Michael Pettis joins Alan Dunne for a wide ranging conversation on trade imbalances, globalization and the future of the world economy. Drawing on decades of research into China, Europe and financial history, Pettis argues that persistent trade surpluses are ultimately rooted in domestic income imbalances rather than national competitiveness. The discussion explores why China struggles to rebalance, why Europe may face its biggest challenge yet, and how US reindustrialization could reshape global trade. From Bretton Woods to modern tariffs, this episode offers a provocative framework for understanding the forces driving the next phase of the global economy.

-----

50 YEARS OF TREND FOLLOWING BOOK AND BEHIND-THE-SCENES VIDEO FOR ACCREDITED INVESTORS - CLICK HERE

-----

Follow Niels on Twitter, LinkedIn, YouTube or via the TTU website.

IT’s TRUE ? – most CIO’s read 50+ books each year – get your FREE copy of the Ultimate Guide to the Best Investment Books ever written here.

And you can get a free copy of my latest book “Ten Reasons to Add Trend Following to Your Portfolio” here.

Learn more about the Trend Barometer here.

Send your questions to [email protected]

And please share this episode with a like-minded friend and leave an honest Rating & Review on iTunes or Spotify so more people can discover the podcast.

Follow Alan on LinkedIn.

Follow Michael on X.

Episode TimeStamps:

00:00 - Michael Pettis warns that the real trade reckoning may still lie ahead

01:07 - Introduction to Michael Pettis and his background in finance and economics

06:34 - Why trade imbalances are ultimately driven by income imbalances

09:59 - Germany’s Hartz reforms and the roots of European imbalances

17:22 - Competitiveness versus productivity and the hidden costs of wage suppression

27:48 - China’s growth model and why rebalancing has proved so difficult

35:54 - Who will absorb China’s trade surplus if the US closes its deficit?

40:24 - Can the United States successfully reindustrialize?

45:31 - Why Europe may eventually turn toward protectionism

52:17 - The US deficit, global capital flows and the burden of dollar dominance

01:01:50 - Why the renminbi is unlikely to replace the dollar

01:10:45 - Historical trade imbalances and how painful adjustments unfold

01:16:21 - What Japan’s experience reveals about China’s future

01:21:02 - Final reflections on debt, globalization and economic adjustment

Copyright © 2025 – CMC AG – All Rights Reserved

----

PLUS: Whenever you're ready... here are 3 ways I can help you in your investment Journey:

1. eBooks that cover key topics that you need to know about

In my eBooks, I put together some key discoveries and things I have learnt during the more than 3 decades I have worked in the Trend Following industry, which I hope you will find useful. Click Here

2. Daily Trend Barometer and Market Score

One of the things I’m really proud of, is the fact that I have managed to published the Trend Barometer and Market Score each day for more than a decade...as these tools are really good at describing the environment for trend following managers as well as giving insights into the general positioning of a trend following strategy! Click Here

3. Other Resources that can help you

And if you are hungry for more useful resources from the trend following world...check out some precious resources that I have found over the years to be really valuable. Click Here

Privacy Policy

Disclaimer

Basically, if you think things have gotten bad in the past couple of years, well, ‘you ain't seen nothing yet’ because nothing has fundamentally changed. What really matters is if the US is able to get its act together and address its trade imbalances. And I think eventually it will. The US has to reindustrialize and as part of that, it must bring down its trade deficit. That's when things really start to get rough for Europe.

Welcome to Top Traders Unplugged. In markets success doesn’t come from predicting what happens next, it comes from being prepared for what you can’t predict.

In each episode we go deep with some of the world’s most thoughtful minds in investing, economics, and beyond to understand how they think, how they prepare, and how they decide, and the experiences that shaped how they see the world. No noise, no short-cuts, just real conversations to help you think better and invest with confidence.

Welcome back to Top Traders Unplugged. My name is Alan Dunne, and this week I'm delighted to be joined by Michael Pettis. Michael is a senior fellow at the Carnegie Endowment for International Peace. He also has taught economics and finance in China for 20 years or so. Prior to that, he worked on Wall Street at J.P. Morgan and Bear Stearns. He's the author of several books. The most recent one, Trade Wars are Class Wars, with Matt Klein. Michael, great to have you on as a guest. How are you?

Very good, thanks.

Well, as I mentioned, you're the author of Trade Wars are Class Wars, with Matt Klein and we've had Matt on before and that was a great conversation. So, I've been really looking forward to this one as well and have followed your work for some time.

I mean, you have a very interesting background. You started off in Wall Street and then you've migrated into teaching and research. What got you interested in economics, markets, finance, in the first place?

Well, you know, when I was on Wall Street, I was running fixed income trading in capital markets desks, specializing in Latin America. I have a strong Spanish and Latin American background. And one of the things that had occurred to me, which occurs to everyone who spends a lot of time trading Latin America, is that you really need to understand Latin American economic history to get a sense of where it is and where it's going.

So, I spent a huge amount of time studying Latin American economic history, and from there I sort of became an economic and finance history junkie and that sort of led naturally into thinking about economics and the development process.

Very good. And I think I'm right in saying you're not formally trained in economics in a sense that you don't have a PhD, you have an MBA in finance, is that right?

Yes, I have degrees in finance, but not in economics. And not to be nasty, but that means I probably make fewer mistakes than people with PhDs in economics.

Well, that was my question. I mean, it is interesting. Some people say he's an economist or he's not. I mean, what qualifies somebody to be an economist? Obviously, you're a well-known and well-regarded economist, I would say now, without a PhD. I mean, do you think that you probably gives you an advantage over people who are more classically trained? Is that fair?

Well, yeah, I'm very much a systems guy. And one of the things that really worries me about economics is that, as you know, there's very little connection. Economics started as a description of the economy, but it sort of developed its own sort of processes that have been divorced from the real economy.

