Random Comments

Apologies for the lack of posts these last few weeks – two links this week, but they are both quite substantial articles. Hoping to get back into a regular cadence again; may publish more frequently but shorter posts. More as we get it.

In the UK, we continue to build up to the budget, with the latest being that the Chancellor has rejected attempts to raise Capital Gains, which is something to be grateful for. On the other hand, we’ve seen Andy Haldane, previously one of Burnham’s closest advisors, heavily criticise Burnham’s economics. Listening to the Times The State of it podcast reinforced the sense that Burnham wants to be a government similar to the 1970s, at a time when we don’t have the finances to do so, and we need far more deregulation and lower taxes than ever.

On that cheery note, here are the links for this week:

https://substack.com/inbox/post/218012659

• I thought this podcast with Logan Wright on his new book was essential listening for anyone interested in China’s economy or macroeconomics more generally. Most Western politicians should be aware of what he is describing in here to inform our China policy.

After the global financial crisis, China saw the largest single-country credit expansion the world has seen in at least the last century, possibly many centuries. China added a third of global GDP to its bank assets in just eight years. We’ve never seen anything remotely like it.

First, there was a deliberate attempt to provide countercyclical support in response to the global financial crisis. The extension after that was essentially path dependence. Growth was strong, it was dependent on investment, and it became too difficult for authorities to shut down without imperiling the overall economy. That facilitated the growth of the shadow banking system, and credit growth became increasingly disconnected from the real economy. A lot of it went into the property sector and local government infrastructure.

The number one cause of the rapid decline since 2021 was the collapse of the property sector. It’s critical to understand that as a proximate cause, not the ultimate cause. After the deleveraging campaign hit developers’ shadow financing channels, the property sector was reinflated by borrowing from households in the form of pre-construction sales.

The other underappreciated part is how the slowdown in domestic demand is directly related to the rise in China’s external surplus and supposed competitiveness. It’s a byproduct of falling prices, but also of continued production across industrial sectors that used to find demand in residential construction in China. Now there’s none, so they need to find markets abroad, typically by cutting prices. This has produced persistent deflationary pressure and a weakening of the real exchange rate. The domestic slowdown and the external surplus are very closely linked, but people still treat them as distinct — they argue the economy is K-shaped — when in reality these are the same phenomenon.

• Apologies for the heavy amount of quotes, but these are needed to understand what has happened to China, and why we in the West must be paying full attention, and how our initial policy responses (particularly in Europe) fail to grasp the challenge. China’s formidable exporting machine is in part due to its genuinely superior manufacturing ability, but also because its financial system has failed and domestic demand is nowhere near enough for China’s economy.
• As we know, China is fully willing to use economic weapons against the West, such as reducing rare earth exports or cancelling investment if it perceives itself under attack. However, as we are now seeing in Europe, failure to act against Chinese imports just dooms your own industry, and there is nothing that you can do to make your manufacturers as competitive as China’s – it’s not a fair fight.

Decay is an easier political choice for China’s leaders — accepting slower growth and inefficient policy tools rather than risking crisis. The path to crisis is not an external shock in China, where everyone assumes the government will provide support. The path to crisis is reform.

• This is also crucial for our understanding of China. For all of this talk about Chinese leaders thinking in decades, they are also just as prone to our own short-term thinking. This has been known about in China for decades – see speeches made by prior Presidents referring to over-investing, and yet nothing has been done about it, as the political cost would be far too painful.
• Now we are at a stage where China cannot bring itself to reform, but the rest of the world no longer can absorb its gigantic surpluses. The USA under Trump, and under Biden previously, have recognised this, and are no longer willing to act as the consumer of last resort. We will see the rest of the world follow suit.
• Interestingly, they say that Japan is the closest analogy in recent history, but note that Japan had 0% monetary policy and needed fiscal stimulus, whereas China can still do some more with monetary policy. But the broader point, of there being a generalised crisis, rather than an acute one, remains.

That pie shrinks further if China’s export prices keep declining and drive disinvestment in the rest of the world, which means your customers, who are largely outside China, are increasingly unable or unwilling to afford everything you’re producing. Those are the limits of the model.

