The shift of economic power between the West and China

“History doesn't repeat itself, but it does rhyme” Mark Twain

It is our central thesis that we are now living in a pre-War period both economically, financially and in terms of power dynamics between countries (like the 1933 to 1939 period just before WW2). The world dominant power (USA) is increasingly challenged by an already equivalent and fast rising power (China). Other countries for which the World Order has been disadvantageous are actively taking advantage of the chaos (Russia with the Ukraine war, Iran with the Gaza war). Western dominance is being challenged on all fronts (militarily, economically, in the media/propaganda space, technologically and culturally). In the last twenty years, the world has radically changed in ways most people do not yet realize. The West has declined, China has risen. This shift of power is causing instability, externally (proxy wars, return of economic protectionism) and internally in the West (increased division, uncontrolled migration, extreme left and right politics, culture wars). We think there is a real risk that this will take a worse turn. The aspiring power (China) could decide to directly take on militarily the current power (USA). Or the opposite: the US will try to defend its dominant status and take on China militarily.

But how have we reached this point? What are the consequences? What will happen in the next two to five years? Are we really heading towards the abyss? And what are the long-term consequences if the West were to lose?

We'll start with this first article by analyzing the change in economic and financial power between the West and China in the last twenty years.

2004

The West: This was a period of continued dominance of the Western led world order. Twelve years before its biggest adversary, the Soviet Union, had collapsed, and after that there was no other country capable of matching the West in terms of economic and financial might.

What this meant in practice is that the world hegemon, the USA, could uphold the norms it instituted after WW2 and other countries would not dare challenge them because they knew they would be defeated if they did so. This was effectively a unipolar world and peace was ensured through this power dynamic. Western society became so used to the idea of peace that people started thinking that the World had evolved in such a way that war would never happen again (like the Belle Epoque in the 19^th century). Most people in Western countries were still benefiting from the democratic and capitalist model (strong middle class) and its benefits were so evident that they thought the whole World would embrace it. And yet this was 2004, three years after 9/11 and one year after the Iraq war, so how does what we just said make sense? It is true that a unipolar world ensured peace, yet cracks started to appear. How? There were countries and people at the sidelines that were losing out or were unhappy about US dominance (in the middle east for instance). Some leaders (think of Saddam Hussein) and terrorists (think of Bin Laden) decided to take on the US led world order by invading other countries (Gulf War), or by leading brutal terrorist attacks (9/11). The US had to intervene to re-establish dominance, credibility and make those actors pay for their decisions and hence it went to war in Iraq and Afghanistan.

China: China's economy was smaller than the UK, half of Japan and 15% of the US with over four times its population. Chinese standard of living was low. But the country's economy was growing extremely fast thanks to the liberalization of China's economy led by Deng Xiaoping 26 years before and thanks to trade with the Western world. Indeed, this was the third year of China joining the WTO (World Trade Organization). The US establishment was in favor of continuing to expand trade with China. Why? Mainly three reasons: 1) the consensus was that China would liberalize like many other countries did previously. How? Thanks to capitalism and free trade, Chinese people's standard of living would grow and they would demand a democratic political system (thus embracing the US led world order) 2) it was extremely beneficial for American companies (their profit margins would skyrocket by outsourcing their production to a country with a large working population and low labor cost) 3) the US needed buyers for their debt (and China savers were happy to get a return on their pensions by investing in US Govt debt). So free trade was it! China became the world factory. Thanks to this and its internal economics reform, China's standard of living and economy size continued their impressive growth.

