Martin Sandbu
We interview some quite impressive economists here at the FT — trusted advisers and confidants to world leaders, governors of powerful central banks, winners of the Nobel Memorial Prize in economic sciences. But few, if any of them, can claim the experience of our guest today. He’s not only an influential economic commentator, he’s also the founder of an underground Chinese record label.
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Hello and welcome to The Economics Show from the Financial Times. I’m Martin Sandbu, the FT’s European economics commentator and writer of the Free Lunch newsletter on the global economic policy debate. And with me today is Michael Pettis. Michael is a senior associate at the Carnegie Endowment. He’s also a longtime professor at Peking University and other top Chinese universities.
He is the author of several books, including, most recently, Trade Wars are Class Wars: How Rising Inequality Distorts the Global Economy and Threatens International Peace. And that’s a book written with my former FT colleague, Matthew Klein. Michael, welcome to the show.
Michael Pettis
Thank you very much.
Martin Sandbu
I would love for us to talk about Chinese macroeconomics, but let’s start with Chinese indie rock. Michael, just tell us about the record label.
Michael Pettis
The original record label, it became the biggest indie label in China and a huge drain on my pocket. So I sold it to a major label a few years ago called Taihe. And last year, a couple of musicians that I’m very close to and I founded a new label, and we’re doing a series of shows, which coincidentally began just two weeks ago focusing more on experimental music, avant-garde, improvised music, that sort of thing. Stuff that doesn’t sell.
Martin Sandbu
Let’s see if we can include some links in the show notes. And I believe you also started a nightclub or a music club, is that right?
Michael Pettis
Yes. I had one in New York in the very old days. I won’t mention the dates. But here in China, I had two that became fairly well known as the centre of a lot of the Beijing scene that emerged, which 10 years ago was honestly one of the best music scenes I thought in the world. Today, not so much. Things have quieted down a bit. But nonetheless, there’s very good stuff happening in China. Not as well known as it should be, perhaps.
Martin Sandbu
When did you first move to China, Michael?
Michael Pettis
I moved in 2001.
Martin Sandbu
So that’s more than 20 years. And you’re clearly culturally immersed and you clearly feel the economy. So let’s start with China itself before we move to the global economy and China’s role in it in a moment.
What is the biggest thing that you think outsiders, westerners, get wrong or misunderstand about China? What’s the kind of big thing that, having lived there, you wish people outside understood better?
Michael Pettis
I would say there may be two things that I found particularly interesting and useful. One is, you know, when I moved to China, I had spent most of my career on Wall Street running trading and capital markets desks, focusing on Latin America, so I had a very strong developing country background. And when I came to China, one of the things that occurred to me is that there’s an awful lot we can understand about China by knowing about economic history in general, and particularly about developing countries.
This may seem obvious to you, Martin, but at the time and even today, there was a sense that China was so exceptional, so unique, that there’s really nothing to learn from the experiences of other countries, and that turned out to be completely wrong. And so I think it’s important and very helpful to put China within a historical context.
Other countries have had similar growth models and many of the problems that we’ve already seen are starting to emerge here. The other thing that I think a lot of people get wrong is there’s the sense that China is so highly centralised that if Xi Jinping tells the country to jump, everybody jumps.
But that’s not the case. Local governments are extremely powerful. Local elites are very influential. And one Chinese friend of mine, a historian at Qinghai University, said the simple view of Chinese history is that it’s a constant battle between centralisation and decentralisation. And that hasn’t really changed in the 24, whatever, years I’ve been in China, we’ve seen that process replicated. There’s constant back and forth between where policy is really determined and driven.
Martin Sandbu
Let me just pick up on the first point. Everyone’s been impressed and has a good reason to be impressed by the growth model. What China has done in terms of development is unprecedented in history, I would say, at least on that scale and at that speed. So maybe you can just give us a quick overview of what that growth model has been and how it’s faring at the moment.
Michael Pettis
Sure. It’s a growth model that you can trace it way back to the so-called American system of the 1830s and onwards. The more recent version of that model, the sort of high-savings, high-investment model that you can argue was actually developed in the Soviet Union and in Germany in the 1930s.
