The China Shock 2.0

The biggest economic story in the world right now is China's growing dominance across advanced manufacturing sector, from electric vehicles, batteries to solar panels, to things that aren't even traditional manufacturing that are software like AI and open models where they become a world leader. What is happening here is very different than what we call the first China shock, where China became a big exporter but of things that were not that important to advanced economies. Things that mattered maybe for particular communities, mattered for many, many jobs, but weren't the frontier of economic growth. But now it's different. China is very much at the frontier and they're dominating it. And that is going to transform geopolitics. It is going to transform the politics of countries, many say in Europe, where China is pushing them out of manufacturing that has been the absolute cornerstone of their economies. And so I think understanding it is about as essential to understanding economics and geopolitics in the coming era as literally anything is. Brad Setser is a person who follows us about as closely as anyone on earth. He is a senior fellow at the council forum relations. He has served in top trade roles and economic roles in the Biden and Obama administrations. And so I want to hear his perspective on it. He joins me now. Brad Setser, welcome to the show. Thanks for inviting me. So you've been arguing that the world economy is going through a China shock 2.0. So for people not familiar with this, what was China shock 1.0? 2002. What happens is there's a big jump up in China's exports. And at the time it's mostly in relatively low-end manufacturer goods, furniture, household appliances, clothing. And I think there was a sense in the US that these were not the industries of the future. And I think what the China shock 1.0 academic literature shows is that even though these weren't the industries of the future, they were still employing a meaningful number of Americans, often in the South, often in the Midwest. And the China shock is how that impacted local, not national local labor markets that had the most overlap with China. And this has sort of a short run negative effect on parts of the economy. You know, when the local factory closes down, local real estate prices turn down. And the people who sell launches to the factory workers have fewer people to sell to. So it becomes a generalized downturn in those communities. That was clearly underestimated. And then people have done all sorts of further studies which correlate the area. It's going to have the resource exposure to the Chinese export, wave to deaths of despair, to political realignments, voting for Donald Trump, voting for Donald Trump. But the basic idea here is that you have a bunch of places in Midwest and the South, primarily that are manufacturing towns, that their factories are outsourced China or the goods are competed by China. And basically the community goes into sharp decline. Correct. And we never have a very good policy answer. I mean, I think at the time we didn't even try to have a policy answer, but it is actually conceptually difficult to deal with the decline of a small town when it's big industry. Let's live in that debate for a minute. What is the argument about whether or not this rapidly accelerating level of trade with China is good or bad for America? The overarching view at the time was that China's integration into the global economy was more less inevitable and that the negotiated terms of entry into the WTO provided a reasonable framework for China's full integration into the global economy. That trade was fundamentally good, that there would be shifts across industries. People would leave their jobs and import competing parts of the economy, but generally moved exporting parts of the economy or into the services sector. And that we had a fairly flexible labor market. And by the way, integration would be a positive force for China's political development. It might lead to some forms of liberalism within China. It might moderate China's global ambitions. Commerce would tame the dragon, so to speak. And the other dimension of the argument, as I've heard it, and remember, it is if China wants to make cheap goods for Americans, people like low prices, they like low inflation, like why would we fight this gift? In particular, because the industries that were going to China were not the source of cutting-edge technology at the time, not generating a lot of highway jobs. So there was, indeed, a sense that consumers would benefit and did benefit from cheap goods, and the adjustment would not threaten the core strengths of the American economy. I think that was the belief. I would put a little tiny asterisks around the cheap prices thing. Unambiguously, China's explosion of exports lowered the price of manufacturers. If you look at the overall evolution of consumer prices during this period, there's not much of a change. China's integration into the world economy, huge amounts of investment ended up putting a lot of upward pressure on commodity prices. So you see oil prices really take off during this period, and that's an offsetting change. So you've got to always look at both sides of the ledge. So when you're going to target our Walmart and you're buying clothes and toys, I mean, they really are cheaper, like in real terms from when I was a kid. But you're saying that what we're not seeing there is the price of oil, the price of oil. It costs you more to fill up your car to get to target. But once you got to target, it was cheap. Okay, so China's shock, the reason we use this term is that this whole argument got re-evaluated. And so which parts of it would you say panned out and which didn't? I think the extent to which China would be a come a big export market was overestimated. China never was fully open to US exports. I mean, one of the more striking things is that after 2004, so two years after China's WTO entry, China's imports as a share of its GDP start to fall. And then it was not expected in a sense that China would succeed as much as it did while retaining the core aspects of its different economic system. The sense that China would have to converge, have to become more like us, maybe politically, but certainly economically. The state would wither away, state on enterprises we privatized. 