Jan 9 • 41M

UN/BALANCED Episode 1: Trade Wars Are Class Wars in 2020-2022

In our inaugural episode, Matt Klein and Michael Pettis discuss the impact of the pandemic--and the varied policy responses--on global trade, financial flows, and inflation.

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Matt Klein and Michael Pettis discuss the global economy and financial system.
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Matt Klein and Michael Pettis—the authors of Trade Wars Are Class Wars—are proud to present a new listener-supported podcast to discuss the global economy and financial system: UN/BALANCED. This episode is available for everyone, but future episodes will be accessible only with a subscription.

Subscribing compensates us for the time we spend to put the show together and also helps cover our production expenses, such as sound mixing and transcriptions. Paid subscribers to The Overshoot can get access to UN/BALANCED for just $20/year through a special link that will be delivered by email.

If you like what you hear (or read) please feel free to share this episode with your friends, family, and colleagues. The complete transcript (lightly edited for clarity) is below the red line. Thanks to White+ for the music and to George Drake Jr. for producing.

References and related reading

“The Saving Glut of the Rich” — Mian, Sufi, and Straub (2021)

“Indebted Demand” — Mian, Sufi, and Straub (2021)

Trade Wars Are Class Wars, 32 Months Later (Part 1) — Matt Klein

Trade Wars Are Class Wars, 34 Months Later (Part 2) — Matt Klein

Matt Klein: Welcome to UN/BALANCED, a listener-supported podcast about the global economy and financial system. I’m Matt Klein.

Michael Pettis: And I’m Michael Pettis. Today we’re going to discuss how we think about the ideas we laid out in our recent book, Trade Wars Are Class Wars, and try to help make sense of the past few years.

Matt Klein: So one of the things that’s really been striking about what’s happened—particularly in 2020, but also more recently—has been the variety of the responses that we’ve seen from different governments and how they’ve been so uneven, and what that has meant for global imbalances and trade and financial flows.

In China, the government didn’t do very much at all to help ordinary consumers. In the U.S. there is now a consensus the government did maybe “too much”. You see variation within Europe. It’s really striking that this happened at all. And I guess I’m really curious why it happened the way it did. Michael, you’ve obviously been living in China, studying China, an expert on the Chinese political economy for decades. Were you surprised at all when the Chinese government responded in the way it did in 2020?

Michael Pettis: It’s hard to say whether or not I was surprised. In one sense the response was, pretty dramatic—and dramatic in the wrong way. On the other hand, for quite a long time, I’ve been arguing, and you and I have discussed this many times before, that there seem to be real institutional constraints on the ability of China to implement the types of policies that would’ve been considered the right policies.

And pretty obviously, I think the really big problem that we’ve seen in China is that almost all of the stimulus is focused on the supply side of the economy. And so what was weak about the economy, which was Chinese consumption is very weak, actually declined. The consumption share of GDP fell about at least three full percentage points from where it was in 2019.

But why don’t you talk a little bit about the U.S. and the European response, and then we can see how together that fits in with the Chinese response and created the kinds of imbalances that we’re seeing.

Matt Klein: Sure. So in the US the, I would say, pleasant surprise as an observer, was that it seemed like there was a consensus among officials in both parties to avoid the kinds of mistakes that hampered the recovery from the 2007-9 financial crisis. The consensus was not necessarily to do as much as was needed, but doing what people thought was a lot early on at the beginning and just shoveling money out the door.

It ended up having to be iterated several times to get the results that people wanted because they overestimated how quickly the pandemic would resolve itself. That interacted with the limitations of the administrative capacities of the state to do things like targeting unemployment aid. So instead of saying, “okay, everyone’s going to get 100% of what they were previously paid” they said “we’re just going to add on a flat $600 a month,” that sort of a thing.

The net effect was to pump an enormous amount of money into the hands of consumers. Not just consumers, but the ordinary people who’d often been disadvantaged in terms of their ability to afford what they wanted to spend because they weren’t particularly high up on the income distribution.

