The China Shock 2.0

Brad Setser follows Chinese trade closer than just about anyone else on earth, and he thinks we’re in the early days of a China Shock 2.0. The first China Shock was when China came to dominate low-end manufacturing in the 2000s, filling American shelves with cheap clothes, toys and electronics, while devastating American factory towns. This new China Shock could be even more destabilizing. China now dominates advanced manufacturing: electric vehicles, batteries, solar panels. It’s outcompeting nearly all high-end manufacturing around the world, and other countries are just starting to feel the pain. And China isn’t slowing down. It’s moving into software, too. Its frontier A. I. models are neck and neck with American ones. China’s success poses a serious threat to the economies and domestic politics of countries around the world. So what should those countries do about it? Setser is a senior fellow at the Council on Foreign Relations. He served in top trade and economic roles in the Biden and Obama administrations. And he is widely cited across the field as one of the top analysts of China’s economy and trade practices.

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:25Ezra Klein?

  The 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've 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.

• 1:10Ezra Klein?

  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 for 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.

• 1:49Ezra Klein?

  He joins me now. Brad Setser, welcome to the show.

• 1:57Speaker 01

  Thanks for inviting me.

• 1:59Ezra Klein?

  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?

• 2:09Speaker 01

  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 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.

• 2:49Speaker 01

  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 areas that have

• 3:27Speaker 01

  the most exposure to the Chinese export wave, to deaths of despair, to political realignments.

• 3:37Ezra Klein?

  Voting for Donald Trump.

• 3:38Speaker 01

  Voting for Donald Trump.

• 3:39Ezra Klein?

  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 to China or the goods are outcompeted by China. And basically, the community goes into sharp decline.

• 3:55Speaker 01

  Correct.

• 3:56Ezra Klein?

  And we never have a very good policy answer.

• 3:57Speaker 01

  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.

• 4:07Ezra Klein?

  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?

• 4:19Speaker 01

  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 moved exporting parts of the economy or into the services sector. And that we had a fairly flexible labor market.

• 5:01Speaker 01

  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.

• 5:21Ezra Klein?

  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?

• 5:36Speaker 01

  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 asterix 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.

• 6:20Speaker 01

  China's integration into the world economy and 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 know, you got to always look at both sides of the ledger.

• 6:35Ezra Klein?

  Yes, when you're going to Target or Walmart and you're buying clothes and toys, I mean, they really are cheaper.

• 6:40Speaker 01

  Oh, yeah.

• 6:41Ezra Klein?

  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--

• 6:46Speaker 01

  It costs you more to fill up your car to get to Target. But once you got to Target, it was cheap.

• 6:52Ezra Klein?

  Okay, so China 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?

• 7:01Speaker 01

  I think the extent to which China would become 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.

• 7:44Speaker 01

  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 US or maybe look like Europe. It wouldn't be distinctively Chinese. And that didn't pan out.

• 8:00Ezra Klein?

  What is distinctively Chinese about the Chinese economy?

• 8:03Speaker 01

  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.

• 8:48Speaker 01

  It hits poor Chinese workers much more heavily. It also does not have a unified national labor market. The so-called HUCO 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.

• 9:29Speaker 01

  And then the state banks intermediates 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 through China, you're selling to the big three state airlines who act as a coordinated block.

• 10:13Speaker 01

  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 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

• 10:55Speaker 01

  intensely. So it's a mix of state-directed and intensely competitive.

• 11:02Ezra Klein?

  I want to draw something out in the 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 like new economic areas it wants to dominate.

• 11:45Speaker 01

  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 costs will be covered. And frequently, there's a lot of upfront payments. And some people also say the one-child policy in 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

• 12:27Speaker 01

  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, 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.

• 12:47Ezra Klein?

  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?

• 12:56Speaker 01

  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,

• 13:37Speaker 01

  Xi 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 the party to throw money into building out sectors where China has an import dependence. The effect is China moves back to growing

• 14:21Speaker 01

  on the back of net exports. China's domestic economy is growing 3%, 4%. So you're getting 1.5% to 2% 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 name the category of machinery, China's exports are growing. It's no longer just consumer electronics. So China starts getting growth, a big part of its growth, from an expanding trade surplus.

• 15:00Speaker 01

  Imports stop growing. This is, 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 sectors-

• 15:16Ezra Klein?

  China is selling ever more to the world, but it is not buying more from the world.

• 15:20Speaker 01

  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 this 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

• 16:03Speaker 01

  in the manufacturing heart of Europe in particular, little less so in the US.

