Arthur Kroeber on China's Industrial Machine and Why the US Needs to Learn to Coexist With It
Dwarkesh Patel
Arthur Kroeber is a founding partner of the research firm Gavekal Dragonomics and the author of China's Economy: What Everyone Needs to Know. In this long conversation, the host starts from a deliberately provocative question: what exactly is the problem if China becomes as rich as America, or richer? Kroeber's position is layered. He believes China's economic model has been fundamentally successful, and that its rise cannot be reversed or contained. He also thinks its supply-side obsession creates real frictions for the rest of the world and for China itself. Much of the blame Washington assigns to China, in his view, is scapegoating for domestic policy failures. The discussion covers how China built its industrial and technological base, the state of its debt, why it remains relatively poor, whether it will win in AI, and what a workable US-China relationship might look like.
Why China's Rise Is Treated as a Problem
Kroeber separates two complaints. The first is economic. Critics argue that China is getting rich "on the backs of everyone else" through a huge export machine and persistent trade surpluses, relying on other countries' buying power. He frames this as a question of how China gets rich, not whether it should. Does it follow the same rules as everyone else and offer a market others can take part in? Or does it make it impossible for other countries to keep the production structures they want?
The host plays devil's advocate. A trade surplus can follow from accounting identities: high savings and too little domestic investment. On paper, Chinese taxpayers and savers are subsidizing foreign buyers, which looks like a good deal for the rest of the world. Kroeber accepts that in strictly financial terms the rest of the world comes out ahead through cheap goods and higher overall welfare. His objection is about social cohesion. Large countries need to keep a diversified production structure. Losing a manufacturing economy that employs many people causes serious disruption. He argues that the "purely financialized economy" the US developed in the early 2000s, partly through its bargain with China, was bad for the American social compact.
The second complaint is political, and Kroeber considers it the deeper one. The US sees itself as the leader of the world's democracies. Its foreign policy was shaped by the "morality play" of World War II and the Cold War: democracies defeated fascism, then communism, and the world seemed to be converging on democratic, market-based systems. China disrupts that story as a highly successful authoritarian state that still calls itself communist. Kroeber says US elites have never become comfortable with the idea that the Chinese political system is legitimate. Even so, he argues that much of today's anti-China sentiment diverts attention from domestic choices about income redistribution and macroeconomic policy. China is now about 20% of the global economy and a third of global manufacturing. What is missing, in his view, is an agreed set of rules under which everyone feels they benefit, and not only financially.
Not a Cold War: Integration and Permanence
The host questions whether World War II and the Cold War taught America a bad lesson: that great-power rivalry ends with the other side collapsing. Kroeber rejects the Cold War framing both on the evidence and in principle.
On the evidence, he points to trade and investment. The Soviet Union never accounted for more than about 1% of US trade, and investment flows were essentially nonexistent. China, at its peak about ten years ago, made up 17% of US trade, about the same as Japan in the late 1980s and early 1990s. That share has fallen on the surface, but Kroeber says it is roughly unchanged once goods routed through third countries are counted. US corporate investment in China is $600 billion or more, generating sales far larger than US exports to China. He calls this level of integration unprecedented in economic history. If the goal were a real Cold War, cutting these flows back to near zero would be extremely hard.
In principle, he argues the rivalry does not end with China disappearing or transforming. China is too big and too successful, and it is woven into a global economy in which most countries have a stake in its success. He also offers a thought experiment. If the Chinese Communist Party vanished tomorrow, any successor able to govern China would likely look very similar. It would insist on geopolitical independence and a strong military. Like every Chinese government since the mid-19th century, it would try to maximize technological progress and meet core technology needs domestically. In Kroeber's view, the problem is not one regime that could be persuaded to change its mind. It is rooted in China's institutional and cultural history and its geopolitical position.
The host recalls asking someone in China what a free election would produce. The answer was that the median Chinese voter might be more reactionary than the government. Kroeber says there is little reliable polling, but he finds this plausible. The Chinese internet is full of nationalist, militaristic sentiment that the government mostly works to restrain, releasing it only occasionally, for example during disputes with Japan. A fully representative Chinese government, he suggests, could be very difficult to deal with.
The Case for Chinese Investment in America
The host raises an idea circulating in Silicon Valley: let China lead in solar, EVs, batteries, and heavy manufacturing while the US dominates AI and semiconductors. Kroeber doubts China would accept that. Many in China would say they want it all and can get it. More generally, he argues that no strategy that requires China to accept arbitrary limits is viable. China refused to be confined to low-value manufacturing and does not want to be confined to manufacturing at all. The US would never accept such limits on itself.
His own preferred path is for the US to be far more open to Chinese direct investment in American manufacturing, especially EVs and their supply chains, green energy, and industrial automation. His reasoning comes from China's own history. Forty-five years ago China was an "industrial basket case," and it industrialized by inviting the world's leading companies in and learning from them. If the US is serious about selectively rebuilding its industrial base, it should do the same. Chinese companies would welcome access to the US market, the US would learn from them, and large two-way investment would itself show that the relationship is not a Cold War.
He explains Washington's bipartisan resistance as mainly a concern about data. Every manufacturing process now also generates data, and the question is where that data goes. Decades ago, most technologies were civilian, a few were military, and only a small share were dual-use. Now, he says, essentially everything is dual-use. Kroeber calls this a legitimate concern and would regulate Chinese investment as carefully as China regulates foreign investment, including data localization rules. He thinks this is achievable in principle but very hard in the current political climate. The host notes an irony: hawks who believe China exploited technology transfer from US investment should find the reverse arrangement especially appealing.
BYD, Tesla, and the Leap Into Electric Vehicles
Kroeber tells the EV story as an example of what such reverse learning could look like. In the early 1990s, China saw that almost every country that had grown rich (the US, Germany, Japan, Korea) had built a large auto industry that drove innovation in other sectors. It required foreign carmakers to form 50/50 joint ventures with Chinese firms, expecting the local partners to learn and eventually push the foreigners out.
Kroeber says this "failed massively." Over 25 years, GM, VW, Toyota, Honda, and others did very well. The Chinese partners mostly "clipped coupons" from joint-venture dividends while technology and design kept coming from the foreign side. Local firms produced many low-end vehicles by volume, but profits and value were dominated by the foreign-led joint ventures. By 2010–2015, China was no closer to having globally competitive conventional carmakers.
Around 2005–2010, policymakers decided to leapfrog by targeting a technology others were not yet pursuing seriously. Much of that bet went into renewable energy and especially electric vehicles, with broad subsidies for companies such as BYD, which Kroeber describes as essentially private. BYD became very good at supply chains and batteries, but by 2018–2019 it was still not an exciting company. Most Chinese consumers found EVs inconvenient and preferred the joint ventures' large SUVs.
The turning point, in his account, came in 2018, when the government let Tesla build a wholly owned Gigafactory in Shanghai. No wholly owned foreign automaker had been approved before. Tesla began producing cars in 2019, and they became hugely popular status symbols. Chinese firms by then had mastered batteries and vehicle software but were "terrible at consumer design." Seeing Tesla's success, BYD and its competitors improved their design, including hiring many German car designers. By around 2022, Kroeber says, they could compete with Tesla on both price and quality.
He draws two lessons. First, the leapfrog bet was sound, and China persisted despite years of weak financial returns. He cites estimates that subsidies to the EV industry and its supply chains totaled $200–300 billion. Second, what finally "flipped the switch" was catalytic foreign investment that showed Chinese companies what they needed to compete for consumers. Asked whether all those subsidies were necessary, Kroeber uses the old advertising line: half of it works, but you don't know which half. China probably didn't need to spend that much, but might not have gotten the same result by spending less. It tried producer subsidies, individual buyer subsidies, and city-level subsidies such as those for electric buses. The crucial element, he says, was a clear, persistent government commitment to keep trying different approaches until something worked.
China as a Giant VC Fund
The host pushes back: central planning isn't supposed to work, and Germany and Japan arguably missed the internet by focusing on heavy industry. Kroeber agrees the approach is risky. He notes that China's list of "strategic emerging industries," drawn up around 2010, is not a precise forecast of the future. It contains obvious candidates such as semiconductors, industrial automation, and new materials, the sort of sectors any VC fund would list.
When the host notes that most VC funds lose money, Kroeber leans into the analogy, which he says he has used many times. China is a giant VC fund willing to lose enormous amounts for a long time, betting that a few winners will pay for the failures. It is uniquely able to spend heavily without caring about returns. He adds that the green energy bet was not especially bold. Around 2007, John Doerr of Kleiner Perkins famously bet on green energy. Kroeber says Doerr was wrong about his investment returns but right that it would become a very big industry.
Why did this work when MITI-style planning elsewhere often didn't? Kroeber gives three reasons. First, like Japan, Korea, and Taiwan before it, China's system strongly emphasizes exporting. In a closed market, companies can win by rigging the market and cultivating political connections. That, he says, is what dooms import-substitution regimes, and he suggests Trump is trying to build such a closed system in the US. Exporters cannot rig the global market, so they have to upgrade. Second, unlike Japan, which kept foreign firms out of its home market, China allowed intense domestic competition that included international companies. That created a "crucible" in which government ideas were tested, whether they were right or wrong. Third, scale matters. In solar, starting around 2005, China deliberately built capacity at every stage from raw silicon to finished panels and tolerated repeated cycles of losses. Kroeber contrasts this with the US, where a single failed government loan to Solyndra was treated as proof that industrial policy doesn't work. China, he says, has "the right answer to that question." Success requires accepting some failures and losing some public money. He stresses that none of this would have worked without the wider ecosystem of export-driven manufacturing, fierce competition, and foreign participation.
Why a Japan-Style Crisis Is Unlikely
The host, having recently interviewed Ken Rogoff, asks whether China's national champions, conglomerates making everything from phones to cars, will lead to something like Japan's 1980s convoy system of favored lending. Kroeber first points to a strategic difference. Japan relied on the US for its security. China is an independent geopolitical actor with 14 land neighbors, including North Korea, Russia, Pakistan, and Afghanistan, and several of its neighbors have nuclear weapons. Japan could afford stagnation. For China, the stakes are existential, which gives leaders a strong, though not guaranteed, incentive to keep the system dynamic.
The more specific difference is financial structure. In Japan, banks and industrial and trading companies held each other's shares, so the whole economy effectively shared one balance sheet. By the late 1980s that balance sheet rested on land values detached from reality. Investors valued companies by their land holdings rather than their earnings. When land prices fell about 80%, stock prices fell by a similar amount, bank capital eroded, and everyone deleveraged at once. The result was debt deflation, in which fire sales push down asset prices and raise the real value of the remaining debt.
China, Kroeber says, studied Japan's crisis and Korea's in the late 1990s and banned this kind of cross-holding. Industrial companies cannot own banks. Large groups may have internal finance arms, but only to manage flows within the group. Banks cannot load up on industrial shares. China does have serious debt problems: overleveraged property developers, a five-year property crash, and local governments that borrowed for infrastructure that now yields little. But Kroeber argues these problems are isolated and can be dealt with one by one. The industrial sector is not highly leveraged. Private firms, long shut out of bank credit reserved for state-owned enterprises, learned to finance themselves from retained earnings. Their leverage is rising somewhat under the recent industrial-policy push, but remains far from Japan's situation.
Local Government Debt: A Sound Model That Went Too Far
The host notes that Kroeber's book describes local government financing vehicles backed by expected land appreciation, which sounds similar to Japan. Kroeber argues the original model was sensible. In the early 2000s, with the backing of the central government and the China Development Bank, local governments borrowed against the expected rise in undervalued land to fund badly needed housing and urban infrastructure. The land-value projections in the first two cases looked absurdly high at the time but turned out to be far too conservative. For eight or nine years, state development banks ran the model in a controlled way and very successfully.
The problem began after the 2008 financial crisis. The government flooded banks and state-owned enterprises with money and effectively said all infrastructure was good infrastructure. Commercial banks with weaker underwriting standards piled into lending to local governments, which treated it as free money. Kroeber calls the result a "Frankenstein's monster." The first couple of years of spending probably still earned decent returns because China was underbuilt, but after three or four years much of it went into wasteful projects, and China has spent the past decade trying to unwind them.
He sees this ultimately as a fiscal problem for the central government. By his estimate, China's combined central and local government debt is probably below 100% of GDP, compared with over 100% for US federal debt. The host cites previous guest Victor Shih's estimate that local government debt alone is 100–150% of GDP and total government debt around 200%. Kroeber "respectfully" disagrees. He says it is impossible to know for sure because of contingent debt issued through corporate vehicles, and he believes many high estimates fail to account for double counting as the same debt passes through several layers. Total debt across the economy, which he says is well captured by macro data, is about 300% of GDP. So a 200% government figure would imply that everything else is much smaller than believed, unless something is being double counted. He puts total US debt across all sectors at roughly 300% as well, with Japan higher.
Kroeber still considers the leverage serious. A 300% ratio is normal for rich economies but extremely high for a country with Brazil-like per capita income. Because the system is closed and the debt is in local currency, he does not expect a financial collapse, but he says it acts as a tax on growth. Asked why high debt is especially bad for middle-income countries, he explains that China's debt was historically justified because it financed productive infrastructure in an underbuilt country. That case is now much weaker. His remedy is macroeconomic. China has too much supply-side strategy and too little demand-side strategy. Stronger domestic demand would raise corporate profits and pricing power and bring mild inflation, generating cash flow to pay down debt while eroding its real value. He says this is roughly how China escaped its bad-loan problem in the late 1990s, and that an updated version could resolve the current debt over a decade or two.
If China Is So Competent, Why Isn't It Richer?
The host points out that China's per capita income is still about a fifth of America's and about a third of Japan's, Taiwan's, and South Korea's, and cites mistakes such as Zero-Covid. Kroeber first notes the irony that China is simultaneously criticized for being too successful. He then argues that during the 1990s and 2000s, China grew about 10% a year for 20 years, which he calls the fastest growth rate ever recorded, so claims that it could have grown much faster with less waste deserve skepticism.
He calls this the "efficiency fallacy." Economists trained in the US tend to treat the developed American economy as the norm, as if its current workings explained how it got rich. China grew by mobilizing huge domestic savings and throwing them, in an uncoordinated way, at many problems. Waste was part of the process. Had banks demanded proven returns for every project, Kroeber believes growth would have been lower and inequality might have been higher, because wasteful investment also reached geographically disadvantaged regions. The host quotes his book's line that for a country of China's scale, what matters is not efficiency in using resources but effectiveness in achieving outcomes, and Kroeber confirms that is his thesis.