2008

The West: 2008 was a pivotal year that changed the course of the subsequent decade until now. The World fell into economic depression (like the 1929 US depression), led by a financial crisis originating in the USA caused by large and unsustainable US private debt (especially in real estate). The middle class suffered in both the EU and US, and cracks started to appear in the system (backlash against the establishment, banks etc.). But what was pivotal was how western policymakers reacted to it. The establishment of both the EU and US decided to shift the debt burden from the private financial sector (Banks, Corporations, and taxpayers) to the public sector (government). How? Firstly, by running fiscal deficits (the government spends more money than it earns from taxes) and recapitalizing (injecting money) the banking system. Secondly, by printing money to buy long term government debt to stimulate the economy (Quantitative Easing). Why? Because interest rates (the lever that policymakers normally use to slow down or accelerate an economy) were at almost 0%, and there was no way of lowering them to spur economic growth. A good metaphor in medical terms for what Western policymakers decided to do is when a doctor injects endorphins to a sick patient to stimulate him and reduce his pain. Are there medium/long term side effects? There sure are and we will see them in the next sections. But these choices ensured the US could exit the recession quite quickly (the EU took longer because it decided to deal with the crisis also by reducing government spending i.e. austerity). At the same time government debts started ballooning and as we will see they continued throughout the 2010s and 2020s.

China: Nothing more than the Summer Olympics held in 2008 symbolizes the opening and fast advancement of China. China's growth averaged 11% between 2004 and 2008. Its share of world manufacturing value-added skyrocketed to 17% thanks to the continued shift of western production and to its increasing manufacturing efficiency. China was also one of the few countries that avoided falling into an economic crisis in 2008. It managed to do so by investing heavily in infrastructure which was particularly needed given its increasing manufacturing output (think of investment in railways, highways, airports). Its economic model continued to be based on the opening to western investments (Western companies setting up joint ventures with local firms to produce in China, taking advantage its low labor costs). A vast share of people living in the Chinese countryside continued to move to the East coast to work in factories. Real estate started to play an increasingly important role in China's economic model. A lot of houses were built to accommodate a growing share of its population in cities. But one notable thing did not change: China's political system did not liberalize, like US leaders expected. China never embraced the Western led order. But this was 2008, and China did not represent a threat to the US, yet...

2016

The West: Eight years after the financial crisis the West was growing again (although at tepid rates). The economic model of the West (especially the US) was increasingly based on the delivery of services (think of financial services, tech, media) and less on manufacturing. Western firms continued outsourcing their production to China (and other developing countries) and became increasingly reliant on Chinese manufacturing expertise and efficiency. They also started outsourcing more advanced manufacturing. But most importantly the side effects of the economic medicines adopted after 2008 (especially Quantitative Easing) were starting to become apparent. What were the main side effects? Maily two: the rise in inequality and the financialization of the economy. Let's start with the first one. As we discussed before, Quantitative Easing (QE) was the main medicine used to treat the 2008 economic crisis. But how does it work in practice? The Central Bank buys government debt from banks and gives them money in exchange. Banks in turn use it to buy financial assets (such as stocks, real estate). This in turn increases the price of those assets. The direct consequence of this is that people who owned a lot of assets (stocks, bonds, real estate) became extremely wealthy during QE, whereas people who did not lost out. This was a system where only a minority of people were reaping the benefits. But how large was QE? In the US alone, between only 2008 and 2016, the central bank created 4 trillion dollars (more than the GDP of Germany) bidding up stock, real estate and bond prices. What happened then? Before QE, in 2004, the top 0.1% owned 7% of total US wealth, by 2020 they owned 25%. Conversely the bottom 90% (9 out of 10 us citizens) owned 35% in 2004 vs 25% in 2020. Funnily enough, the same recipe was adopted in the 1930s following the '29 depression and it led to the same side effects. Inequality has second order consequences: it creates resentment in society and loss of trust in the system. The have-nots against the haves. Western society was becoming increasingly divided and fractured. And division means fragility.

The second consequence of these policies was the increase financialization of the economy. What does it mean? Most of the money created though QE ended up being deployed in financial assets and only a little trickled down in the real economy. Debt became cheaper. Thanks to cheap debt unproductive companies (zombies) could re-finance their debt and were kept alive artificially. Money was deployed in risky and unproductive assets (think of Crypto) and less was spent on real innovation (R&D, science, infrastructure). Under a seemingly strong stock market, Western economies were becoming structurally weaker and less competitive.

