With the continuing discussion of the need for the U.S. and China to enter trade negotiations, it is important to understand that any negotiations will be about much more than trade. In my dreams, I can imagine the two countries working out a beautiful rebalancing—one in which the unsustainable excesses both countries now face are reduced to levels that are sustainable.
The problem as I see it is that both countries are currently stuck in an unsustainable cycle in which Americans buy massive quantities of inexpensive manufactured goods from China. These purchases are financed by the United States borrowing enormously from China so that China is now massive holder of U.S. debt.
In the process of this cycle, the United States has lost its ability to manufacture effectively, which has contributed to the plight of the bottom 60% of U.S. earners, who have been losing ground economically and have become increasingly frustrated over many years. With nearly 60% of the U.S. population reading at only a 6th grade level, it is a significant challenge to training undereducated workers in this group and getting them into productive jobs. They face worsening prospects for earning a living and educating their children, and because they are unable to be productive contributors, are increasingly a net cost for society.
It is also the case that the loss of manufacturing in the U.S. doesn’t just have domestic political and economic consequences; it has also led the U.S. to develop a geopolitically threatening dependence on manufactured goods from China.
At the same time, China (and other countries) has developed an unhealthy, excessive dependence on the returns of U.S. debt assets (and other American capital market assets). This creates risks for China because history has shown that, when countries get into too much debt, they always seek to devalue that debt. This can happen in expected ways (e.g., by printing more money, depreciating the currency, etc.) and in ways that would seem shocking to most people alive today because have not experienced these events before in their lifetimes (e.g., refusing to honor debts owed to “enemy” countries, defaulting on debts, changing the type of money in circulation). The debt devaluation dynamics can become self-reinforcing, as holders of U.S. debt grow worried about receiving the value they expected from it. This makes them less inclined to want to hold onto the debt so they seek to sell it, which alters the supply-demand dynamics for the debt and drives its value down further, making matters even worse. In the most extreme cases, this can lead to what I call a “debt death spiral” which is a terrible situation for debtors and the debt-holders alike.
Said differently, as a result of these excesses, the US has become the world’s dominant consumer and borrower thus building foreigners’ unhealthy dependencies on selling their goods to US consumers and on the returns of US bonds and other American investments, and China has become the world’s dominant manufacturer and lender thus building unhealthy dependencies on selling and lending/investing in other markets. All of these factors are creating an obviously unsustainable imbalance that, one way or another (in a coordinated, well-managed way or in a crash), must come to an end. And as it does, we will move from a world in which the mutual dependencies globalism has created become threatening—so, they must be rectified.
What needs to be done about this situation? Said over-simply, the U.S. needs to cut its deficit, increase manufacturing, lower imported consumption, and reduce its debt burden. Meanwhile, China needs to cut its surplus, lower manufacturing, raise consumption, and reduce its debt burden.
In thinking about how to best engineer these changes, each country has adequate tools to manage this situation well but they also each have their own domestic issues to consider and different approaches to managing their economies. For example, production in the United States is primarily driven by free-market participants in pursuit of profits while what is produced in China is primarily driven by governments, especially local governments, pursuing volumes of output. That means that with cooperation and capable decision making, orderly big progress to greatly reduce these unsustainable imbalances can be made.
There are many ways that both sides working together can engineer a beautiful rebalancing. But whatever form it happens in, this rebalancing, which is especially important given what the new world order is like, can and needs to happen in an orderly way. Looking forward, there are three important questions which must be answered. First, will the two sides work well together to engineer big reductions in these imbalances so they take place in the least disruptive way possible? Second, how will a deal be enforced? And, perhaps most importantly, will this deal be adhered to?
The views expressed here are Ray Dalio’s and not necessarily those of Bridgewater.
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