It's almost a cliche to say that whether economists are right or wrong has almost no impact on the credibility of what they are saying, on the prestige of what they're saying. So, I would argue when you have two systems with their own internal processes and no feedback mechanism between the two, the tendency is inevitably that they separate.

So, what I would argue is that academic economists do a very good job of describing a particular type of economy. Unfortunately, that economy doesn't exist, probably never has existed, and bears very little relationship to the Anglophone economies, and even less relationship to the non-Anglophone economies, and are almost incompetent in dealing with something like the Chinese economy, which is a very different economy.

Okay. I mean, the economists will say their models are a simplification, but they can still draw reasonable inferences from their models. But I guess you disagree with that.

Well, you know, the Ptolemaic model was also a simplification, but its basic assumptions were wrong. They didn't apply to the universe. So, they ended up retarding the science of astronomy.

And you know, I would say most economists, when they talk about trade, whether they realize it or not, they're basing their work on models that assume balanced trade. And for example, the Comparative Advantage model of David Ricardo's. If you go through the arithmetic, you realize the arithmetic only works when trade is balanced.

So, if you assume that trade is balanced, if your models assume that trade is balanced, that there is no intervention in currency markets (that's another fundamental assumption of most trade models), then it becomes very hard to take conclusions from that model and use them to describe the actual world of trade.

And it's interesting, because eventually, if you hit someone on the head enough times, he'll start to feel the pain. And I think economists are finally starting to recognize that trade imbalances are a very deep problem and need to be resolved. But this is something that, if you're a business person, or an investor, or a policymaker, it wasn't so hard for you to figure that out. It became pretty obvious pretty early on. Economists are just starting to recognize that the existing trading system that we have has real fundamental problems with it.

Okay. And as I say, you wrote a book called Trade Wars are Class Wars, with Matt Klein, a few years ago, and this kind of sets out your framework for thinking about international trade, and trade imbalances, and trade conflicts. And I guess it is maybe counterintuitive, maybe (I don't know if it's fair to say), but it definitely brings a different perspective on the source of trade imbalances. So, maybe if you could maybe, in your words, set out what that is and what consensus gets wrong and trade imbalances.

Well, you know, one of the things that Matt and I have tried to do is to make sure that people understand we haven't really invented a new theory of trade. Nothing that we say is especially original. Had you gone back and read John Maynard Keynes or Joan Robinson or Ragnar Nurkse or Michał Kalecki, any of those guys, I don't think they would have said anything. You know, they would have heard anything particularly novel.

A very famous economist, probably the most famous economist in the world who hasn't yet won a Nobel Prize, told me recently, we had this big discussion on trade. And amazingly enough, I was able to bring him around to my side, even though he's famously very arrogant about people he disagrees with.

He said, you know what the issue is? I finally understood the issue because I've known him for a while. We've had many, many discussions. And he said, economists typically think in terms of price effects because that's much easier to model, but you think in terms of income effects. And that had never occurred to me, but I think he was absolutely right. I think when you think systemically, you think in terms of income effects.

When income is well distributed within a society, total consumption plus total investment is able to absorb everything that's produced within the economy. It's only when you have very high levels of income inequality, in which the average person retains a very low share of what he or she produces, that you end up with problems of excess capacity and trade imbalances.

And that's the main point of our book. If you see trade imbalances, this almost certainly means that there have been significant income imbalances.

Yeah, and just maybe to trace that through then. So, from the perspective of the big surplus economies such as China and Germany, as you write about in the book, what you're saying is basically that average wages are kept down and consumption is not as strong as it could be, there are surpluses that arise to the corporate sector and they tend to save more and export those surpluses. And I guess the counterfactor of those capital count surpluses has to be a trade deficit elsewhere. Is that fair to say?

And interestingly enough, they all went crazy at exactly the same time that Germany started saving a huge amount of money and running massive current account surpluses, which is really convenient. Right? Because the silliness of the peripheral Europeans match the thriftiness of the Germans.

After the Hartz reforms, productivity continued to grow a little bit more slowly, but wages stopped growing altogether. And instead, what ended up happening is business profits surged. Business profits, of course, are saved, whereas a worker's income is mostly consumed.

So, the result was the Germans suddenly became thrifty. The German saving rate soared. Even if you look at household savings, they didn't go up, they went down. But the story developed that the Germans were extremely thrifty, and their thriftiness found its counterpart in the lack of thrift in Spain, Ireland, Italy, etc. And what I would argue is that that's not what happened at all.

What happened in Germany very clearly was savings went up not because of thriftiness, but because of labor policies that repress the growth rate of wages and so repressed consumption and forced up domestic saving. That saving had to go somewhere. And because of the creation of the euro, it was very conveniently redeployed within Europe.

And interestingly enough, all the countries that entered the euro with high inflation rates were the ones that received all of the German inflows. And that makes sense, because as interest rates converged across Europe, real interest rates became negative in the former and positive in countries like Germany. So, money poured into a country like Spain (I'll call it Spain, rather than all the others, to make it easier).

But if money pours into Spain, if there's a net inflow of saving from Germany into Spain, then that changes Spain's external account, which must change its domestic imbalances. Which means that if there is a net inflow of €100 into Spain, we must see a gap between Spanish investment and Spanish saving.

Now, if Spain were a developing country with huge investment needs, perhaps that might have resulted in a surge in investment, in which case Germany's surpluses would have contributed to global growth. But like most advanced economies, Spanish investment is constrained not by the lack of saving, but by the lack of demand. So, investment didn't go up.

There was a bit of an increase in investment in Spain in infrastructure. Spain has very good transportation infrastructure. Part of it went into the property bubble. And of course, in Ireland, you're very familiar with that. But very little of the net inflow resulted in an increase in investment. And so, therefore there had to be some other shift in the Spanish economy that caused unemployment to go down.