This horrible viral pandemic was so destructive—particularly for public health, which particularly affected people who tended to be at the lower end of the income distribution because those were the jobs that couldn’t be done remotely, and those people were more likely to get sick and they were more likely to get laid off. Yet, despite all that, the net effect of the economic policy response was actually that it was one of the most effective anti-poverty programs the government had ever done, at least for the period of 2020 and 2021. Which is really remarkable.

Many of those changes that the government put in place were designed to be temporary and they’ve since unwound, so that’s no longer the case, but it is nevertheless very striking that whether it was direct distribution of the “economic impact payments” (the checks), or the enhancements to unemployment benefits, or various other measures, the eviction bans, the debt forbearance, the combination ended up being a massive anti-poverty measure, and that dramatically increased disposable household incomes. Not so much the business sector, but they were helped indirectly.

That was obviously sort of the diametric opposite of what the Chinese government did, which as you said was supply-side oriented. One thing that really struck me about the Chinese response, looking at it, and I don’t know how much of this is sort of institutional political constraint versus administrative capacity constraint versus a judgment that it wasn’t the right thing to do, was the lack of unemployment insurance coverage. And the implications of what that meant for the very large population of migrant workers who’d come to Chinese cities from the countryside and then ended up essentially having no resources to fall back on when they lost their employment. What was your sense of what motivated that kind of non-response?

Michael Pettis: Um, you know, there’s a lot of puzzle about it. So, for example, last week I had a meeting with an extremely senior academic, the dean of a major economics department of a major university. For obvious reasons, I’d rather not say who he is. But we had a discussion about that and he was telling me that among his associates, among other economists that he speaks to, there was this widespread recognition that the Chinese response had not been the correct response.

And in fact, he told me, “I’ve strongly argued, and lots of other people have strongly argued, that we should have taken at least 1 trillion of the stimulus, or take a trillion of new stimulus, if that’s what it takes, and direct it to the household sector in the form of consumption vouchers, or in the form of stronger social security benefits, pensions, whatever, but just given them a trillion renminbi.”

Which is about $150 billion, or a little less than 1% of GDP to the household sector. And I thought that was a really interesting comment, because first of all, it’s not a very big number. Let me just read you some numbers here. In 2019, total consumption in China was 55.8% of GDP.

Household consumption is much, much less, below 40%. But, you know, to give you a comparison, in most other low-consuming countries the consumer share is around let’s say 65% of GDP. So this was an incredibly low number, and in 2020 it had dropped to 54.3%, so from 55.8% to 54.3%. Then it rose a little bit in 2021 to 54.5%, and then finally in the third quarter of this year, it was 52.4%. In other words, it was 3.4 percentage points lower than it had been before the pandemic. And, that’s just the third quarter. The first two quarters were much worse, but I sort of exclude them because they were very exceptional quarters.

So when you think about the amount of, of rebalancing that needs to be done, you’re really talking about at least three to four percentage points of GDP, which means more than that in terms of a redistribution of income, just to get back to the really horrible levels of 2019.

So a group of academics are talking about 1 trillion renminbi. China’s GDP this year will probably be 130 trillion renminbi. So we’re talking about 0.7, 0.8 percentage points of GDP. It’s not a huge number. And yet he said that there seems to be no chance of passing that. And I asked him “why is that?” And he said he wasn’t really sure. He felt part of the reason is that Beijing is very worried, and you’ll remember Xi Jinping actually said this in a speech, that we have to avoid doing what Latin America did and sort of convert our workers into welfare workers.

But even accepting that argument, it’s not as if the big problem in China is that workers are getting too much or have been getting more than they deserve. On the contrary, workers in China, households in China, generally most of whom are workers, receive the lowest share of GDP of any country in the world. And that’s gone down really substantially in the last three years. So it’s hard for me to believe that the concern is that if we pay workers too much, we’re going to create a “welfare society”, because that’s clearly not what’s happening.