20 years after China joined the WTO, China's economy was, you know, the thinking was it would kind of look like the US or maybe look like Europe. It wouldn't be distinctively Chinese. And that didn't pan out. What is distinctively Chinese about the Chinese economy? One thing that is distinctly Chinese, which is not what you would normally think about in a communist led society, is that China actually has a rather thin system of social insurance. It doesn't actually collect that much tax. Personal income tax collections are like 1% of China's GDP. It's 8% here. If you're not collecting personal income tax, you're not going to have the resources to be very generous in helping, you know, low wage work. There's nothing like our earned income tax credit where you get a subsidy, basically, money back from the government if you don't get paid that much. The taxation system relies heavily on taxes on consumption. It's really quite regressive. It hits poor Chinese workers much more heavily. It also does not have a unified national labor market, the so-called hookah system basically means, you know, you're supposed to work where you were born. You can migrate and leave, but when you migrate and leave, you give up certain social rights. You got a financial system that is fundamentally state controlled, heavily banked, the Wall Street part of the Chinese economy exists, but it's much smaller. The old fashioned put your money on deposit in a state bank, very much the dominant moment of savings, and then the state banks intermediate so they can direct credit towards the goals of the party, towards the goals of the government. Sometimes under the direction of the local government, sometimes under the direction of the national government. The commanding heights of the Chinese economy are still primarily in the hands of centrally-owned state-owned enterprises. So this is, you know, why it's sometimes difficult to sell to China. You want to sell soybeans. Actually, you have to generally sell to the state oil seeds monopoly. You're not selling to an individual soybean crusher. Selling airplanes to China, you're selling to the big three-state airlines who act as a coordinated block, telecommunications, you're selling to three state-owned companies whose executives are picked by the party, who take direction centrally. And then on top of that when the government sets a policy direction, you know, say we want to have a semiconductor industry. Ambitious provinces will say, well, we should be the province that builds up China's national champion. Here's an ambitious guy, he or girl. Looks like they got a good idea. Here's a whole bunch of money. We're gonna subsidize your factory. Maybe we're gonna take equity. We're gonna make sure you get bank loans. And so a whole bunch of different firms spring up in that sector with support and they start competing very intensely. So it's, you know, a mix of state-directed and intensely competitive. I want to draw something out in the description. I thought it was great of how their economy is different. China has gotten a lot richer and less of that wealth than you might have thought has gone into things like a universal health care system, a social insurance system for the elderly. America got richer, we built Social Security, Medicare, Medicaid, welfare, earned income tax credit, child tax credit. China's gotten richer because it has not allowed a lot of that. Because also you have such power over the financial system. It has just been able to move much more of that money into subsidizing production innovation and like new economic areas it wants to dominate. You know, the basic retirement benefit that anyone in China gets no matter what your residency status is like tens of dollars a month. It's really, really trivial. The health insurance system, people aren't confident and they walk into the hospital that the cost will be covered. And frequently there's a lot of up-front payments. And some people also say the the one child policy in an incredibly competitive marriage market has made it, you know, a requirement for young men to save if they want to get married. All this has produced an economy that just saves an incredible share of its national income. Over 40% of GDP, uniquely high. And that means the state financial sector is just flush with money. So part of it is that China has the capacity to direct investment through the state. Part of it is just it can finance out of its own savings. Levels of investment that no other country has matched. So this is all true through China Shock 1.0. The view is maybe more of it would change as time went on, but it didn't. So what is China Shock 2.0? So I date the start of China Shock 2.0 to the collapse of China's property market in 2021. Now, we all know there was an awful lot going on in 2020. The pandemic she gets concerned. There's too much investment in property. Probably rightly so that there were empty buildings piling up. He introduces a policy. Three red lines for sort of restricts finance for the property sector. And it succeeds too well. And the property market basically tanks. And then in order to offset the economic impact of this fall, she more or less gives the banking system guidance to lend to finance a new wave of manufacturing investment and particularly manufacturing in more cutting edge sector. So electric vehicles being the leading example, but in general its investment in any sector where China has import dependence. And for she, that's a vulnerability. And so he really directs the state's financial sector and the party to throw money into building out sectors where China has an import dependence. The effect is China moves back to growing on the back of head exports. China's domestic economy is growing 3-4%. So you know, you're getting one and a half to two percentage points of growth from that exports. That's a lot of statistics. But what it basically means is China's exporting a ton of cars. China is supplying the entire world with batteries. China is now the leading exporter of tunnel boring machines. You know, you name the category of machinery. China's exports are growing. It's no longer just consumer electronics. So China starts getting growth, big part of its growth from an expanding trade surplus. Imports stop growing. This is, you know, I think one of the key factors around the second China shock. Normally you would say imports would grow with domestic demand. Chinese imports basically aren't growing. And in case that is selling ever more to the world. And then Chinese exports are not buying more from the world. Exactly. And Chinese exports, particularly in the years right after the pandemic, after the currencies