为什么中国制造业经济正在占据主导——Arthur Kroeber

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 recommended it to me while I was in China, 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.

First question: What really is the problem if China becomes as wealthy as America, or if its economy grows as big as, 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 great to be here. Thanks.

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. This is basically not fair, not sustainable, and 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 it gets 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 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 and the Chinese saver are 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’m playing a little bit of 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 that 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 2 or 3 years. There are some question marks around that, but historically, it’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 toward a world of convergence of systems where everyone was 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 are 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, and 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, macroeconomic policy, and so forth.

But there is also a legitimate question about how China now accounts for 20% of the global economy, probably more 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.

The end state for any great-power competition for America—history is long, and there will be more than just these next few decades—cannot be that, if there’s a different political system, 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. 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 it as well. I don’t think people have the sense that, 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.

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 are many other countries in the world that have much lower labor costs than the US. If it wasn’t for China, it would be 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 that, with TSMC’s leading-edge 5-nanometer wafer, very little of what it costs to make that is the process engineers themselves. That is just: Can your country produce it?

There are a few different questions in there, so let me break that down. The first thing that you alluded to is 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 nonexistent. 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 2 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 from 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 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 and 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, the government 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 it 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 whip 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 a 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 as 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, and 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.

1. BYD, Tesla, & Chinese EV industry

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, Volkswagen, 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, as did 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 carmakers 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 we would. 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 or 2019, BYD was 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. Tesla started cranking out cars in 2019, which became immensely popular.

It seems like one of the things that happened was that, by 2019, the Chinese companies 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 who 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, number 1, the Chinese government made a pretty good bet on this leapfrogging idea: "There are technologies in the future. We need to get in early and 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 billion to $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 billion to $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 at 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 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 have been many cases of countries that have tried to do this. Germany, Japan, and many other countries missed out on the internet because there was a centrally directed effort toward 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, and new materials. It's all this kind of stuff that would be on anyone's list if you were running a VC fund.

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 Industry and 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 and as a government, is uniquely able to throw a lot of money at things for a really long time and not care about what the returns are.

They 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. 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 are a couple of things. First of all, even if you go back to 2005 or 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, who 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 it.

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 that, 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 is compete. 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 by raising your game.

Japan did this successfully. Taiwan did this successfully. Korea did this successfully. China has done that successfully.

So that's answer number 1. You had this underlying system that was heavily incentivized toward 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 competitive environment that was really cutthroat and involved a lot of international companies. This is a little bit different from Japan, which always kept 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 was create 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 companies at every point in the supply chain. And they were willing to go through cycles of companies not making any money.

The obvious comparison in the United States is that the US government gives 1 loan to 1 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 so. I just interviewed Ken Rogoff, so Japan is top of mind for me.

2. Will China have a Japan-style financial crisis?

That’s really interesting. 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 that have become national champions and are conglomerates—the same companies producing a phone, 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 that 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 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 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 that were collateralized by land. 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 that, 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 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.

That 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 overleveraged; it’s a huge problem. We’ve had a massive property crash in China over the last 5 years. That is a big, big problem.

You have local governments that borrowed a lot of money and invested in infrastructure, which is now delivering very little return. 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 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.

3. Local debt situation is manageable

This is just stuff from your book that I’m citing back to you. You talk about these local government financing vehicles. 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 2 cases 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 8 or 9 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. 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. They just took all the money and ran with it. That created this kind of Frankenstein’s monster. Even so, you had quite a lot of that money in the first 2 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 3 or 4 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 this 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% and 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% of GDP, something like that. Total gross debt of all sectors—government, corporations, and 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 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 are largely accepted, with some structural modifications, by the IMF and 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 at 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 when they have a high debt-to-GDP ratio? You would think, naively, that they're in a position to have higher growth over the 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 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 that they 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, debt-financed infrastructure investments. How do you move on and have a more productive return on capital in the future?

There are ways of solving that problem. To me, the fundamental issue is that they have too much of a supply-side strategy and 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. You would get a little bit of inflation.

So you would have more cash flows within the economy 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 and a lot of inflation. That basically strengthened their debt problem.

What they need now is a revamped, updated version of that strategy. They need to 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 a decade or two.

4. If CCP is so competent, why isn’t China richer?

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 Chinese industry and how that's been successful in many key sectors.

I guess the big-picture question I have is: If that's true, they're still at about a fifth of American national income per capita, and 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 1990s 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 1 or 2 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 in using the resources, but effectiveness in 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 and South Korea got to whatever they are relative to U.S. 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 has 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 at the 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 and technology goals.

I have a question just to react fast to some of the things you said. Obviously, there are places in China now, like Shanghai or Guangdong, which have per capita incomes approaching those of 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 10 times as many people doing the same thing?

5. How China keeps tech under control

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 technological fetishism, as I would call it. 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 came and crushed them repeatedly, militarily, and imposed 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 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, and 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 specifically on the technology question.” Everything that he has done—particularly since about 2015 or 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 U.S. really wants to prohibit and 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 U.S. 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 materials, 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 and 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's—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 are a few examples. The famous one is that they woke up in November 2020 and realized that Alibaba’s financial subsidiary, Ant Financial, 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 create. 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, with almost no regulation whatsoever, except for political censorship.

Pretty much anything else you wanted to do, you could do 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 a 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 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 power. 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—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 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 are 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 1 thing for 1 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, 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 created 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 1 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 it is 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, and I’d just like to put a little bit more emphasis on them. 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 would be able to retain the basic political system and structure that it’s had for a really long time. That’s 1 of its enduring strengths: 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. The 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 in 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 because they picked the right industries and more because they were very adept at building the right enabling infrastructure.