• China, for all of its superior industrial capacity, is fundamentally limited by being dependent on the outside world, and in particular the USA. (Which perhaps does make the bet made by American administrations to entwine the Chinese and American economies to prevent war look a bit better in hindsight). But this is the key advantage that Europe still has over China – we still have the consumption demand that China does not. This will be costly should we choose to use it, namely higher-priced goods, Chinese retaliation to our industries, and a worsening of relations. Europe needs to follow the American lead and arguably go further – import controls, and demand localisation of Chinese goods. Of course, this also must be tied to domestic reform across Europe, in particular its hiring and firing practices, along with energy.
• An interesting problem is that Chinese youth unemployment is being ignored by the main leadership – we’ve seen this in the past with Xi’s comments about needing to maintain discipline in tough times, but apparently, according to this interview, leadership believes that industries simply haven’t adopted AI yet, and once they do so it will be fine. Again, if I were a Western policymaker, I would be thinking about how to accelerate this problem for the CCP, or at the very least be aware of how sensitive this area is to senior leadership.

The trend now is more party governance of the financial system and treating finance as a utility.

The net result is: lend to state-owned enterprises and go home.

• Incentives are everything – in finance, you should be guided by your rate of return. China’s political economy does not operate in this way. Consumption will not grow for the foreseeable future until the underlying political economy changes.
• An interesting comparison was made here to the Brezhnev era of stagnation and decline:

Brezhnev chose decay. He chose decay, the scientific-technical revolution, and cybernetics, because the Soviets thought technology would work for them — we’re better planners, so we’ll use technology to allocate resources effectively. Kevin Rudd has recently published on how China thinks about AI the same way: AI is the way we get out of relying on markets, because AI will tell us how to allocate resources. It’s ideologically where they’re coming from.

• Therefore, is it strategically imperative for the USA to continue to be at the frontline of AI research? Probably so, but it seems the AI companies and hyperscalers are doing that for the USA already. Arguably, here the USA should continue to be hands off with its approach to its technology giants, given the overwhelming lead it seems to have in this space.

The net result: China has not been successful with this model, and is under more pressure than everyone thinks to maintain access to open markets for its manufactured goods. The rest of the world has a lot more leverage over China than it is currently using. That leverage is best delivered collectively, because China is less vulnerable to trade restrictions from any individual country, including the United States.

• The obvious forum for this would have been the G7, but given the USA’s erratic leadership, this is (for now) unlikely, though we are seeing European movements towards restrictions on Chinese imports. From a UK perspective, I’m highly concerned by recent moves to continue Chinese car imports – great for consumers, dire for our car industry, which is already under significant strain. This is where I would suggest some alignment with Europe, for our own domestic interests.
  

https://www.lrb.co.uk/the-paper/v48/n17/arthur-downing/asset-sweating

• This piece in the LRB by Arthur Downing focused on Britain’s new energy crisis and how we have ended up here. Starting with this shocking quote:

Others were concerned about the potential impact on prices of future shocks. In 2010, the energy industry regulator, Ofgem, concluded a major study into the resilience of the system. One of the scenarios it tested was a Russia-Ukraine conflict. The resulting report, Project Discovery, warned that ‘consumer bills rise in all scenarios due to the levels of new investment required … and especially so if oil and gas … prices spike sharply.’ Project Discovery was swept under the carpet then and is almost never mentioned today. To remember it is to admit that the British state lacked the capacity to do anything about the crisis it correctly predicted would happen.

• It’s quite incredible that we were able to anticipate a potential conflict’s impact on our energy situation, but could do nothing about it. I’d be interested to see what current UK energy ministers and civil servants make of it.
• As we know, we have some of the highest electricity prices globally. What is more interesting is how much of this is down to renewables, how much of this is down to gas prices, and how much of this comes from elsewhere. Downing writes:

There are elements of truth to both positions. A third of the increase in the average electricity bill between 2016 and 2026 was due to the increase in gas prices. But another third was due to increased subsidies for generators (resulting in part from higher interest rates and the growing cost of equipment and labour). A further 20 per cent was due to rising electricity network charges following a wave of construction after decades of underinvestment. Whatever the reasons for rising bills, the bigger problem for renewables is trust. For at least a decade, the British public has been told that renewables are cheap and will bring down bills. Between 2000 and 2025, the share of electricity generated by renewable and clean sources (wind, solar, hydroelectric, nuclear) rose from 24 per cent to 50 per cent. But this has failed to translate into stable or reduced electricity prices.

