China’s Involution Trap | Michael Pettis on China's Excess Savings, Industrial Overcapacity, and Exporting of Deflation
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Podcast Summary
This episode features an in-depth discussion with Michael Pettis, senior fellow at the Carnegie Endowment, about the massive economic imbalances between China and the rest of the world. Pettis explains how China's model of suppressing domestic consumption to subsidize manufacturing has created a system where the US runs massive deficits to absorb China's excess supply. (00:40) He argues this model has reached its limit and discusses "economic involution," where Chinese companies were selling products below variable costs due to massive overcapacity. The conversation explores why current tariff regimes are merely shifting trade routes rather than solving fundamental problems, and what a true "Great Rebalancing" would require.
• Main Theme: The unsustainable global economic system where China controls its external accounts through domestic policies that force trade imbalances onto countries like the US, creating a need for fundamental restructuring of international trade relationships.Speakers
Michael Pettis
Senior Fellow at the Carnegie Endowment for International Peace and expert on global trade imbalances. Pettis is recognized for his deep understanding of how domestic economic policies in surplus countries like China drive external imbalances that affect their trading partners, particularly deficit countries like the United States.
Jack Farley
Host of Monetary Matters podcast, focusing on macroeconomic analysis and global financial markets. Farley conducts detailed interviews with leading economists and financial experts to explore complex economic relationships and market dynamics.
Key Takeaways
Domestic Policies Drive Global Imbalances
Countries with strong control over their external accounts can implement domestic policies that effectively become the trade policies of their partners. (02:22) When China implements policies that create massive domestic savings through consumption suppression, this excess saving must be invested abroad, primarily in safe economies like the US. This forces the US economy to adjust by reducing manufacturing and increasing consumption, even though no American policymaker chose to abandon manufacturing. This demonstrates how powerful economies can externalize their domestic problems onto trading partners.
China's Investment Shift Creates Global Ripple Effects
China has systematically shifted investment from real estate to manufacturing to maintain GDP growth, creating dangerous overcapacity. (13:33) When China's property bubble collapsed in 2022, investment dollars moved almost dollar-for-dollar into manufacturing, particularly electric vehicles, batteries, and solar panels. This created "involution" - companies selling below variable costs due to massive overproduction. As China now shifts away from these involuted sectors, the excess capacity is moving to other industries like petrochemicals and steel, threatening manufacturers globally, particularly in Europe.
Bilateral Tariffs Cannot Fix Systemic Imbalances
Current tariff policies are fundamentally flawed because they address bilateral rather than systemic trade imbalances. (23:51) Pettis explains that as long as the US trade deficit continues to grow, it accommodates China's growing surplus regardless of bilateral tariff changes. The income created by US imports gets recycled through other countries, which then buy Chinese goods. Effective tariffs would need to be universal (like a 30% tariff on all imports) rather than the complex bilateral and sectoral approach currently being used.
Consumption Rebalancing Requires Massive Structural Change
Increasing China's consumption share of GDP requires transfers that would fundamentally disrupt the current economic model. (44:45) Chinese households receive the lowest share of GDP of any major economy, while businesses and governments capture most economic output. However, these sectors aren't efficient - they're competitive only because of massive direct and indirect subsidies. Reversing these subsidies to boost household income would likely collapse manufacturing competitiveness, requiring a painful economic adjustment similar to what Japan experienced in the 1990s.
The Current System Will Collapse Through Debt or Policy Change
The global trading system faces an inevitable adjustment because current imbalances are mathematically unsustainable. (26:52) If the US, UK, and Canada (which account for three-quarters of global deficits) reduce their deficits, surplus countries must either reduce their surpluses or Europe must replace them as the deficit absorber. China's debt continues growing much faster than GDP, creating the same dynamic that led to crises in other countries. The system will change either through managed policy adjustment or through forced rebalancing when debt limits are reached.
Statistics & Facts
- China's current account surplus collapsed from more than 10% of GDP during the 2008 crisis to 3% within two to three years, but this was offset by a massive increase in infrastructure investment to prevent recession. (14:42)
- Chinese manufacturing represents 28% of GDP compared to the global average of around 16%, making it bigger than China's property sector at its peak. (49:47)
- The US, UK, and Canada together account for nearly three-quarters of all global trade deficits, with the US representing more than half of all global deficits. (26:06)