• 16:08Ezra Klein?

  So I think this point about the Europe versus US is really interesting. 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.

• 16:29Speaker 01

  Germany didn't move as heavily into kind of software platforms. They retained a more traditional manufacturing sector and focused on exports, including to China. So 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. The tunnel-boring machines, the high-end sedans, fancy SUVs, also aircraft. All these

• 17:08Speaker 01

  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 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.

• 17:51Ezra Klein?

  I want to focus in on another dimension of this. It's kind of inside the story you're telling. So China Shock 1, it's lower on the value chain of manufactured goods. It's clothes 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 China Shock 2 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.

• 18:31Ezra Klein?

  How did they go from low to mid-level manufacturing to the absolute frontier in batteries, solar, et cetera, that quickly?

• 18:45Speaker 01

  There was certainly something in the air in China around manufacturing. The critical mass was built up and the foundations were laid. And I think it's a complicated story. So if you think about electric vehicles being like one of the famous sectors, what do you need to make an electric vehicle? Well, 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.

• 19:25Speaker 01

  And they didn't have really much of a choice because China had a 25% auto tariff for a very, very, very long time. If VW's 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.

• 20:14Speaker 01

  At a certain point, and 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, auto market was 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 because they, you know, 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.

• 20:55Speaker 01

  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 springing 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.

• 21:33Speaker 01

  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.

• 22:32Ezra Klein?

  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?

• 22:54Speaker 01

  To me, the most coherent way of defining the concern about Chinese overcapacity is a set of sectors where China produces more than its 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

• 23:36Speaker 01

  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 a 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 entrants going to displace old capacity.

• 24:19Speaker 01

  But it does feel different when a closed market suddenly is adding capacity to an industrial sector where in aggregate, there's plenty of capacity and they're squeezing margins, squeezing production out of the rest of the world.

• 24:36Ezra Klein?

  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. You know, when the country is founded, it does, over time, displace great companies from other countries. It does lead to competition that, you know, is harder for other countries. But I do think economically, America's rise is not in every respect, but broadly 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?

• 25:12Speaker 01

  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.

• 25:38Ezra Klein?

  So one argument here is simply China is winning. They're outcompeting 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 whine and keep China down. And that 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, have cheap Chinese solar panels. How do you take that argument?

• 26:10Speaker 01

  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.

• 26:55Speaker 01

  China could supply out of capacity that it has already built, the entire European auto market, 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 going to be moving to an export sector because there, no one's exporting to China. So you're going to move to necessarily a services sector. So you're going to become less focused on producing traded goods. Now, you might say, who cares?

• 27:40Speaker 01

  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 going to jump to a more innovative sector. They may jump to less innovative, less well-paid sectors. And in the end term, your economy is going to suffer. And then I think there's a sense that people have discovered that supply chain dependence can be weaponized. China dominates magnets, rare earths. If you want those magnets, you want those rare earths, you better say nice things about China. You better not do what Japan did and say you're going to come to Taiwan's defense if something were to happen.

• 28:24Speaker 01

  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 want to 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 was going to be Tesla made in China with 90% Chinese content.

• 29:07Speaker 01

  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 going to get the cheap cars, but you're not going to get the EV industry. And I think many countries are reluctant to just cede more industrial ground to China.

• 29:39Ezra Klein?

  So for a long time, the critique that you heard in American trade debate, most often of China is that they were a currency manipulator. Then you stopped hearing that as much. I think your view is that that has actually become a bigger part of the story again. So let's do this in two parts. What is currency manipulation? Why does it matter? And then where are we on the roller coaster of Chinese currency manipulation?

• 30:06Speaker 01

  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.

• 30:49Speaker 01

  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 the, what you're seeing is this shifting from being an American debate to be in a global debate.

• 31:35Ezra Klein?

  When we were preparing for this conversation, something I found myself thinking about a lot was the question of whether or not it matters if the competition is fair. I'd say for a long time, the narrative that at least we were comfortable with in this was a very procedural narrative about China betraying the principles of free trade. 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,

• 32:14Ezra Klein?

  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, right? 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

• 32:59Ezra Klein?

  a kind of healthy national ecosystem?

• 33:03Speaker 01

  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, you know, 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 are you just subsidizing

• 33:45Speaker 01

  that sector? Is a government guided fund that puts money into private equity funds and venture funds to invest in chip manufacturing, is that a subsidy? Yes and no. It may not be a subsidy under the rules. So the rules themselves are contested and not uniformly followed. And to some degree, in certain sectors, I think we care much more about outcomes than about the rules. That's obvious in sectors of national security importance. So a lot of the rare earths, famous sector, have very, very direct and important military applications. We should probably not, even if China played completely fairly, want

• 34:29Speaker 01

  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.