And as we argue in the book, there's basically… I'm sorry, that caused saving to go down. There are basically three ways saving can go down. The classical way, described by Joan Robinson, who was one of the Keynes's friends and disciples, she explained that these inflows would drive up unemployment. And as you know, an unemployed worker has a negative saving rate. So, Spain adjusts that way; higher unemployment, lower saving. Everything balances.

Of course, in the modern economy, we don't want unemployment to go up, and we have tools to prevent it. One tool is to encourage household lending. So, you lower lending standards and households borrow more. And of course, debt is negative saving. And the other way is to increase the fiscal deficit. And of course, the fiscal deficit is a negative saving.

So, the purpose of the book is to argue that either there was a whole bunch of very surprising and very lucky coincidences, or you can treat the European imbalances as changes in the distribution of income, driven particularly by policies in Germany.

Yeah, I mean, it's very interesting and as you say, it kind of mechanically has to be the case. I mean, in terms of the flows, capital account has to balance, current account, etc. As well it raises a couple of questions.

One, I mean, it's kind of like the thinking at the time in Germany was we have to boost productivity, we have to boost competitiveness. It's all about competitiveness. Better competitiveness will mean more jobs, better for everybody.

And I've just started reading Wolfgang Munchau’s book about Germany, and it's very much aligned with your thinking that this kind of flawed thinking about fiscal responsibility, keeping your fiscal house in order, is consistent with your point. I suppose my question is, was it a conscious decision to favor corporates, to favor the elites, or was it misguided thinking?

Well, I'm glad you put it that way because you said, the Germans decided that they needed to increase productivity and competitiveness. And what I would argue is that those are two completely separate things.

First of all, productivity didn't grow after the Hartz reforms. It grew more slowly than before the Hartz reforms. So, if that was the point, they were clearly a failure. But competitiveness went up significantly. Right? And why did German competitiveness go up even when productivity didn't? Because German wages went down. And this was the so-called Kalecki paradox. Right?

Kalecki argued that you can improve your profits if you lower your wages, but if we all lower our wages, our profits will not all go up. In fact, they'll go down. And the reason is because it's wages that drive demand and wages that drive productivity improvements.

So, I would say that lowering wages is not a way of increasing productivity. It actually reduces productivity, but it increases competitiveness. And that's the point. So, what ended up happening with Germany is it became not more productive, but much more competitive. And that caused enormous losses in Germany's trading partners. And that's what we see at the global level. Right?

So, if you want to increase productivity, that's a very different issue. And when I go to Europe and speak to EU officials, I try to make this point as strongly as I can. In Europe, you have a competitiveness problem, not as big as the US. The US has a huge competitiveness problem, and you can see that in the size of the trade deficit. And you also have a productivity problem, which the US doesn't have. The US has pretty good productivity growth. And these are very separate things.

If you want to improve productivity, there are all kinds of things you can do. But if you want to improve competitiveness, there's only two things you can do. One is to match countries like China, which have very low unit labor costs - not low wages, low unit labor costs, low wages relative to productivity.

So, you can wipe out your social welfare system, you can lower wages, you can do all of these things that'll make you much more competitive. Is that a good thing? No, not really. Because as you lower wages, not only will you have political problems, but more importantly, your contribution to global growth will go down, your share of global growth will go up, and that's the Kalecki paradox. Right? If you cut wages, you benefit, but the world is worse off. And if we all cut wages, nobody benefits, we're all worse off.

So, one thing you can do in Europe, is cut wages, Right? Eliminate your social safety net. I think that's a terrible idea. But if you want to do that to regain competitiveness, that'll work. The only other thing you can do is to intervene in your external account. Right? And since you can't really intervene in your currency, then you have to do what countries do when they can't intervene in their currency, and that is to implement tariffs. But if you were going to implement tariffs, I would say, there you have to make very sure you don't do it the way the US did it. Bilateral tariffs, sectoral tariffs are a waste of time. The purpose of tariffs is really to replicate a currency devaluation if you can't do a currency devaluation.

How can you say, like, that side of it is the primary driver? That the German capital coming our way is a bigger driver than our own consumption, our own property boom, or is it just coincidence, or how do you reconcile those?

Well, if there were a special Irish thing about property bubbles, I would say, okay, it was probably your fault, but there isn't. Ireland has no more property bubbles than anybody else. And what's really striking is that you guys went crazy about property at the same time everyone else did. And so, I have real trouble believing that that's domestic.

What ended up happening is that Spanish banks significantly lowered their lending standards because of massive inflows from Germany that had to be recycled. And I suspect the same thing happened in Europe… I'm sorry, in Ireland.

Something very similar happened in the United States, in part because of mortgage securitization. Massive amounts of capital flowed into the mortgage industry. And by now it's pretty well documented, the way American banks responded was by lowering their lending standards. They used to have very strict lending standards and they eliminated them… basically eliminated in the famous NINJA loans - you know, no income, no job, no assets. You could still borrow money and buy property.

And I would argue that that's really what drives the process. It was changes in the underlying liquidity of the banking system which were driven, I would argue, by the flow of capital from Germany into countries like Ireland.

And back to the point, I mean, do you think it was just misguided policy or a policy choice to favor the corporate sector?

The problem with reducing wages in a closed system is that if you reduce wages, you reduce demand. Right? But in an open system, if you reduce wages, you can increase your trade surplus and therefore you don't suffer the unemployment consequences of lower wages. You pass them on to your trade partners. So, I would say what Germany did was perfectly rational for Germany.

‘Beggar thy neighbor’ policies are perfectly rational, but they're bad for the global system, which is why they should be prevented, which is why Keynes's proposal at Bretton Woods insisted that countries not be allowed to run large persistent trade surpluses.

It was all about let's reduce real wages to solve the unemployment problem. Where did it get lost along the way? And why is this counter to the orthodoxy?