And so what I would argue is that there are all sorts of institutional constraints that make it very difficult. And you know, “the institutions” are sort of a vague word, but the way I think about it is for over 30 years, you’ve had a very successful growth model that systematically transferred income from the household sector to subsidize manufacturing. That’s been such a powerful model and there’s been so much growth that inevitably you had, you know, all of the political and business and financial institutions and even household institutions, borrowing practices, et cetera, have been structured around either formally or informally this particular type of system.

It’s very easy for economists to say, “well, let’s just switch it over: take a trillion away from what we were doing and redirect it.” But it’s very hard to do. And I think China literally doesn’t have the systems for doing so. They’re in the process of trying to figure their way around. So you mentioned the U.S. and Europe. Their response to Covid was basically to boost demand in China.

The Chinese response to Covid has been to boost supply. Even that’s been quite tough because the economy’s been very, very weak, but there have been enormous amounts of subsidies thrown into the supply side of the economy. But what they haven’t been able to do, is even with sluggish growth and output, they haven’t been able to keep incomes in line with that growth and output.

This is getting to be a long answer, Matt, which is a problem with me always.

Matt Klein: No, this is fine!

Michael Pettis: But you’ll remember in our book, our balance of payments approach, we point out that this is an accounting identity. It’s not debatable. The current account surplus and, you know, let’s call it the trade surplus, is by definition equal to the excess of savings over investment. And the problem is that when the consumption share of GDP goes down, by definition the savings share of GDP goes up. GDP is consumption plus savings.

And if savings goes up, there’s only two ways that can be resolved. Well, there’s a third way, but the two other ways it can be resolved is either the trade surplus must go up, because if savings goes up relative to investment, by definition, the trade surplus is higher. Or, you prevent that gap from widening so that as savings goes up, investment must go up. The problem is the private sector isn’t investing at all. Investment growth in the private sector has been flat, not surprisingly, with consumption.

So, they’re not investing. So if you want investment to go up, it’s got to be basically public sector investment in infrastructure. And as you and I have discussed many times before, China has probably the best in infrastructure in the world, and certainly much better infrastructure than its level of development requires. And so if you spend more on infrastructure, which they don’t really want to do, then you know, then the debt burden explodes.

So I said there’s a third way out, and the third way out is not to do either, in which case output goes down and you, you rebalance in the form of rising unemployment. Remember: unemployed workers have a negative savings rate. That savings-investment constraint tells you there’s only three things China can do, thanks to its policies of subsidizing the supply side. One is to increase its trade surplus, which is problematic, because it becomes ever more reliant on the rest of the world.

The other is to increase domestic investment in infrastructure, which is also problematic because it means a surge in debt. And then the third option is to allow unemployment to rise, which of course nobody wants. So that’s the problem. We’ve got ourselves caught up in China. And I think the focus on consumption in the rest of the world was a nice match for China, but it’s not sustainable. And so, you know, the big question is what happens next?

Matt Klein: Yeah, it’s really striking that what ended up happening was that China’s trade surplus expanded very, very dramatically. I remember, and I’m sure you remember, that before the pandemic, there was a lot of talk about how China’s trade surplus was shrinking, and the current account was naturally heading down to zero for some reason, and that has completely vanished.

The trade surplus and the current count surplus are basically at all-time highs in China. And in fact, there’s now controversy about the extent to which the current account surplus may be understating the trade surplus. There’s a weird discrepancy between what the customs data are showing and what the balance of payments data are showing. And it’s very difficult to make out what that means—

Michael Pettis: Well, I suspect what it means is that there’s flight capital disguised within the current account.

Matt Klein: So in other words, the customs data are correct and there’s financial outflows that they’re not capturing, is what you’re saying. That would certainly make a lot of sense. It’s consistent with the kind of response you were describing, which is that either the trade surplus has to expand or investment expands, or output goes down. I guess they’ve done a mix of output being lower than it otherwise would have been.

You mentioned that household share fell, and I think that’s really important to recognize. Who benefited, in your estimation? I mean, someone, someone, even if the whole economy is smaller than otherwise, there would’ve been someone who I guess is at least relatively better off. Who do you see as being the beneficiaries there of this particular approach?