Scale also explains the income gap. Taiwan had about 20 million people and South Korea about 40–45 million, and each moved its population into high-wage urban jobs within a generation or two. Kroeber argues this is physically impossible for 1.4 billion people. For years, China added about 20 million people a year to its urban population. He recalls calculating that it was building housing and infrastructure equal to New York plus Philadelphia plus San Francisco every year for 20 years. Even at that unprecedented pace, raising 1.4 billion people to US-level incomes takes a very long time.
He adds an important caveat. He sees little evidence that China grew below potential on average from 2000 to 2020, but considerable evidence that it is doing so now. In his view, China is sacrificing faster catch-up in ordinary living standards to pursue industrial and technological goals.
Technological Fetishism and the Missing Demand Side
The host asks why there should be any trade-off between technology and growth. Kroeber says China's leaders share a "technological fetishism" with Silicon Valley techno-optimists. He traces it to the 1840s, when Britain repeatedly defeated a long-dominant Chinese empire and imposed humiliating settlements through the Opium Wars. The elite conclusion was that China had fallen behind technologically and had to catch up. Late imperial politics blocked real progress. The republican government after 1911 said and did similar things, less effectively, amid civil wars. The Communist Party has finally carried the idea out.
From the 1980s, though, this coexisted with an agnostic pursuit of growth from any source. Local officials were told their key performance indicator was GDP. Kroeber says leaders understood that telling them to maximize technology would produce "dumb stuff" and waste. That approach was enormously successful. Xi Jinping, taking power in 2012, concluded it had produced corruption, inequality, and duplicated investment. Especially from 2015–2016, Xi focused state resources on technology, assuming growth would take care of itself. Trump's trade war and Biden's export controls pushed this further, convincing Beijing it had to replicate core technologies to avoid relying on the US and its allies. Kroeber stresses that the technology Beijing meant was physical, such as semiconductors, materials, green energy, and industrial robots, not Alibaba and Tencent.
Kroeber sees a flaw. Most people do not work in these sectors, and it is unclear how gains spread to the roughly 90% of the economy doing something else. The US answer was a demand-driven consumer economy in which companies emerge to meet consumer wants, increasingly for services and experiences, supported by a financial system that rewards them and creates many high-paid service jobs. East Asian industrial-policy models, he says, are "very materialist." They assume that getting good at physical things will spill over to everyone, and the evidence suggests it largely doesn't.
The host objects that a $100 billion semiconductor fund should not require lower overall growth. Kroeber agrees that it doesn't have to, but says that is how China has executed its strategy, because the industrial push came alongside a crackdown on services. In November 2020, regulators halted Ant Financial's giant IPO, rejecting the idea of building a financial system like America's circa 2005, with securitization and financial risk. The internet sector, which for about 20 years had faced almost no regulation apart from political censorship, was told that fintech, telehealth, and broader social media ventures were off-limits because of financial, social, or political risk. Alibaba and Tencent remain great companies, he says, and their share prices fell more than their revenue losses justified, but they are tightly constrained. Financial deregulation from about 2008 to 2017 brought shadow banking and risk but also gave private firms and households new financing options. It has since been reversed, pulling activity back into a small number of mostly state-owned banks. Plans to open healthcare to private business were also reined in.
The host observes that these moves reflect political control, not trade-offs forced by chip development. Kroeber agrees it is a political choice. The result, he says, is a real-world experiment. Technology sectors advance, but aggregate demand stays persistently weak, producers lack pricing power, prices fall, households save more out of worry, and China is now on the edge of a deflationary spiral. Kroeber says the government has recognized in recent months that it needs a demand strategy, but after 45 years building a "magnificent" supply machine, it is only at the very early stages of building a demand machine.
Getting the Enabling Infrastructure Right
The host notes how contingent technological progress is. AI, for instance, depended on GPUs developed for video games and data from people posting on Reddit and Twitter. The host also cautions against judging a system by 20–30 years of good calls, which is like praising dictatorship because one dictator chose well. Kroeber agrees that China's success was not a master plan. It involved a lot of groping and randomness, with credit due mainly for getting a few big directions right, sticking with them, and adjusting quickly when things failed. He adds that past results do not guarantee future ones. He is now less confident the US will keep its long-standing political system. In China, Xi has made himself effectively leader for life, which Kroeber notes did not end well last time. The long-running balance between growth and control has swung toward control.
His main argument is that China's industrial policy succeeded less by picking winning industries than by building the right enabling infrastructure. The first example is "informatization" (xìnxīhuà), a 1990s drive to spread information technology throughout society. In the late 1990s, conventional wisdom held that the internet would doom authoritarian regimes. Beijing bet it could both accelerate technological development and strengthen control, and Kroeber says it was right on both counts. Heavy early investment in fixed-line, then mobile, then nationwide government networks let China build its own internet with its own companies. It also gave leaders something sought since the second century BC: the ability to know what people across a vast empire are thinking. Kroeber describes the result as a panopticon.
The second example, which he calls severely underappreciated, is electrification. In most countries, electricity is still only 15–20% of final energy consumption. China began building capacity, mostly coal, in the early 2000s simply to end power shortages at factories. Then other goals reinforced one another. EVs offered a way around failure in combustion-engine cars. A high-speed rail network, which Kroeber describes as China wanting something like Japan's but 20 times bigger, would run on electricity. Coal is dirty and bad for both climate and local air pollution. Gas and uranium would have to be imported, and nuclear is hard to scale. Renewables promised permanent self-sufficiency because "you don't have to import the sun or the wind."
According to Kroeber, China's generating capacity is now more than double America's, its renewable capacity alone equals total US capacity, and electricity has risen to about 30% of its energy consumption, climbing rapidly while others barely move. He believes Beijing has concluded strategically that cheap, abundant power is central to every major 21st-century growth industry, including AI data centers. It is pursuing maximum generation from any fuel and leading in ultra-high-voltage transmission. He thinks electricity prices low enough to undercut competitors everywhere in electricity-intensive sectors will be a real advantage, and he believes they are basically right.
Does China Win AI?
The host makes a strong case for Chinese AI dominance by 2035. China has plenty of talent, as shown by High-Flyer and DeepSeek coming close to the frontier. SMIC will eventually produce H100-class chips, and in the host's view that will happen within the next 5–10 years even if export controls were still worthwhile. After that the contest is about scaling chips, energy, and deployment, which is China's strength. Kroeber notes that China adds roughly a France or a UK of generating capacity each year on average. The host argues that once AI reaches human level, the key question becomes how many AIs you can run, and power determines that.
Kroeber says he does not claim deep AI expertise and is unclear where the economic benefits will accrue. He draws on Amar Bhidé's The Venturesome Economy, which emphasizes the feedback loop between consumer demand and producers rather than producers alone. If, as he understands the consensus, large language models are a substrate and most value lies in applications built on top, the question is which system offers the most fertile ground for figuring out uses. There he gives the US a fairly strong edge. China has become more closed and obsessed with self-sufficiency, creating a walled garden, while US and Western AI firms have the rest of the world to work with.
On Victor Shih's view that Beijing might slow AI for fear of losing control, Kroeber respectfully disagrees. He expects China to make the same bet it made on the internet: the technology could be dangerous, but it is too useful to forgo, and China's control systems can manage it. He notes that DeepSeek came not from a state program but from a quant hedge fund founder in Hangzhou, and that reports suggest this caused some unease in Beijing about someone operating outside the official plan. Overall, though, he expects promotion rather than restraint.
The host suggests that, given scarce advanced chips and steep increases in training costs, China would benefit from pooling compute, for example by ordering Huawei and ByteDance to hand their chips to High-Flyer. Kroeber says with high confidence this will not happen. Huawei, ByteDance, Xiaomi, and Alibaba all have enough revenue, capital, and connections at central and local levels to pursue their own paths, and national monopoly solutions almost never happen in China. The host says this lowers their estimate of China's chances. Kroeber agrees the fragmentation is a real constraint, while noting that it matters less if China quickly solves domestic chip production.
Communication Breakdown and AI Safety
The host argues that a US-China "red telephone" is needed for AI. They are not mainly worried about an all-powerful AI, but about a more coordinated group taking control, as Cortés and Pizarro did. The Spanish learned from each previous conquest, while the Aztecs and Incas did not know what strategies had been used against others. If each side's AI does something dangerous, the other needs to hear about it. The host adds that a split world has safety value because it provides an independent line of experiments.
Kroeber calls this a terrific question but admits he has no great answer. The Cold War hotline dealt with a problem controlled centrally by a few people, and Thomas Schelling's game theory, which he does not want to minimize, addressed a problem of perhaps two or three dimensions. AI is far more diffuse and unpredictable. The host compares it to setting up a red telephone for the Industrial Revolution, and Kroeber agrees.
What Kroeber can say is that US-China communication has shrunk alarmingly, in some ways resembling US-Soviet relations in the 1950s before the Cuban Missile Crisis. When Trump took office in 2017, he inherited about 100 working-level government dialogues with China and eliminated all of them, replacing them only with trade talks. Kroeber traces a direct cost to this. After SARS in 2003, US CDC staff were embedded in China's disease-control counterpart, and that relationship grew. Without it, he says, the US had no window into early COVID, and he believes many deaths and much social chaos trace back to that failure to communicate. The Biden administration, in his account, largely kept the same approach, waited two years before adding a few channels, and was stingy about them. Those channels have reportedly gone unused since. He criticizes both administrations and says the current Trump administration does not value respectful communication with anyone.
He sees both sides stuck in self-reinforcing narratives. In the US, China is seen as an illegitimate systemic rival, and members of Congress avoid visiting because they would pay a political price and believe they already know what they need to. In China, nearly three years of COVID isolation deepened the self-sufficiency mindset, gave a long-standing discomfort with outside communication an excuse, and strengthened a paranoid narrative about US intentions that Kroeber considers significantly, but not entirely, justified. He is pessimistic about progress soon.
The Information Asymmetry
The host describes visiting cities of 20 million people such as Chongqing and Chengdu and seeing almost no Westerners, which inspired this series of episodes, and says the country's sheer size is badly underestimated. Kroeber agrees that its size, geographic and demographic, is a banal but constantly underestimated fact. He also defends personal exposure more than the host does. His book, he says, reached a few thousand readers, while more than 300,000 Chinese students have been in the US at any given time over the past 15–20 years.
He gives an example from teaching an executive MBA course at NYU on China's rise. Before COVID, each class of 20–25 reliably included four or five people who had spent time in China, often on the program's short and fairly superficial study tours. Those classes had nuanced discussions because people could say their own experience differed from the stereotypes. After COVID, the tours stopped, and for a couple of years no student had been to China. The baseline view became far more negative and "cartoonish," formed entirely by media and preconceptions.
For years, Kroeber dismissed Chinese experts' claims that they understood America better than Americans understood China. He now thinks it is "completely true." He lists the evidence: about 300,000 Chinese students in the US versus a struggle to reach 1,000 American students in China. The US closed China's Houston consulate in 2020, and China retaliated by closing the US consulate in Chengdu, leaving western China without official American eyes. Washington forced Xinhua journalists to register as government agents, which he calls "sort of true," and Beijing expelled many American journalists, which he calls a massive own goal. This asymmetry, he says, now disadvantages the US.
The host worries that, looking back, escalation could seem as mystifying as World War I. Kroeber agrees and says the US in particular must accept that the relationship has no endpoint: "There's no winning, there's no losing, there's just managing." He thinks Chinese elites, despite official talk of US decline, mostly have too much confidence in America's long-run resilience to believe it, and that they are right. He links swings between "China will dominate" and "China is collapsing" to ignorance. With less knowledge, it is easier to turn one truth into an absolute story. He cites the Trump administration's trade negotiations, which assumed China's economy was so weak it would quickly give in to tariffs.
He also calls much US blame of China scapegoating. US manufacturing's share of employment has declined in a straight line since 1946, and he says you cannot find the Cold War, Japan's rise, NAFTA, or China in it, only technological progress. The real failure was not updating redistribution and the domestic social contract. He calls BYD, Huawei, and CATL very good companies, but argues US firms remain strong across many sectors, often including in China. If the US loses its auto industry to BYD within five years, he says, it will be because of bad American policy, not the competition itself.
A Deep, Still Ocean
Kroeber first went to China in 1985, lived there more or less full-time until 2015, split his time after that, and now lives mainly in New York. He describes China as a turbulent, deep ocean. The surface shows enormous change in cities, high-rises, industrial parks, and high-speed rail. Underneath lies a still layer of ideas and bureaucratic tendencies built up over centuries. In terms of how people fundamentally understand life together in society, he argues the US has changed more since 1985 than China has: acceptance of gay, lesbian, and trans people, attention to race, and the immigrant experience. China, in his view, remains more cohesive and attached to deep-rooted ideas about gender relations and patriarchy. He does not want to understate China's transformation, especially the social change from replacing the planned economy with what he calls a basically capitalist system inside a "Leninist political carapace."
Returning from China, he was always struck by how much grassroots cultural activity exists across the US, compared with a few cultural hotspots in China and relative calm elsewhere. He attributes this partly to income: a poorer society has less surplus for activity that is not economically productive in a narrow sense. It is not only political repression but also ingrained social structure.
The host warns about two opposite traps: seeing China as the new Stalin or Hitler, or, among those wanting good relations, concluding that central planning and authoritarianism work. Kroeber agrees these are bad lessons. It should be possible to want a productive relationship while believing authoritarianism is morally wrong and harmful to growth and everyday life. He adds that American attitudes toward China have historically swung between seeing kindred pragmatic, business-loving people and seeing a vast, devilish system, and that the US has always struggled to find the middle.
After Liberation Day: What a Good Outcome Would Look Like
Asked for the most positive plausible outcome of the US-China negotiations following "Liberation Day," Kroeber says his expectations are very low. The US side has a collection of grievances that have not become a coherent agenda. It is hard to negotiate without knowing what you want from yourself and from the other party.
Normatively, he says the goal should be terms of coexistence for the coming decades. The most desirable outcome would allow much more Chinese investment in key US industries. He believes the US let parts of its manufacturing base atrophy too much, and rebuilding selectively should draw on the best firms anywhere, some of which are now Chinese. He also sees investment as an even better communication channel than trade, because it forces companies to put down roots and learn how the other side works. The obstacles are enormous: the US narrative that such investment is inherently unsafe, and likely Chinese reluctance to let leading technology firms set up in the US and risk leaks. At best, he thinks terms might be negotiated over one to three years.