Once investment is constrained by the lack of demand, then demand becomes very important. This is one of Keynes's big insights. Demand really does matter. In, I think, January or February, the ECB came out with a report which I think is pretty important. They asked European businesses, why aren't you investing more? Why aren't you expanding capacity? Why aren't you investing in productivity enhancing technology?

And they didn't say it's because we lack saving, it's because capital is too expensive. They said it's because there is no demand. That was the number one reason. The number two reason, which is basically the same thing, is because it's not profitable, which is just another way of saying there's no demand.

So, if you really want to increase business investment in productive capacity, either you have to increase demand for that capacity domestically or you have to run trade surpluses basically to take demand away from your trade partners. The latter is a problem. And again, Keynes was very much opposed to this.

He said that you shouldn't be able to grow off the back of demand of your trade partners. It should be domestic demand, which means domestic wages, which should drive growth. But we live in a globalized system in which it makes a lot of sense to play the Kalecki game - to grow faster by taking demand from your trade partners. And you do that by lowering your unit labor costs.

It's not a coincidence that China has the lowest unit labor costs perhaps of any economy in the world, certainly of any meaningful economy, and it has the highest trade surplus. That's not an accident.

Moving to China, obviously this has been a policy choice. It's kind of been this neo-mercantilist approach for many years. From reading your work, you seem to be quite pessimistic on things changing in China. There is, I suppose, a government bias towards keeping consumption levels below where they maybe should be and focusing on investment and manufacturing. Talk to us a little bit about the structure of the economy. How is it set up that way?

And Hirschman's question was, why is it that no one ever changes to a new model? And what he argued is that because a successful growth model creates political, legal, economic, financial institutions that depend on that model and they become disproportionately powerful. And it becomes very difficult to shift to a very different model once the model has run its course.

So, I would argue what happened in China, which very much is what happened in Brazil in the ‘50s and ‘60s in the Soviet Union during that same period, in Japan in the ‘70s and ‘80s and at least a dozen other countries, is that they started this process hugely underinvested.

So, Japan was underinvested because it was basically destroyed by war. China was underinvested because it had gone through five decades of anti-Japanese war, followed by civil war, followed by Maoism. The Soviet Union was also destroyed by war. It's a pretty common pattern. And what these countries needed more than anything else was a lot of investment to rebuild infrastructure, rebuild manufacturing capacity, rebuild housing. And so, they put into place very powerful growth models that did exactly that.

So, when you have very high investment rates, those investments have to be funded by saving. And typically, you import saving from abroad. So, the United States in the 19th century was a huge net importer of foreign capital to fund its very high investment. But depending on foreign capital is very risky. Every time England had a cold, the United States had a depression.

Now, was this a bad thing? No, not necessarily. Because when you reduce the wage share of GDP, you force up saving. And if the saving pours into productive investment, you end up with such rapid growth that wages also grow rapidly. They grow more slowly relative to GDP. But when China was growing at 10%, wages were growing at 7%. Right? More slowly, but still a great rate of growth. So, this was a great model.

But they just go from bubble to bubble. And it's not because they want to run surpluses out of any vicious tendency. It's because it's extremely difficult to change the model without accepting a significant slowdown in growth and a significant reduction in their share of global manufacturing. And as long as they can't accept those two things, they cannot rebalance.

No, it was pretty silly. It's the type of reasoning that comes from people who haven't bothered reading the history. You know, China didn't invent this model. We've seen this model many times before, and it's always run into the same problems. The only interesting question is whether the adjustment is really quick and brutal, you know, socially and politically brutal, or is it very slowly drawn out and economically much worse, but spread out over a long period of time.

Yeah. Okay. I mean, taking us to today, and obviously China still has a huge trade surplus. I mean, obviously you could say the US is resisting that with its tariffs. In Europe it's a big issue. We're seeing more EVs coming in, solar, etc. So, it presents a big dilemma from the European perspective. And obviously Germany initially benefited from that, the Mittelstand, as kind of supplier of capital goods to China, that's all changed now. I mean, who will absorb China's trade surplus, do you think, going forward?

Well, this may surprise people, but nothing has really changed in the sense that most of the surpluses of the world continue to be Chinese, roughly half. But most of the deficits of the world, again roughly half, continue to be American. And if you throw in two countries with very similar financial markets, Canada and the UK, those three countries together account for 70% to 80% of global deficits. Right?

So, what we've seen is a shifting round of trade patterns, but we haven't really seen an adjustment yet. And in fact, this is what I tell my friends in Europe. Basically, if you think things have gotten bad in the past couple of years, well, ‘you ain't seen nothing yet’ because nothing has fundamentally changed. What really matters is if the US is able to get its act together and address its trade imbalances. And I think eventually it will.

It's very hard, you know, to shift from one model to another, but I think there is a strong bipartisan consensus in the United States that the US has to reindustrialize. And as part of that, it must bring down its trade deficit. That's when things really start to get rough for Europe, because right now the Chinese surplus with the US has gone down, but the Chinese surpluses with the rest of the world, including Europe, has gone up. But meanwhile, the US deficit with China, which has gone down, has been more than matched by a rising US deficit with the rest of the world, including Europe.

So, what ends up happening is that although China is not running huge imbalances with the US. US imbalances are, nonetheless, funding Chinese imbalances. If the US is able to bring down its deficit, then the world faces a simple arithmetic problem. Because if the US is more than 50% of global deficits, and the US, the UK, and Canada are more than 70% of global deficits, then if the US is able to bring down its deficit, probably the UK and Canada will be forced to do the same. In which case that leaves us with a problem.

Either the surpluses of the manufacturing surplus countries have to come down just as quickly, which will be brutally difficult, not just for China, but also for Taiwan, South Korea, Sweden, probably Germany, or somebody else must replace the US as the big deficit country. And given the type of manufacturing, which we're increasingly seeing in China and which will be part of the manufacturing revival in the US, it cannot be the developing world that ends up replacing the US as the big deficit source. It must be Europe.

