221. Why Reeves Should Put Up Income Tax

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0:51There.

1:02Hello and welcome to The Rest is Money with me, Robert Peston. Steph will be back in a couple of days, but I'm delighted to be joined by one of our absolutely favorite guests. That's Mohamed El-Erian, who is the professor at the Wharton Business School at the University of Pennsylvania. Mohamed, so good to see you. I think you're in the US at the moment, aren't you? I am, Robert, and thank you for having me. It's always a pleasure. And we have just witnessed a summit or a meeting between President Trump and President Xi, which President Trump declared was a 12 out of 10 meeting in terms of, for him, its success and importance.

1:44How would you rate it? So I think that both sides escalated tension in order to de-escalate. We got the de-escalation. However, it is a truce. This is not a peace accord. This is simply a truce. It is what I call tactical de-escalation. And I think that we are likely to see more tensions happen. The choice of a one-year truce is really important because that takes you to the midterm elections in the U.S. Because if there's one thing that both parties agree on in the U.S. is that China is a threat to American dominance. Yeah, I think, as you say, that's a sort of fairly widespread view. In terms of the detail, can we be confident that, for example, all those incredibly important manufacturers in every space between sort of mobile phones and motor cars to pretty much every aspect of technology will now have secure access to those vital minerals, those rare earths that China effectively can use?

2:52controls? No, we cannot. We've gone from confrontation to tolerance. So both sides are going to tolerate each other, but it would not take much for us to step back into confrontation space. The critical aspect for both sides, including the companies, both Chinese and American, is how do you take advantage of this truce to reduce your vulnerability? That is issue number one. You cannot assume that this truce will continue. So you've got a plan for the return of confrontation. But is there any scenario in which Western businesses can secure alternative sources of these precious materials? Because, you know, if there is, I can't see it.

3:43I think it will take time. I think there are alternative sources. They're not as developed as the Chinese sources are. But you've got to ask yourself the question, are we ever going to get to a first best world where everybody trusts each other? You know, economists have this tool called game theory. And I don't want to suggest that this is a game because this is really serious. But what game theory forces you to do is forces you to identify the conditions under which the game is played. Trade is inherently a cooperative game. I trust you, you trust me, we trade. If we don't trust each other and we try to turn trade into an uncooperative game, it doesn't solve well.

4:27And I think the reality is, certainly between the US and China, is that trust is lacking. So can we get a truce? Yes, we can. But as I said earlier, we're not going to get a peace accord. We're not going to go back to the world that we had some 11 years ago where both sides believed that they could continue trading the way they were trading before. I mean, in terms of the classic game in these circumstances, the prisoner's dilemma, this is, I think, what we've just heard, certainly not the worst outcome. Correct. The worst outcome would have been prohibitive levies or outright restriction on trade.

5:05So the US would have had a prohibitive levy of 100 % tariff. China would put outright restrictions on export, and both trade would simply stop. In the US, that translates into the so-called empty shelf syndrome. And there's nothing that the Americans worry most about, especially at Christmas time, than empty shelves. And in the case of China, you would take away a major growth engine. So we're not where we could have ended up, where both sides would have been significantly worse off. But let's not kid ourselves. At least I don't believe that this is going to solve in a very nice cooperative fashion in the next 12 months.

5:46I think we will see the return of tensions. And it does seem to me that, I mean, it just sort of captures how the world has changed since the inauguration of Donald Trump earlier this year, that, you know, So tariffs, I mean, depending on which sectors you're looking at, but we're still looking at, you know, well, certainly if you'd asked me, you know, a year ago, you know, what kind of tariffs can the world live with? We've still got tariffs of a very significant sort and between the two world's most powerful economies. Yes. And I think economists are embarrassed if that is the truth. And you're looking at one who's surprised by where we've ended up.

6:33I thought we would slip into a trade war where people would retaliate against the U.S. with the exceptions of China, Brazil, and India. Most countries said, U.S., you can have whatever you want, and that includes Europe and the U.K. From a U.S. perspective, if you look at what the objectives were, most economists told you you cannot achieve multiple objectives with one tool, and yet whatever we have happened, We have got$300 billion of tariff revenue being raised on an annual basis. So the tariffs are sticking. We have no retaliation, meaningful retaliation. We have more deals being made with the U.S.

7:19than we had before. So as far as the Trump administration is concerned, there's been nothing but upside for the weaponization of tariffs. Now, there are longer term issues that we worry about. We source misallocations, what sort of culture you create. But in the short term, it seems that the weaponization of tariffs has delivered what the Trump administration was hoping for. Can I just ask, in your view, if we hadn't had this astonishingly huge investment in artificial intelligence infrastructure, everything from the chips through to new power, would these tariffs have led to a rather more significant slowdown both in the American economy and the global economy?