He identifies China's biggest problem for the world as its unwillingness or inability to generate enough domestic demand. Firms that cannot sell at home export their surplus, raising trade frictions with many countries and reinforcing the view that China is in it only for itself. He thinks China may be forced to change. The metrics his team tracks show falling returns on investment and a rising number of zombie companies that cannot cover their interest costs. Outside pressure toward more balance would help.
His last point is aimed at the US. Both the Trump administration and, to some degree, the Biden administration have believed China can be contained by an alliance, dusting off the Cold War bloc playbook. Kroeber says this will not work. Beijing saw it coming and chose not to build a rival bloc but to make it impossible for the US to build one. He says 140 countries trade more with China than with the US. Ask Southeast Asian or Latin American countries to join an anti-China alliance and, in his account, they will refuse, because China supplies their industrial inputs and consumer goods and is their first or second economic partner. The workable alternative, he argues, is to accept China's integration as reality and rely on American strengths: a dynamic system and a more creative, flexible financial system. That means fixing America's own economic and social imbalances and keeping engagement with China competitive but bounded, to avoid a hot conflict, which he calls the worst of all possible worlds.
Today I'm interviewing Arthur Kroeber, the founder of Gavekal Dragonomics, a research consultancy focused on China, and the author of China's Economy: What Everyone Needs to Know. A friend, while I was in China, recommended it to me. And it's been the most valuable and useful resource you can get today on how China works.
Arthur, thanks for coming on the podcast and taking the time to chat with me.
It's great to be here, thanks.
First question: what really is the problem if China becomes as wealthy as America, or if its economy grows as big, or even bigger than America's? I know it may not be your perspective to be a China hawk, but I've never really understood why this is a problem in the first place.
It's a very good question. There's a lot of criticism of China from the standpoint of, you're trying to get rich, that's fine. But you're basically trying to get rich on the backs of everyone else in the world by running this gigantic manufacturing export machine, where it seems like the Chinese ambition is to produce all the manufactured goods in the world for everyone, run an enormous trade surplus, which means they are depending on other people's buying power to support them.
And that this is basically not fair, not sustainable, not a stable way to participate in the global economy.
That's more of a question not of, if China does get rich, but how does it get rich? Does it get rich by operating on the same rules as everyone else and having a market other people can participate in? Or does it get rich by making it impossible for anyone else in the world to have the kind of production structure that they want to have, and relying entirely on these ever-growing trade surpluses?
In principle, from a welfare standpoint, it would be great if China got to be as rich as everywhere else in the world. Even as rich as America. But that is likely to have difficult and destabilizing political consequences, because of the vast differences between the Chinese political system and that of the US and all the other major industrialized countries.
On the trade surplus point, to the extent that it is made possible by the government involvement in industry… It's actually not even clear to me that that's the case. If you have high savings and not enough investment domestically, the accounting identities are such that you will have a trade surplus. But suppose that's even the case.
On paper, it just seems like what is happening is that the Chinese taxpayer, the Chinese saver, is subsidizing foreign importers. On paper, it just seems like we're getting a good deal. I'm sure some people are upset about this, specifically people who manufacture outside of China. But it's certainly not something obviously insidious.
So it seems like if it wasn't for this, there'd be some other reason that China can't grow as wealthy as us. I am playing a little bit of a devil's advocate here. But I don't really understand why this is such a big issue that there needs to be very powerful competition about it.
There are a couple of things beneath that. One is the systemic political difference is really important. The US self identity is that it is the leader of democracies around the world. We are very invested, at least for now, in our democratic system. We'll see how that evolves over the next two or three years. There's some question marks around that, but historically that's been a really huge part of the US identity.
Basically the morality play of World War II and the Cold War—which have really been the crucible in which US foreign policy has been formed—is that you had an alliance of democracies that fought back first against fascism, then against communism. They won. The result was that you created a world where most major countries were democratic. They operated on market economic systems. We were heading towards a world of convergence of systems where everyone's essentially playing by the same rules.
China really gets in the way of that narrative because it's this incredibly successful authoritarian system where the authority still calls itself communist. US elites have never, to this day, really gotten comfortable with the idea that the Chinese political system is legitimate. As long as you have that underlying problem, it's going to be very difficult to erase these difficulties.
On the economic side, I think it is a problem, the way that China has chosen to organize its economy. In a strictly financial sense, the rest of the world comes out ahead in the sense that China is willing to subsidize a lot of low cost production. The rest of the world gets a lot of cheap goods and the overall welfare of the world improves a lot. I think that's clearly true.
But if you look at what has happened to the US politically over the last 20 years, there are a lot of flies in that ointment. The fly is that it is important for large countries to be able to maintain a diversified production structure and maintain social cohesion. If you lose the capacity to run a manufacturing economy that employs large numbers of people, there's a lot of disruptions that come as a result of that. The purely financialized economy that we had growing up in the United States in the early 2000s as a result of this bargain with China wound up being pretty bad for the social compact.
So there is a legitimate question about how you integrate China's growing power, wealth, industrial might, into the world in a way that societies around the world can tolerate. It's a legitimately difficult problem.
I think a lot of the problems have to do not with China but with US domestic policy. A lot of what's going on right now is scapegoating of China as a way of diverting attention from decisions that need to be made domestically about income redistribution and macroeconomic policy and so forth.
But there is also a legitimate question to be made about how China now accounts for 20% of the global economy, probably larger in the future, and a third of the global manufacturing economy. There has to be an agreed set of rules about how it interacts with the rest of the world so that everyone feels that they are benefiting, not just in financial terms. We don't really have that agreement now.
Two points. On the political system, I wonder if we've learned a bad example from World War II and the Cold War, which is that great power conflict culminates in the other party totally collapsing. I think that was actually necessary, obviously, for Hitler and even for the Soviet Union. I think they were evil regimes. I think China today is an evil regime in a way, but it's just not in the same order as Stalin or Hitler. So the end state for any great power competition for America… History is long, there will be more than just these next few decades. It cannot be that if there's a different political system that it has to collapse the way that the Soviet Union collapsed or that Hitler collapsed.
The first thing to note here is that this could be true of any country. I think people conflate these two arguments. Whereas it's worth noticing that if Australia was producing everything the world consumed and had an economy the size of America's, these arguments should apply to them as well. I don't think people have the sense of if Australia were producing a bunch of stuff for us, we would need to form a coalition against them and have this adversarial attitude.
But suppose we did. There's a question of, "How could you prevent this dislocation and is it Australia's fault?" The analogy is breaking down. Let me just go back to China.
So there's low value-added manufacturing where labor cost is a big fraction of cost. That kind of stuff was shipped off to China. But if it wasn't for China, there's many other countries in the world that have much lower labor costs than the US. If it wasn't for China, it'd be like Vietnam or Bangladesh or something.
Then there's high tech manufacturing. There I haven't crunched the numbers, but if I were to guess, I don't think with TSMC's leading-edge 5 nanometer wafer, I doubt very little of what it costs to make that is the process engineers themselves. That is just, "Can your country produce it?"
There's a few different questions in there, so let me break that down. The first thing that you alluded to there. Essentially, is a Cold War the right framing for whatever this conflict is with China? My answer to that is absolutely not.
You can address that question both empirically and conceptually. Empirically, if you just look at patterns of trade and investment during the Cold War, the Soviet Union never accounted for more than about 1% of US trade and investment flows were basically non-existent. China at its peak about 10 years ago accounted for 17% of US trade, about the same amount as Japan did in the late 80s and early 90s. That number has come down a little bit on the surface. But when you take account of stuff from China coming in through third countries and so forth, basically that remains the same.
If you talk about investment flows, there's $600 billion or more of US corporate investment in China. That generates huge amounts of sales, much larger than US exports to China. The integration of the two economies is just extraordinary. There's basically no precedent for it at any point in economic history. It is just a completely different order of magnitude to what was going on during the Cold War.
So one question would be, "Okay, if you really want a Cold War, does that mean that what you want to do is you want to reduce those trade and investment flows back down to essentially zero? If so, how do you do that?" That's a very difficult problem.
You got at the more core conceptual issue, which is, how does this end? This does not end by China going away or turning into something completely different. It's too big. It is too successful. The economic model is successful on its own terms. It has a lot of problems, but it's fundamentally successful. It is deeply integrated with the entire global economy in ways that are beneficial for China and beneficial for most of the other countries in the world. Everyone has some sort of a stake in China continuing to succeed.
This is just not going to go away. There's another sense in which it's not going to go away. Let's say you could wave a magic wand and make the CCP disappear tomorrow and replace it with something else. What would that something else look like? If that something else were to be successful at governing China, it would almost certainly share many of the characteristics of the Chinese Communist Party.
It would have a strong determination for China to be an independent geopolitical actor, taking care of its own security with a very strong military so that it could defend itself against all of its real and perceived security threats. It would be committed—as every Chinese government since the mid 19th century has been—to maximizing the rate of technological progress and making sure that as much as possible of China's core technology needs were met by domestic production rather than imports. It would be very, very similar to what we have today.
It's a fantasy to think that we have a problem here with just this particular regime, that we can just get them to change their minds. No, the Chinese approach on this is very deeply rooted in both the institutional, cultural history of China itself and its geographical and geopolitical position in the world. So it's going to have interests that create a lot of friction and conflict with the perceived interests of the United States under any government. It's probably going to be quite successful at managing this economy because they've been very successful for many, many decades.
When I was in China, I asked somebody I met what would happen if there was an election in China tomorrow. His answer was that it's possible that the median voter in China is much more reactionary than the government. In fact, this might be much more liberal than the regime you would get out of a democratic election.
Yes. We don't know for sure because there really isn't a lot of public polling. But a lot of people say that and my perception is that could well be true.
All you have to do is look at the Chinese Internet, the blogosphere. They don't have Twitter but they have local equivalents. There is a lot of unfettered nationalist, highly militaristic thinking there that the government spends most of its time keeping in check. Every so often they unleash it because they're in a spat with Japan or whoever and they need to gin up popular opinion. Mostly they try to tamp that down.
A Chinese system that was fully representative of actual popular views… We don't know exactly what that might be, but it could be very, very difficult to deal with.
Going back to this discussion about what should be the grand bargain between the rest of the world and China. I live in Silicon Valley and as you know, a big topic of conversation is AI. In particular the race between China and the US on AI. One idea I've heard is that what we should do is give them free rein on solar, electric vehicles, batteries—all this other real world heavy manufacturing that they seem to have greater proclivity for anyways. They consider it more real. And, say, on AI and semiconductors, we'll dominate that. Everything else we'll import. Is this a plausible deal worth making? Because if you take AI very seriously, this might be an amazing bargain.
You can say what you want in your ideal state of things, but how do you get there? There are a lot of people in China who'd say, "No, we want it all and we can. So why should we make that deal with you?"
If I basically take this down to the level on which the United States and China are now starting to negotiate, my personal view on this is that it would make a lot of sense for the US to be much more open to direct investment by Chinese companies in manufacturing in the United States. I'm thinking particularly of things like electric vehicles and that whole supply chain, green energy, industrial automation, all of those things.
Why do I think that? First of all, if the US is serious about revitalizing its industrial base—and I think there's a good case for trying to do that selectively—it is not going to happen unless you invite in the world's leading players and have them compete. That is how China industrialized. 45 years ago, they were an industrial basket case. They said, "We want to get industrially strong. How do you do that? Get all the leading companies in the world to invest here and we'll learn from them." That's how you do it.
If we're serious about that, we should be serious about figuring out ways that we can bring Chinese industrial investment into the United States. That to me would be a win-win, because Chinese companies at an individual level would love that. They see the US is a huge market. They can't get into it right now. They would love the opportunity to tap into it more. We could learn from them.
And if you did that, basically you would be saying that whatever we're in with China, it's not a cold war, because we are willing to have high levels of direct investment by both sides. You might want to put protections around that, all kinds of rules of the road. But in an ideal world, we would have a lot more of that.
The first question is, why is that so difficult? Why do you essentially have a consensus in Washington that not only do we have to prevent the export of US technology goods to China, but we also have to prevent Chinese companies from investing in the US? This is basically agreed on in Washington. And the reason is data.
Fundamentally, there is a view that any manufacturing process today is also a data creation machine. Where does that data go and who benefits from that data?
The other thing is that, back 30 or 40 years ago, you used to be able to divide the world into technologies which were essentially for civilian use, a few technologies that were military, and then a very small proportion of dual-use technologies that could go either way. It was those dual-use technologies that had to be controlled very carefully. Now basically everything is dual use. Any technology that you can imagine can be put to some kind of military use.
So it becomes much more risky to have these patterns of investment, particularly when you don't know where the data is flowing and how that will feed into someone else's defense production base. That is a legitimate concern.
In my ideal world, you would have a lot more Chinese investment in the United States, but it would be very carefully regulated in the same way that China very carefully regulates the direct investments by foreign companies in its economy. They have rules about data localization, etc. I think that could be achieved. I think it will be very difficult in the current political environment.
In terms of the grand bargain that you suggest, China is very interested in not being pigeonholed. They didn't want to be pigeonholed in low value-added manufacturing. They wanted to do the high tech stuff, now they're doing that. They don't want to be pigeonholed in manufacturing. They want all of technology, including AI.
I don't think that any strategy premised on the idea that China should accept arbitrary limits on what it can do is viable. Would we accept that? Absolutely not. So why should we expect them to accept something that we would consider an absurd and completely unreasonable infringement on our sovereignty? It just doesn't work that way.
It's funny because one of the main arguments that China hawks will make, or one of the big parts of the worldview, is that China really cheated us. Our companies would invest in China, build up factories in China, and technology would get transferred there. This was a huge arbitrage that China was able to pull. So if you actually believe that, it should just make the reverse of that incredibly compelling. Because you get a chance to do that again.
Do you want to tell the story of BYD and Tesla in 2018 and 2019? Because I think this really illustrates the point of what could be done in reverse very well.
If you go back to the early 1990s, China recognized that pretty much every other country that had gotten rich had done so in large part by building up an automotive industry that then served as the mechanism for creating innovations in other sectors. Look at the US, Germany, Japan, even Korea which is very successful. They said, "We have to have a big auto industry. This is one of the key industries that we have to support."
So starting in the early 1990s, they had this strategy of bringing in foreign companies and making them do joint ventures on a 50/50 basis with Chinese auto companies. The theory was that eventually the Chinese companies would learn. You would be able to develop your own national champion auto companies and kick the foreigners out.