depreciated, start growing at two times or three times the pace of world trade. So China's imports of autos used to be about a million cars a year. It's now under half a million cars a year. And over the same period, China's exports of cars have gone from little under a million to 10 million in the space of five years. Just a stunning shift in a range of industrial sectors and heavily industrial sectors that compete with Japan and compete with Europe. And so you sort of see bad economic performance in the manufacturing heart of Europe in particular, little less so in the US. So I think this point about the Europe versus US is really interesting. And in one of the pieces you wrote about this, you wrote, the US share of global output has been remarkably constant over the last 40 years. China's rise has come at the expense of the other G7 countries. Can you talk about what that looks like? I mean, I know you've let's use maybe Germany as an example. Germany didn't move as heavily into, you know, kind of software platforms. They retain a more traditional manufacturing sector and focus on exports, including to China. So, you know, Germany after the global financial crisis is exporting close to 3% of its GDP to China and manufacture goods. That reflects the fact that Germany remained a very manufacturing centric economy. You know, the tunnel boring machines, the high-end sedans, fancy SUVs, also aircraft. All these industrial sectors tended to be industrial sectors which had a lot of overlap with China. And then you throw in the fact that the EV industry just took off in China. A lot of government support. And the German companies, they were made their own efforts to make EVs in Europe, but those never took off globally in the way that China's EV industry has, nor are they cost competitive. So what you see is German exports to China have fallen by about a percentage point of German GDP. And what was a strength? Germany benefited from selling to China right after the global financial crisis became a weakness. I want to focus in on another dimension of this. It's kind of inside the story you're telling. So China's like one, it's lower on the value chain of manufacture goods. It's close and consumer calculators and all these things that the story that was told was we don't want these industries in the long run. What happens in the Chinese arc two is that China is starting to dominate industries on the technological frontier. I mean you mentioned electric vehicles. You mentioned batteries. We could talk about solar panels. We could talk about AI where they're basically neck and neck with us. How did they go from low to mid-level manufacturing to the absolute frontier in batteries solar, etc. That quickly. There was certainly something in the air in China around manufacturing. The critical mass was built up and the foundations were laid. And as I think it's a complicated story. So if you think about electric vehicles being the one of the famous sectors, what do you need to make an electric vehicle? You actually need to be able to make a car. It is a smartphone mixed with a car. So how does China learn how to make cars? Good cars. Well, a lot of foreign companies come in and Ford and GM and VW all had to partner with generally Chinese state companies to produce in China. That was just the rule. And they didn't have a really much of a choice because in China had a 25% auto-tariff. For very, very, very long time. If VWs on the other side of the tariff with a JV partner, they're going to have a big cost advantage. So GM had to also jump the tariff. Toyota had to jump the tariff. Everybody does the JVs, joint ventures. And then you want your parts suppliers to come and produce high-quality parts. So they come to China. Well, guess what? Once they learn how to make parts in China, They are making parts at a much lower cost in China because China is relatively cheap. And you're starting to use those parts to export to the world. So China ends up having world-class automotive parts production well before its companies suddenly master EVs. At a certain point, in China was sort of, they liked the results of the joint venture, but they didn't completely like the fact that, for a while, most of the Chinese market was being met by automarkers being met by joint venture output, the indigenous Chinese owned companies were not all that competitive. There was a sense that the auto manufacturers who had a JV were fat and lazy, 'cause they were too happy producing through their JVs. So there was a sense that, okay, well, this sector was still a little too foreign dominated. And then there was a correct sense that, well, we should try to take advantage of the transition to EVs. So China makes it a priority. When China makes something a priority, credit is available to local firms that want to enter the EV market. The state banking system gets mobilized, local governments start throwing money at it, get a lot of small companies spring it up. China supports the development of an indigenous local battery industry. Then Tesla's market entry is also viewed as significant. When Tesla enters, it's not required to do a JV, but in order to qualify for Shanghai government local support, has to meet a lot of local content requirements. So a supply chain that serves Tesla can also serve others. And when China sets up their consumer subsidies in order to qualify for that subsidy, the car initially had to be made in China. The battery had to be made in China. That supported not just the Chinese battery industry, but the Chinese owned EV industry. And so all of a sudden you just get an explosion, which has been built on a foundation from the migration of Western parts makers, copying, emulation, and then an awful lot of industrial policy. (upbeat music) (upbeat music) - So something people may have heard is this argument that China is overcapacity. That that overcapacity is a crisis. This is sort of related maybe to trade imbalances. I don't think that makes a lot of intuitive sense. Like why is that a problem if they produce more cars than they buy? So how would you describe what the overcapacity issue is? To me, the most coherent way of defining the concern about Chinese overcapacity is a set of sectors where China produces more than a domestic market can absorb. And where globally China's adding capacity in a sector that in aggregate already has more capacity than there is global demand. So in batteries, for example, China's ability to make batteries is a multiple of current global demand. So