• 34:57Ezra Klein?

  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 is 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?

• 35:17Speaker 01

  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 the first China shock happened. So the timing was maybe strange, but a lot of the policy direction, I would agree, was more or less right. 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

• 36:00Speaker 01

  edge of the rules. The targeted first wave of tariffs were actually in sectors where it was reasonable, generally speaking, to have tariffs.

• 36:11Ezra Klein?

  And you're talking here in the first term?

• 36:12Speaker 01

  First term, yeah. So like, in the first term, the tariffs were basically on China. In the second term, the tariffs were basically on everyone. And I am much more comfortable with putting tariffs on China, particularly now, because, you know, China's economy has shifted dramatically and become much more export oriented, much more of a competitive threat now than it was then. So I think Trump won, got that bit right. Like Bob Lighthizer, the United States Trade Representative under, in Trump's first term, was sort of the first step of moving us from the WTO consensus to a world of reciprocal interdependence, supply chain vulnerability, supply chain warfare, a world where everything is using

• 36:54Speaker 01

  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.

• 37:08Ezra Klein?

  So maybe before then, we get to Trump two, it's worth talking about Biden. Because, you know, there's a lot of democratic criticism of the way Trump talks about China, to some degree of Trump's tariffs on China. But the Biden team comes in. 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

• 37:52Ezra Klein?

  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, the AI competition with China. How do you think about the way the Biden administration approached this and both kind of tweaked, but didn't upend the Trump one approach?

• 38:17Speaker 01

  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 risks associated with that. I think that was the right decision, but it unambiguously was viewed by China as a directly hostile act. And I think if someone had done that to us, we would have viewed

• 39:01Speaker 01

  it as a directly hostile act. So it put us into a world, unambiguous world of rivalry and competition, and in a position where we don't, there is no way China is not going to try to engineer us out of their chip supply chains. That's become a national priority. And so we are trying to reduce our vulnerabilities to Chinese economic coercion at the same time. But it didn't really go far enough in critical minerals, rare earths. I mean, there's 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

• 39:44Speaker 01

  are almost 100% sourced from China. So I think, you know, it was a step in a necessary direction. It was controversial because industrial strategy, industrial policy, you know, for a long time, the thought was that was something other countries did. It wasn't something that America did. And it wasn't something we're necessarily very good at. And in some cases, like rare earths and the magnets, like active ingredients, it means finding ways to incentivize production in sectors where you know you can't compete with China on cost.

• 40:40Ezra Klein?

  So that then brings us to Trump, too. So how would you rate what they have done and where it has hit? The right balance and where it's been off?

• 40:51Speaker 01

  So in general, I like Bob Lighthizer's trade policy, i.e. Trump's first term, better than I like Donald Trump's trade policy, i.e. Trump's second term. Lighthizer was careful to only threaten things that the US economy could sustain. So 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.

• 41:32Speaker 01

  We need to raise our tariffs and you need to lower your tariffs, lower your barriers to US exports to put trade on a more fair footing. You shouldn't, in other words, retaliate for our tariffs. China retaliated. China said, this is coercive. Plus, China knew they were going to be in the crosshairs. She did a good job of getting ready. He'd spent four years plotting this out. So China retaliates. We counter retaliate. China retaliates some more. 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.

• 42:14Speaker 01

  So the administration was in a position where they needed to negotiate a rollback in the tariffs. There's a rare earths component as well.

• 42:23Ezra Klein?

  But China, where China was holding back rare earths, which would cripple our manufacturing.

• 42:27Speaker 01

  Yeah, so that was real. But it's, I think, even if China had not done that, even without the supply chain restrictions, the administration knew it needed to roll back the 145% tariffs. The example that I like to give is that in the summer of Trump's first year with 100-ish plus tariffs, all the retailers who import artificial Christmas trees, which like all come from China, think Christmas tree harness, 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 something crazy. And the Christmas tree importers weren't sure, because they're building up inventory

• 43:12Speaker 01

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

• 43:57Speaker 01

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

• 44:40Speaker 01

  Canadian aluminum is, not that this administration cares, but it's made in a kind of green way, trapped hydropower in Quebec. It has been part of our aluminum industry since World War II, 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.