And there’s a specific reason for that: because the traditional developing country’s story was that developing countries had very high investment needs and insufficient domestic savings, so they imported domestic savings. But of course, in the 1930s, Nazi Germany and the Soviet Union were both pariah economies and they were unable to import domestic savings. So in order to meet their domestic investment needs, they forced up the domestic savings rate to very high levels, and that allowed them to fund investment out of domestic savings rather than rely on very unstable foreign capital inflows.
Martin Sandbu
And just to be clear, this is difficult because it means an already poor population sees their consumption even further depressed, right? That’s just what it means, arithmetically.
Michael Pettis
Yes. But what’s happened in many countries is that if you do it at a period in which there is great growth potential — in the case of Japan, rebuilding after the second world war, in the case of Brazil and China, rebuilding from a very low base — then you can resolve the problem of repressing consumption. Because what you do is you have consumption and household income grow, just more slowly than GDP. So China was a particularly successful version of that.
During the 1990s and 2000s, while Chinese GDP was growing at around 10 or 11 per cent, household income was growing at only 7 per cent, 6 per cent. So if you were the ordinary Chinese worker, your income was rising very quickly. It wasn’t rising nearly as fast as GDP. And as I don’t need to tell you, if GDP rises faster than consumption and consumption is based mostly on the growth and income, then by definition your savings rates are going up. So China did this to an extent, probably never before seen in history. And one of the results was that in the 1980s, China was sort of a normal saving country. It saved a little bit more than the global average, but in line with many other developing countries. By the year 2000, China was among the highest saving countries in the world. And by the year 2010, 2011, where consumption bottomed out as a share of GDP, its savings rate was so high that we’ve probably never seen anything comparable in history.
Martin Sandbu
I suppose this unique combination of high, particularly high consumption growth rate, but even higher capital growth rates, I mean, that was in part a function, I suppose, of China’s unique scale and the degree of liberalisation in the world economy in the 1990s. So a lot of good things came together at once for them.
Michael Pettis
And also don’t forget how incredibly underinvested China was by the end of the ’70s. It had gone through five decades of anti-Japanese war, civil war and Maoism. So China from a social point of view was almost a middle-income country, but from an economic point of view, it was one of the poorest countries in the world, largely because it lacked investment in anything.
So this model, which generates very high growth and investment funded by a very high growth in savings, was exactly what China needed.
Martin Sandbu
So this is a really useful reminder that this characteristic of being a net saver is really very deeply rooted in the Chinese economic experience that, as we’ll get to in a moment, that’s obviously a difficulty now in the global economy.
Michael Pettis
Exactly.
Martin Sandbu
But before we get to that, what’s the current state of the economy? What should we be thinking about the Chinese economy today?
Michael Pettis
You know, it helps to go back a little bit because what we’re seeing, and even this new phrase, involution, that’s so popular, is nothing new. This is part of a process that’s really developed over the last 10 to 15 years.
Martin Sandbu
Explain involution.
Michael Pettis
Involution is a new word for an old problem. It’s a highly concentrated excess capacity. Since maybe 2008, 2009, we’ve seen China develop excess capacity everywhere, right? And we can go into why that was the case, but it’s been shifting around.
After the global crisis when China’s current account surplus collapsed from 10 per cent of GDP to 3 per cent — I mean, collapse is not too strong of a word — because of a cutback in foreign spending, China responded with a massive increase in infrastructure investment, which it probably didn’t need anything near what it ended up doing, but that’s how it responded.
So infrastructure spending surged to the point where there were increasing concerns that maybe China has far more infrastructure than it can productively absorb. That started to come down in the middle of the last decade, and we had a series of problems — I won’t get into them — but you’ll remember that period in which reserves collapsed by about $1tn, the stock market collapsed, etc. Beijing responded to that by initiating a new surge in the property sector, which was already one of the most expensive property sectors in the world relative to GDP.
So we had the last stage of that property bubble. But that came to an end, as you know, in 2020, ’21, around that period. And as property investment dropped very sharply, China, in order to prevent growth from slowing, engineered a massive increase in manufacturing investment.
