over time on both Chinese models and then the Chinese ships will display their dependence on you. And I think that's in that sector, that's a real set of risks. I'd be a bit cautious there. I think conceptually, mutual interdependence, reciprocal vulnerabilities, control over offsetting choke points is a way that competing great powers, great military powers now, great economic powers that are rivals, not allies, can coexist. You cannot supply chain restrict me because I can supply chain restrict you and we can deter each other. You apply strategic and military concepts around deterrence.

1:02:15So it's a vision that allows trade, but it's kind of hostile trade, so to speak, where you're always worried that interdependence is shifting towards dependence. Particularly because Xi has said that his goal is dependence. He wants the world to rely on Chinese supply chains. Arguably, that's one theory he has about how he could achieve victory in Taiwan without actually fighting. Everyone needs us so much they can't react, can't respond. the other vision is a vision where okay either fully split off into rival blocks china has its ev ecosystem the u.s u.s and europe our block has its own ev ecosystem own battery supply chains own battery chemical supply chains own ev companies own EV designs.

1:03:08China has its. There's a vast part of the world which gets to choose, but there are rival ecosystems that don't have a ton of interdependence. I think you can hive off some of the strategic sectors and do that trade with allies and maintain some trade with China. I mean, we're not going to tell our farmers they can't sell to China. We're just not. And there are certain products which I think we should be fine importing from China. But defining the lines is hard. On top of that, China cannot continue to rely on the world's demand to make up for the fact that it doesn't generate its own demand. There's a macroeconomic component.

1:03:51China's economy, the export side of the economy has done great. No question. Booming. Growing faster than global trade. The domestic side of the economy, people doubt whether the domestic side of the Chinese economy is really growing faster than the domestic side of the U.S. economy. It is not doing great. There's a lot of unemployment. There's deflation. There's real internal problems. An aging population. We have an aging population, too. But China's aging a little faster. And now there's a looming problem of overinvestment, not just in property, but in manufacturing capacity. Too many auto plants, not enough demand.

1:04:26Internal demand is down 20 % for Chinese cars. So they're forced to export because their own market is shrinking. That's a real problem because China's internal economy is incredibly unbalanced. It's second biggest world economy in the world, but with the biggest domestic distortions across the board, the most unbalanced pattern of savings and investment, there will need to come a time when China doesn't have to have an expanding trade surplus to grow. So I do think that that is a problem. And of course, it's tied on our side to our fiscal situation. We're going to borrow insane amounts to build AI, and we're also borrowing 6 % of GDP to keep our consumer engine going.

1:05:10There probably eventually are limits on our side too. I think that's a good place to end. Always our final question, what are three books you'd recommend to the audience? Well, the one book that most shaped my own understanding of China is an old book, actually. It's by a friend of mine, Richard McGregor, a long-time Beijing correspondent for the Financial Times, who wrote a book called The Party. And he really showed that you can't understand modern China without understanding the modern Chinese Communist party. And, you know, vivid scenes with like red telephones where, you know, your special party line where you get the instructions if you're the CEO of a big company about what you should be doing.

1:05:56Second book is another old book, actually. It's called The Volatility Machine by Michael Pettis. It is a thin book. It is not an easy read. It is actually not even about China, even though Pettis is now very well known for his work on China. It's about how to think about financial vulnerabilities in the global economy and in emerging economies in particular. I think it's a modern classic. And it's really important for understanding, I think, not just how emerging markets can get into trouble, but somehow some of the financial structures that are now being used to finance the AI build-out could get in trouble, that kind of framework.

1:06:42And the third book, a book that exceeded my expectations, is, you know, How to Win a Trade War by Chad Bowne and Samaya Keynes. Whatever side of the trade debate you're on, you're going to learn something. It is not a polemic. It is, I think, the best guide to a world where people are thinking about trade in terms of vulnerabilities, not just in terms of opportunities. Brad Setzer, thank you very much. Thanks, Ezra. It's been a pleasure to be on the show.