China:

The 2010s in China were characterized by steady growth (although lower the 2000s) and by the rebalancing of the economy from an extremely export driven model to a slightly more balanced model. How did they do that? By reforming the banking and financial sector! China's financial institutions were mainly owned by the state (SOEs) and followed the government (local and central) directives. They preferred lending and investing money in public enterprises and export-oriented firms. But the reforms enacted allowed SOEs to invest a larger share of their capital into private companies and liberalized investments from foreign financial institutions, especially in the tech sector. The technology sector was booming (think of Alibaba, Tencent etc), and Chinese billionaires like Jack Ma were celebrated by the government and idolized by young people. China's economy was strong and was modernizing extremely fast! Chinese companies were making incredible technological advancements and China overtook the US in terms of number of patents filed.
At the same time China had already taken over the US in terms of trading volume and in 2016 China was the major trading partner for 124 of countries in the World (US was top trading partner for only 58). China was also engaging in a diplomatic effort to sway developing countries by lending them large amount of money and developing important infrastructure projects (railways, dams etc.). The so-called China Silk Road.
This is also a time where Chinese leaders were drafting extremely ambitious plans to dominate key high-tech sectors within the following ten years (Made in China 2025). Some of these sectors might resonate: EVs (Electric Vehicles), Battery technology, Biotechnology, Artificial Intelligence! Back then it seemed unlikely China would be able to lead the West in these technologies in such a short amount of time. But this was a pivotal moment nonetheless, because China was talking about it. Why is this important? Chinese leaders since the 70s followed Deng Xiaoping philosophy of “hiding your strength, biding your time”. Instead, they were now talking openly about surpassing the West. At the same time China was also investing heavily in the modernization of its military. All these things could not go unnoticed in the US which was increasingly worried about China's ambitions. This was the beginning of increased tensions between the two countries.

Where are we now?

 

West: Well, we know what happened in 2020 right? The largest pandemic since 1919 hit the World, and so the world shut down. How did Western policymakers react? By unleashing the largest monetary easing and the biggest financial transfer since WW2. What is the difference between these policies and what the West did after the 2008 financial crisis? In the 2010s central banks flooded financial markets with money but governments spent only a little on the real economy (therefore the impact on growth and inflation was limited). This time policymakers transferred money directly into the pockets of people and businesses. Why? Because this time the economy experienced a sudden shock: people were forced into quarantine and businesses shut down temporarily to top the spread of the virus. What were the consequences of these transfers? Both businesses and consumers started spending like crazy and the result was inflation, supply chain bottlenecks etc. But Western governments did not stop here, and continued printing and transferring money even after covid restrictions were lifted. And this is how inflation really ramped up throughout the West. But in Dec 2021 something changed. What? Central banks (starting with the Fed in the US) realized inflation would persist and decided to raise interest rates to slow the economy and tame the increase in prices. Why? Raising interest rates increases the cost of financing for companies that therefore need to cut costs by firing employees. People out of jobs spend less, and this is how overall demand is reduced in the economy and inflation with it. But inflation persisted even with high interest rates, very few layoffs happened (think of tech layoffs of 2022) and central banks have had to keep for a long time and are keeping interest rates at a high level. What are the consequences? Western countries are now starting to pay high interest on their government debts. What this means in practice is that governments will need to use a high proportion of their budget to pay for interest payments on their debt and will be able to direct less and less money on other types of spending (defense, healthcare, infrastructure). Why am I using the future tense? Because right now Western governments are still running high deficits (spending more than they earn through taxes) and are compensating for this by borrowing more. When will this stop? When the rest of the World reduces demand for western currencies (like dollars, euros) and stops buying their government bonds. And this might happen sooner than expected, as countries like China and Russia (which was sanctioned after the 2022 Ukraine invasion) are rushing to sell US government bonds. What happens then? Central banks will be forced to print money to buy government bonds. But this time the supply of money will not be absorbed by other countries and will circulate in the economy causing a reduction of its value and with-it massive inflation. Spending will need to be reduced to slow inflation and so Western economies will experience a negative shock. Only that this time governments will not be able to save it by printing money or running deficits. Quite scary right?

