Michael Pettis is a former investment banker and a senior associate at the Carnegie Endowment for International Peace. George Magnus contributed to this essay.
As the era of hyper-globalization grows increasingly contested, so must Britain’s role in it.
In terms of shaping financial flows and the fault lines between trade and capital, the U.K. punches well above its weight. Thus, it presents a particularly sharp case study of the resulting internal economic and political distortions that occur when countries insert themselves into a global trading system on terms that prioritize capital over labor, finance over industry, asset inflation over productivity and trade surpluses over trade deficits.
To understand this, one must look at the wider global imbalance: For decades, the world economy has needed to recycle structural surpluses. As countries like Germany, Japan and China suppressed domestic consumption and wages to drive export-led growth, one inevitable consequence was their large and growing trade surpluses. And for every surplus, the global system demanded trade partners willing and able to run the deficits needed to absorb them.
It was largely the Anglophone economies that did so, accommodating these surpluses mainly through efficient and welcoming financial systems. The U.S. served as the primary absorber, running massive trade deficits year after year. But the U.K. played a central role too. By offering a deregulated financial environment, high-quality corporate governance and a wide variety of “safe” assets, London attracted waves of capital from nations in need of foreign assets to balance their surpluses.
However, since all inflows and outflows must be equal for any country, these net capital inflows had to be balanced by current account deficits. So, it is no coincidence that together, the Anglophone economies with the deepest, most liquid and best-governed financial markets — the U.S., the U.K. and Canada — accounted for between two-thirds and three-quarters of all global deficits.
Put another way, Britain accepted capital inflows, and in return, it exported debt, claims on assets, and industrial capacity. It imported not just goods but the insufficient demand of surplus economies — what economist John Maynard Keynes warned against at Bretton Woods in 1944.
Internally, the consequences of this were stark. Capital inflows lifted the pound, making British goods less competitive and imports cheaper. The U.K. evolved into a consumption-driven economy, where financial services and asset inflation — especially real estate — replaced industrial employment as sources of income growth.
London, in particular, benefited enormously from these inflows. Property values soared, banking and legal services flourished, and inequality rose. Meanwhile, the rest of the country — especially the North, Wales and parts of Scotland — bore the cost of this transformation. Built around manufacturing sectors no longer able to compete with industrial and trade policies abroad, they became victims of a national model increasingly dependent on foreign money, foreign imports and speculative finance.
This divergence wasn’t just economic — it was also political.
It is no coincidence that the Brexit vote split so dramatically along regional lines. It reflected not so much a rejection of Europe as a rejection of a global model that left large parts of the country behind.
But now, the global environment that enabled this system is eroding. Washington has made clear that the U.S. will no longer passively absorb the world’s surpluses. And there is a bipartisan consensus in Washington toward reversing the decades-long process that saw the U.S. share of global manufacturing decline.
Surplus economies like Germany and China still need new absorbers of their excess domestic manufacturing capacity, though — which leaves Britain in a uniquely vulnerable position. It remains fully open and very welcoming to capital, addicted to inflows and overexposed to the financial sector. Yet, it lacks the industrial infrastructure, political consensus, and regional investment capacity it would need to transition easily.
So, if the global recycling of surpluses shifts away from the U.S., the U.K. will face a hard choice: either double down on financialization or rebalance toward production and demand.
It will have to choose because the interests of London’s financial elite are not the same as those of Sunderland or Sheffield. A strategy preserving the privileges of the City may perpetuate the decay of Britain’s industrial base. While a reindustrialization strategy may require restrictions on capital mobility, the taxation of financial rents and a new industrial policy designed to promote investment and productivity growth across regions.
The standard defense of capital openness — that capital shifts toward its most productive use — works well in theory, but in practice, international capital does not flow from capital-abundant sectors to those that need it. Instead, it is driven mainly by speculative behavior, herding, currency intervention, flight capital and other policy distortions. Global capital flows not to where it is most needed but rather to where it is safest, most liquid and most protected.
Simply put, Britain’s openness has not generated investment in manufacturing or infrastructure. On the contrary, by overvaluing sterling and effectively subsidizing imports, capital inflows have actually reduced the competitiveness of British manufacturers. And instead, they have inflated housing markets, subsidized consumption and benefited those who already hold capital.
If the U.K. is to achieve more balanced growth, it must tame these capital inflows and abandon the idea that market distortions and regional dislocations will self-correct. However, rebalancing toward a greater role for British manufacturing means rejecting the U.K.’s role in the global capital and trade regime, where its domestic economy must absorb and accommodate the industrial policies of foreign countries.
Like it or not, by choosing an open trade and capital account, the British economy is already subject to industrial policy. The important question is whether that industrial policy should be designed in London — or in Berlin, Beijing and Washington.
The great risk for Britain now is that it becomes even more reliant on speculative capital. But choosing instead to reverse decades of underinvestment, close regional gaps and reassert control over the direction of the economy would require a dramatic policy shift. It would require confronting the entrenched power of the City, building institutional capacity outside London and prioritizing long-term productive growth over short-term asset inflation.
It might be nice to think that with the right mix of policies, a country could be both a world-beating exporter of debt and national assets, as well as of manufactured goods. But the conditions that lead to one may undermine the other. And Britain must seriously consider what kind of economic power it wants to be.
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