• This latter point is absolutely crucial to our situation. We have been repeatedly told that renewables would lead us to energy security, a green boom, plentiful jobs, and low prices. We can argue, technically, that we do have a green boom and plentiful jobs, even if this is on net worse for the UK. What we cannot dispute is our lack of energy security and low prices, the two essentials for any government.

One important metric is the share of final energy demand serviced by electricity: it has barely increased over the last two decades, going from 19 per cent in 2000 to 21 per cent in 2023. Between 2000 and 2019 electricity consumption per capita actually fell by 22 per cent. Only Yemen, Zimbabwe, Jamaica, Tajikistan and Syria have had greater drops.

• That list of countries should be part of the energy consensus epitaph from 2008 to 2026. What a damning indictment of UK energy policy.
• Downing goes into this in further detail in the article. Initially, energy policy was set by the market – the UK government, as per Nigel Lawson, was to set a framework for the efficient production and consumption of energy. What is quite interesting is that this was abandoned under the Cameron government in the mid 2010s, through the contract for difference for renewables.

But its real purpose is to protect the generator. Renewables have no fuel costs, so they bid into the market at close to zero, and because they generate at the same time – when the wind blows, for example – they drive down the wholesale price at the very moment they are most productive. Wind cannibalises wind: each new wind farm erodes the price the others earn. The contract for difference takes that risk off the investor and puts it on the bill-payer. A second protection is built into the market design. Britain runs a single national wholesale price, the same across the country, so a generator is never penalised for its location.

• The initial thinking for this was to encourage investment to get the renewables industry off the ground, but this has never been challenged. If the renewable sector in the UK, after 20 years still cannot stand on its own, it’s time to cut loose and go back to basic principles. I would prefer us to move to zoning, to better align supply and demand. But if we wish to continue the nationwide price, we need to adjust our subsidies accordingly.
• Downing notes how the renewable industry actually fought back against proposed reforms:

In summer 2025, the government decided to abandon a set of major reforms to the electricity markets, after facing bitter opposition from the renewables industry. These reforms were called ‘zonal pricing’, and would have replaced the single national price with regional prices. A wind farm in a remote corner of Scotland would have earned a lower price if its output depressed prices and would no longer be paid the national price to switch off when the network was congested. Having built such assets on the promise of national pricing, the industry fought hard against the reform. The government claimed it was giving ‘certainty to investors’. This contradicts the notion that under capitalism investors earn their returns by taking risks. It also makes clear that the role of the British state is now to ensure ‘investability’ by ‘de-risking’ projects. In this new world, critical infrastructure is perpetually financially reconfigured so that it will generate dependable returns for investors.

• We have got our energy strategy the wrong way around – we are seeking to serve investors, under the guise of this misguided Net Zero view. By leading with a legalistic view (i.e., Britain must reduce its carbon emissions), and not a strategic view (what best serves British interests, including present and future), we have created a monstrosity of an energy system.

f Britain’s political classes genuinely believed in markets, they would have pursued something like the Texan model, with limited subsidies and markets relatively free of government interference. If they genuinely believed in the power of central planning and statism, they would have pursued the French, Norwegian or Chinese model, in which the state owns power stations and electricity networks, and funds their construction through a combination of taxation and bills. Britain has private ownership while making the state responsible for planning via subsidies. The result is a zombie system, a muddled and dysfunctional hybrid of state and market, with the benefits of neither and the costs of both.

• Absolutely no argument from me here. Naturally, I tend to prefer the market-led approach, but it’s foolish to deny alternative approaches in this area, particularly given the security concerns. Downing actually writes later on about the successes of nationalisation in the UK – but the key is that we have eliminated state capacity and rely on legal approaches to solve our energy issues.