And when that happens, Europe faces a really, really difficult problem. It must either see the same kind of collapse in its manufacturing that we saw in the US, or it must protect its manufacturing by increasingly intervening in its external accounts to match Chinese intervention in its external accounts.

And the problem with Europe is that it's not really clear that Europe is politically powerful enough and a unified entity, that it will be able to do so. So, I would say the real test for Europe is not now, it's quite difficult. But the real test for Europe will come when the US is finally able to address its trade deficit.

And on that, I mean, you're talking about US reindustrialization, which does seem to be the policy now. I mean, is that plausible, do you think, in the US? Obviously, they're trying to bring a lot of the manufacturing and semiconductors, etc. onshore to the US. Is the labor able to transition into that? Manufacturing has already been hollowed out, but it sounds like you do think they can be successful in reindustrializing.

Yeah, well, we have to be careful when we say manufacturing is hollowed out. The US still is, by far, the second largest manufacturing power in the world. Now, the problem is that manufacturing represents roughly 11%, 12% of US GDP. Globally, manufacturing represents around 16%. Right? In countries like Germany, Japan, Sweden, manufacturing represents around 19% of GDP. In China, it's truly exceptional, it's around 25%, 26% of GDP.

So, when we say manufacturing has been hollowed out in the US, it hasn't really. The US is still the second largest manufacturing power. But that's what creates the problem for Europe, because the US accounts for about 17% of global manufacturing - it's 24% of global GDP and 17% of global manufacturing. China, which is about 17% of global GDP, accounts for around 31% of global manufacturing. So, the US and China together are roughly almost half of all global manufacturing. China is locked into a growth model in which manufacturing has to expand. It's the only way to keep growth up.

I don't think it can expand many more years, but at least for the next three to four years, we may see manufacturing continue to expand in China. And in the US, if we start to see a reversal of the contraction in manufacturing, then again we face the same problem.

You can't have half of the world expanding its share of global manufacturing without the rest of the world reducing its share of global manufacturing. And for all practical purposes, the rest of the world means Europe. So, they're left, once again, with that same set of policies. Either do nothing and allow a significant reduction in its share of global manufacturing, which will be particularly difficult for countries like Germany, or intervene in the external account so that Europe is not forced to absorb US and Chinese intervention in their external accounts.

This is a thing, Alan, that I think a lot of people don't understand. If you and I trade, and let's say we have open capital accounts, open trade accounts, balance trade. That's an optimal system in which it makes no sense for either of us to intervene. But if I do intervene with ‘beggar thy neighbor’ trade policies, with industrial policies that are designed to expand my share of global manufacturing, and if I'm able to intervene in my external account so that my expansion in global manufacturing isn't reversed by changes in my currency, because normally if I run a surplus with you, my currency should go up, your currency should go down, and those surpluses and deficits are eliminated.

But if I intervene to prevent that from happening, then not only am I designing industrial policy for my country, but I'm also designing industrial policy for your country. You may think your economy is adjusting to market conditions, but it's not. The very fact that I'm expanding my share of global manufacturing means that I am also forcing a contraction in your share of global manufacturing.

And I think, you know, that's something that countries, that the EU in particular, has to decide the extent to which they want that to happen. So, we see a lot of debate about, you know, isn't it a good thing that Europe is switching out of manufacturing into services, particularly tourism?

Well, I think that's a bad thing. I think productivity growth and manufacturing is much higher than productivity growth and services. But more importantly, whether you agree with me or not about manufacturing, the real point is that you did not decide to switch out of manufacturing into services. I decided.

And obviously, as you say that, I mean, obviously the US is trying to enhance its share of global manufacturing. China is already its policy. And so, by definition, then Europe should accept a lower share. But equally, it seems like policy in Europe, with the Draghi report, it is all about growing European reindustrialization too. So, I mean, something has to give. Do you think the kind of policy mix that's been talked about in Europe is incorrect? Or what is the correct response, do you think, in Europe?

Well, here I'm a straight disciple of Joan Robinson. She argued that when countries engage in ‘beggar thy neighbor’ trade and industrial policies, at some point their trade partners will no longer be able to absorb the costs of those policies. And that will cause a rise in trade protectionism and a contraction in global trade.

What she would have argued was that what started that was the original ‘beggar thy neighbor trade policies’. The protection is simply a reaction to that. But what she did point out was that it was also inevitable. Eventually countries would react and we would see a breakdown in global trade.

And one of the big concerns, and you're probably not surprised to hear this, one of the big concerns with many of the people that I speak to is that the longer this goes on, the stronger is the populist right-wing response. And eventually we're going to move in that direction. So, the question is, under what conditions will we move in that direction?

And I would argue sooner is better than later. But does that mean that there's no role for globalization? No, what it means is that the system of globalization that we have today, which is one of many potential globalized systems, simply doesn't work. We need to go back to Bretton Woods and dust off the original proposal by Keynes, which was rejected by the US, although in my opinion, it was the right proposal. Then Keynes said, look, let's have a system where you as an individual sovereign country, you can follow any economic policy you like. What you cannot do is externalize the costs of your domestic policies to your trade partners and you externalize them basically through trade surpluses.

So, he wanted a system in which we had a definition of the maximum amount of permissible imbalances and then automatic mechanisms that reduce those imbalances. I won't revive the whole Bretton Woods debate, but he proposed a system of what he called the currency union, under which imbalances would be penalized until they were drawn down to zero. I think we need to go back to that kind of globalized system.

Interesting. I mean, just in terms of Europe, I mean, so it sounds like you think they will intervene, is that you think tariffs are inevitable? I mean, going back to your original hypothesis, I mean, should Europe be trying to stimulate consumption or is it that China needs to consume?