8:11Has Trump, to an extent, been bailed out? Maybe this is just lucky old Trump, as it were, and lucky old world. But has he effectively been bailed out by the AI boom? So first, you're right to call it astonishing. The numbers are eye-popping in terms of how much is being invested in the enablers of AI, let alone in the science itself. So it is totally eye-popping. The latest estimates show that those investments alone accounts for about 60 % of the growth of the U.S. So consumption, which typically was the growth engine, is now relegated. And that's why the U.S. has gone from growing at 1 % to 1.5%.

8:54It's currently growing at 3%, which was unthinkable for an economy as large as the U.S. So these are astonishing numbers. The question is, are they sustainable? That's the first question. And the second question is, is there a pot of gold at the end of all this? Is there the productivity improvements that people are investing for? I'm really comfortable on the second one. I think the U.S. will benefit from major productivity improvements. On the first one, is it sustainable? Depends on mitigating the risks. And we haven't seen much risk mitigation so far. And when you talk about risk mitigation, tell me what you're thinking of.

9:38So there's four major risk mitigations. One is to do with bad actors, to make sure we don't repeat the mistake that we did with earlier technical innovations, where we don't have enough standards regulation to limit the probability of bad actors. The second one is diffusion. Unlike China, unlike the United Arab Emirates, all the focus in the U.S. right now is on who's working on AI. But productivity is about who is working with AI. So there isn't much attention being paid to diffusion. The third element, which worries me a lot, is that corporate America, with the exception of a few firms, is more in love with the labor displacement aspect of AI than the labor-enhancing aspect of AI.

10:31AI has both labor displacement and labor enhancement. The balance depends on how the companies that implement AI think about it. And so far, we've seen just a focus on cost minimization and too much on layoffs, which means we will ultimately lose the support for AI that is so needed. And then the fourth one has to do with what I call the rational bubble. The financial side of AI has bubble aspects to it. It's rational because the payoff is so big, but it's a bubble because people are investing in anything that has an AI label on it. And there is going to be a small set of winners and quite a few losers in this race.

11:20there certainly are i mean there's a lot to unpack there i can i before i we go through each of those one by one which i think we should could i just ask um whether you believe that the astonishing surge that we have seen in the stock market since that dip in april we're seeing companies like NVIDIA with a$5 trillion market value. I mean, that is a sum so big, it's very difficult to get your head around what it really means. Basically, all the mainstream Wall Street banks think there is quite a lot further to go in this bull market. What is your view? So, bull markets tend to have certain attributes that end up in what I call overshooting world, that you will overshoot what is reasonable, and then there will be some sort of corrections.

12:19The first one is human, FOMO, the fear of missing out. And what we've seen happen is every single sell-off has been a buying opportunity. So the durations of sell-offs are now very short because people think they're being given an opportunity. And there is this incredible fear of missing out right now, Robert, especially when it comes to something to do with AI. The second element is that people, when they are in a bull market, they start taking on risk they don't understand. And Jamie Dimon captured it really well when he pointed to a few credit accidents, fraud, and called them cockroaches. We are going to see more and more cockroaches.

13:05And this is in that area, this very fast-growing area of what's called private credit. This is essentially lending that takes place out of the traditional banking system. Correct. All that happens is a so-called shadow banking system that can have a way to come back and contaminate what you and I regard as sort of conventional finesse. But, you know, there's so much money being thrown at opportunities right now that due due diligence in some cases is not being done well enough. And then the third element that is happening right now is that the U.S. is attracting a ton of investment from the rest of the world, from Europe.

13:47And we have this very strange phenomenon whereby people are very excited about corporate U.S. So the flows into the U.S. stock market from the rest of the world are very high, but they hedged the dollar they're worried about the mess as my daughter said you go long u.s enterprise and you short the mess so they're not willing to take the dollar exposure but they just want the u.s corporate exposure yeah which is i mean i mean one of the things that has been absolutely fascinating for me over many many years is how you have this extraordinary powerhouse economy in America and a political system that, to use your daughter's phrase, is just a mess.

14:36And it has been for years. I mean, whatever you think of Trump, let's be clear, politics in America has been dysfunctional for a hell of a long time. And yet, as an economy, my God, it is formidable. So let's just say, you know, the problem with what we used to call irrational exuberance is you're never quite sure when it's going to come to an end. You're never sure when the bubble is going to burst. It will burst. All history proves anybody who believes that this time it will be different will be bankrupt at some point. There will be a bursting of this, let's call it a bubble. Some of it is definitely showing bubble characteristics.