But because a lot of this was driven by local governments, and because local governments wanted to be seen doing the good thing, which was to promote industries that Beijing had said were the industries of the future — EV, electric vehicles, solar panels, batteries, things like that — most of the increase in manufacturing investment was concentrated into a very small group of industrial sectors.
And the consequence was perhaps not surprising. They already had small amounts of excess capacity. And with investment pouring into increasing capacity, they ran into problems of massive excess capacity to the point where producers were engaged in incredibly vicious price wars not to gain market share so much as to be able to continue producing without running up huge inventories.
So involution was the name given to this process where companies are at each other’s throats, cutting prices as rapidly as possible simply in order to keep inventory from running up, which had to be financed by a very reluctant banking system. So, involution is just excess capacity concentrated in a limited number of preferred industries.
Martin Sandbu
This is fascinating because you’ve given a very interesting account of three big phases of investment — infrastructure, housing and now manufacturing — in just 15 years. It’s quite impressive. I have two questions for you about this. So one is in development economics, we sometimes talk about this concept of the middle-income trap, that many countries could get up to middle income and then they kind of get stuck.
And the reason often given is that, well, you can grow by adding capital. It’s a different story when you’ve added as much capital as you need and you have to make that capital become more cutting edge, more productive, more at the technological frontier. It seems — at least if you look at the green tech sector, for example — that China has managed to get to the frontier, technological frontier in quite a few sectors.
So my first question is, how did they do that — go from just accumulating capital to actually being at the technological frontier? The second question is, the way you describe it is, you know, has that critical tone, and I hear this from many experts on the Chinese economy in China that actually, this was hugely wasteful, some of this policy. And yet the rest of the world is in awe and kind of looks at China and the Chinese green tech sectors and say, we want that. At least the US did under Biden, maybe not anymore. Europe still does. Are we wrong to be impressed? Were they wrong? Were the Chinese wrong to get to where they have got in terms of technological development? Did they spend too much on it in the end, and will it all end in tears?
Michael Pettis
To address the first question, I’m always a bit nervous about the middle-income trap. To me, it sounds like the name we give to explain something that we can’t otherwise explain. There have been many different versions of this trap. You know, there’s this assumption a lot of people have that investment always generates growth, and that’s not true. Investment that can be productively absorbed generates growth. But when you start overinvesting beyond your capacity to absorb it productively, then you’re generating advances in technology, you’re generating great production, great infrastructure, whatever you like, but it’s no longer economically viable. We forget, but in the 1960s, Soviet technology in so many areas was so advanced. It was not just satellites; it was computers, a number of things that many people in the US believed that Soviet technology would overtake US technology within a couple of decades. And in the end, it didn’t. And I would argue the reason is probably that the Soviets supported technology for the sake of technology, not for the sake of the economic growth associated with technology.
I would argue something similar happened in Japan. You’ll hear many Chinese economists say the big difference between Japan in the ‘80s and China today is that China is on the cutting edge of technology, whereas Japan was involved in smokestack industries. And of course, if you’re old enough to remember, you know, it’s total nonsense. The Japanese were way ahead in many of the most important technologies, and in the end, it also didn’t solve their problem.
I think the thinking is that if you invest in enough technology, that will cause enough of a boost in productivity that if the productivity gains are all shifted to the household sector, then you can adjust in the form of a surge in consumption growth, right?
Let me step back for a minute, Martin. If your problem is that you’re producing far more than you’re able to absorb, right? There’s two ways of solving the problem, well, there’s three ways. One is you run bigger and bigger surpluses, but that only works for small countries, so China can’t do that.
The other way is that you bring production down, which you don’t wanna do because obviously that means unemployment and a slowdown in growth. And then the third way is somehow you get consumption to surge. No country that I can find has ever managed to do the third way, but that doesn’t mean it’s impossible.
And I think the thinking in China today, like in Japan in the ’80s and ’90s, like in the Soviet Union in the 1960s, is if we just advance technology rapidly enough, it will by itself generate rapid growth and productivity, and that growth and productivity will allow us to have an increase in consumption such that we can rebalance without the need to slow GDP growth.