there's just no scope for anyone else to enter the market. The concern in a sector like autos where there is overcapacity globally, there are more auto factories in Europe and in the US with capacity than there is demand. So many factories are operating at low levels of capacity or being underused and there's overcapacity in China. A lot of Chinese factories are not being fully used. And China is adding to its capacity. So China has the ability to make 55 million cars, which is well over half close to two thirds of world demand. And so China's expansion necessarily means the exit of capacity elsewhere when there's already spare capacity. Now you can say that's just the operation of a market. New entrance is going to displacement capacity, but it does feel different. When a closed market suddenly is adding capacity to an industrial sector where in aggregate, there is plenty of capacity and there are squeezing margin, squeezing production out of the rest of the world. One thing I've heard people ask is, how is this different than America? America rises as a manufacturing juggernaut from being a much more modest economy when the country has founded. It does over time, displace great companies from other countries. It does lead to competition that is harder for other countries. But I do think economically America's rise is not in every respect, but probably considered to have been win-win in a lot of ways. So what is different about the rise of America as a manufacturer, like the rise of Detroit, the rise of all these dimensions from what China is doing? So our story is much more one of industrial investment for our own rapidly growing internal market. And we only really become a big exporter after World War II when the world's on its back. And that doesn't last that long. China's industrial rise is much more tied to exporting and it's a much bigger exporter than we ever were except for that brief period after World War II. So one argument here is simply, China is winning. They're out competing the world, you know, pretty fair and square here. And if the world doesn't like it, it needs to build better cars, build cheaper solar panels, create stronger supply chains. All this talk of China shocks and a China problem is just kind of a way to win and keep China down. And there's no problem here. Like it would be great to have cheap Chinese electric vehicles. It's good for the world and the climate transition up cheap Chinese solar panels. How do you take that argument? - Look, if your only goal is maximizing benefits to consumers in the short run, you should certainly import Chinese EVs, Chinese solar, open economics, say buy from whoever is cheaper and then the competition will raise everyone else up. I think that misses a few things. One, it misses the shock that happens to our economies if traditional, even like traditional, but still kind of cutting edge sectors disappear. China could supply out of capacity that it has already built the entire European automarket, all of it, 10 million cars, no problem. That's just giant compared to the global market. If an industry suddenly goes away, you have all the China shock 1.0 type effects, communities that grew up around building cars will just kind of disappear. Now in the China shock 2.0, you're not gonna be moving to an export sector 'cause no one's exporting to China. So you're gonna move to necessarily a services sector. So you're gonna become less focused on producing traded goods. Now you might say who cares? On the other hand, in Europe, an awful lot of research and development, an awful lot of innovation actually has emerged out of their automotive sector. So it's not clear these people are gonna jump to a more innovative sector. They may jump to less innovative, less well-paid sectors. And in the end term, your economy's gonna suffer. And then I think there's a sense that people have discovered that supply chain dependence can be weaponized. China dominates magnets, rares. If you want those magnets, you want those rares, you better say nice things about China. You better not do it, Japan did, and say you're gonna come to Taiwan's defense if something were to happen. You kind of need to respect China if you want access to their supply chain. That's kind of the argument that they are making. That kind of dependence scares people. Finally, I would just say look, if you wanna emulate China, if you admire China, you like the way China's electric vehicle industry has developed. It did not develop without industrial policy. China's EV industry developed behind some of the highest tariffs in the world at the time, 25%, huge local preference. You know, Chinese made battery, ideally from a Chinese company, Chinese made car, could be a Tesla, but it could be Tesla made in China with 90% Chinese content. And then an awful lot of local government support. There are stories of entire factories being built not by the company, but by the local government to the specifications of the company. So there's a story of protection and industrial policy that leads to the creation of this sector. You throw your doors open to China, you're gonna get the cheap cars, but you're not gonna get the EV industry. And I think many countries are reluctant to just seed more industrial ground to China. So for a long time, the critique that you heard in American trade debate most often of China is that they were currency manipulator. Then you stopped hearing that as much. I think GearView 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? What 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, factor 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're 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 its state banks, buying a lot of foreign currency in the market, 50 billion a month, 600 billion a year. So 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 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. Let's 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. They 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 is 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? They'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 question here 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. And 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 the 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. That's obvious in sectors of national security importance. So a lot of the rareers, 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. What 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 US political system reacted to the China shock five to 10 years after that 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. I 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 the first term. 