Finally, let's look at the US specifically. The US became increasingly confrontational with China economically. How? In 2018 Trump set tariffs on $250 billions of Chinese made goods to retaliate for China stealing US intellectual property. He also set export controls (China cannot buy US made technology, goods etc.). One example is the export restrictions against Huawei which meant the company was not able to source semiconductors made with US technology (you are not hearing about Huawei phones since after these sanctions the company found it difficult to produce them as it could not get advanced chips). President Biden kept these sanctions and doubled down by adding additional ones. The U.S. also encouraged American companies to diversify their supply chains away from China, offering incentives to relocate manufacturing to other friendly countries (friendshoring) or back to the U.S. And this is big since the US is the largest buyer of Chinese manufactured goods.

China:

The Chinese economic growth model had become over-reliant on real estate. Chinese house prices had been booming for twenty years and savers had been investing most of their savings in real estate. But developers had taken too much debt and overbuilt too many apartment units. Ghost neighborhoods had become quite a common sight, and this was because a lot of real estate was used for investment purposes and not for living. But now prices were too stretched for most of the population and this situation was clearly unsustainable and was putting the Chinese economy under the long-term risks. So, what did the Chinese government do? Instead of waiting, the government decided to intervene and burst the bubble. How? By forcing developers with too much debt to sell their assets. Many developers failed (the biggest one called Evergrande) and so an economic crisis started (like the 2008 crisis in the West).

China's economy is also under strain because its mercantilist economic model (manufacturing and exporting goods for the whole world) is not working as well as before. Why? Chinese manufacturers built too much capacity to respond for the boom in demand of goods after covid, but now Western economies are slowing due to an increase in interest rates and importing less. At the same time Western corporations (especially American) are diversifying their production outside of China (think of Apple in Vietnam, India). Chinese factories have low orders and high inventories. Western countries and developing countries (like Brazil) are worried about China dumping cheap products into their markets as this could put their industries at risk of being decimated and are therefore raising tariffs. So, producing more does not increase China's economic pie and it makes China increasingly disliked even by developing countries. This would be the perfect time to diversity the Chinese economy by allowing Chinese consumers to spend more and reduce the dependency on exports. Right? Isn't this what China wanted to do to become a modern sustainable economy? It seems like the opposite is happening and the Chinese government is to be doubling down on the mercantilist strategy by handing out subsidies and facilitating financing for manufacturers. Why so? In our opinion Chinese leaders, unlike in the 2000s and 2010s are now making decisions not based on economic efficiency. Their real focus is on the long-term goal of taking over the West, especially the United States. How? By putting Western industry out of business and making China the only country with the capacity of producing advanced manufacturing.

China has indeed had a lot of successes on its strategy to take over advanced industries from the West (Made in China 2025). Take the example of automobile manufacturing. EVs, if you remember, was one of the technologies China was vying to dominate, and one of the sectors where the government had been giving huge subsidies to companies to innovate and increase production. And it was extremely successful! Chinese companies are more efficient at producing EVs at a large scale and are far outpacing western companies in the production volume, at a much lower cost than them. Famous producers like BYD, Geely, Xiaomi have now emerged. The Chinese automobile market that was previously dominated by Western brands (like Volkswagen) is now increasingly taken by local producers. And now China is looking to export them to Europe and all the major developing countries. Think about this: China went from being outside the top 15 producer of auto in 2018 to the top producer in 2022. And the same is true for solar panels, wind turbines and battery technologies. China is becoming dominant in a lot of advanced industries and is innovating more than the West.