Basically this failed. It failed massively. Over the next 25 years, foreign companies came in: General Motors, VW, Toyota, Honda and so forth. And they did very, very well. The joint venture partners in China basically just sat around and clipped coupons from the dividends that these joint ventures were producing. All of the technological inputs continuously came from the foreign partners, all of the design ideas. The local partners were never able to succeed.
In volume terms, you had a lot of smaller scale, locally sponsored vehicle companies in China building low-end vehicles. So a lot of the cars that wound up getting made in China were made by local firms. But if you look at the share of profits and total value in the system, it was dominated by these joint ventures, which were in turn dominated by the foreign partners.
So China, circa 2010-2015, had been doing this for 25 years. They were basically no closer to having globally competitive conventional car makers than they had been 25 years before.
So in the late 2000s, 2005-2010, they started thinking, "Well, this and other related industrial policies are not working very well. We are not generating the national champions that we thought would be. So what do we do about this?" Their answer was to leapfrog: "Let's try and figure out what is the next stage of technological development that people really aren't working on yet. Let's work on that and then maybe we can get in on the ground floor." What they came up with in large measure was renewable energy and specifically electric vehicles.
They started having a pretty comprehensive set of subsidies and other kinds of industrial support for companies like BYD to produce electric vehicles. BYD is basically a private company. This worked okay for 10 or 12 years. BYD got pretty good. Particularly what they started to figure out was the supply chain. They got very good at making the batteries.
But still by 2018-2019, BYD was still not that exciting a company. Most people in China really didn't want to buy electric vehicles. They seemed really inconvenient. The sexy cars were the big SUVs that the joint ventures were putting out and so forth.
Then in 2018, the Chinese government made the decision to allow Tesla to come in and build a wholly-owned Gigafactory in Shanghai. They had never approved a wholly-owned automotive company before. They started cranking out cars in 2019, which became immensely popular.
It seems like one of the things that happened was that the Chinese companies by 2019 had gotten pretty good at the underlying technology of electric cars, specifically the batteries and the software systems that govern the cars. But they were terrible at consumer design. They had not figured out how to make appealing products that people would want to buy. Tesla did have appealing products that people wanted to buy. They were big status symbols.
So BYD and its competitors said, "Okay, this is the part we have to figure out. How do we achieve this?" Basically, they recognized that they had to up their design game. Among other things, they went to Germany and loaded up on a lot of German car designers that were able to transform their technology base into much more appealing packages. Then by 2022 or so, they were able to compete with Tesla both on price and on quality.
What that shows you is that, number one, the Chinese government made a pretty good bet on this leapfrogging idea: "There are technologies in the future. We need to get in early, subsidize the heck out of them." Some of the estimates that have been made about the level of subsidies given to the EV industry and its supply chains range from $200-300 billion. It was a huge, huge amount of money that did not generate that much of a financial return for a really long time but they stuck at it.
Then the thing that finally flipped the switch was this catalytic foreign investment that showed the Chinese companies what they needed to do to actually compete in the consumer market. Then they got very good at that very quickly.
How much was the $200-300 billion actually relevant given the fact that BYD, as you mentioned, is a private company? How much of that was actually necessary or counterfactually important to creating this outcome?
It's like the old slogan about advertising: half of it works, but you don't know which half. Did China need to spend that much in subsidies? Probably not. But had they spent less, would they have had the same effect? Maybe, maybe not.
They tried various different types of subsidies. Initially there were producer subsidies to just get companies to produce more. Then they had a lot of buyer subsidies at the individual level, but also the city government level to promote things like electric buses. I think all of that played a role.
What was important was that the government set a very clear direction and they said, "We want this to happen, we really want it. We don't know how long it's going to take. We're just going to keep trying different things until it works. Because the goal of creating this electric vehicle sector and the whole supply chain for it, that's what we want at the end."
Why are they able to identify these kinds of sectors in advance? Central planning isn't supposed to work. There's been many cases of countries which have tried to do this. Germany, Japan, and many other countries missed out on the Internet because there was a centrally directed effort towards these heavy industries or manufacturing, which actually turned out not to be relevant in the 21st century.
No, it's definitely perilous. China has a list of key industries. It's called the strategic emerging industries. They came up with it basically in 2010. It built on previous iterations of industrial policy. Most of it is not really an effort to predict with a high degree of specificity what comes next. They're mostly pretty obvious things like semiconductors, industrial automation, new materials. It’s all this kind of stuff that would be on anyone's list if you were running a VC fund and saying, "What are the sectors that we think are—"
But most VC funds are losing money. Actually, maybe only a couple of firms in the world were able to make this prediction correctly. So it's like a couple of firms in the world plus the Ministry of Information Technology in China are the only people who can predict the future?
No, I think basically the analogy with the VC fund is a pretty good one. I’ve made it many, many times. Think of China as a giant VC fund that is just willing to lose huge amounts of money for a really long time on the assumption that a few of the bets will pan out.
China as a state, as a government, is uniquely able to throw a lot of money at things for a really long time and not care about what returns are. And say, "We're going to identify this universe of potential winners. We're going to promote all of them, basically. Some of them may work and some of them may not, and the successes will pay for the failures."
I guess I'm still confused on why… Many other countries have tried similar things. MITI was a Japanese version of this, right? Look at their economy now and their high tech sector.
There’s a couple of things. First of all, even if you go back to like 2005-2006, when we started thinking about this, everyone was saying that green energy was going to be an important industry in the future. You had the Kleiner Perkins guy. John Doerr was the big VC who said circa 2007, "I'm going to put all of my bets on green energy because this is the future." He turned out to be wrong from the standpoint of his investment returns. But he turned out to be totally correct in terms of this being a really big thing. It was just not that wild a bet to say that green energy was going to be really important and that we should place a lot of bets on that.
Why does this work and why is this different from a central planning thing? That's a really important point.
First of all, the Chinese system, like the systems that preceded it in East Asia—Japan, Korea, Taiwan, and so forth—has always put a lot of emphasis on being good at exporting. There are a lot of pressures within the system to create industries that can export.
The reason this is important is if you have a totally closed system—which frankly is what I think Donald Trump is trying to create in the United States—and people are just producing essentially for domestic consumption, there's no incentive to keep up with global technology developments. If you have this constant export focus, essentially what everyone is trying to do… If you have a closed domestic market, you can rig the domestic market and buy off your connections in the government to make sure that you, as a company, have your market share. There are a lot of ways to win that do not involve technological upgrading. That is what dooms all import substitution regimes.
If you're an export-driven economy, you can't rig the global economy. Ultimately you have to compete. You can't compete just on price, you have to compete on raising your game. Japan did this successfully, Taiwan did this successfully, Korea did this successfully. China's done that successfully.
So that's answer one. You had this underlying system which was heavily incentivized towards technological upgrading across the board. That's what you were sitting on top of. It was completely different from the old central planning regime, which was autarkic and inward-looking.
Second, you had this domestic competition environment which was really cutthroat and involved a lot of international companies. This is a little bit of a difference from Japan, which always kept the foreign companies out of its domestic market. Their companies operated globally very, very well, but the domestic market was very protected. China's domestic market was not that protected. They were always willing to bring in companies that they thought would be able to spark some technological change.
So what this did is it created a field in which maybe the government has the right ideas, or maybe they don't, but you have a crucible in which their ideas can be tested. You have a very competitive domestic market where you have a lot of the big international players doing their own thing as well. So the things that work get some validation and you can keep building on those successes. That's really important.
Then just the sheer scale at which they were able and willing to support what appeared to be losing bets for a long time does matter. You could contrast their view, for example, in solar energy. They said, "Look, we want to be big in solar energy." Again, they started thinking about this in 2005. "What do we need to do?" So they identified the whole supply chain, from the raw silicon inputs to all of the modules in the finished panels. They said, "We want to be in every stage of that." So they had a pretty deliberate strategy of trying to create people at every point in the supply chain. And they were willing to go through cycles of people not making any money.
The obvious comparison in the United States is that the US government gives one loan to one company, Solyndra. It goes bad and everyone says this is proof that industrial policy does not work. China actually has the right answer to that question. We had the wrong answer to that question. You have to be willing to accept some failures and some loss of government money along the way if you want to get to the end.
But I really stress the ecosystem because a lot of this would not have worked just by the government saying, "Oh, we want to do solar." It would not have worked unless you had this broader ecosystem of export-driven manufacturing, high competition, and international participation across many, many sectors of the economy. They all converged to create a successful result.
I want to put some of these bureaucrats in a Factorio speedrun and see how they do.
I just interviewed Ken Rogoff, so Japan's top of mind for me. That's really interesting that even though Japan had this export discipline, maybe the reason that the growth didn't continue after the 80s is because you had this convoy system where banks were incentivized to lend to people they knew in these conglomerates. These conglomerates have been around for decades, even before World War II.
I have a question now about China. You have these companies which have become national champions and are conglomerates, the same companies producing a phone and a car and everything in between. Given the intrinsic nature of authoritarian systems, or systems with financial repression, will we go to a system that is closer to what Japan had in the 80s? Where they’re going to give money to Huawei, because Huawei or BYD are the right people. Or will it remain dynamic, especially in the sectors which are coming up over the next few decades?
It's a good question. I would start by emphasizing the ways in which China is very, very different from Japan. The central thing that is really different and lies at the root of a lot of this, is that China is an independent geopolitical actor. Japan was not. Japan, at the end of the day, could rely on the US for security. They were demilitarized.
China basically is on its own. They're in a very dangerous neighborhood. They have 14 land neighbors they share borders with. They have names like North Korea, Russia, Pakistan, Afghanistan, a lot of dangerous actors. Several of them have nuclear weapons: North Korea, Russia, Pakistan, and India. So China, just in a very narrow sense, lives in a very dangerous neighborhood.
They quite legitimately have some pretty significant national security needs. They also have aspirations to be a great power, and they want to do it on their own. The incentive to get things right is much more existential in China than it was in Japan. Japan essentially could take the choice to sort of say, "Oh, we're going to have a stagnant economy and that's bad and whatever, but actually we'll be fine." For China, it's not fine. So underlying it, there's a spur that increases the chances that the Chinese leaders will do the things that they need to do to keep the system more dynamic. It's not a guarantee, but it's a pretty strong incentive.
Then, if you look at some of the specifics, the big difference between the way that China and Japan are economically organized is essentially the relationship between the financial and the corporate sector. Japan had a system where banks owned equity in these giant industrial companies and trading companies, and vice versa. There were these cross shareholdings, which meant that essentially the entire economy of Japan, the entire corporate and financial sector, had one big balance sheet. All of that balance sheet rested, by the late 1980s, on land values that had just gotten completely detached from any form of reality.
There was an investment thesis among investors who were playing the Japanese stock market in the late 80s, that you did not look at the earnings of Japanese companies. Those were irrelevant. What you looked at was the value of the land they controlled. You looked at essentially a capital ratio where you assumed that the value of their underlying land capital was a permanent contribution to their wealth and prosperity. The valuations of these stocks, which again got crazy, you couldn't justify them by earnings. They said, it doesn't matter because the land they're sitting on is so valuable.
Then the land values collapsed by 80%. The stock values had to collapse by a similar amount, 80%. Everyone was holding shares of one another. So the banks’ capital got eroded because a lot of their capital was tied up in the land and in the stocks which were collateralized by land. So they were unable to lend. They just had to deleverage as fast as possible. The companies had to deleverage as fast as possible. The entire economy got engulfed by this phenomenon of debt deflation, which basically means in the act of paying down the debt—because you're doing fire sales of assets—you're reducing the prices of those assets and introducing deflation. So the real value of your debt continues to grow even as you are supposedly reducing it, because of the deflationary effect. It's very, very difficult to get out.
China does not have this problem at all. They looked at the problems that Japan got into, they looked at similar problems that Korea had in the late 1990s, and they said, "We will never allow this kind of cross shareholding between financial companies and corporations. This is way too dangerous." They have kept the two quarantined. It is illegal for industrial companies to own a bank. The bigger ones are allowed to have internal financing subsidiaries, but they can only sort of manage finance inflows within the group. It is also illegal for banks to load up on shares of industrial companies. So you have a distinct financial system and industrial system. Which means that the particular type of macro problem that Japan got into is very, very unlikely to occur in China.
You do have huge debt problems. The property developers are very over leveraged, it’s a huge problem. We've had a massive property crash in China over the last five years. That is a big, big problem. You have local governments that borrowed a lot of money, invested in infrastructure which is now delivering very little returns. They have a big debt problem. You have very substantial debt problems in China that have significant negative macro consequences. But they're all isolated and they can be dealt with sort of one by one.
If you look at the industrial sector, it's not very highly leveraged. Debt levels in fact are not high. Most private companies in China have learned for many years that they couldn't get access to bank credit. The banks only wanted to lend to state-owned enterprises which were secure, had physical collateral, and had a state guarantee. Private companies for years have learned to make do by basically financing their investment out of retained earnings. Their leverage ratios are not that high. They're creeping up now over the last few years because of the big industrial policy push. But fundamentally they're in a very different position from the Japanese companies.
This is just stuff from your book that I'm citing back to you. You talk about these local government financing vehicles which are backed. The local government takes out a lot of loans in order to build this infrastructure. That is backed by the presumed appreciation of the land, which should go up as this infrastructure goes up. That sounds actually very similar to the problem you were describing with Japan. You say, "Look, this is debt that's on the local government's balance sheets. But fundamentally it's like one country." You have this system where the government can just hand the debt to somebody. So how immune is the private economy really? Will it just take down the local government and then nobody will make a fuss? These other companies will just never have to hear about it again?
I guess my view on this is that this local government land based financing model was actually a pretty smart thing to do initially. For a decade or so it worked quite well. Local governments were sitting on a lot of these land assets. The land assets originally were undervalued quite substantially. So it made sense for the local governments essentially to try and capitalize some of the future value of these things and use them to finance infrastructure development.
This was not a rogue policy that local governments came up with on their own. It was actually sponsored by the central government and the China Development Bank back in the early 2000s. They were grappling with the problem that China at that point had a severe shortage of housing and infrastructure of all kinds, including urban infrastructure. The question was, "We need a lot more of this stuff. How do we build it? How do we finance it?" They realized, "Actually as we build this stuff out, the values of the land are going to skyrocket. So let's essentially take some financing against that future land price appreciation and use that to build the infrastructure that makes everything possible."