Michael Pettis: Well, a study done by Renda, by People’s University, last year showed that what happened in China is frankly not very different from what happened in the U.S. and in Europe. If you order the various households within China in terms of income level, you know, the top 10%, the second 10%, the third, etc. those all the way down the bottom suffered horribly from the impact of the pandemic. And the higher up you went, the less pain there was, until in the top 30, in the top three deciles, their incomes actually went up quite substantially. I think that’s the story in the U.S. and in Europe too, right?

Matt Klein: Well in the U.S. it’s complicated. With labor income, that’s how it worked out initially. But then you have sort of the offsetting factor of the government aid that I mentioned. So a lot of people at the lower end saw their incomes go up.

In Europe, I think it was more balanced. They kind of did an intermediate approach where they actually had the administrative skills to support businesses and to keep people on payrolls. So there was more help to keep people employed and paid—much more than in China—but not as much as in the U.S. relatively speaking. So Europe and Japan and Canada were kind of in the intermediate stage. But yeah, in terms of market income, in the U.S., the layoffs were overwhelmingly concentrated at the low end. It’s just that the net impact was offset by the government aid that you didn’t see in China.

Michael Pettis: Yeah. Now you had an article in the Financial Times not so long ago, in which you talked about this and you argued, correctly, I think, that the problems in China actually for the first time in a long time benefited the rest of the world because of its impact on inflation. Can you go through your argument?

Matt Klein: Yeah. So this is also something really kind of significant for, I think, understanding how our view of the book relates to the world today. You know, we are very much now in a world where there is not enough stuff, whether it’s manufactured goods or physical commodities. Or at least it seems like there isn’t enough stuff to meet global demand, and that’s put a lot of upward  pressure on prices and created a lot of challenges for consumers in a lot different places. It’s very acute in terms of energy, to a lesser extent food and other things.

To the extent that Chinese policies have been suppressing domestic consumption and domestic demand, it means that they’ve been reducing what historically has been voracious Chinese demand for a variety of raw materials, particularly energy and industrial metals. In the past, it’s been a problem that Chinese demand has not been sufficient to absorb production elsewhere. And it had been leading to sort of a “great glut”. But right now, it’s basically helping prevent energy prices from being higher than they otherwise would be, whether it’s coal or natural gas or oil, and probably other commodities, whether it’s more iron or copper or things like that.

Chinese consumers have been suffering horribly for this, but there has at least been some attendant benefit for consumers in the U.S. and Europe and in places that quite frankly have less disposable income, but that are also dependent on energy.

I think the reason that’s interesting is that it really kind of goes against something that we wrote about in the book, which I’m grappling with myself. We made a point that there is a superabundance of unused productive potential, and that the reason that there’s all these trade conflicts comes from the fact that there’s this excess of supply relative to demand. Not that there’s too much supply, because there are obviously plenty of poor people and poverty in the world, but that for various reasons, we have been living below our means. And that’s one of the reasons why inflation had been quiescent and it’s why it was so problematic that the Chinese political economy and elsewhere were leading to under consumption.

And so now we’re in a world where it doesn’t seem like that’s quite right. I’m really curious. I have my own views on sort of how to reconcile this, and I’m really curious how you’re thinking about the return of inflation over the past couple years and how that relates to our views about how prosperity is not a scarce resource. We don’t have a zero-sum world, but at least right now it does look a little bit zero-sum in the sense that if China were fully going back to work and production and consumption, then oil prices would be much higher in the rest of the world. And that would obviously be painful.

Michael Pettis: My response is that unfortunately we can’t really take the Covid world as very representative. There have been a lot of disruptions caused by the pandemic in China, in Europe, and the U.S., et cetera. And so what we may be seeing with these high prices is an attempt by the global economy to make adjustments, and the adjustments are always slow.

Now whether this is the case or not, we’re not really going to know until Covid is behind us. So, you know, I would want to see this continue for a few years before I thought that we really were in a different supply constrained world. I continue to think that the real pressure is demand constrained.