I would point to 2 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 1, promote technological development at a high speed in China, and number 2, 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 it very, very early, initially just through ordinary fixed-line telecom networks, but then they were very early in mobile and in building 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.

That’s why they were basically 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 2nd 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 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’ve 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? 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 for 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 all these things that came together. The result is that 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 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 the grid as efficiently as they 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 enabling, all-purpose technology decisions right earlier and then scale them up, 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.

6. Does China win AI?

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 still have 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, and maybe scaling 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. 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.

Dan Wang

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 difficult for other people to operate in China, and it's creating some difficulties for people operating outside of China. They have this walled garden of Chinese people and whatever they do to create 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 at full speed because of the destabilizing effects it might have on the political system, or the potential inability to control it. What's your sense of what will happen as AI becomes more economically valuable and 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 well.

My hunch is that they will look at AI as a similar 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 4× 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 downward on the probability of China winning in AI. So you think the fragmentation becomes an obstacle?

I think that's a fair point. That then comes back to how fast they can solve the chip problem domestically. If they can solve that really fast, then that constraint goes away.

Yeah, especially given the availability of compute in China. The ability to concentrate your limited compute resources in one thing instead of scattering them around.

7. Communication with China key for AI safety

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 because 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 for different human groups to be in tight contact with each other and have the same kind of mechanism that vaccination creates for 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, or how steel works.

How that translates here is that there might be some crazy things that 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, 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 2 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 that 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 need to think broadly along those terms.

But the specific problem that we were dealing with there was that these were very self-contained systems that were clearly under highly centralized control by a couple of people. So having that 1-to-1 line of communication was an effective response to that particular problem. With AI, it's much more diffuse, much more decentralized, and much more unpredictable in terms of what the problems could be.

It was easy, we say in retrospect, but it was hard at the time. It was, if you will, maybe a 2- or 3-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 2- or 3-dimensional problem. With AI, you have a problem with more than 3 dimensions. It is consequently more difficult to figure out how to create a game theory solution to this that is 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 diminution in exchange and communication over the last 6 or 7 years is really alarming.

I'll give a simple example of 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 1, 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 and Prevention embedded in the Chinese Center for Disease Control and Prevention, or its equivalent organization. That relationship, in fact, grew significantly, in part because of SARS over subsequent years.

That was a very useful channel for 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, when 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 dire consequences. You can probably trace 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, which I think have not been made use of. So we're back to essentially zero, except for 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 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, that they have an illegitimate government, and that they are a systemic rival. We basically have to contain, constrain, and 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 3 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 paranoid narrative about what the U.S. 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—in different ways—for how they handled this. I think the Biden administration could have done a lot more, a lot faster. I think they had the idea that it was good to have more communication, but they waited for 2 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 suspicion about China, it just creates—I don't want to say paranoia; that's too loaded a term—but more suspicion, fear, and distrust of China. It's very hard to see how you get there. 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 and the charismatic nature of American politics. Everybody knows who the main senators and Cabinet people are, all around the world. When I visited China 6 months ago, it was shocking to me that you could go to cities with 20 million people like Chongqing and Chengdu. 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 trip was what motivated me 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 as 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 that should be obvious—but probably aren't obvious to these congresspeople who are cavalier about what information they get, and certainly weren't obvious to me, at least on a more subliminal level—include just how big the country is. I think people talk about it as if it's 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, or 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. 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 3 or 4 years before COVID and then 2 or 3 years after COVID started. In the years that I taught it before COVID, there were always reliably 4 or 5 people in the class who 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.

You would go to this country or that country and you would be there for a couple of 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 who 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 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 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 of years.

The baseline view of what China was like 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 understood China just as well as they understood the U.S., and their blind spots towards the U.S. 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 U.S. until their visas get revoked. We're struggling to get to 1,000 U.S. 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 is really important, and we have no eyes on it officially anymore. We decided that Xinhua journalists are not really journalists, which is sort of true, so we forced them to register as foreign 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 a result of Chinese government action, partly a result of really misguided actions on our part, and partly because of 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 of 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. 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 in what we define as core interests on either side that are tough to resolve. This is not easy. But we basically both have to recognize that 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 about 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 endpoint 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 a 1% higher growth rate or a 1% lower growth rate, it’s just going to be a powerful nation at the technological frontier.

There’s no sort of 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 toward 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 a place, the more you can construct these fictional stories which take some truth and then absolutize it.

The more you know about reality, the messier it is than that. It’s neither that nor this. That, I think, is just another argument for why you have to have much deeper 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 and, to some extent, in China as well, 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, the 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.

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 1990s 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 their 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 and industrial side, we are sort of existentially threatened by this. There are some real challenges there, but a lot of this notion that we will not have an auto industry in 5 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.

8. What foreigners get wrong about China

You first went to China in 1985. 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 reflects that the US is intrinsically a somewhat more complex society than China, with all of these layers of races and the whole immigrant experience. Just in terms of the number of foreign-born people, it was much lower in 1985 than it is today. There’s just been a lot more change and a lot more evolution of people’s basic attitudes toward 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 many 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 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 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, 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 2 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, on the day-to-day life of people and their culture, or whatever else. I think people sometimes have trouble just holding 2 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.

9. China-US relationship future

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 the terms of coexistence between the US and China in the coming years and decades are. The most desirable outcome would be some kind of 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 from 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, 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 2 or 3; 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 of return on investment in China that my team and I follow, they're going down. The number of zombie companies that still exist but don't even generate enough revenue to pay the interest costs on 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, and 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 nonviable 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 can bring 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 coexistence 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, which 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.