Again, it’s never happened, but at least it’s theoretically possible. So the question is, what’s the point of advanced technology? If advanced technology increases the productivity of your workers, then you’re getting richer, right? The only way to get richer is to increase the productivity of your workers. But if you are losing money on advanced technology, you’re contributing your advances to the world, and the world really will benefit from Chinese technology, but it’s not clear that you will benefit.
And I think that’s the problem where we are in China. The technology is great. It’s just not clear. Once you remove the enormous amounts of subsidies, it’s just not clear that these are actually value-creating for the economy, right? So people often say that there are two different views of China. One is that China has significant imbalance problems and growth is gonna slow sharply, that’s the bear view. The bull view is China’s got fantastic technology and is moving forward. What I would suggest, Martin, is that those are not opposing views; those are the same thing. It is precisely the latter that is helping cause a part of the former.
Martin Sandbu
I think we just should pause here and take note of this possibility that what China has done is good for the rest of the world, perhaps not so good for China. To put it mildly, that’s not the prevailing view in governments around Europe and the US, but this theme of whether China’s economic goals are compatible with the goals of other big economic blocs, I think that’s the single biggest question for the global economy now and in the years to come.
We’ll have to take a short break, but when we’re back, Michael, I would like to hear your analysis of that question.
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Martin Sandbu
Right, we are back. I’m here with Michael Pettis and we are talking about China’s role in the global economy. Michael, in your book Trade Wars are Class Wars, you argued that Chinese policies have the effect in the US at least to trade deficits for the US and a loss of manufacturing jobs. This is a view you’ve promoted in other writings since. So let me put this as a bit of a tabloid question: is Donald Trump right?
Michael Pettis
I think he is a response to a real problem, a problem that the US had been failing to address for a while. But if you read Joan Robinson, who is one of my favourite economists, and certainly on the issue of trade. What Joan Robinson argued way back in the 1930s and ’40s is that if countries run persistent trade surpluses, and they run these surpluses not because they’re oil exporters with tiny populations, but rather they run these surpluses because in order to grow more quickly, they channelled transfers from the economy — which effectively meant the household sector — to subsidise rapid manufacturing growth, then they will only be able to balance the gap between rapid growth in production and slower growth in consumption with what she called beggar-thy-neighbour trade surplus. She actually called them beggar my neighbour, but we’ve changed the phrase. And what she said is that this is only sustainable for a period of time because what it does is if my production, if the structure of my economy requires that my production grow faster than my consumption and we trade openly among each other, then you have no choice but for your consumption to grow faster than your production.
And one of the consequences of that is if your policies heavily subsidised manufacturing, your share of global manufacturing is going to grow. And the share is always 100 per cent. If your share grows, my share must contract. And so that’s the basic argument. You know, Martin, I’ve been called a maverick for saying this, which really kills me because we all used to know this a few decades ago.
And what Robinson argued is that inevitably that’s gonna lead to trade conflict, and trade conflict will inevitably be bad for the economy. But it will happen because the alternative will be worse. And I think that’s what we’re going through.
Martin Sandbu
Another way, maybe, or paraphrasing you, I think, let me know if I’m right, is that if one part of the global economic system uses state intervention and policy tools actively, whereas another follows a laissez-faire approach to the economy, the latter is more likely to become the balancing item for the decisions made by the former than the other way around.
Michael Pettis
Absolutely. In fact, and again, this is a very Keynesian thing that you’re saying, so one of the ways you can think about it, Martin, is imagine that there are two different possible scenarios.
So in one scenario, the governor of the People’s Bank of China, I’m simplifying in caricaturing the process, but to make the differences clear. In one scenario, he picks up a newspaper in the morning and reads that, you know, oh dear, the Americans are saving less. We’ve really gotta help them out. Let’s buy American assets in order to balance the gap between their domestic savings and domestic investment.