And the reason I say that, which is the reason in our book, is because that’s simply the way, uh, rising income and equality works, right? When income inequality goes up, you’re basically transferring income from those who have a higher propensity to consume to those who have a lower propensity to consume. And so the only way you can maintain existing levels of consumption is with a rise in household debt. I know you’ve seen those papers by Atif Mian, Ludvig Straub, and Amir Sufi, which would sort of make that point domestically in the United States. I still think we’re in that world.

We’re in a world of very uneven distribution of income. There may have been a temporary reduction in that because of stimulus policies implemented by Washington, Brussels, et cetera. But I don’t think the underlying problems have changed. Until we see a major redistribution of income, I think we’re going to be a demand-constrained world much more than a supply-constrained world.

And by the way, remember that the way you resolve the demand constraint is either through a rise in unemployment or through a rise in debt. And the Fed and the ECB have always chosen the latter rather than the former, and debt continues to rise very quickly.

Matt Klein: Yeah. I guess one interesting follow up thought I wonder about: if we were to have the kind of healthy rebalancing, redistribution, whatever we’d want to call it, of incomes to get to our kind of preferred world from the pre-pandemic world we were writing about—would that be inflationary? What would be the kinds of things that we would look for in terms of knowing that that was what was happening and what would be the ways that policymakers might potentially want to think about managing the transition in a way that would make it palatable?

Because it seems like—one thing that’s been striking to me is that even when people’s incomes are rising enough to more or less match what’s going on with inflation, that inflation is very unpopular. And that seems like a big inhibition to even a temporary adjustment. I’m sort of curious, based on looking at this and also obviously, you know a lot about little Latin America and other places, how would you think about those tradeoffs?

Michael Pettis: Let’s start off with the perfect scenario, right? The scenario in which there are no frictional costs that prevent adjustments. In that case, what’s the impact of rising wages? If the US were a developing country with very high investment needs, then rising wages could limit the amount of investment. That happened in the US in the 19th century. As you know, that was made up by very large inflows of savings from England and the Netherlands.

But in a well-functioning system, what high wages do is they force businesses to invest in productivity-enhancing technology. And it’s interesting, you know, I don’t want to be too pedantic here, but when you look at British innovations in the 18th century, they were mostly about better ways of harnessing energy. And when you look at American innovations in the 19th century, they were mostly about increasing the productivity of workers. You could argue that that made a lot of sense because wages in the United States were extremely high. They were the highest in the world, and so businesses were constantly trying to increase workers’ productivity as a way of reducing labor costs, which were extremely high.

So in a very well-functioning system among advanced economies—I’m not talking about developing economies, which have a very different sort of setup—but among advanced economies, as household income rises, demand for goods and services rises with it, and businesses would be forced to respond to that rising demand by increasing investment. And because that rising demand would come almost by definition with rising wages, they would be investing very heavily in productivity-enhancing technologies.

So it’s possible to redistribute income for wages to have a much higher share of GDP without inflation. In fact, you know, in the 1950s and 1960s, we had almost no inflation. And yet the distribution of income was far more, how do I put it? There was a much less unequal distribution of income in the 1950s and sixties than there was today. So high wages aren’t really inflationary.

If you had really rapid increases in wages—faster than the ability of the business sector to respond—then presumably you could get temporary increases in inflation. But I think even the most leftwing analysts don’t really think it’s possible to have a really rapid redistribution of income. I think that’s likely to be a slow process. So what I would argue is that perhaps the inflation was caused by these very large one-off transfers. But what we need are a permanent set of transfers spread out over a long period of time, and then you can have rising wages without rising inflation.

Does that make sense to you?

Matt Klein: Yeah, that makes sense to me.

Just trying to play sort of Devil’s Advocate with myself here, and with you, I’m thinking about the assumption that, in a market economy, if there’s more consumer spending that will encourage more production. And if there isn’t enough productive capacity, it will lead to more investment that will create that capacity. That’s what businesses want to do. They want to be able to meet customer demand. And yet in the past few years, for the most part, we haven’t seen things play out that way. And I think you make the point that the pandemic has gotten in the way, and I think that’s reasonable.

