As mentioned in my recent Paper Portfolio update, I think investors need to brace for a return to an extended period of rough relations with China. While COVID19 is certainly part of the reason why the US and China are arguing, again, COVID19 is only one symptom of the underlying issues that were already in motion.
The underlying issues are ultimately labor, capital, and technology.
For those that have studied some economics before, you will recall that GDP growth is a function of these elements – Labor growth, Capital growth, and Productivity growth (often driven by technology).
The US and China are already in a geopolitical war. The US and China are already in an economic war. The US and China are already in an ideological and systems war.
But ultimately I believe it all comes down to the different games that the US and China have played and will play when it comes to labor, capital, and productivity. The arguments the US and China are having are a direct result of the different approaches that the US and China have when it comes to labor, capital, and productivity. This directly filters through to economic, geopolitical, and governance systems considerations and tensions.
To understand why, we have to revisit history and explore why the US and China are the two countries that in many ways have both left deep marks in history books as well as actively shaped the world we live in.
On a global stage, the US is very clearly recognized as a country that is historically different. The US is, theoretically, a meritocratic country with equal opportunities for all regardless of race, ethnicity, religion, sex, socioeconomic background…while in practice, not all of these things are likely absolutely true, it’s widely accepted that the US is a country built on meritocratic ideals.
The ideals that form the foundation of the US are not necessarily unique and were certainly already in motion in many parts of Europe before the writing of the Declaration of Independence in 1776. For example, many monarchies including the United Kingdom were already forced to make way for more democratic systems of governance with ideals not too dissimilar to those that underpinned the foundation of the US.
While the ideals are not necessarily unique, what has and continues to make the US different from every other country globally is that every other country globally is, at its core, founded around a group of people with a shared race / ethnicity.
For thousands of years, there have been immigration between countries, but historically, countries were more or less defined by ethnicities. China is the country of the Chinese. Japan is the country of the Japanese. Italy is the country of Italians. For example, for centuries, Chinese people have been at the forefront of immigrantion due to the need to establish outposts along frequently traversed trade routes. This brought Chinese people to Southeast Asia, to Central Asia, parts of Europe, and parts of Africa. However, even through centuries, these Chinese people never fully assimilated and in many cases are often regarded as outsiders despite being citizens of the countries they live in. This goes back to the pre-modern view that countries are ethnocentric.
The US is the first country in the world to choose, as a founding ideal, to be race and ethnicity agnostic. Again, I think it’s quite debatable whether this is true in practice, but this should in no way detract from the different game that the US has played and will continue to play in this arena.
Why does this matter?
This matters because prior to the industrial / information revolution, the vast majority of economic growth throughout thousands of years of human history is driven by largely one single factor: Labor growth.
GDP Growth ≈ Labor Growth + Capital Growth + Productivity Growth.
For much of human history, humans had limited tools at their disposal with primitive banking and credit systems, which meant limited capital growth. In addition, for much of human history, most humans had very limited knowledge of anything…and most people did not even know how to read or write. The lack of knowledge limited human capital growth, technology growth, as well as productivity growth.
Here’s one estimate of what world GDP looked like over the last millennia:
Prior to the (knowledge) Renaissance and industrial revolution, China and India were the world’s two largest economies. This makes sense because China and India had the largest populations in the world, and throughout most of history, GDP was approximately correlated to population / labor force size. The larger the population, the larger the economy. And within that, the largest reproduction rate also drove the fastest economic growth.
China and India essentially played the old game better than others.
However, China also played a slightly different game that often allowed it to excel just a little more than others. While capital and productivity were scarce for most of human history, there were still ways to fight against those forces. Starting from the earliest dynasties, China has always prioritized international trade. Whether China knew this conceptually or not, international trade helped China build small amounts of capital and productivity advantages that would compound massively over centuries.
How does trade create productivity? In a society without trade, society needs to be self-sufficient. However, any single person or any single society is unlikely to be the best producer of every single item. Even if a society is the best producer of every single item, it is unlikely to be equally productive across all goods. In the 19th Century, a brilliant philosopher (economics as an area of study and profession did not exist, yet!) by the name of David Ricardo formalized this concept as comparative advantage. He theorized that through trade, productivity would increase because it allowed different trading partners to specialize in the areas where they had the greatest natural productivity.
By engaging in prolific international trade, China was able to eke out small productivity advantages by allowing its citizens to focus on the areas that they were most productive at.