In the other scenario, the governor of the People’s Bank of China says the trade surplus went up. We have to acquire foreign assets. Let’s acquire foreign assets in the United States. Those are two completely different scenarios. In the first scenario, China forced itself to save more in order to accommodate an endogenous reduction in American savings. In the second scenario, China saved more and exported the excess savings to the United States. Now, notice what happens if foreigners export savings into the US or the UK — UK is suffering from exactly the same problem, maybe even worse — there has to be a gap between American investment and American savings, right?
That’s equal to the net capital inflows, right? Now, American economists assume, as a matter of course, that must drive up American savings. After all, that’s what happened in the 19th century. But if you look at American businesses, they’re sitting on pools of cash, which they’re not using. They’re using it for stock buybacks. They’re not using it for investment. So if a foreigner comes along and says, here’s an extra $100 to do whatever you want with, they’re not going to use it to increase investment. They have all they need and they’re not investing.
Martin Sandbu
So they’re consuming.
Michael Pettis
Their constraint is demand, not scarce capital, but we still need that gap. So somehow the US has to adjust in a way that drives down savings. If investment doesn’t go up, something must happen to drive down savings. What Joan Robinson told us is that unemployment will go up because as Americans stop buying American goods and buy Chinese goods, American factories will close down and lay off workers.
That was true under the gold standard, but since the break-up of Bretton Woods in ’71, ’72, there’s an alternative, and that is to prevent unemployment from going up. Either the Fed can encourage an increase in household debt so that higher debt-fuelled demand replaces the demand that went to China, or the central government through a fiscal deficit can do the same thing.
But, so notice what happens in the US, what in that case, if China made the decision to invest its surpluses in the US and if American businesses did not use those inflows to increase investment, then basically the US chooses a couple of things. One, and choice is a strong word there, it chooses to allow unemployment to go up, or it chooses to prevent that by allowing household income, by encouraging household debt to go up or by expanding the fiscal deficit.
In addition, you automatically get a transfer of production in the US from the tradeable goods sector to the non-tradeable goods. So the US shifts out of manufacturing into services. Now, many American economists will say, this is what advanced economies do, but that’s nonsense. Japan didn’t do that. Germany didn’t do that. It’s the deficit countries where you see the shift out of manufacturing into services. In the surplus countries, their manufacturing sectors are all higher than the global average. In the deficit countries, they’re all lower.
So what I would argue in that case is that because we have a global economy and everyone must accommodate everyone else, you can locate agency in a lot of different places. And in this particular case, I would argue Americans did not make the decision to reduce manufacturing. Italians and French and British did not make a decision to reduce domestic manufacturing. They had to do that to the extent that they accommodated industrial policies in other countries.
Martin Sandbu
Yeah. Let me just note one place where I possibly part ways with you. I mean, this analysis of lost manufacturing depends a bit on whether you measure it in terms of volumes produced or in terms of employment, where even rich country surplus nations have, of course, reduced employment in manufacturing because they become more productive and volumes of manufacturing continued increasing in most of the west until the global financial crisis. It’s a story we can pick a bit at, but let’s take the big point here that Chinese policymakers have used their agency to shape a very big economic actor. That has repercussions for other economies in the world. What then can the US do if they don’t want to be a balancing item in this sense?
Michael Pettis
I wanna go back to your first point. It is true that manufacturing employment is going down everywhere. But in the US there are two reasons that it’s going down. One reason is because manufacturing employment just goes down as workers in manufacturing become more and more productive. The second reason is that manufacturing is shifting out of the US into Germany, Japan, Sweden, South Korea, China, etc, etc, right?
Now, the first reason is a good reason, right? We want productivity to go up. So the argument that who wants manufacturing employment just going down is just the reverse of the argument who wants manufacturing productivity is going up. We want to be in areas where there’s growth and productivity, right? So the fact that manufacturing employment is going down is a good thing. The fact that manufacturing employment is going down because you’re losing manufacturing to your more aggressive competitors (inaudible).
Martin Sandbu
What can we do about it, or what can the US do about it?