If you look at the first two cases of where this was done in the early 2000s, they had these estimates of what the land would ultimately be worth that seemed ridiculous and astronomical at the time. They were in fact way too low. They were way, way conservative on what the actual land price appreciation would be. So you had a period of about eight or nine years where essentially the state-run development banks were doing this in a fairly controlled way, very successfully.
What happened was that after the 2008 financial crisis, the government said, "Oh, we just have to spend a lot of money to gin-up growth because there's been this global economic catastrophe." They did a massive cash infusion into the banks and to the state-owned enterprises. They said, "Spend, spend, spend, and basically all infrastructure is good infrastructure or just build whatever you want." What happened at that point was that all of the commercial banks got into this business of lending money to local governments for these infrastructure projects. Their underwriting standards were much less robust than the China Development Bank’s had been. For the local governments, it was just free money to them. They just took all the money and they ran with it. That created this kind of Frankenstein's monster.
Even so, you had quite a lot of that money in the first two years that probably generated a pretty good return because China was still underbuilt relative to what it needed to be. But after that had run for three or four years, it became clear that a lot of this was going into wasteful projects that didn't deliver a good return. Now they've been struggling for the last decade to unwind that. But it's important to understand that the underlying model was actually an okay model. It just wound up being done in a way that was completely uncoordinated and excessive. You didn't have incentive structures that enabled local governments to rein it in when they needed to.
So I still think that that is fundamentally a local government fiscal problem, which ultimately is a central government fiscal problem. If you look at the consolidated balance sheet of the central and local governments, put all together, China's government debt is still probably less as a share of GDP than US federal government debt. The US is over 100%, China is probably under 100%.
So my previous guest, Victor Shih, estimated that the local government debt alone is somewhere between 100-150% of GDP. If you add it to the central government debt, I think he estimated that government debt in China is 200% of GDP.
I would respectfully disagree with Victor on that. It's impossible to know for sure. You have the problem of formal debt, which is debt issued by government entities, and then you have contingent debt, which is debt issued by corporations that may or may not essentially be fronts or windows for local governments. There is also a very significant problem of double counting, which is hard to resolve. Debt gets counted at different levels in the system. It's one piece of debt, but depending on how long the chain is, it gets counted in various different places. I've long had the view that many of these much larger estimates of debt don't fully account for the double counting problem.
It's quite possible that the true debt level is higher than what we think it is. It's unlikely, in my opinion, to be as high as Victor says it is. It also matters what the debt goes to and who is actually formally responsible for paying it. Are there project flows or income flows that can be used to pay for it? The structure of the servicing of the debt matters. At the end of the day, we do have a pretty good sense from the macro data of how much total debt there is in the economy. It's on the order of 300% of GDP. So if you want to say that government debt is 200% of GDP, then unless you're double counting, you're basically saying that everything else is a lot less than you think it is.
Do we know what the total debt, private and public, is in the US?
I don't have it off the top of my head. The federal government debt I think is around 110% GDP, something like that. Total gross debt of all sectors, government, corporations, households, I think would be on the order of around 300% of GDP. Japan is substantially higher.
You can get into an endless debate on these things where it becomes kind of a numbers game. But I have a pretty high conviction that China has a significant macro leverage issue. If you take my numbers, say gross debt to GDP—which by the way are the official numbers of the Chinese government and largely accepted with some structural modifications by the IMF, so forth—it’s 300% of GDP. That is in the ballpark for highly developed economies. It is extremely high for middle-income economies. So if you look at China as an economy that has average per capita income that's kind of like Brazil, China is way more leveraged than any other country of its level of income. That is potentially a problem.
So I don't want to make light of the problem because I think it is quite serious. It's an important constraint on policy and it is an important constraint on growth, at the moment. I don't think that it leads to a financial collapse situation because the system is contained and all the debt is denominated in local currencies. But it does impose a tax on growth and it is one of the things that makes China's growth more sluggish now than it probably could be.
Why is it the case that middle-income countries are especially in a bad position with having a high debt to GDP ratio? You would think naively that they're in a position to have higher growth over coming years, so it may make sense for them to take on more debt so they can use that to finance the greater growth that will come—theoretically assuming they use it to invest in high return things—as opposed to the US or Japan where you're just going to be stuck with this debt load for a long time.
One of the things that you could say about debt historically in China was that it tended in general to finance productive assets, whether it was industrial production or infrastructure. For many years China was a very infrastructure short country relative to its needs. So you could justify quite substantial debt-financed infrastructure investments on the basis of these would deliver good economic returns for many decades. The case for that is a lot weaker now than it was before. The problem is how you essentially retire this enormous stock of very low-productivity, infrastructure investments, debt-financed. How do you sort of move on and have a more productive return on capital in future?
There are ways for solving that problem. To me the fundamental issue is they have too much of a supply-side strategy, not enough of a demand-side strategy. It's really a macroeconomic issue. If they had stronger domestic demand, that would generate more profits for companies. They would be able to have more pricing power for companies. You would get a little bit of inflation. So you would have more cash flows within the economies that would enable people, and local governments, to pay down debt. A little bit of inflation would erode the real value of the debt.
That's essentially how they got out of their last debt problem in the late 1990s. They had gigantic bad debts in the banking system, essentially representing legacy loans to state-owned enterprises. They had no way of paying them back. They had a very, very growth friendly program that generated a lot of growth, a lot of inflation. That basically strengthened their debt problem. What they need now is a kind of a revamped, updated version of that strategy. They do a lot more to promote domestic demand, to get more profits, more cash flows, and a little bit more inflation into the system. That would probably solve the debt problem over, you know, a decade or two.
I want to keep asking you more questions about the nitty gritty of the situation, but before we keep deep diving I want to step back and ask this question. The valence of things you've said so far has been, "Look, they've been remarkably competent even at the things which economists criticize them most for." For the majority of the period of these schemes they've actually worked out quite well. For example, this local government financing through land sales on estimated future income and so forth. Obviously we've been talking about the Chinese industry and how that's been successful in many key sectors.
I guess a big picture question I have is, if that's true… They're still at like a fifth of American national income per capita, a third of similar countries in East Asia, like Japan, Taiwan, and South Korea. How do we explain the relative poverty on a per capita basis in China? How do we explain obviously bad decisions like Zero-Covid? I guess I'm having trouble squaring the circle. If they're making all these great calls, why isn't China more successful?
They're not successful enough? I thought one of the problems in the world that we're facing today is that they're too successful at too many things and that this is creating difficulties for other people.
Yeah, that has come up from time to time.
During the period in the 90s and 2000s, they were growing at 10% a year, which is the fastest growth rate recorded by any economy in the history of mankind. They were doing it not for one or two years, but for 20 years in a row. People often say there's all this waste and there's too much debt on enterprises and that they could grow much faster if they were just more efficient. It's like, "Really, could they?"
They're already growing faster than anyone has grown before. Is it really the case that they could have grown a lot faster than they have? Maybe, but I doubt it.
The reason is that there's what I would call an efficiency fallacy. Global macroeconomists have all been basically trained in the United States since the end of World War II and particularly since the 1990s. They view the US in its developed state as the norm rather than as the result of other processes. It's like, "The way we operate now is the way we got here." Actually, that's not quite the case.
The reason China was able to grow so fast for so long was that they were able to mobilize these huge swaths of resources, domestic savings, and throw them in an uncoordinated way at a lot of problems. There was a lot of waste along the way. That was part of the equation.
So if they had tried to be maximally efficient and said, "No, no, we're not going to allow banks to lend unless they can prove that this project is definitely going to have an ROI of X." They would have lent a lot less and they would probably have had a lot less growth because they were not willing simply to create that wall of money that would create broad-based growth. They might in fact have had substantially more inequality than they did.
Their wasteful method allowed them to spread out investment in a lot of areas which were geographically disadvantaged. Those areas might not have done so well in a purely efficiency driven system. I think we need to be careful about assuming that inefficiency is bad. I think inefficiency sometimes can be, as long as it is basically the result of a desire to be effective, a byproduct of a successful growth story. That's basically my account of China.
Is it your quote in the book, something like, "For a country of China’s scale, what matters not is efficiency of using the resources, but effectiveness of achieving outcomes"?
Basically that's my thesis. I think they've shown that this works quite well. That's also part of the answer to why aren't they richer on a per capita basis. Well, there are 1.4 billion people. It is just gigantic.
Think about the scale problem. Taiwan, South Korea, they got to whatever they are relative to US per capita GDP—60-70%, something like that—within a generation or two. Taiwan had 20 million people. South Korea had 40-45 million people. To move that number of people and get them all working in high wage industrial or service jobs in urban areas, you can do that in the course of a generation, 20-25 years. I think it's just physically impossible to achieve that on the scale that China's been operating on with 1.4 billion people.
You look at the urban migration that they've done. It is completely unprecedented in the history of humanity, the speed at which they have converted people from rural residents into urban residents. For many years they were urbanizing at the rate of 20 million people a year added to the urban population. I forget the precise calculation that I made, but in terms of housing and urban infrastructure, they were building the equivalent of New York plus Philadelphia plus San Francisco every single year for 20 years. No one has ever done anything like this before.
The lesson of this is that there's an arithmetic problem there. Even if you do this on this unprecedented scale, and do it faster and bigger than anyone has done it before, if you're trying to move 1.4 billion people into an income of United States-level, it just takes a really, really long time.
Now of course, what's happened is that they have gone too far off the deep end of industrial policy and thinking the supply side will solve all of their problems. Growth has slowed down quite a bit in the last few years. It's probably well below potential. I don't think that there's a lot of evidence that China's growth was below potential from 2000 until 2020 on average. I think there's a lot of evidence that it is below potential now. They are sacrificing the ability of the average Chinese person to do more rapid catch-up with the living standards of the West, in order to achieve these industrial policy technology goals.
I have a question just to react fast to some of the things you said. Obviously there's places in China now like Shanghai or Guangdong, which have per capita incomes approaching these East Asian neighbors that are really rich. To the extent that that's possible through this high tech manufacturing—and to the extent that it's already a problem that other countries are complaining that China is doing too much high tech manufacturing—I guess it makes sense then, how could you have literally 10x as many people doing the same thing?
You said that the government has decided to prioritize this high tech development rather than the growth rate. You said that as if there's a trade off. But naively, isn't high tech supposed to lead to growth? Why are we on this Pareto frontier with technological development and growth?
Here you get to a sort of conceptual fork in the road. In many respects the communist leaders in China have a lot in common conceptually with the techno optimists of Silicon Valley in their, what I would call, technological fetishism. The Chinese leadership throughout the last 40 years, but even going back further, has had this notion that technological upgrading is the key to wealth and power.
The fundamental idea here goes back to the 1840s when you had this great Chinese empire that had been sitting around for a thousand years doing great. They thought they were the best in the world. Then these upstarts from England come and crush them repeatedly, militarily, and impose this very humiliating political settlement on them through the Opium Wars. The basic analysis among the Chinese elites was, "Okay, we fell behind technologically. Therefore we must catch up technologically. This is the central thing that we need to do."
This was recognized among some elites, but it ran into a lot of encrusted political pressure in the late imperial Chinese regime. They didn't get very far. After the empire fell in 1911 you had a republican government. Basically, if you look back at the things that they were saying and doing, they're pretty similar to what the Chinese Communist Party has been saying and doing. They just did them somewhat less effectively. They were dealing with civil wars and various other problems. The basic insight remained the same, "We need to catch up with the west technologically. This is the fundamental thing. It's just a question of how do we do this?"
What the current regime in China has been able to do is to take that basic idea and actualize it. They have been successful at this task of technological upgrading and catch-up. This is really central to the conception of Chinese elite thinking. The number one job of the government is to figure out how to mobilize the resources of Chinese society so as to maximize technology acquisition, creation, and upgrading.
Starting in the 1980s, that was a big part of the philosophy. But the other part of the philosophy was just, "We have to grow as fast as possible and we are fairly agnostic as to where the growth comes from. We realize that there are many different sources of growth. Foreign investment, exports, construction, infrastructure. We're going to do all of these things."
Basically the incentive structure that they set up was just to tell local officials that their job was to maximize GDP growth. "That will make all of these other things happen. If they tell local government officials, 'Your job is to maximize technology development,' they'll do a lot of dumb stuff and waste a lot of money. That's not the right way to do it. Let's just have GDP as the KPI. The end." That turned out to be incredibly successful.
Then Xi Jinping comes along in 2012 and says, "The problem with this is that it's now gone too far. It's led to a lot of corruption, it's led to a lot of inequality. It's led to a lot of local governments doing wasteful and duplicative things. Now we need to hunker down and focus a little bit more on the really central task, which is this technology task."
So less of "growth at all costs." Basically, the implicit idea there is, "We've got this figured out. Growth will take care of itself. We have a growth machine in China. The resources of the government now need to be focused on specifically the technology question." Everything that he has done—particularly since about 2015-2016 when he really started to see this come into focus—has been, "Let's worry less about the growth target and more about the technology targets."
Particularly after Trump launched his trade war and the Biden administration followed that up with a lot of controls on exports of technology to China, the focus got intense. They were saying, "The US really wants to prohibit, constrain our technological rise. They kind of have the ability to do so. Therefore we have to double down on efforts to replicate all of these core technologies so that we're not reliant on the US or its allies anymore. We just have to go full tilt on technology at all costs." That was an accelerant of this tendency.
But then there is also a macroeconomic theory. Go back and read some of the statements that he put out in the late 2010s about their vision of the future. They talk about all these technological developments. They didn't mean Alibaba and Tencent and all of these great Internet companies. They meant physical technology, semiconductors, new material, green energy, industrial robots, all this stuff. Essentially their view was, "This is going to be the productivity engine of the future. Growth in the overall economy and incomes, it's all going to be driven by these technological investments." That is essentially what they sincerely believe.
There are some problems with that. The vast majority of people in the economy do not work in those sectors. You can get very good at making semiconductors and industrial robots and whatnot. The people who work in those industries do extremely well. But that is a tiny fraction of the totality of the population. How do you have spillovers that enable everyone in the economy—regardless of how remote they are from this engine room of the high tech sector—to enjoy gains to income?
The answer in the United States historically has been, "We're just going to have this great consumer economy. We're essentially going to be demand driven. Consumers will tell us what they want and companies will arise to make what they want, which is increasingly not stuff, but services, experiences. We will create a financial system that produces very good financial rewards for the companies and people that produce these kinds of services." Then you generate huge amounts of actually very high paid employment in the services economy.