This, for example, allowed Chinese citizens to migrate from grain farming and into higher-valued / more productive areas such as tea farming and eventually luxury goods like silk and ceramics. Trade not only increased productivity but also allowed China to build financial capital by selling highly desired goods around the world.
On top of this, by engaging in international trade, China was often one of the first nations to know about (the few) technological breakthroughs that would happen every few centuries.
Together, this was a different game. China had the largest population but also small advantages in capital and productivity that would compound over centuries in a way that no other country was able to do so for similar durations of time.
In fact, a lot of late imperial China’s troubles can be traced back to the late Ming Dynasty when China decided to turn away from foreign trade and enter an extended period of isolation.
This is a very ironic outcome since China invented arguably the single most important substance in human history, gunpowder, yet through isolation, did not learn of the truly world-changing technology it would enable – guns. Three centuries later, China would buckle under the strength of European nations despite Europe collectively having much less of the labor that was so important in the millenniums prior.
With that context, China today looks a lot like the China from the past – A nation with a dominant economy due to sheer size of the population / labor force with some advantages in capital and productivity.
That was the world in which the US was born into, and the US struck a decidedly different path.
None of the old countries could beat China or India when it came to population or population growth, but the US came along with a different strategy.
The US became the world’s most favored destination for immigration. The US, conceptually, promised equal opportunities for everyone including those that come with nothing as long as they have merit and can work hard. And in a little over two centuries, the US has become the world’s third largest country. More importantly, the US is the world’s only developed country that still has a meaningfully growing population. While this does not sound like it should make that much of a difference, it’s likely one of the key reasons why formerly powerful nations are declining in power including Japan, Russia, Italy, etc. Their populations are shrinking, and these countries are either not attracting enough or do not want to attract immigrants.
This is also an important consideration since China’s population is likely to start shrinking in the coming years. China will remain far larger than the US, but it will shrink and this will be a negative drag on GDP growth.
So where does that put us on this key factor?
China has a massive advantage in labor, but the growth in labor is likely to decline and will likely be below US labor growth in the decades ahead. Interestingly, this was the single factor that helped China remain relevant to the global order for centuries and will become the anchor at its feet.
We cannot truly understand how different of a game the US has played until we consider Capital and Productivity.
By pushing a governance system that protected and celebrated personal / property rights, the US is one of the first countries to create a legal environment that was conducive to capital formation. In the old world, you owned things but only if the King did not decide to take it. But because property rights were so central to the founding of the US (We should not forget that the colonists rebelled against the British crown because of taxes on personal activity and property!), this created the optimal environment for an explosion of Capital in a way that no other country in the world had ever seen before.
And as a meritocratic country, the US also helped educate people that likely would not have been educated in their home countries. This is critical for the formation of human capital, development of technology, as well as improvements to productivity.
The game that the US played allowed them to be relatively good on Labor, but massively better than every other country when it came to Capital and Productivity.
The game that China played allowed them to be the best on Labor and very good on Capital and Productivity as well.
But unfortunately the world is changing.
China’s labor growth advantage no longer exists. But it has caught up relatively quickly on productivity / technology.
The US still has a small advantage in Labor growth (but maybe President Trump’s policies aimed at preventing immigration may change this), a small advantage in productivity / technology, and a large advantage in Capital.
I think that’s the most accurate description of where we are in the world today. The US recognizes that their traditional advantage in technology is narrowing at the same time that China recognizes their traditional advantage in Labor is narrowing. China needs to close the technology gap before the absolute advantage they have in labor size (1.2 billion people vs 330 million) narrows.
On the Capital dimension, we need to keep in mind that the US’ Capital advantages are all predicated on a system that protects and celebrates personal property rights. However, increasingly US capital formation is actually happening abroad. For example, Apple investing in China. (For those that have studied economics before, you will know that this is not counted in US GDP…and that is a very important point that is worth discussing in a future post.) I believe a lot of the disagreements over systems of governance largely comes down to this: China likes its own system and believes it is the best system for protecting its own interests globally. The US needs its own system to be projected abroad in order to protect the Capital that it is increasingly creating abroad. The proliferation of more authoritarian systems of governance like the ones supported by / pushed by China puts American Capital at risk.
Like a Shakespearean tragedy, I think ultimately both sides will be victims of their own strengths and weaknesses.
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