The problem in Europe is not weak consumption. The problem is that if Europe stimulates consumption, much of that demand will go to supply countries that repress consumption. In other words, you know, raising wages is the right thing to do under normal circumstances. But in this kind of globalized system, if Europe raises wages, that will increase demand for Chinese manufacturers and increase productivity growth in China, not in Europe.

So, that's why I think, unless we come up with a new global trading regime along the lines Keynes proposed, which doesn't permit persistent imbalances, then we're stuck. Right? Countries that help the world by boosting demand don't help themselves. They help the countries that repress demand.

In other words, it's a version of the Kalecki paradox. So that's why I would argue that the option for Europe really is do we do something now? Does Germany do something now? Or does Germany wait for the AfD to win the elections and do something then?

I mean, Germany is already shifting policy. Obviously, they've unwound or they've taken off the debt break, there are plans to boost infrastructure, plans to boost defense spending. Will that benefit or is that kind of saying that will primarily facilitate the surplus countries?

Well, yes, as long as you're running a deficit, what you want is for that deficit to be balanced by an increase in investment rather than by a reduction in saving, for example, through an increase in unemployment or an increase in debt fueled consumption. Now Germany is “lucky” in the sense that it has very poor infrastructure. So, it can direct some of its deficit towards funding a larger investment in infrastructure.

But if you're going to fund a larger investment in infrastructure, it would be ideal if you would get the full benefits of that increase in demand. Germany won't. It'll share the benefits with countries like Sweden, or South Korea, or China, that have policies that result in persistent surpluses. But at least investing in infrastructure is better than balancing a declining trade surplus with an increase in domestic consumption fueled by debt.

Okay, fair enough. I mean, going back to the US and I mean you're talking about US reindustrialization. I suppose taking your framework and applying it to the US, I mean the US is a bit of an outlier. It's a special case. And I think you talk about that in the book in the sense that we have rising inequality in the US. I think labor share of GDP is at the lowest ever. So, in theory that's similar to China in terms of labor has not fully been compensated for the work that's been done. But still the US is a deficit economy. So, explain why the US is a special case.

Yeah, that's an important point because a lot of people say the problem with the deficit is the blame can be shared between Chinese policies that suppress domestic consumption and American policies that result in large fiscal deficits.

And I don't think that's true because there is nothing intrinsically low saving about the US. As you pointed out, income inequality is at among the highest levels in American history. And one thing about income inequality is it should lead to high saving. Right? The rich save more than the poor and yet the US doesn't have high saving. Something is driving the saving down. And I would argue again, it's a very Keynesian argument.

So, there are two models of the world. Right? In one model of the world, the President or the governor of the Chinese central bank picks up the newspaper and says, oh my God, the Americans are saving less than ever. We had better help them by saving more and running a trade surplus so that we can finance their debt.

In the other model of the world, the Governor of the central bank of China says, oh my God, the domestic saving rate went up as expressed in a higher than ever trade surplus. We need to purchase foreign assets. Let's do it in the United States. Those are two very different stories. Right?

In the first story, it's low American savings that force the Chinese to save more. In the second story, it's high Chinese savings that force the US to save more. And how does it do that?

For many American economists who grew up with a sense of only the US has agency, nobody else does, it's very hard to reconcile this with the belief that the Chinese, or the Germans, or the South Koreans, can determine the U.S. savings rate. But that's exactly what happens, not just in the US but also in Canada and the UK.

And the way it works is this, and again, Keynes explained it very clearly, if Chinese savings go up and they run a trade surplus, the trade surplus has to be balanced by acquiring foreign assets. So, where do you acquire foreign assets? Well, you don't want to do it in the developing world because it's very risky. You don't want to do it in Europe because there are all sorts of concerns about the European economy. Basically, you do it in the Anglophone economies because they have very deep, very liquid, very well functioning financial markets in which foreigners have much more protection than in other countries.

And it's not just, you know, the Chinese central bank. If you're a Colombian drug dealer, if you're a Belgian dentist, and you want to save, you know, you want to acquire foreign assets, the best place to acquire foreign assets tends to be in the Anglophone economies and particularly in the United States. Right? So, the decision to invest in the US was generated abroad, not by the need of Americans to borrow.

But remember, if US$100 enters into your economy, by definition you must run a US$100 trade deficit. And the gap between domestic investment and domestic saving must be US$100. So, either domestic investment must go up by US$100 or domestic saving must go down. It has to balance. So, the question is, which is more likely?

And that's, you know, to go back to my old argument, if the US were a developing country with very high investment needs, as occurred in the 19th century, then that US$100 worth of foreign money could probably drive up US investment and the whole world is better off. But US investors, US businesses don't need foreign saving.

American businesses are not competitive. As foreigners invest in the US they drive up the dollar, making American businesses even less competitive. American businesses are sitting on the largest pools of cash in history. Right? And if they had all of these investment needs, they wouldn't be sitting on cash, they would be investing it. So, when you come to the US and say, here's an extra US$100, why don't you go and invest it? It's going to have no impact, right?

They're not going to invest it because already they have fulfilled all of their profitable investment needs. But something still has to adjust. And if investment doesn't go up, saving must go down. So, the question is, why would American saving go down? Well, as I discussed before, there are roughly three ways. There are several ways, but the three most obvious are that American businesses become less competitive and fire workers so unemployment goes up. That's the classic ‘beggar thy neighbor’ mechanism. In the more modern version, the American Fed might decide it doesn't want unemployment to go up, so it loosens monetary conditions. Banks end up reducing their lending restrictions, more Americans borrow and so consumption goes up along with debt. Or Washington can decide to prevent unemployment by expanding fiscally. And again, fiscal deficit is negative saving. Right? So, the saving rate goes down.