15:17I was talking to some big investors the other day. My sort of analysis, but correct me, please, if I am wrong about this, is that when it bursts, it is likely to feel more like the bursting of the dot-com bubble than the global financial crisis of 2007-8. And what I mean by that is, I think, but do tell me if I'm wrong, the real disaster in 2007-8 is that because banks effectively went bust, the credit creation process globally collapsed. And that led to the mother of all recessions that hurt millions and millions and millions of citizens. One of the things that I still regard as absolutely remarkable about the pricking of the dot-com bubble is actually it didn't lead to a global recession.

16:11in social bankers cut interest rates there was a lot of bailing out in terms of easier credit and the hit was taken by you know either a bunch of wealthy people or some investment institutions but we sort of got through it as i say my sense would be it'll be painful if you're too long of and nvidia's share price collapses but it probably won't bring the global economy to a halt do you think that's that's a reasonable assessment i do i share that assessment um so let me tell you what First, let's talk about the characteristics of a rally that goes too long. You mentioned the global financial crisis.

16:47That really was September 2008. The previous December, the head of a Wall Street bank comes and sees me. And we're talking about where we are. And I said, where are we in the cycle? So he draws an upside down U and says, we are near the top. And I said, oh, so how are your position? he said, maximum risk on. And I said to him, if we near the top, shouldn't you be taking risk off the table? He said, no, for three reasons. One, I don't know what the exact top is. Two, I'm judged on short-term metrics. And finally, everybody else is maximum risk on. Now, of course, that bank had to be saved by the US government nine months later.

17:35But it's less damaging than the internet bubble because there's something at the end of this rainbow whereas what was at the end of the internet bubble was illusionary so there is something there but it certainly think of it as a race where there's lots and lots of horses a few will win the rest will be in the blue factory yeah let's hope neither you or i are too exposed to the you know the knackered old horses. Anyway, let's go back now to your four points. And I was really struck by your point number two, because this is something that gives me a lot of anxiety about the UK, which is this issue of diffusion.

18:15And you made the compelling point that China and indeed the UAE are both massively encouraging their businesses to adopt AI and improve their productivity. Why do you think we are so behind the curve when it comes to taking the measures in terms of adoption of AI that would improve productivity and growth for the whole economy? I think there's three factors. One is while the government talks about it and certainly is committed to growth, we do not have a comprehensive growth strategy. And if we had a comprehensive growth strategy, it would go beyond planning. It would be about innovation and an innovation-driven economy.

19:01So that's the first answer because there are pockets of excellence in the UK around King's Cross in London, the Oxford, Cambridge area. There are incredible areas of excellence, but there is no comprehensive innovation policy that's powering a growth strategy. That's issue number one. Issue number two is one of risk aversion. You know, I often wonder why it is when you offer an American company an 80-20 proposition, 80 is good, 20 is bad, it will tend to embrace the 80 and forget about the 20. Go to Britain or go to the UK, offer an 80 and 20, the obsession was with the 20. And it's really important to realize that it is an 80-20 proposition.

19:52You try to unleash to 80 and risk manage to 20. That's the second issue. And the third issue is funding, private funding. The scaling up that is required right now in this world, the UK capital markets cannot provide it. So when you put all these three things together, you don't get the sense that you get in the US that this is fundamentally transformational. transformational. It is what people call a general purpose technology. It's like electricity. It will change fundamentally what we do, and we better figure out what to do with it. China and the UAE have taken that extremely seriously. They have very detailed diffusion policies.

20:34The US is allowing the private sector to do it. The UK is neither here nor there right now. Yeah, it is very depressing. We talk a lot on this podcast, actually, about the absence of scale up capital and how much damage that's doing to the UK. I'm also really struck because we have talked recently again on the podcast, talked a bit about this with an analyst who may have come across God as E. Mazar. And one of the things we were talking about is the data, particularly out of the States, about the impact of AI on the jobs market. And one of the things that seems very striking is there's been, you know, a significant falling off in hiring of younger people, which does look as though it may well be associated with essentially AI enhancing the productivity of older workers and individuals just thinking, well, we don't want these sort of starter job people.

21:22You are going further than that and saying that in terms of the psychology, shall we say, of employers, they are now thinking significantly about replacement rather than AI being used to augment essentially the output of individuals. Tell me why you've got those fears. So first, let me say there's some notable exception. Walmart is an exception. Accenture is an exception. But in general, if you ask about labor displacement versus labor enhancement, Labor enhancement involves you retooling, retraining your workers. It involves you understanding that your organization structure is changing. You're flattening your organizational structure enormously.

22:06You have to do a lot of work to unleash the labor enhancement side. The labor displacement side seems really easy. We no longer need entry-level employees to do the things that AI can do really well now, data collection, doing literature surveys, all this other stuff. So the temptation is to go for the labor displacement. As you point out, you end up in this low hire economy because you're not hiring the young people coming into the labor force. And you and I know, because we saw it in Britain in the 70s and the 80s, when young people are unemployed for a long time, they become unemployable. And that is a real social, political, economic risk.