• 45:25Speaker 01

  So it was pure self-harm, fully on board with limiting imports of aluminum from China, having a more self-contained North American market. But this was kind of silly. 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 electronics got excluded, chips got excluded, because you can't penalize dataset or 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.

• 46:06Speaker 01

  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 was a huge win for them. Most important developments, China showed it can punch back.

• 46:24Ezra Klein?

  Yeah. People worried for years about them unwinding purchases of US treasuries. They didn't do that. I mean, the sense that if this escalated, they had more dependencies that they could weaponize, I think, has been very salient.

• 46:37Speaker 01

  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, gets real technical. But at the end of the day, we actually have a counter if China sells treasuries. The Fed can always buy more treasuries QE than China can sell. We showed that in 2020. We actually showed that in '08 and '09, when China was selling agencies, Fed-y, Franny, mortgage-backed securities, and the Fed started buying them.

• 47:20Speaker 01

  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.

• 47:35Ezra Klein?

  One of the charts, as I was preparing for this, that struck me is that if you look at America's trade deficit, the world doesn't look that different than at the beginning of Trump's term. So in terms of what we've been trying to achieve with our various trade wars or trade policies, have we achieved anything? I mean, in Trump's own sort of conception of the world, manufacturing, trade imbalances, is there progress that they can point to?

• 48:04Speaker 01

  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 as 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 got to be not tariff us. We have leverage over you. We haven't changed that. And we haven't changed China's broad trajectory. China is a bigger exporter globally, runs a bigger global trade surplus, not just by

• 48:48Speaker 01

  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, because it's not at all been targeted. It alienated the courts, because not a lot of thought was put into conforming to reasonable

• 49:33Speaker 01

  expectations of what the law allowed, and it generated a bit of revenue.

• 49:38Ezra Klein?

  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, like a united set of goals between us and Europe. We all want to protect our auto industries. We all don't want to be dependent on Chinese chips or China taking over Taiwan, and then we have a huge chip problem. I guess the question is, what do you think our goals should be here? What do you think the set of outcomes we are trying to generate should be? And can they be generated?

• 50:21Ezra Klein?

  Or is there an inevitability to all this, given China's size, given its manufacturing capacity? People sometimes talk about where we're going as having an almost, yeah, an inevitability to it. I'm curious if you buy that.

• 50:37Speaker 01

  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, quite significant. Look, I was, I was part of the Biden administration at the beginning. I'm implicated in some of those decisions. And in the early days of the Biden administration, the overarching goal of the trade policy was to avoid a trade war with Europe, which was sort of where Trump was heading, had he won

• 51:17Speaker 01

  reelection that year, and convince Europe that whatever our traditional sources of friction, we had a common interest in thinking through how to handle China and taking real action against China, you know, make, you know, bring our policies into harmony, but 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 got to go back to the rules.

• 51:53Ezra Klein?

  Nothing Europe loves like a procedural argument.

• 51:56Speaker 01

  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, you know, I think Trump came in and he said many times that Europe's almost as bad as China. Allies, not allies, not how he thinks of the world. Xi, great leader, we should be doing deals with Xi. Bunch of European leaders, not great leaders.

• 52:38Speaker 01

  You know, they, you know, they, they, they've allowed themselves to have their hands tied by the European Union. Real leaders like Xi, like Trump, don't allow their hands to be tied by supranational institutions, 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, you know, they wouldn't, it wouldn't be called against China, but it would effectively be an alliance to create a bigger market

• 53:18Speaker 01

  outside of China with a, some sense, 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 too, 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

• 54:01Speaker 01

  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's 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.

• 54:32Ezra Klein?

  What do you think about the notion of a China Shock 3 that you're beginning to see on the horizon, which is, we've been talking about how China Shock 1 was kind of low-end, middle-end manufacturing. Number two has been high-end batteries and cars and things like that. But the thing that America's had that has insulated it, that has made our stock market such a booming part of the global financial system is, as we talked about, sort of software, finance, and more recently, of course, AI. And we are still have real leadership in AI, but it's amazing how strong the Chinese open source models are, how close they are. They're a lot cheaper, they're cheaper to run, and China's able to, I mean, China does

• 55:16Ezra Klein?

  not have the chips we have, but they are able to pump energy into it. They're not going to have the data center slowdown that we're going to have, right? You're not going to have, you know, local data center protests that are stopping China from building enough data centers. So it's not crazy, given how much more difficult it is to create the infrastructure for AI here, that China will pull ahead in the coming years.