So, when people say if the US reduced its fiscal deficit, it would no longer run a trade deficit, that's because Americans genuinely don't believe that foreigners have agency. Right? Because let's say the US were able to get its house in order and reduce its fiscal deficit. Would people in Ireland now say we should not invest in the US? Would the Chinese central bank say we should no longer balance our surpluses with US assets because the US has become more risky? No. If anything, you're likely to invest more in the U.S. Right? So, the trade deficit could actually go up.

What I'm saying is that it's the trade deficit that's driving debt in the US. It's not debt in the US that's driving the trade deficit. If it were the latter, then the point that you originally made, with so much income inequality in the US, why don't we have high saving and trade surpluses? That's exactly right, we would. But we cannot for the same reason the English and the Canadians cannot because, as long as countries are running surpluses, they need to invest them abroad, and the best place to invest them remains the Anglophone economies.

So, I mean, this is a topic that, I mean, you've written about in the past, whether the dollar is an exorbitant privilege or an exorbitant burden. And it was picked up in Stephen Miran's paper, going back, I don't know, maybe 18 months or whatever it was. And he was maybe suggesting measures to limit capital inflows, so, taxes on foreigners, buying US financial assets, is that the solution?

I think that's the best solution. People like Robert Lighthizer agree now, and they say that's the best solution. But, and here's the caveat, they say it's extremely difficult to explain to policymakers why a tax on capital inflows would reduce the trade deficit. It's much easier to talk about tariffs. I think that discussion has advanced much more quickly than I ever expected. And I think eventually we're going to go back to understanding the problem with unfettered capital flows.

By the way, I keep mentioning Bretton Woods, you know, Harry Dexter White, the American representative, and John Maynard Keynes, the British representative, disagreed on many things, but they both agreed that there was no good reason to allow unfettered international capital flows. Capital does not flow to its most productive use. It tends to flow for speculative or capital flight reasons.

I mean, you mentioned Bretton Woods a lot, and, obviously, Keynes had a proposal of a special currency Bancor, I think, at Bretton Woods. The Chinese, Europeans, have always looked at the dollar as the US's exorbitant privilege. And we're seeing now more emerging markets, central banks are acquiring gold. And the Chinese have long, I suppose, debated whether they should internationalize renminbi more. But at the same time, the US wants to maintain the dollar as the reserve currency. That seems to be Trump policy. How do you see those trends playing out?

Do you think there will be a movement for either greater use of gold in emerging markets, central banks in their reserves, or to try and internationalize the renminbi from the Chinese? I mean, in terms of that US seller reserve status, do you see that as increasingly under risk or not?

Well, I think part of the problem is to ask, what does the US want from global dominance of the dollar and what does China want for the use of the renminbi? Because There is no US or no China. There are different constituencies in each of those countries.

So, from the US point of view, if you're in the foreign affairs establishment, or more importantly if you're part of Wall Street, the global dominance of the dollar is clearly an exorbitant privilege. American banks are the most important in the world because of the global dominance of the dollar. Right?

If you're an American worker or a business owner, a middle-class saver, then dollar dominance is an exorbitant burden because it reduces manufacturing, it forces up domestic debt, etc., etc. So, the question is not whether America benefits or hurts from the dominance of the dollar. The question is which parts of America benefit and which part pay the price?

And it's true in China because when people say China wants the renminbi to be a dominant currency in line with the US, you know, they've been saying that for 20 years. I've been in China for 24 years and every time they say that, I say no, it doesn't no it doesn't no it doesn't. And you can see the renminbi, for all of this talk, is a very minor currency.

Chinese bankers would like to see the renminbi play a much more important role. The Chinese foreign affairs establishment in the military are very concerned about dollar sanctions. So, they would like to see the renminbi play a much more important role in the world. And yet China has done absolutely nothing, you know, except a few symbolic things, to raise the value of the renminbi.

If they really wanted the renminbi to be a dominant currency, they would support a much stronger renminbi. They would remove all capital restrictions. Right? Which means, among other things, giving up control of the domestic banking system, which also means allowing the rest of the world to de-industrialize China. And they refuse to do any of those things. So, the renminbi will never be a dominant world currency unless we have a massive change in domestic policy.

So, nobody really wants to pay the cost of this privilege. And until that happens, the dollar will remain the dominant currency or until the US wises up and realizes that what's good for Wall Street is not necessarily good for American workers or American manufacturers.

Obviously, one of the concerns we had in markets last year was after Liberation Day, and the tariffs, and then concerns about, you know, US policy. And there was a general pessimism about the outlook for the dollar. And I mean, obviously you're talking about the flows into the US on the capital account, but, I mean, from a kind of a stock versus flow perspective, foreigners have acquired a huge amount of US assets over time. So, is that a risk for the system?

That's the kind of the market argument. At some point the world has overrate the dollar, US assets, and we could have a disorderly adjustment if they decide to reduce those asset holdings.

Yeah, that's the Triffin Dilemma. And as we know about the Triffin Dilemma is that you can foresee a problem that continues much longer than you expected. As long as the US remains a fairly dynamic economy, and it is the most dynamic rich economy, it can continue losing assets to foreigners. That won't undermine its credibility. Can this go on forever? I don't think so.

At some point it will be a real problem for the world, but it might not be in our lifetime. I don't really know. For me, the real question is, is the US better off giving up manufacturing in favor of services? And for me, that's a productivity argument. As long as productivity growth in the manufacturing sector remains higher, I think we are better off with a larger rather than a lower manufacturing sector.

Okay. I mean, you started off in markets on Wall Street. You were a sovereign debt investor. I mean, you take a different lens to this. You're talking about the imbalances in the system now. But if you were taking that investment lens, I mean, to US debt, deficit policy mix, etc., do you think it's become more worrisome with the deficit that we have now or not?