The Achilles heel of any industrial policy-driven growth model like China—but you can see variants of this basically throughout East Asia—is that they are very materialist. They're convinced that it's only really the physical stuff that matters. They think if you get really good at making the physical stuff, that will somehow magically spill over into the rest of the economy. The evidence that we have is that that actually doesn't work that much. Most of the demand in a modern industrial economy, the really high wage, high income economies, comes from intangible services. There's a more complicated interaction between this high tech core and wider economic growth. I don't see in China how they set up the linkage between all these great high tech industries that they have and 90% or so of the economy which is doing something else.
I guess I still don't understand. Point taken that maybe in the short run these other sectors don't generate as much growth as just building more housing or something. But by that same token they don't take that much capital, in the scheme of a national economy, to sustain. If China wants to make a $100 billion fund for semiconductors, that shouldn't detract from its ability… I just don't understand why the macro growth number has to go down for it to be able to do that $100 billion semiconductor fund or something.
It doesn't have to, but the way that they have in fact executed this tends to lead in that direction. Here's why. At the same time that they have been doubling down on industrial policy, they have also been much more tightly regulating their service sectors. Here’s a few examples.
The famous one is that they woke up in November of 2020 and realized that Alibaba's financial subsidiary was about to do this gigantic IPO. The premise of that was that China should build a financial system that resembled that of the United States in 2005 and that this was a really smart idea. They said, "Oh, actually that's a really dumb idea because look what that led to in the US. We don't want securitization. We do not want this financial risk generation that Ant Financial is trying to talk about. We really need to crack down on these guys." So they did.
They were also simultaneously concerned with a lot of other things that the Internet platforms were up to. So there was this broad-based regulation of the Internet sector which, weirdly for about 20 years, had operated in a complete free-for-all land of almost no regulation whatsoever, except for political censorship. Pretty much anything else you wanted to do, you could do it with very little government interference. It was a strange exception to the regulatory norm in China. They finally caught up and said, "No, no, we have to regulate all these guys."
They went around to all of the Internet companies and basically told them, "There are things that you can do that are fine and there are things that you cannot do. There are a lot of business models that you might be interested in doing, such as fintech, such as telehealth, such as wider social media applications that you may not do. We think it creates too much financial risk. We think it creates too much social stability risk. We think it creates too much political risk for us, the Communist party." So a lot of the avenues of growth for the Internet companies were shut down.
They still did okay. They're still very big companies. I think their share prices fell way more than was justified by the actual loss in revenue. That's starting to correct itself. Alibaba, Tencent, they're still great companies and they're figuring it out. But they were severely constrained. They were much, much more tightly regulated.
You look at the financial sector generally. It was significantly deregulated from about 2008 to about 2017, with some bad consequences. Increased financial risk, shadow banking, lots of bad stuff. But you also got lots of good stuff. Private companies, which were essentially shut out of loan finance, got the ability to finance themselves through debt in the way that they had not been able to previously. You had a lot of new financial services going to households.
Basically the government said, "No, this is a little bit too dangerous. We're going to re-regulate it." Now most financial activity in China has been constricted back into a small number of basically state-owned banks. So there was severe re-regulation of the financial sector.
There was a lot of talk about the healthcare sector, opening that up much more to private entrepreneurship. That again has been reined in. So you can go down the list. There has been a massive re-regulation of the service sector which limits the opportunities for profitable expansion by companies, limits the opportunities for entrepreneurship, and limits the opportunities for employment.
But the examples you mentioned all seem like the potential growth was constrained not because it was cutting off against high tech development in other more physical fields, but because it was a threat to political power, or to perceived social stability. Growth has gone down because of all these actions. It doesn't seem like it's happened because they needed that to happen in order to get SMIC up to snuff.
No, it's a political choice. That's right. This is what happens if you say technological development, particularly in hardware, will solve all of our problems. It will generate all this growth and so therefore we
don't need this service sector. We have a real life experiment. What happens if you do that? What happens if you do that is you get a lot of progress in the technological sectors. You get basically a persistent shortage of aggregate demand, which means that even the people who are making all this great technology stuff don't have any pricing powers. They have to keep lowering their prices. So you get deflation.
When you get deflation and less employment growth, at the household level people say, "Oh, people aren't hiring. I guess I need to save more and spend less because my income is not going to go up." You create the risk of this deflationary spiral which they're sort of on the edge of right now.
Again, this gets back to the techno-optimist view of things. If you have this very narrow view of the economy as purely the expression of the emanation from this technological core, you're missing a lot of stuff. You will basically take yourself into a blind alley if you think that that is going to solve all your problems.
The Chinese government in the last few months I think has begun to recognize this and say, "Oh, actually we need to have some kind of a demand strategy." This is very evident in their top level statements. The problem is they've been working for 45 years to build this magnificent machine of investment and industry and manufacturing. They're very, very good at it. But they have basically devoted no time in the last 45 years to figuring out how to create a demand machine. They're just at the very early stages of figuring out that part of the problem.
There's another problem with this focus on specific parts of technology development. In any field you understand well enough, you realize how contingent and random the steps leading up to what we now consider to be this self-contained high tech thing were.
The field I know better than others is AI. There's just so many weird things. People wanted to play video games and so we had decades of progress in making these graphics processing units which contributed to AI development. People were just posting on Reddit, on Twitter and so forth. That fossil fuel of data has been powering these AI models. The idea that you could have just said in 2000, "We want to make progress towards AGI" and somehow that would have led somewhere as opposed to what actually ended up happening. You can scale that analogy up to China, just its total economy.
In terms of how they got here, the thing you want to be careful about is that this was not the result of some carefully crafted master plan that they knew all along. It was a lot of groping and a lot of random stuff. They did one thing for one reason and another thing for another reason. Then through this random process, it all coalesced in the end. The amount of intelligent design behind that was I think actually quite low.
They got a few big directional things correct. They stuck with them. That's where I would give policy credit. They were also willing to adapt when things were obviously not working and cut things off and adjust with pretty high frequency. But a lot of it was essentially a random walk where a lot of things that were enabled then started to interact with each other in the way that you talked about with AI. Then they create these other results which could not have been preplanned.
Another thing to consider when discussing the virtue of such a system is that you can't just look at the results over the course of 20-30 years and say, "Since they were able to pick the key technologies over this period, therefore this system is preferable." It's somewhat similar to looking at one successful dictator and saying, "Because they made the right calls, dictatorship is the right model."
I actually don't know that much about what Japan was doing from the 40s to the 70s. But I assume MITI, or whatever, made some right calls about which electronics and cars are important. But in order to judge, how plausible is it that this level of competence and foresight and luck or whatever mixture they're in will continue into AI. What happens after that? Whatever's required as an input into that, speaking of which, let me ask you about that.
Well, actually can I just stop you there. There are a couple of things that you touched on there that I think are really interesting that I'd just like to put on a little bit more. Past results are no guarantee of future returns, right? Just because you did it before doesn't mean you can keep doing it.
We're seeing that now in the US. A few years ago, I would have said I had very high confidence that the US will be able to retain the basic political system and structure that it's had for a really long time. That's one of its enduring strengths, that that infrastructure remains. I'm much less confident about that.
Similarly, in China, you have this problem that they've had a succession of top leaders since Deng Xiaoping with very different styles and power bases and so forth. They've managed to succeed through a range of these things. That gives you more confidence that they're probably more likely to do it right in the future than not. But there are still a lot of concerns about that. Xi Jinping has basically declared himself president for life. We haven't been in that situation in China for a long time. Last time we had that, it did not end well.
There's always been a trade off between growth and control in China. This is kind of the central dilemma that the Communist Party has had, "We want as much growth as possible, but we also want to maintain a pretty high level of control." That pendulum has swung much more towards the control side of the equation the last few years. Growth is slowing. So you have a lot of problems.
However, I would make a couple of points. One is that China has been successful in its industrial policy less so because they picked the right industries and more because they were very adept at building the right enabling infrastructure. I would point to two things in particular.
One was a program that they had starting in the 1990s, which in English has the very ungainly name of informatization. So it translates to the Chinese term xìnxīhuà. It means informatization, taking information technology and putting it everywhere in society. They were early adopters of the IT revolution, including the Internet.
If you think back to the discourse around the Internet in the late 1990s, everyone was saying the Internet was the death knell of authoritarian regimes because it empowered everyone to have information. Information control is no longer possible. Social control is no longer possible. Would that that were true, right?
The Chinese government very, very early said, "No, that is wrong. We think that the Internet can be an instrument. We can use it to, number one, promote technological development at a high speed in China, and number two, enhance our control of society." They have been proved absolutely correct in that bet on both counts.
They had a drive to network the entire society. They started to invest in very, very early, initially just through ordinary fixed line telecoms networks, but then they were very early in mobile and then getting government network systems that communicated across the whole country. They invested huge amounts in that. It's been, I think, very beneficial to the rise of all kinds of things. It's why basically they were able to create an entire Internet of their own with its own companies that doesn't have the participation of the US global companies and is on its own terms basically just as successful.
What they also recognized was that if everyone's on the Internet, and we have people watching the Internet, then we know what everyone is thinking all the time. We can see that. This is the holy grail of Chinese leadership since the second century B.C. "We sit on top of this vast empire. It's great. We have all this territory, all of this wealth is flowing in. But we have no idea what people are thinking or doing far away."
This has bedeviled every Chinese administration for thousands of years. Even into the 1990s, it was an authoritarian system but it was very fragmented and it was very, very hard for the central government to really have any idea what was going on. Now we have a panopticon because everyone is online. If we control the online universe, then we see everything and we're pretty confident that we can keep the discourse under control. They won that bet.
The comparable move that they are making today, which I think is severely underappreciated, is that they believe in the power of electrification. Electricity has been around for a long time. But still in most countries it only accounts for about 15-20% of the total final consumption of energy. It is still actually a minor player in the global energy equation, despite having been around for 150 years and being very critical in a lot of applications.
China very early on recognized that they needed a lot more electric power. The original reason was very prosaic. They had a lot of power shortages in the early 2000s that were making it hard for their factories to run. They said, "Oh, we have to build a lot more generating capacity, most of it fueled by coal, just so we can keep our factories running." That was the first thing.
Then they started to think about it a little bit more and they started to say, "Actually, what do we want? Well, we know we're failing in this drive to make cars with internal combustion engines. It looks like we're never going to be able to crack that nut and have our own Toyota or General Motors. But no one's making electric cars. Maybe we can be the first to do electric cars." So they said, "We got to do that."
Then they said, "Oh, we need to enhance our domestic transport infrastructure. Wouldn't it be great if we had a giant high speed rail network just like Japan, except we're 20 times larger than Japan, so it has to be 20 times as big. Let's do that. By the way, this is all going to be electrified." So they created a couple of core hub industries.
The premise for them was that you need gigantic quantities of electricity to get these things working. If everyone has an electric car and everyone's charging their battery, it’s a huge draw. If everyone is riding on electric trains instead of on planes, it's a huge draw on electricity. So we need to have a much more comprehensive idea about what our electricity grid is going to look like to support these industries that we want for other reasons.
Well, where do we want this electricity to come from? Well, coal. Yeah, we have a lot of coal, but it's really dirty. It's a climate problem. It's a very severe domestic air pollution problem. This is really dirty. So from an energy security and pollution standpoint, we're probably better off doing renewables because any other source of fuel for thermal power plants, we're gonna have to import. We don't have enough natural gas. We can build nuclear, but that's hard to scale and we don't have enough uranium. If we build a renewable powered domestic electricity grid, we will be self-sufficient forever. You don't have to import the sun or the wind, it's just there.
You can see how these things begin to build on one another. Again, it was not that they had the intelligent design plan in the year 2000. It was just sort of all these things that came together.
The result is today, China has generating capacity that is more than double that of the United States. Their renewable generation capacity alone is as big as the entire generation capacity of the United States. Electricity as a whole is now about 30% of China's total energy consumption. It's going up like this, it's rising very rapidly. Everyone else is increasing their electricity consumption very, very marginally.
Now you see it in things like AI. What is one of the big constraints on AI development? At scale, it is essentially the power that you need to power these data centers. Who is best placed in the world to do this at home? China.
They have also concluded that AI aside, having cheap abundant electricity is really central to all of the major growth industries of the 21st century. They are now determined, I think, on a strategic basis to have an electricity system that just produces as much power as humanly possible from whatever fuel source you can find. They want to interconnect this via grid as efficiently as you can, so they're leaders in ultra high voltage distribution technology.
They will be able to keep our electricity prices so low that it will be very difficult for anyone anywhere else in the world to compete with their manufacturing, with their AI, with their whatever, anything that electricity goes into. They will have this competitive advantage. I think they're basically right about that.
The point here is that if you're able to get a few of these sort of enabling all-purpose technology decisions right earlier and then scale them up, then a lot of good things can happen as a result of that, regardless of how effective you are at picking winners sector by sector in industrial policy.
What is the story in which China doesn't win AI? In terms of the talent of AI researchers themselves, it's a big country with lots of smart people. That will be there. We've already seen examples with High-Flyer and DeepSeek where they can come close to the frontier.
In terms of chips, eventually SMIC will be able to produce the kinds of H100 equivalents that the 5 nanometer process at TSMC can produce. I don't know how many years away it is. Export controls might have still been net good. But this is not something that will not happen within the next 5-10 years.
Then it's a matter of scaling, scaling production of the chips, scaling energy scaling, maybe people and data collection. What is China good at? It's scaling. I think the numbers on energy production are just absolutely staggering. What is the time interval in which China adds an America-sized amount of power generation? Well, they add basically a France or UK on average every year. Extrapolate that forward.
So far we've been focused especially on the training of AI models. When these models start becoming super economically productive—basically by the point at which they are at human level—the more important question will be how many can you deploy? Why is China such a powerful country or America such a powerful country? A big part of the reason is we just have more people. That's why China could take over Taiwan. China has like a billion people and Taiwan has like 20 million. Now you just have more AIs, more AI people if you have more power, which is ultimately what's upstream. That was all just a preface for asking, in 2035 what is the story of how China doesn't absolutely dominate AI?
It's a good question and we're verging a little bit beyond my realm of competence here because I don't pretend to understand AI very well. I'm still very unclear as to economically where all the benefit accrues.
Let’s abstract away from AI and just think about this. This is a situation where you've got a new technology, it's entering society. What is the innovation cycle that's going to drive it? I'm pretty partial to theories of innovation like the one that was propounded by a guy named Amar Bhidé who wrote a book a number of years ago called The Venturesome Economy.