22:57So that's why I worry about it so much. I think there isn't enough focus on this is not just about labor displacement, this is about labor enhancement. Like you, I am deeply anxious about all of this, have been for some time. And I do worry that actually leaders across the world are not thinking enough about the further damage to social cohesion that these sorts of economic and technological developments may well cause. We ought to go to a break in a minute, but there's just one final aspect of this that I'm slightly obsessed with, which is the impact on fairness, equality, distribution of income and wealth, and indeed the sustainability of the tax system.

23:45When I talk to those really at the sharp end of not only developing these products, but also analyzing the economic impacts, you know, they do say that it is not unrealistic that in about five years, we will have the kind of artificial intelligence that is capable of replacing humans on a very large scale in employment. Now, the ramifications of that are huge. I mean, if you don't have employed people in large numbers, you don't get income tax revenues, for starters. And if I were any chancellor of Exchequer or finance minister anywhere, I would be thinking now about what on earth I do to raise money in a world where my primary source of income, of revenue, are taxes on millions of people.

24:41If there are not going to be millions of people employed, where do you get your tax revenue from? Secondly, if you're not going to get millions of people employed, how are they going to live? Right. I mean, you know, there's a lot of talk about we need to move towards a system of universal basic income, which is essentially, you know, would be a system where the state expropriates vast amounts of the profits being made from AI and then redistributes it to its citizens in the form of welfare payments. But then what are those people going to be doing? I mean, this world of plenty is in some ways amazingly attractive.

25:14But, you know, I don't think we probably want a world of whatever the level of incomes these people have just sitting at home aimlessly thinking, what am I going to do with the day? So, you know, these are huge potential issues coming down the track, which are just not being debated anywhere. And is it just that the scale of what could happen is so terrifying that there is no politician out there who simply has the courage to talk about it in public? Why do you think there is no debate about any of this stuff? First, as an issue of speed. So let's just think three and a half years ago, I first learned of chat GPT.

25:53I had no idea what what what generative AI was. and along comes something which as far as I'm concerned, you ask it a question and it answers. Two years ago, it became about give it a task and it will complete the task and deliver your task. Today, it is your intellectual companion. It's like having 100 PhDs. They're not perfect, but they're a lot better than what we had before, right there sitting next to you. That is a really rapid evolution. Now, the scenario that you set out is one scenario of many, Robert. Let me take you to the other extreme. Okay, just to that. The other extreme is your clinic in Africa that suddenly has access to top doctors.

26:37It is your school in a very poor part of the country that suddenly has adaptive teaching going on in a manner that's not possible. so this technology depending on how we use it and what context we establish for it can either be equalizing or at the other end incredibly disruptive but isn't it probably going to be both because your vision is completely consistent with the scenario that i painted you could you know it seems to me it's very likely that we will have both of those phenomena it's true so question of balance. And I said in the beginning, it's an 80-20. Some people say it's 20-80. We have an influence on this balance, right?

27:23And I agree with you. These issues should be debated. You know, if I were forming a government, I would have in every single meeting, a growth czar, someone who forces the question of, how did we discuss this? Is it leading to inclusive, sustainable growth or not? And sometimes you have to force yourself to ask that question because things are changing so quickly that if you don't ask it over and over again, you're going to miss important turns. Yeah, no, I think that's exactly right. Now, Don't go away. We'll be back in just a couple of minutes.

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29:09Offer registration closes on the 2nd of March, 2026. T's and C's apply. With investing, your capital is at risk. Welcome back to The Rest is Money with me, Robert Best. And I'm delighted that Mohamed El-Erian is still with me. We've got this budget at the end of November, November the 26th. And we know the chancellor is going to have to put up taxes pretty significantly because she's ruled out significant spending cuts and she's going to have to find. And I'm not going to go over these reasons again because it listens to this podcast know why she's got to find about 30 to 40 billion. But, you know, she's got to have to find a significant sum of money.

29:44Now, the big agony within government is that they're given that they box themselves in with their manifesto saying, you know, they can't raise VAT. They can't raise income tax. They can't raise corporation tax and they can't raise national insurance. That's what the manifesto says. What they're agonizing over is whether they should break the manifesto because this is an enormous sum of money. And there are all sorts of reasons why doing lots of little tax changes would be suboptimal. putting up VAT looks like an absolutely disastrous thing to do because the Bank of England might well see that as inflationary and it might lead to slower reductions in interest rates were they to do that so what the Treasury is alighted on is a possible rise in the basic rate of income tax each penny just on the basic rate raises about eight billion pounds just over eight billion pounds a year.