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 China's economy has shifted dramatically and become much more export-oriented, much more of a competitive threat now than it was then. So I think Trump won got that bit right, like Bob Lighthizer, the United States trade representative under 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 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. They 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 buy American standards on all this. And they begin talking a lot in terms of strategic technological competition, AI is a big thing for them, AI competition with China. How do you think about the way the Biden administration approached this in both kind of tweaked but didn't upend the Trump one 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 US in a difficult position if China were ever to put an embargo or attack Taiwan. And at a certain point, the US just made a decision that we did not want China to have the ability to make the world's best chips too many risk associated with that. I think that was the right decision, but an unambiguously was viewed by China as a directly hostile act. I think if someone had done that to us, we would have viewed it as a directly hostile act. 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 chips supply chains. That's become a national priority. And so we are trying to reduce all our vulnerabilities to Chinese economic coercion at the same time. But it didn't really go far enough in critical minerals, where 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% source from China. So I think it was a step in a necessary direction. It was controversial because of industrial strategy, industrial policy. For a long time, the thought was that was something other countries did, it wasn't something that America did. And it wasn't something like that. were necessarily very good at. And in some cases like rares 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. So that then brings us to Trump too. So how would you rate what they have done and where it is hit? The right balance and where it's been off. So in general, I like Bob Lighthizer's trade policy. I Trump's first term better than I like Donald Trump's trade policy. I 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. Trump 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. You know, 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. We 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, we're China was holding back rare earths with poor manufacturing. 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. The example that I like to give is that in the summer of Trump's first year with a 100-ish plus tariffs, all the retailers who import artificial Christmas trees, which like all come from China. Think Christmas tree ornaments. Think, 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 you know, 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. So they just stopped importing. And you know, when there's a hole in their 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's just, it was too broad, too high, too fast. It was disrupting the US economy. That was a mistake. And I think light hyzer 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 wouldn't are looking for a face-saving way to pull things back. That was, I would say, mistake one. Mistake two was the breadth of the tariffs. Not targeted reasonably by countries. Just everyone got hit with the Liberation Day tariffs. Some 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 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 terrifying at really high levels Canadian aluminum. Canadian aluminum is, you know, not this administration cares, but it's made in a kind of green way, high trapped hydro power and Quebec. It has been part of our aluminum industry since World War 2, 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 US without Canadian imports, which meant that just prices shot up. And then the final problem was like, hey, aluminum is electricity distilled, credibly energy intensive and electricity intensive. So it is competing with data centers for power. And 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, have in a more self-contained North American market, but this was kind of silly. The, 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, it can't penalize data center constructions right or wrong. The richest companies basically found ways out. So 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 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 US 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. There 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 the China was selling agencies, feddy, franny, mortgage-backed securities, and the Fed started buying them. It's not maybe ideal, but we have an alternative. For the rare earth magnets that go into weapon systems, 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 conception of the world, manufacturing, trading balances, is there progress that they can point to? Not much. We haven't grown our exports to China with the deals. Our exports are actually down relative to where they were. Certainly down is a share of US 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 agricultural hostages that it takes whenever we threaten. You want to sell soybeans to us. You want to sell beef to us. You've got to be not tariff us. We have leverage over you. We haven't changed that. We haven't changed China's broad trajectory. China is a bigger export globally. It 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 US market away from China to Vietnam, to Taiwan, to Mexico. But the components are still coming from China. So I think the main thing you can say that Trump's second term trade policy unambiguously is achieved. Is it's alienated a lot of allies? It's 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, and it generated a bit of revenue. And there's an oddness to the first part about allies to me. Because given everything that we 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 question is, what do you think our goals should be here, right? What do you think the set of outcomes we are trying to generate should be and can they be generated or is there an inevitability to all this, given China's size, given its manufacturing