What he stresses there is the feedback loop between consumer demand and what producers are doing. His view is that we focus too much on what the producers are doing and not enough on what the consumers are driving. I think that's a pretty good insight generally. It helps explain a lot of why the US has maintained its position with such a dynamic economy, even though we've abandoned a lot of the physical processes that underlie it.
So my question is, "Okay economically, when we say AI, what's the most important part of it? Is it the large language models?" I think the consensus is no. That's just the substrate. What really matters are the specific applications that get built on top of that. That's where most of the economic benefit is going to accrue. If that idea is correct, then the question you want to ask yourself is, "What economic system offers the most fertile ground for people figuring
out how to use AI in specific zones?"
There I would give the US a fairly strong edge over China because China has become more self-enclosed. They have become more obsessed with self-sufficiency. They've made it very, very difficult for other people to operate in China. It's creating some difficulties in people operating outside of China. They have this walled garden of Chinese people and whatever they do that creates applications.
But whoever the big US or Western AI operators are, they have the entire rest of the world to play with. That's a much bigger universe. I would rate the likelihood that you get interesting applications higher outside the Chinese walled garden. So if you want the case for why China does not dominate, I think something like that would be the reason why.
A previous guest I just had on, Victor Shih, said that the Chinese government might be reluctant to let AI development go full speed because of the destabilizing effects it might have on the political system or the inability potentially to control it. What's your sense on what will happen as AI becomes more economically valuable, a focal point in discussions about technological development and so forth?
I have a lot of respect for Victor. I think he has a very good grasp of the Chinese bureaucratic mindset and how political calculations get made. That's his territory more than mine. So I'm very respectful of that view. I however tend to think that the Chinese are going to be pretty in favor of high-speed AI development.
The reason is essentially the same reason that I was talking about earlier, about informatization and electrification. This is essentially a basic enabling technology that is useful for all of the things that can flow from it.
My hunch would be that they would make the same bet with AI that they made with the Internet back in the 90s. With the Internet they said, "This technology could be dangerous, it could be out of our control, but we think actually it's going to be really beneficial and that we can control it." That bet paid off for them very, very well.
My hunch is that they will look at AI as a similar sort of thing. Yes, it's possible that this could get out of our control, but we think on balance, this is really important technology. It's going to enable a lot of other things and we'll probably be able to figure out how to control it because our control systems are so good.
It is interesting because if you look at the big development in Chinese AI recently, DeepSeek, it was not the result of some state program. It was the result of basically a quant hedge fund guy in Hangzhou sitting around and saying, "Oh, I could actually build a pretty good LLM model flowing out of my quant activities. Let's give it a go, see how it happens." It worked great for him.
The reports that I have seen suggest that this created a certain amount of disquiet in Beijing. They said, "Well, where did this guy come from and why is he not coming out of the official plan?" So there is some risk that they would be a little bit nervous about freelancing on this. But on the whole I think they'll see this as another basic enabling technology that they should promote and figure out how to control over time.
To the extent that China's advantages lie in its ability—in situations where centralization is important—to do it… Ironically, this might be a case where centralization might be helpful and they might not do it because there are these tremendous economies of scale in AI training. You have to keep increasing the training cost by 4x every single year. Especially given that the availability of these advanced chips is lower in China, it would be even more helpful to have one person who can use them all for training. This might be the situation where it would make more sense for the government to say, Huawei and ByteDance, you have to give all your chips to High-Flyer.
I think we can say with high confidence that that's not going to happen. As powerful as the Chinese government is, they do not have the ability to force everyone into one room for this. Huawei's got its own thing going. ByteDance is going to have its own thing going. Xiaomi is going to have its own thing going. Alibaba is going to have its own thing going.
All of these have sufficiently large revenue streams and access to capital that they can move independently. They will also be able to leverage their connections within the system, both at the central level and the local government level where they get a lot of their support to do their own thing. You will not have a national monopoly solution to this. That almost never occurs in China.
Interesting. That's a significant statement and maybe updates me downwards on the probability of China winning in AI. I think one of their key advantages would have been—
So you think the fragmentation becomes an obstacle.
Yeah, especially given the availability of compute in China.
Right. The ability to concentrate your limited compute resources in one thing instead of scattered around. I think that's a fair point. That then comes back to how fast can they solve the chip problem domestically. If they can solve that really fast, then that constraint goes away.
One thing that will be important as this AI stuff is happening, is to have something that is equivalent to the red telephone. I do buy some of the crazy or scary stories about what could happen with AI. It’s not necessarily because God takes over, but more so… It's happened many times in human history that some more coordinated group has managed to do some coup or slowly take over control. It’s the kind of thing Cortés did or Pizarro did.
A key way that can be prevented, or a way we can reduce the risk of that, is that different human groups should be in tight contact with each other and have the same kind of mechanism that vaccination creates with diseases. The key advantage that the Spanish had over the New World empires was that the Spanish knew how each previous conquest had gone, but the Incas and the Aztecs didn't know about what strategies were used, how horses work, how steel works.
How that translates here is that there might be some crazy things these AIs try. Especially if you have this bifurcated world, which is actually very valuable from an alignment and safety perspective because you have this independent experiment or independent lineage… If their AI tries to do something crazy, it's very important that they feel that they can tell us and we do the exact opposite. It's a long preamble to ask the question of how we set up that kind of high trust or prerequisite understanding on these kinds of issues.
That is a terrific question. That really gets to the heart of a lot of stuff. I don't have a great answer to that because fundamentally what you're saying is that there needs to be a communication system, a network of interactions between two highly competitive zones, the US and China, where they have to be able to operate with some degree of trust.
I think the problem that we face in trying to analyze this is a lot of the analogies that you might reach for break down at some point. You brought up the red telephone, which basically is a reference to the line of communication the US and Soviet Union had during the Cold War. The threat that you were trying to avert there was nuclear holocaust. In some ways I think that's an apt analogy and we kind of need to think broadly along those terms.
But the specific problem that we were dealing with there were these very self-contained systems that were clearly under highly centralized control by a couple of people. So having that one-to-one line of communication was an effective response to that particular problem. With AI, it's much more diffuse, much more decentralized, much more unpredictable, what the problems could be.
It's kind of easy, I think, to create… Easy, we say in retrospect, but it was hard at the time. But it was a sort of, if you will, maybe a two or three dimensional process to come up with game theory to enable us to manage the nuclear balance of terror. I don't want to minimize Thomas Schelling's achievement. It was great. But it was like a two or three dimensional problem. With AI, you have a more than three dimensional problem. It is consequently more difficult to figure out how to create a game theory solution to this that is kind of stable.
I think what you can say at a minimum right now is that there are ways in which the US-China relationship today resembles that of the United States and the Soviet Union in the 1950s, before the Cuban Missile Crisis. I don't want to exaggerate this too much, but the sort of diminution in exchange in communication over the last six or seven years is really alarming.
I’ll give a simple example on this. When Trump came into office the first time in 2017, he inherited a structure where there were approximately 100 working-level dialogues between US government and Chinese government officials. Plus you had all of this investment in private sector stuff that was going on. But just at the formal level, there were over 100 dialogues. He got rid of all of them, 100%. He then replaced them with one, which was the trade talks that he had in his first term. That was the only mechanism that we had of communication.
Did this create a specific problem? It did. If you look at the early stages of COVID, back when SARS came out in 2003, there were staff members of the United States Centers for Disease Control embedded in the Chinese Centers for Disease Control or their equivalent organization. That relationship, in fact, grew significantly, in part because of SARS over subsequent years. That was a very, very useful channel of getting information out. It was not perfect, it had plenty of problems.
But the absence of that channel, I think, was really catastrophic in the early days of COVID where we literally had no way of understanding what was going on within the Chinese system. There was no back channel that enabled us to get even a little bit of a head start on what was going on. I think that had very, very dire consequences. You can probably trace many, many, many deaths and a lot of social chaos to the inability of the US and China to communicate at that critical moment.
We have essentially dismantled the whole structure of communication. The Biden administration basically took the same view. They introduced a few more things. There were a few more communication channels that they handed off to Trump that I think have not been made use of. So we're back to essentially zero, except for the trade.
That is a very, very dangerous situation to be in with regard to global public health, any kind of global coordination, whether it be on macroeconomics or climate efforts or whatever and on these issues like AI. I think that's a really bad place to be. We're starting at a rather dangerous position. It should be a priority to figure out how we can get there. It's very hard to see how we get there given the political environment, frankly, in both countries.
In the United States you have this narrative that China is this bad actor, they have an illegitimate government, they are a systemic rival. We basically have to contain, constrain, control them. Any kind of interaction with them is in and of itself dangerous. You have people in Congress saying, "I don't want to go to China. There's no point in going to China because I'll pay a political price for it. If I go there, I will be tarred as someone who went to China and therefore is tainted. And what can I possibly learn? I already know what I need to know." So you have a deliberate effort in the United States to reduce the channels of information that we have with China and direct experience, which is very bad.
I think one of the bad outcomes of COVID in China was that they kind of locked themselves off from the rest of the world for almost three years. They got really obsessed by this self-sufficiency industrial policy complex. The Chinese system has always had a lot of difficulty communicating with the rest of the world. This has been persistent for many decades and centuries. This gave them a great excuse to just not do the thing that made them feel very uncomfortable, which is engage in communication with the rest of the world. They concluded that that was kind of okay.
So they also retreated into a very sort of paranoid narrative about what the US is up to, which is to a significant degree justified but not entirely. I think they lost sight of the value of a really robust communications alliance with the rest of the world. Both sides are entrenched in very suspicious, self-reinforcing narratives about the other, which makes it incredibly difficult to forge a better communication system.
I have to say I'm fairly critical of both the Biden administration and the Trump administration, different ways of how they handled this. I think the Biden administration could have done a lot more, a lot faster. I think they sort of had the idea that it was good to have more communication, but they waited for two years before they did anything. Then they were very parsimonious about how they did it. I think they could have been much more aggressive. They weren't. That is a problem.
Then I think the Trump administration unfortunately just doesn't place strong value on having respectful communications with anyone in the world, frankly. Then when you compound this with the paranoia about China, then it just creates more—I don't want to say paranoia, that's too loaded a term—but the suspicion, the fear, the distrust of China that exists. It's very hard to see how you get it. So I agree with you that we need something like that. I'm kind of pessimistic that we'll get there anytime soon, unfortunately.
The red telephone point you made is actually really interesting. It didn't occur to me before that AI is such a diffuse thing. It's like saying we're going to have a red telephone for the Industrial Revolution.
Yeah, exactly. How do you do that? You can't.
But on the point about the ability of both sides to perceive each other… It is true, as you say that because maybe China has become more closed off, their perception of what's happening in America has been diminished. I would argue that the opposite is even more true. Our understanding of China is more limited than theirs. A big part of this is just that every country in the world has some understanding of what's happening in America because of the overwhelming cultural significance, the charismatic nature of American politics. Everybody knows who the main senators and Cabinet people are, all around the world.
When I visited China six months ago, it was shocking to me that you could go to cities with 20 million people like Chongqing and Chengdu and… I don't think I saw a single white person in Chongqing, which is insane. You're literally seeing seas of people and none of them are from the West. In fact, that was what motivated me, that trip, to do these kinds of episodes.
I think people are right to say, "Look, fundamentally I read a book like this and I'm learning a lot about how China tangibly works." That’s opposed to, "I go there, I'm going to chat up taxi drivers." I'm not going to learn about whether they're going to invade Taiwan by chatting up taxi drivers, right?
The kinds of things which should be obvious—that probably aren't obvious to these Congress people that are cavalier about what information they get, certainly wasn't obvious to me at least on a sort of more subliminal level—is just how big the country is. I think people talk about it as if it's like a small thing, "Oh, China's over there and we're going to deal with it." Especially when you think about how we're going to change its government, we're going to constrain its global impact or something. It's really big.
It is really big. It seems like a very banal observation, and yet I keep coming back to it as one of the fundamental facts that continues to be underestimated about China. It's just how big it is geographically and in terms of population.
But the question there is, what is the value of these things?
It's a fabulous book. I'm very proud of it and a few thousand people read it.
At any given moment over the last 15-20 years, there have been north of 300,000 Chinese students in the United States. I don't know what the total number is over time, but it is quite a large number. The cumulative effect of personal experiences can be gigantic, particularly if it is extended over time. It's really, really important.
Then you have the impact of these more structured engagements. You go as a tourist, you talk to some taxi drivers, you see this and that. What do you learn? I'll give you a concrete example.
So one of my side gigs is that for a number of years I taught an executive MBA course at NYU on China's economic rise, and what that meant for companies and so forth. Usually I had about 20-25 people in the class. I taught it for three or four years before COVID and then two or three years after COVID started.
In the years that I taught it before COVID, there were always reliably four or five people in the class that had spent some time in China. Many of them had done so just as part of this executive program. Because part of what you got by signing up for this EMBA is that they took you on these global study tour trips and you would go to this country or that country and you would be there for a couple weeks and you would talk to a few companies and this and that. It's pretty superficial.
But what I found was that when I had a class that had a few of these people sprinkled in that had that experience, or a little bit of work experience—or they may have gone as a tourist, had some kind of student experience or something—the class discussions were always much more nuanced. People did not retreat into these sort of cartoon stereotypes of what China was like. Everyone who had been there could say, actually it was a little bit different because here's my personal experience.
Then the classes that I did after COVID had set in, they weren't doing these study tours so no one in the class had been to China as part of the program. Luck of the draw, I didn't find any people who had been there as part of work or whatever. I had zero direct experience of China in the class for a couple years. The baseline view of what China was was way more negative and much more stylized and, dare I say, cartoonish. They were essentially getting their view formed entirely by whatever they were picking up in the media and from their preconceptions. There was no check on that.
So I saw in just a very small but very concrete way that if you don't have people going back and forth and there aren't some people in the mix, you don’t get people who say, "Wait a second, what you're saying doesn't make any sense because I was there and I saw this, and it's totally different." I'm convinced that has a gigantic impact.
I think it's really, really damaging if people in positions of authority in our government and our political system refuse to expose themselves to the actual reality of what China is, which is essentially what they're doing now by making it politically impossible for anyone to go to China and see what's going on there. That is a very, very dangerous place to be. It's ignorance.
One of the things that drove me and many Western China types crazy about being in China for many, many years is that you would go and frequently you would have this experience. You'd be sitting in a seminar room or think tank or whatever. Some Chinese experts would say, "We Chinese, we understand America much better than you Americans understand China."