Michael Pettis
I think, you know, there are multiple options, right? And again, I wanna go back to Keynes. At Bretton Woods, Keynes’s proposal was that we don’t really know all the different ways you can intervene in trade. There are so many ways you can do it, but the proof of trade intervention is these large, persistent trade surpluses. So we will create a trading system that simply disallows them. Through Bancor, there was a penalty for countries that ran large persistent surpluses. And Keynes’s argument back then, his reasoning back then was you as a country can do whatever you want. You wanna be socialist, fascist, capitalist, communist, whatever. What you cannot do as part of the global trading regime is externalise your domestic costs in the form of persistent surpluses, right?
So his argument was we need a customs union, which he called the clearing union, in which countries that run persistent imbalances are penalised. And the whole tendency is to balance out the trading system with a few acceptable and reasonable exceptions. Now, is that possible? Everyone says no, we all hate each other, and so we’re never gonna come together with a new clearing agreement, a new customs union.
I’m a bit more optimistic than that. But if that’s not an option, then the most likely option is countries like the United States and, by the way, UK and Canada, who all suffer from the same problem, take unilateral steps to remove themselves from the process of accommodating imbalances in other countries.
What’s the most efficient way of doing so? There are a lot of ways. I’ve always argued that attacks on capital inflows is the best way to do it, the least contentious, the most efficient. Then it directs the pain to where it belongs. Tariffs work. They’re not a particularly useful way of doing it, and they’re incredibly contentious politically, but they work if they’re implemented in the right ways.
I’m not sure that the Trump administration is implementing tariffs in the right ways. That’s separate from whether or not tariffs can work. But the argument that I would make, which is just Robinson’s argument, is that if the system cannot continue, it will break down, and it’ll break down in the form of trade conflict.
Martin Sandbu
Just to finish up, can I ask you what likelihood of success in terms of reducing the trade deficit and boosting manufacturing do you think Donald Trump’s policies might have?
Michael Pettis
Clearly, the trade deficit isn’t contracting, right? Now, I speak to some of the people in the administration and they say we need time. This is a much larger programme. It’s not a tariff country-by-country programme. So let’s see.
But to me, that’s the key. And what I would add to that, Martin, is that everybody complains about trade conflict and all of the disruptions that have taken place.
But, you know, what I would argue is you ain’t seen nothing yet because there has been a shift in trade but there hasn’t been a change in the structure of trade. Chinese surpluses continue to grow. US deficits continue to grow more indirectly than in the past, but basically, growing deficits or financing, growing Chinese surpluses, growing US deficits are doing so.
If the US is ever able to contract its trade deficit, that’s when the real problems start, right? Because either the surplus countries will have to contract their surpluses or somebody else, and that means the European Union, will have to shift the structure of its economy and accommodate all of these imbalances, either of which will be very painful.
Martin Sandbu
Listeners, you ain’t seen nothing yet. That’s a good place to end, so stay tuned to this podcast because we’ll obviously keep continuing to follow these developments.
Michael, before we finish, I wanted to ask you a completely unrelated question, or maybe not, depending on your answer. Can you recommend to listeners a book to read, and given your experience, a record to listen to or a song?
Michael Pettis
There are so many good books. I always cop out by saying, go for quantity, not quality, read everything. But Martin Daunton’s book on globalisation, which came out very recently, I forget the title, but it came out recently, it’s a very fat book. I found that just a great place to sort of, you know, recover a lot of the knowledge we used to have on trade.
Martin Sandbu
And on the record recommendation?
Michael Pettis
I love Carsick Cars, I love White+, I love P.K. 14. I think Yang Fan is a genius. Every time she puts out a record, it’s completely different from the last. I have a thousand. I won’t overwhelm you with them.
Martin Sandbu
That’s already something to get started with. Michael, thanks so much for coming on The Economics Show.
Michael Pettis
Thank you very much, Martin.
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Martin Sandbu
That’s all for this week. You’ve been listening to The Economics Show from the Financial Times. If you enjoyed the show, please do rate and review us wherever you listen.
This episode was produced by Josh Gabert-Doyon and Mischa Frankl-Duval with original music and sound design from Breen Turner and Sam Giovinco.
Our executive producer is Manuela Saragosa. Andrew Georgiades is our broadcast engineer. And I’m Martin Sandbu. Thanks for listening.