Yeah. You know, when I started off on Wall Street, I had taken several courses in economics. And so, you know, I hate to say it, but I was as stupid as everybody else. I really did think that what I was doing, I was a bond trader, was good for the world because I was helping reduce the frictional costs of having capital flow from where it is not needed to where it is most needed. By the end of the’ 90s, when I was running Latin American capital markets at Bear Stearns, I realized that was simply not true. We were extremely profitable, but we did not promote global productivity growth one wit. If anything, we hurt global productivity growth by creating a lot of capital driven instability.

So, I think that's something that we become so ideologically committed to this idea that as long as the US does not intervene in the capital or trade account, everything in the world is working fine. That is going to take some time for us to get out of it. But I think we are inevitably moving towards a world where there is greater and greater understanding of the risks of unfettered flow of international capital and of persistent trade imbalances.

So, we're definitely moving away from that. I would prefer that we moved a little bit more quickly than we are, but we are moving away from it. We've even got the IMF to acknowledge that imbalances are a problem. The OECD has acknowledged that imbalances are a problem. The bank of England acknowledged that imbalances are a problem. It took a long time to get them there, but they've gotten there.

Yeah, the problem with the whole Bretton Woods II argument was that the imbalances didn't matter because trade imbalances were matched by the opposite capital imbalances. Well, you know, that's totally idiotic because, by definition, the trade account must balance the capital account. Imbalances, in that case, are always imbalanced and they never matter.

Now, that's sort of a dangerous thought because what it suggests is that these imbalances are never resolved in a way in which everyone is better off. What really matters is how you allocate the costs of the adjustment. And that's a much more dog-eat-dog world, I'm afraid.

But looking at the history, it's very hard to escape from the conclusion that the question is not whether the world will be forced into a very difficult adjustment, but rather, how the costs of that very difficult adjustment are likely to be allocated between surplus and deficit countries.

And I mean, practically what determines that? I mean, we're kind of speaking in general terms of an adjustment. But can you paint out what the sequence of events may be that would lead to that adjustment?

So given the huge amounts of debt in the US and particularly in China, many people don't realize that China has the second highest debt burden in the world after Japan, and the fastest growing debt burden in history, and the US of course also has a great deal of debt. What that suggests is that this next one is not going to be resolved very easily. There's to be going to be a pretty costly resolution.

I mean, speaking in simplistic terms between say, the US and China, if the US enforces the adjustment on China, China has to reduce its manufacturing sector and rebalance, presumably go through a prolonged period of weak growth until it can stimulate consumption. Is that one scenario? And then what's the opposite scenario where the US would bear the adjustment?

China has very competitive manufacturing, not because it's particularly efficient. In fact, it's not efficient. Chinese companies, even with enormous subsidies, can barely break even. It was very competitive, in part for the same reasons that domestic consumption is so low, unit labor costs were the lowest in the world. And so, the way to resolve the consumption problem, everybody knows what to do. It's very straightforward. You've got to pay workers, either directly or indirectly you've got to pay them more. You've got to raise the household share of GDP.

But here's the problem. If your manufacturing is so competitive precisely because the household share of GDP is so low, then the only way you can solve the consumption problem is by undermining manufacturing competitiveness. And while you may need to do that in the medium and long term, it's very hard to do that in the short term without rising unemployment and slower growth.

So, China has been stuck, like Japan, with postponing the resolution in exchange for rapidly rising debt. And so, the question is, how much longer can debt continue to rise in China? And I don't know, it's very hard to predict the end of debt capacity. But what we do know is that you don't want to find out what the limited debt capacity is, because basically you find out in the form of a crisis. So, you've got to get debt under control well before that happens.

Is that happening in China? No, the debt to GDP ratio is growing faster than it ever has been before. It's accelerating. So, you know, to give you a sense of the magnitude, in the US, people are very worried about debt. And some of the biggest worriers of debt. US debt is roughly 270% of GDP, and they're saying that in the next five to 10 years it may rise by another 10 percentage points.

Well, China's debt to GDP is officially around 315%, probably higher, and it is rising. Last year it rose by 12 percentage points in a single year, the year before that by 11 percentage points. The year before that, conveniently enough, by 10 percentage points. So, it's accelerating, it's not decelerating. And of course you cannot have an acceleration in your debt burden forever. At some point you must bring it under control or you'll be forced to bring it under control.

Well, we've covered a lot of ground and we've gone well over on time. But yeah, very much appreciate you coming on to talk to us. And it sounds like there's a whole lot more we could get into, so maybe we'll have you back again at some point in the future, if you're open to that. But thanks very much for coming on. People can obviously follow your work online and at the Carnegie Endowment for International Peace. You publish papers from time to time as well.

But from all of us here at Top Traders Unplugged, thanks for listening and we'll be back soon with more content.

Thanks very much, Alan. It was a pleasure.

Thanks for listening to Top Traders Unplugged.

If you feel you learned something of value from today's episode, the best way to stay updated is to go on over to your favorite podcast platform and follow the show so that you'll be sure to get all the new episodes as they're released. We have some amazing guests lined up for you and to ensure our show continues to grow, please leave us an honest rating and review.

It only takes a minute and it's the best way to show us you love the podcast. We'll see you next time on Top Traders Unplugged.

This podcast expresses the views of its hosts and the guests appearing on the podcast as of the date of its recording, and such views are subject to change without notice. Top Traders Unplugged do not have any duty or obligation to update the information contained herein.

Furthermore, Top Traders Unplugged make no representation to its accuracy and it shall not be assumed that past investment performance is an indication of future results. Moreover, wherever there is a potential for profit, there is also the possibility of loss.

This content is made available for educational purposes only and should not be used for any other purpose.

The information contained in this podcast does not constitute and should not be construed as investment advice or an offer to sell or a solicitation to buy any securities or related financial instruments in any jurisdiction.

Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Top Traders Unplugged may believe that the sources from which such information are obtained are reliable.

However, Top Traders Unplugged cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. This podcast, including the information contained herein, may not be reproduced, copied, republished or posted in whole or in part in any form, without the prior written consent of Top Traders Unplugged.