For years and years I basically thought this was BS. First of all, most people in China don't travel. They have no idea. Even in the expert class, they had a fairly superficial kind of understanding. So I always felt pretty confident that I and people in my cohort, we understood China just as well as they understood the US and their blind spots towards the US system were very, very clear. For years and years that drove me nuts when people would say that. Now I think it's just completely true.
All you have to do is look at the student numbers. You have 300,000 Chinese students in the US until their visas get revoked. We're struggling to get to a thousand US students in China.
In the US we closed down the Chinese consulate in Houston as part of a trade spat back in 2020. China responded by closing down our consulate in Chengdu. It’s a complete disaster, the whole area of western China, really important, that we have no eyes on officially anymore. We decided that their Xinhua journalists are not really journalists, which is sort of true. So we forced them to register as government agents. The Chinese responded by kicking out a lot of our journalists. That was a massive own goal.
The types of interactions that US people have directly on the ground in China have been massively restricted compared to what they were a decade ago. That’s partly as a result of Chinese government action, partly as a result of really misguided actions on our part, and partly because of just fallout from COVID and various other things. But where we are is bad. There is an information asymmetry which I think operates to the disadvantage in the United States right now.
I worry that this sort of cycle of escalation will seem in retrospect to people—especially if it leads to a hot conflict—as mystifying as World War I seems to us now. If it's instigated by something in Taiwan, that's a different story there. You can just tell a very direct through line there. But you look back at World War I, why did Germany do what it did? Was it worried about encirclement? Why was it worried about encirclement? There's this weird thing with the Russian ambassador who didn't get back in time or something. It would just be this kind of thing where it's like, "Why did we have to have this adversarial relationship with China again?" Explain it to me when we're 50 years removed and the day to day news isn’t as salient.
I basically agree with that. We should be spending a lot more time trying to figure out how to make this a workable relationship. There's going to be competition, there's going to be conflict. There are some real conflicts of what we define as core interests on either side which are tough to resolve. This is not easy.
But we basically both have to recognize… This is more of a problem on the US side. I think the Chinese recognize that the US is not going anywhere. There is a little bit of a meme in Chinese foreign affairs circles with the decline of the US and the rise of the east. That is very officially popular. I think most people don't really believe that because they just have too much confidence in the long-run resilience of the US system. I think they're basically right about that.
I think we on the US side have to get a little bit more attuned to the idea that there is no end point to this. This is a relationship which will go on forever. There's no winning, there's no losing, there's just managing. We need to do a much better job of figuring out how to manage it and keep the conflicts and friction in as contained a zone as we can. It’s not easy to do.
There is this interesting volatility in how people think China is doing. Some piece of news will come out about electric vehicles and people will be like, "China will obviously dominate us". Then maybe some economic data will come out and they say, "China is collapsing." People in their own countries have this sense that a lot of things are happening. Some things are going well, some things are not going well. But in 20 years, America's not going to collapse and it's also not going to have destroyed every other country. There's a long-run trend. Whether China has 1% higher growth rate or 1% lower, it's just going to be a powerful nation at the technological frontier. There's no very immediate implication of what exact growth trajectory they are on, with respect to the most important questions about how we should engage with them and so forth.
That is a really important point. I want to just dwell on that a little bit. The attraction that people have towards extreme narratives about China—total domination or total collapse or so forth—is very strong. In my view it's a product of ignorance. The less you know about the realities of place, the more you can construct these fictional stories which take some truth and then absolutize it. The more you know about reality, it's more messy than that. It’s neither that nor this.
That I think is just another argument for why you have to have much more deep engagement so people are engaging with realities rather than fantasies.
You can see this again in very mundane ways. If you just look at the way that the Trump administration has conducted its trade negotiations with China, it was premised on the notion that China's economy was so weak that you hit them with tariffs and they will immediately capitulate. That was a ridiculous idea. It's taken them a couple of rounds to figure out, maybe that wasn't quite right and we have to take this more seriously. Getting away from the extreme narratives is important in general.
I think also on the US side, also to some extent in China as well, is that a lot of the things in the US political context are blamed on the rise of China. We have this problem or that problem because of China. They are predominantly exercises in scapegoating.
We were talking at the beginning of the conversation about the change in the industrial sector, hollowing out of US manufacturing employment and so forth. If you look at the trend of US manufacturing employment as a share of total employment, it’s a straight line from 1946 to today that looks like this. You cannot find the Cold War, you cannot find the rise of Japan, you cannot find NAFTA, you cannot find China. You cannot find anything. What you find basically is the march of technological progress. That's basically what that line tells you.
So all of these stories about China did this or China did that… There was some impact. But mainly what the United States failed to do as the world was transforming in the late 90s and early 2000s, was to take seriously our responsibility to change our systems of redistribution, helping people out. We failed on the social contract domestically. There were failures of domestic policy which were then blamed on China.
I think similarly, if you look at scare stories about how China's going to take over the world… BYD is a very good company. Huawei is a very good company. CATL is a very good company. You look at the totality of the corporate universe in the world, it's still pretty big. US companies are incredibly powerful and adept across many technological sectors. They are very good at what they do. In many cases, they still have very strong positions in China because they're so much better at what they do than the Chinese competitors. We're dealing with the rise of a new entrant on the global stage. That's uncomfortable and there's some jostling there. But we should also not overstate the degree to which, even on a commercial industrial side, we are existentially threatened by this.
There's some real challenges there, but a lot of this notion is that we will not have an auto industry in five years because of BYD… Let's get a grip, folks. We could end up there, but if we end up there it's because we will have made a bunch of really bad policy decisions that got us there, not because this competitive threat exists. Mostly it's on us to figure out how to get things right on our own terms, within our own system. Then I think basically we'll be fine. But right now that isn't where the conversation is particularly.
You first went to China in 1980…
’85.
You've been visiting and living there on and off ever since. We're all aware that obviously China's developed a lot since then and so forth. What are some non-obvious changes you've seen or maybe even things that have stayed the same through all this change?
I often describe China as a very turbulent and very deep ocean. You skim along the top and you see the huge waves: all the stuff that's been built, all of the cities, the high rises, the industrial parks, the high speed rail and so forth. Then you go below that and there's a very deep still ocean of ideas, concepts, bureaucratic tendencies and so forth that have built up over centuries that in a lot of ways does not change that much.
I think about what the United States was like socially in 1985 compared to what it is today in terms of the space for gay and lesbian people, trans people, social acceptance of different lifestyles, awareness and attention paid to racial issues, all these kinds of things. The changes that have occurred in the United States over the last 40 years are substantially greater than the changes that have occurred in China over that time period in terms of people's fundamental understanding of how we interact together in a society. Partly that just reflects that the US is intrinsically a somewhat more complex society than China with all of these layers of races, the whole immigrant experience. Just in terms of the number of foreign-born people, it was much lower in ’85 than it was today.
But socially we are much more… There's just been a lot more change and a lot more evolution of people's basic attitudes towards what they think about society and how we should interact. China in that sense has been more stable. It's more cohesive, it's more attached to rather deep-rooted notions of gender relations, patriarchy, and how society should hang together.
So as we think about all of the change that occurred in China, which is real—and some of the changes in social relations that have come with the abolition of the planned economy system and the replacement by this basically capitalist system with a Leninist political carapace—those are very significant. So I don't want to underestimate how much transformation has gone on in China over that period. I think it's been substantial, but in the US it's been even more in many ways. That is something that's worth reflecting on, particularly as we do these comparisons.
There's a kind of intrinsic churning dynamism to the American system that is just always there. It is often very uncomfortable to live through and we're living through a particularly uncomfortable moment now. In China there's some of that, but there's a lot of containment and there's more stasis in a lot of the fundamental social relationships.
I lived in China more or less full time until 2015, and then I started doing half and half after that. Now I principally live in New York. One of the things that always struck me when I would come back from China to the US is just how much grassroots cultural activity you have all over the United States. We have a very distributed system of cultural activity here. In China you have a few big cultural hotspots where things happen, and then it's all kind of placid. The variety of experience that you have in the US is still unrivaled.
You were talking earlier about the fact that there's still this huge discrepancy between the average income in China and the average income in the US. This is partly a reflection of that. It's still, on average, a much poorer society than the US. So the surplus that's available for people to do stuff that's interesting, but not economically productive in a narrow sense, that space is still a lot smaller. It's not just political repression that's doing that. It's a combination of the level of income and just the ingrained social structures.
The broader point you're making here is important to emphasize. Sometimes if people are hawkish on China, they have the sense that they're doing everything wrong. They're this aggressive, belligerent power. This is the new Stalin or Hitler. But conversely, when people say that there should be a productive relationship, then there's also this other attractor state where people are just so uncomfortable with cognitive dissonance that they say, "You can see how well their system works, central planning works, authoritarianism works."
Right, let's not take those lessons. Those are very bad lessons.
You just see those two patterns of correlation so often that it's worth emphasizing that you can have a productive relationship with a country
and still think that not only is authoritarianism morally wrong, but it actually has had bad impacts on growth or on the day-to-day life of people and their culture or whatever else. I think people sometimes have trouble just holding two thoughts in their head at the same time there.
There's also a very strong pattern. There have been a few good books written about this. American attitudes towards China in particular have tended to swing from one extreme to the other. Americans and Chinese are kind of the same because they're both pragmatic. They like money, they like business. If you go to China, it's very easy in my experience to chat with people and get along. So that level of connection is fairly easy.
Then the other swing of the pendulum is that they're this enormous amorphous force that is committed to a devilish system that we don't like. Finding the middle ground in that historically has been very, very difficult for the US to do.
Final question. Right now, the US and China are engaged in this negotiation to figure out some somewhat stable way to come back from Liberation Day. What is the most positive, plausible story of what comes out of this?
My expectations for this are very low. I think the basic problem here is that we have on the US side a collection of grievances and complaints that have not coalesced into a very coherent agenda of what we want from ourselves and what we want from China. If you don't know what you yourself want and you don't know what you want from the other party, it's very hard to engage in a constructive negotiation. That's my fundamental take on where we are right now.
This is a normative statement but to me, what we should be aiming for is trying to figure out what are the terms of coexistence between the US and China in the coming years and decades. The most desirable outcome would be some kind of an agreement under which we create a broader permission structure for Chinese companies to invest in the United States in a lot of these key industries that we're talking about.
I think that's good for the United States because I think it is reasonable for us to try and rebuild certain aspects of our industrial manufacturing system. I think we let those atrophy too much. So selectively, it does make sense for us to try and rebuild that. Rebuilding that should incorporate the best anywhere in the world. Some of that is now coming from China.
I also think—just in terms of enhancing mutual understanding and getting better communication channels—investment is even more than trade a very good communication channel because it forces you to go to the other guy's place and put down roots there and figure out how things work and figure out ways to communicate with one another.
Now the obstacles to that are enormous, both because of the US narrative that this is intrinsically unsafe and because I think the Chinese will be very reluctant to allow a lot of their technology high-flyers to go and set up in the US and risk having their technology leak away there too. So I'm not saying that that is easy or achievable, certainly not in a few months. This would be over the course of a year or two or three, you might be able to negotiate some terms of engagement there.
The big problem that China creates for the world as a whole right now is this fact that they just are unwilling or unable to generate enough domestic demand to keep their own economy running at full steam. That's bad for their own economy. It creates a lot of friction in the rest of the world. What it then means is that companies that can't sell in China are forced to export their surplus production. This creates rising trade frictions, not just with the United States, but with lots and lots of countries.
It does contribute to the narrative that China is not really all that interested in creating a situation where everyone benefits from their growth. It's much more a "We're in this for ourselves."
It would be helpful for the world economy, helpful for the Chinese people, and helpful for general stability, if the Chinese could recognize that they need to do a lot more to promote the demand side of their economy. It can't just all be about endless investments in new technologies.
I think they're coming to a point where they may be forced into that. If you look at most of the metrics that I and my team follow of return on investment in China, they're going down. The number of zombie companies that still exist but don't even generate enough revenue to pay the interest cost and their debt, that's going up.
There's a lot of pressure that's building within the Chinese system because of this obsessive concern with the supply side of the economy. They'll continue to do quite well overall in technology production, but the financial constraints are rising. They have some self-interest here in coming up with a more balanced economic model. Having some pressure from the outside to get them in that direction would be good.
The final point I would make on this though is that on the US side—which is of course where I generally sit—it really is critical to have a realistic understanding of what's happening in China and how they're interacting with the rest of the world.
One of the big dangers that we have in the current Trump administration strategy—which was also to some degree apparent in the Biden administration strategy—is that there is this belief that China can be contained and that you can essentially construct an alliance of countries that will stand up to China and try to constrain it with you.
It's kind of a replay or dusting off of the Cold War playbook where you had the Soviet Union and the Warsaw Pact, you had the United States and NATO and all of the informal allies everywhere else. You had the blocs against each other and the bigger and more economically productive bloc won. That is just not going to work.
The Chinese have seen this coming for a long time. They have long had the view that the US was going to try and constrain them. They said, "How do we get around this?" Their answer is not, "You build a bloc, I'll build a bloc against that." Their answer is, "I will operate so that it is impossible for you to build the bloc that you want."
Look at China's international engagements. More countries have China as their number one trade partner than any other country in the world. 140 countries trade more with China than they do with the United States, which was not true during the Cold War.
You go to Southeast Asia or Latin America and you say, "How would you like to join our anti-China alliance?" They will say, "No way, this makes no sense for me. I import a lot of my industrial inputs from China, a lot of my consumer goods. This is really a critical relationship. I might have some concerns about the trade balance, but I am not going to go up against this country that is now either my number one or my number two economic partner, certainly on the trade side and increasingly on the investment side."
So that is a non-viable strategy. It will never work. China has integrated itself into the global economy very successfully. This is just a fact that we need to live with. We need to have a strategy that recognizes this is a reality but that there are a lot of strengths that the US has to bear if it's willing to play them. We have the advantages of a dynamic system and frankly, a lot more creativity and flexibility in our financial system than the Chinese do.
It's perfectly possible to come up with a coexistent scenario in which we do really well. We have domestic policies that sort out our own imbalances, both economic and social. We have a significant degree of engagement with China that is competitive, but hopefully can be bounded so that we don't wind up in a hot conflict situation that would be the worst of all possible worlds.
All right, that's a good note to close on. Arthur, thanks so much for coming on the podcast.
Great. Thanks so much. I really enjoyed it.
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