• 55:39Speaker 01

  So I do think that's, that is a possibility. If you think of China Shock 3.0 as sort of services, but services not as in haircuts, 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 it wanted political control, but that sort of meant that China's search engine is never really that competitive globally, which left

• 56:22Speaker 01

  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 an even more important part of the stock market. Look, AI is up for grabs. We don't know if the US models will, that people are willing to pay as much as the people who are spending tons of money to build all the data centers and buy all the Nvidia chips are willing to invest. That's an open question. It is quite possible that it will prove to be a competitive market and no one will make

• 57:07Speaker 01

  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 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.

• 57:43Ezra Klein?

  Is what we want or what we should want for China to be exporting less, for them to have less of an overcapacity, as it gets called, or is what we want for China to be more open to imports, right? 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, somewhat under the push from Jensen Huang of Nvidia. And Nvidia's argument, and the argument that I heard from Trump people around this was, look, we actually want China somewhat dependent on Nvidia's chips. We have all these dependencies on China. The idea that they're somewhat dependent on us is not a bad thing.

• 58:24Ezra Klein?

  Now, even once we sort of opened that back up, China's not been excited about Nvidia chips. They have, you know, made strides on their own. And yes, they were like the very best stuff and there's some things we're still holding back. But I felt like in there you saw this kind of emergent fight, which is, do we want to be more separated or actually is a problem that, you know, there's been more openness in one direction than the other? It's like, that's the, the thing we should be targeting. How do you think about that?

• 58:54Speaker 01

  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. So 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. And I think that's, in that sector, that's a, a real risk, set of risks. I, I'd be a bit cautious there.

• 59:36Speaker 01

  I think conceptually, mutual interdependence, reciprocal vulnerabilities, control over offsetting choke points is a way that competing great powers, great military powers now, great economic powers that are rivals, not allies, can coexist. You cannot supply chain restrict me because I can supply chain restrict you and we can deter each other. You, you apply strategic and military concepts of round deterrence. So it's, it's a vision that allows trade, but it's kind of hostile trade, so to speak,

• 1:00:17Speaker 01

  where you're always worried that you're, that interdependence is shifting towards dependence, particularly because Xi has said that his goal is, is dependence. He wants the world to rely on Chinese supply chains. Arguably, that's one theory he has about how he could achieve victory in Taiwan without actually fighting. Everyone needs us so much, they can't, can't react, can't respond.

• 1:00:42Speaker 01

  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 are 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 has to choose, but they're 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.

• 1:01:26Speaker 01

  I mean, we're not going to tell our farmers they can't sell to China. We're just not. And there are certain products which I think we should be fine importing from China. But defining the lines is going to 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 has done great. No question, booming, growing faster than global trade. The domestic side of the economy, people doubt whether the domestic side of the Chinese economy is really growing faster than the domestic side of the US economy. It is not doing great. There's a lot of unemployment. There's deflation. There's real internal problems.

• 1:02:11Ezra Klein?

  An aging population.

• 1:02:13Speaker 01

  We have an aging population too, but China's aging a little faster.

• 1:02:15Ezra Klein?

  Yeah.

• 1:02:16Speaker 01

  And now there's a looming problem of overinvestment, 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, that's a real problem because China's internal economy is incredibly unbalanced. Like it's second biggest world economy in the world, but with the biggest domestic distortions across the board, the most unbalanced pattern of savings and investment. There will need to come a time when China doesn't have to have an expanding trade surplus to grow. So I do think that that is a problem. And of course, it's tied on our side to our fiscal situation.

• 1:03:00Speaker 01

  You know, we're, 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 are, there probably eventually are limits on our side too.

• 1:03:11Ezra Klein?

  I think that's a good place to end. Always our final question. What are three books you'd recommend to the audience?

• 1:03:16Speaker 01

  Well, the, 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, longtime Beijing correspondent for the Financial Times, who wrote a book called The Party. And he really showed that you can't understand modern China without understanding the modern Chinese Communist Party. And, you know, vivid scenes with like red telephones where, you know, your special party line where you get the instructions if you're the CEO of a big company about what you should be doing. Second book is, is another old book, actually.

• 1:03:58Speaker 01

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

• 1:04:43Speaker 01

  is, you know, How to Win a Trade War by Chad Bown and Sumaya Keynes. Whatever side of the trade debate you're on, you're going to learn something. It is not a polemic. It is, I think, the best guide to a world where people are thinking about trade in terms of vulnerabilities, not just in terms of opportunities.

• 1:05:07Ezra Klein?

  Brad Setser, thank you very much.

• 1:05:09Speaker 01

  Thanks, Ezra. It's been a pleasure to be on the show.