The China Shock 2.0

The Ezra Klein Show - New York Times Opinion

In this episode of The Ezra Klein Show, economist Brad Setzer discusses 'China Shock 2.0'—the current phase of China's economic rise in advanced manufacturing

Key takeaways

• China's current dominance in advanced sectors like EVs, solar, and AI marks a fundamental shift from the first China shock, which focused on low-end manufacturing.
• China's economic model is distinct: it features state control over finance, heavy investment via state-owned enterprises, minimal social welfare spending, and high national savings rates (over 40% of GDP).

Main topics

• China Shock 1.0 vs. China Shock 2.0
• State-led economic model and its global implications

Notable quotes

China is very much at the frontier and they're dominating it. And that is going to transform geopolitics.

The sense that China would have to converge, have to become more like us... that didn't pan out.

Conclusion

China's current economic strategy—centered on state-directed investment, high savings, and minimal social

Transcript preview

Speaker 4 (0:02) The Speaker 3 (0:26) biggest economic story in the world right now is China's growing dominance across advanced manufacturing sector after 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 Setzer is a person who follows this about as closely as anyone on Earth. He is a senior fellow at the Council of Foreign Relations. He has served in top trade roles and economic roles in the Biden and Obama administrations. And so I wanted to hear his perspective on it. He joins me now. Speaker 3 (1:56) Brad Setzer, 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 Speaker 2 (2:07) 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 manufactured goods. furniture, household appliances, clothing. And I think there was a sense in the U.S. 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 lunches 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. You can 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 Speaker 3 (3:42) in the Midwest and the South, primarily, that are manufacturing towns. Mm Speaker 5 (3:46) -hmm. Speaker 3 (3:47) their factories are outsourced to China or the goods are outcompeted by China. And basically the community goes into sharp decline. Correct. And we never have Speaker 2 (3:56) a Speaker 3 (3:56) very good policy answer. Speaker 2 (3:58) 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 Speaker 3 (4:07) debate for a minute. What is the argument? about whether or not this rapidly accelerating level of trade with China is good or Speaker 2 (4:17) bad for America. The overarching view at the time was that China's integration into the global economy was more or 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 move to 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. Speaker 3 (5:21) 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 Speaker 2 (5:35) 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 high wage 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 asterisk 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. So, you know, you got Speaker 3 (6:33) to always look at both sides of the ledge. Yeah. So when you're going to Target or Walmart and you're buying clothes and toys, I mean, they really are cheaper. Oh, yeah. Like in real terms from when I was a kid. But you're saying that, you know, what we're not seeing there is, you know, the price of oil, the price of. It Speaker 2 (6:46) costs you more to fill up your car to get to Target. But once you got to Target, it was cheap. Speaker 3 (6:52) OK, so China's shock. The reason we use this term is that this whole argument got reevaluated. And so which parts of it would you say panned out and which didn't? Speaker 2 (7:01) I think the extent to which China would become a big export market was overestimated. China never was fully open to U.S. 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. You know, the state would wither away, state-owned enterprises would be privatized. 20 years after China joined the WTO, China's economy was... you know, the thinking was it would kind of look like the U.S. 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. Speaker 2 (8:19) 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 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 hukou 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 mode 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 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. So ambitious provinces will say, well, we should be the province that builds up China's national champion. Here's an ambitious guy or girl. Looks like they got a good idea. Here's a whole bunch of money. We're going to subsidize your factory. Maybe we're going to take equity. We're going to 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 a mix of. state-directed and intensely competitive. I want to Speaker 3 (11:02) draw something out in that description, which I thought 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 healthcare 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 in new economic areas it wants to dominate. You Speaker 2 (11:45) 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 that when they walk into the hospital that the cost will be covered. And frequently, there's a lot of upfront payments. And some people also say the one-child policy and an incredibly competitive marriage market has made it 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. Speaker 3 (12:49) The view is maybe more of it would change as time went on, but it didn't. So what is China Speaker 2 (12:55) 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. Xi gets concerned that there's too much investment in property, probably rightly so, that there were empty buildings piling up. He introduces a policy, three red lines, which 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 sectors. So electric vehicles being the leading example. But in general, it's investment in any sector where China has import dependence. And for Xi, that's a vulnerability. And so he really directs the state's financial sector and, you know, 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 net 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 net exports. That's a lot of statistics. But what it basically means is China is 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 growth. 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 key sense... China's selling ever more to the world, but it is not buying more from the world. Exactly. And Chinese exports, particularly in the years right after the pandemic, after the currency's 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 this same period, China's exports of cars have... gone from a 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, a little less so in the US. So Speaker 3 (16:08) I think this point about the Europe versus... U.S. is really interesting. And in one of the pieces you wrote about this, you wrote that the U.S. 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. Speaker 2 (16:29) Germany didn't move as heavily into, you know, kind of software platforms. They retained a more traditional manufacturing sector and focused on exports, including to China. So, you know, Germany, after the global financial crisis, is exporting close to 3 % of its GDP to China in manufactured 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 made their own efforts to make EVs in Europe, but