And you can make the point that, you know, the magnitude of the spending power increases was very large in this one-off sort of way, and that created challenges. I just wonder, are there other potential limitations that we might be needing to think about? Were there these capacity constraints that businesses were sort of either unwilling or unable to overcome, leading to the inflation that we've seen?

Not just in the U.S. This seems like a global problem. Even China, right? China has not had the inflation issues that we’ve seen elsewhere, but they also have had a massive underperformance consumer spending, like 11% below trend in yuan terms. It doesn’t seem like anyone has really avoided this kind of tradeoff here.

Maybe it’s just the pandemic, maybe it’s the one-off nature of the pandemic response, but the thing I’m wondering about, and it keeps kind of bothering me in the back of my head is the non-response of businesses, even if they’re trying. And that instead of responding with more production, more investment, it seems like it’s shown up in prices much more than I would've guessed. And maybe that’s a function of the pandemic. Maybe that’s a function of the one-off nature of the spending power increase. But it does make me wonder, because everything you said makes sense to me. It’s what I think. It is what is intuitive. It is what is born out in the historical data. But it hasn’t really quite lined up with the past couple of years and that, and it makes me concerned.

Michael Pettis: One of the mistakes that people can sometimes make from our thesis is to assume that because of this rise in income inequality—part of which, you know, was a function of the way our global trading system works—that that weakened demand by transferring income from those who consume most of their income to those who consume very little of their income, i.e., the rich.

But remember, that’s not necessarily the case. There’s two ways you can get consumption to grow. One way is by getting household income to grow. And the other way, if household income doesn’t grow, is by getting household debt to grow. So I would argue a redistribution of income is not necessarily going to show up as much more rapid growth in income. It should show up in some more rapid growth in consumption, but a lot of it will show up as much slower growth in debt. The Fed won’t need to encourage credit expansion in order to keep unemployment from rising if there are income transfers from the rich to the poor or from the non-consuming parts of the economy to the consuming parts of the economy.

And then the other point I would make is that we never want to get caught up in this idea that high wages are inflationary, because we know in previous periods in American history when the income of the bottom 20%, the bottom 50%, however you want to count it, was much higher than it is now, we were able to maintain very low inflation rates. So it’s some other mechanism that’s causing inflation. It could be one-off redistributions, one-off large redistributions of income, but it isn’t the redistribution process that’s driving the inflation.

Matt Klein: Right. That does make a lot of sense to me, and hopefully we’ll see that. I guess the real test would be if we see an increase in the personal saving rate, but more importantly, because obviously there’s so much variation within the household sector, a reduction in the aggregate growth rate of debt, which is not something we’ve seen. We saw it in the beginning of the pandemic, when credit card balances fell a lot. But we’ve not seen that more recently. And I think that’s a good way of thinking through all of this.

Michael Pettis: Yeah, I think that reinforces the argument we made in the book, which is it’s either going to be an increase in household debt or an increase in income that’s going to drive consumption. And so that temporary increase in income was matched with a reduction in the increase in debt.

Matt Klein: Yes.

Michael Pettis: One of the things that a lot of people noticed about our book is that we were pretty hard on Germany. We argued that imbalances within Germany, particularly the very low share of income workers were receiving in exchange for very rapid growth in business profits was really at the source of Germany’s fabled “hard work and thrift”, and was responsible for the very large imbalances within Europe that came closely destroying either the Euro or the European Union.

And, um, in recent years, you've been much kinder to Germany, so what's going on?

Matt Klein: That’s a great point. Yeah. And we definitely should talk about what’s happened in Europe. The problem, as you said, was that for almost 20 years in the run up to the pandemic, you had a situation where the German government was just very, very tightfisted in its responses to any kind of economic problem.

Public investment net of depreciation was negative. You had a situation where the welfare state was deliberately cut back in order to basically force people who are sort of at the edge of precarity—maybe they would have retired early under the old system—were pushed into these very low paid part-time jobs.