capacity? Well sometimes talk about where we are going as having 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 and 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 re-election that year and it convinced 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. You know, bring our policies into harmony by bringing European tariffs closer to US tariffs, not by bringing US 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 gotta go back to the rules, nothing Europe loves like a procedural argument. People love procedure. We actually love procedural arguments too, but 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 I think Trump came in and he said in many times that Europe's almost as bad as China, allies, not allies, not how he thinks of the world. She, great leader, we should be doing deals with she. A 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 she, like Trump, don't allow their hands to be tied by supernatural institutions, just kind of disdain. And so he missed an opportunity to explore if Europe was willing to join the US in some kind of economic alliance, North America, plus Europe and North Atlantic alliance. Yeah, 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 a sometimes common barriers to China that would, you know, 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? I think we should have moved in that direction. There are ways to do better coordination of industrial policies to, but basically like extend our security alliances into economic alliances, 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 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. If 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 three that you're beginning to see on the horizon, which is we've been talking about how China's one 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 is 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. And we are still have real leadership in AI, but it's amazing how strong that 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? We're not going to have 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, the China will pull ahead in the coming years. So I do think that's, that is a possibility. If you think a China shock three point out is sort of services, but services that not as in the air cuts, but as, you know, software, AI, the models, there is a world where China and the US compete directly in a way that they didn't compete in the big platforms, you know, China protected its search market because I want to 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 US platforms, using US software, using US cloud, huge businesses, incredibly profitable businesses, the businesses that have propelled the US stock market to a stratospheric heights that have made, you know, US stocks two-thirds of the global stock market index. So an enormously important part of the US economy and even more important part of the stock market, look, AI is up for grabs. We don't know if the US models will, the people are willing to pay as much as the people who are spending tons of money to build all the data centers and biolian video 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, alphabet, Microsoft, Apple generated out of the digital world we now live in and that AI will either be dominated by China or will 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 US 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. Because 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, whereas what we want for China to be more open to imports, right? This 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, someone 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 and yes, they would like the very best stuff and there's some things we're still holding back. I feel like in there you saw this kind of emergent fight, which is, do we want to be more separated or actually as a problem that there's been more openness in one direction than the other? It's like that's 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. The risk is that you would become dependent over time on both Chinese models and then the Chinese chips will displace their dependence on you. I think that's in that sector that's a real risk out of risk, so 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 ours. 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 of round deterrence. So it's a vision that allows trade, but it's kind of hostile trade, so to speak, where you're always worried that your inner dependence is shifting towards dependence, particularly because she has said the day's goal is dependence. He wants the world to rely on Chinese supply chains, arguably that's one theory as about how he could achieve victory in Taiwan without actually fighting. Everyone needs us so much they can't, 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 US, US, and Europe, our block has its own EV ecosystem, own battery supply chains, own battery chemical supply chains, own EV companies, own EV designs, China 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 or 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. China's economy, the export side of the economy is 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 domestic side of the US 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 is aging a little faster. Yeah. And now there's a looming problem of over investment not just in property, but in manufacturing capacity. Too many auto plants, not enough demand. Internal 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. The 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. There probably eventually are limits on our side too. I think that's a good place to end. All is our final question. What if 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, long time Beijing correspondent for the Financial Times, who would have 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. Second book is another old book actually. It's called the volatility machine by Michael Patis. It is a thin book. It is not an easy read. It is actually not even about China, even though Patis 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, that kind of framework. And the third book, a book that exceeded my expectations is, you know, how to win a trade war or by Chad Boun and Samaya Keynes. Whatever side of the trade debate you're on, you're going to learn something. It is not a controversy. 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 Sutter, thank you very much. Thanks, Ezra. It's been a pleasure to be on this show. [Music]