It was not a good outcome for many ordinary Germans. And since many German businesses weren’t exposed to the domestic market, but to the global market or the European market, the net effect was that you had an increase in Germany’s trade surplus, where exports just kind of kept chugging along at whatever the global growth rate of GDP was and imports lagged very dramatically because the domestic economy was so weak.

This was starting to turn right before the pandemic. And I think there were two things we can look at, at a very sort of granular level. One is the governing coalition that came into office starting after the 2017 election: the Social Democrats, got the finance ministry. And they’d spent enough time, even though they’d been in government much of this time as junior partners, or even leading some of the welfare cuts in the early 2000s, they, I think, had internalized some of the message that the government had gone too far in squeezing the public investment—it had become within Germany, increasingly a prevalent view that the quality of infrastructure investment was actually quite weak.

There’s a stereotype I think we have outside of Germany that, “oh, you know, they have great trains, right?” But it’s actually not true anymore. I mean, that was true maybe 30 years ago. But the roads and bridges collapse or they’re shut down for being unsafe. The trains are slow. There was a story recently about Switzerland, basically there’s some train connection from Germany to Switzerland and they had to essentially change what they’ve been doing. The Swiss side, basically said, “no, we don’t trust the Germans to actually have the trains run on time.”

Michael Pettis: I don’t know if you’ve been in Spain recently, but contrary to the stereotypes, Spain has much better transportation infrastructure than Germany.

Matt Klein: It's been a few years, but I do remember—I was there on my honeymoon actually, and yeah, the trains there are phenomenal. That was a build out, one of the really quality investments that was done in the 1990s and the early 2000s. I think it’s exactly right that there’s a stereotype of what Germany is like versus other countries, but it’s not really accurate on those dimensions.

The Social Democrats, they get the finance ministry in 2018-2019 and they start to realize this and public investments start ticking up. It’s way too low relative to the backlog of needs that have accumulated. But it is improving and I think it’s something encouraging.

And at the same time, around 2018-2019 globally, there’s a big slowdown in manufacturing trade. Whether it’s due to the policies of the Trump tariffs or whether it’s due to internal changes in China or both or whatever, that ends up hitting Germany disproportionately hard. In fact, the German economy was kind of on the verge of either shrinking or stagnating in 2019, basically before the pandemic is hitting, and that was already creating pressure for more kind of domestically demand driven growth. They didn’t have a solution for it, but I think that sort of planted the seed.

The pandemic then hits and the German government, uncharacteristically relative to sort of what we might have thought based on their past behavior, they go all out. And in fact, relative to the size of the German economy, the amount of money the German government spent to support consumers, to support businesses initially was on par with what was done in places that were very generous, such as the United States. On top of that, they also put in a lot of credit guarantees and other things like that. Now, the United States ended up exceeding German government spending through subsequent programs that were put in later. But if we’re focusing on the initial, say, six months, Germany was right up there.

Moreover, they also—and I think this was really important and not what one might have expected—they were willing to partner with France and with Spain and Italy and put forward this joint plan for saying the EU as a whole is going to issue EU debt and that is going to finance a package of aid for all of Europe.

Something that got less attention, but was also significant, was this joint unemployment reinsurance scheme, which was modeled very much on what exists in the United States. Each country, each national government would administer its own unemployment insurance system, but if that system ran out of money, they could borrow at zero from this centralized fund and then have a very, very long payment window to repay it if they needed to. Which maybe is not the ideal system, but still a big improvement compared to what existed before.

The German economy didn’t do phenomenally well—there were a lot of other things going on—but it’s striking that the German economy did reasonably well and the domestic economy actually did better. Part of the reason German economy did only okay was that the trade account was not helpful.

And if you look at countries that felt relatively more constrained in their ability to provide that kind of aid, such as Italy for example, they spent a decade plus before the pandemic essentially in a slow-moving financial crisis and the government there was much more cautious. Even though in theory, the European Central Bank was buying a lot of bonds and trying to encourage more debt issuance, they were still very cautious, they didn't want to put themselves in that kind of position. Their economy shrunk more than Germany’s, that’s not good. But to the extent that their recovery was more export-led there was a bit of an internal rebalancing within Europe.

Now there obviously could have been better outcomes for everyone if all those governments had been more expansive. But I think that’s encouraging. And we’ve seen that more recently in response to the energy crisis as well, where the German government—now I should note there was an election in between there. In 2021 there was a German election. And for the first time in quite some time, the leading Christian Democratic party lost, and they were not in government. They’d been in government continuously since 2005 and holding the chancellery. At the end of 2021, you have a new coalition coming into office led by the Social Democrats.

Now the Social Democrats were the people who put in the welfare cuts of the early 2000s and they were junior partners of the Christian Democrats for much of the period since then. This could have meant a lot of continuity. And in fact, the Chancellor, Olaf Scholz, campaigned as being a continuity chancellor saying, “I’m the normal sober one. I’m the closest to Angela Merkel, who you, the German public, all like.”

And yet the coalition they ended up forming with the Green Party and then with the Free Democrat Party, which is sort of a libertarian grouping within Germany—because of the experience of the preceding two decade plus, because the 1990s were not a great time for Germany either, but for slightly different reasons—there was a social consensus to say, “we’re going to do more investment.” And that ended up happening.

And the way around it with Germany’s debt limit was they said, “oh, we can come up with a special fund that’s outside the debt limit.” And the Free Democrats are basically happy to go along with it saying, “we have a dedicated fund, we’ll do that.” And in fact, we’ve seen that in the past year really being important where suddenly we have a dedicated fund to deal with an energy crisis or a dedicated fund to deal with defense spending because the Bundeswehr had been neglected for basically since the end of the Cold War. And at this point adding up to being several hundred billions of euros of additional spending, which is significant for an economy of that size and significant, even for Europe as a whole.

We’ll see how it all plays out. I think there’s still room for more European-level solidarity and thinking less about how one country does what’s best for itself, but thinking about Europe as more of an integrated economic system. But there is a lot there to be encouraged about. It’s a slow process. We’re talking about a consensus of experts that has governed the country for a long time, being unwound in the face of experience. But I think, I think broadly speaking, it is encouraging.

I remember at the end of 2021, I was most optimistic about how things were going to unfold in Europe based on the changes I was seeing there and really many other places in the world. Japan’s another interesting one. But I think that it’s really encouraging and heartening to see that kind of change, because that is something that, as you said, we were very critical of. Maybe not because they listened to us necessarily, but either way we’re seeing some positive changes. It’s easy to be pessimistic, but it’s nice to see and recognize when things are actually moving in the right direction.

Michael Pettis: That’s really great. I would remind us of the Chinese problem, the institutional problem, which I think will also affect Germany and a number of other countries: it’s very hard to switch from an export-oriented economy, a trade-surplus-oriented economy, more correctly, to a domestic demand economy.

When you look at the historical precedents, it takes a very long time and a great deal of pain to do so. So it’ll be great if Germany is starting in the right direction, but I think we both would agree we’re going to have to wait and see.

I think we’ve gone on long enough, but I think we’ve only just started to explore some of the implications of the ideas we introduced in the book. And maybe on the next session we can start off by talking about Germany and South Korea and Japan, all of whom have seen their current account surpluses come down quite dramatically. And all of them, particularly in South Korea, are in a total panic about the implications.

I think it’ll be really interesting to consider why their surpluses have come down, whether that sustainable or a one-off impact of covid and continue along those lines.

Matt Klein: I think that’s a great idea. So I am looking forward to our next episode. I hope all of you listening are looking forward to our next episode next month. So thank you very much. I’m Matt Klein.

Michael Pettis: And I’m Michael Pettis.

Matt Klein: And that’s it for this episode, our very first one! Thank you for listening to UN/BALANCED, a podcast on the global economy with Matt Klein and Michael Pettis. Thanks very much to George Drake Jr., our producer, and thanks very much to White+, a Maybe Mars band for giving us that great music you heard. We look forward to having you come join us again next time. Your support is greatly appreciated. Thanks again!