Superfusion: How China and America Became One Economy and Why the World's Prosperity Depends on It

January 28, 2010


JOANNE MYERS: Good afternoon. I am Joanne Myers, Director of Public Affairs Programs, and on behalf of the Carnegie Council I'd like to thank you all for joining us.

Today it is a special pleasure to be introducing our speaker. Zach Karabell is someone I've known for quite some time. He is a prolific writer with a wide range of interests and is replete with information about many topics. His articles have appeared in Newsweek, The Wall Street Journal, The New York Times, The Los Angeles Times, Foreign Affairs, and The Washington Post. You can also catch him on CNBC, where he is a regular commentator on issues of international and financial concern. We are delighted that he is here today.

In his most recent book, Superfusion: How China and America Became One Economy and Why the World's Prosperity Depends on It, Zach draws on his expertise as president of RiverTwice Research, where he is an analyst of economic and political trends, to write about what happens when two countries—one a superpower, the other on its way to becoming one—are dependent on one another for their economic well-being. He traces the 20-year history that began with the suppression of the protests in Tiananmen Square in 1989 to tell us the incredible story about a developing country that opened its doors to the West and allowed a market economy to flourish.

Though this remarkable tale was accelerated by the admission of China to the World Trade Organization in 2001, in the intervening years before China joined the WTO the Chinese leadership adopted a policy of aggressive economic reform and courted U.S. companies, such as Federal Express, Kentucky Fried Chicken, Avon, and Walmart. No one realized how critical this initiative would be to China's success and important for its growth.

However, as a reading of Superfusion will reveal, while China was becoming a producer of low-cost goods, a consumer and banker to America, neither the governments of China, the United States, nor the populations of either country saw the implications where this relationship was headed as these two countries were growing more and more reliant on one another.

Today both countries find themselves in an unfamiliar and challenging position. On one side of the Pacific Ocean we have China, who has begun to question the wisdom of their union with the United States; and on the other side of the Pacific there is the United States, which faces a level of dependency on China that has generated considerable anxiety. The association between the two has enhanced the global economy but undermined the sovereignty that governments so crave.

At this stage I'm wondering, if we were to redefine our relationship with China, assuming that it would not cause greater instability in the world, what will the implications be for our future, their future, and the future of our global economy? Zach just may have the answer.

Please join me in giving a very warm welcome to a very special guest.


ZACHARY KARABELL: Thank you, Joanne. You've done a wonderful job summarizing the book, so I think we'll just go right to questions. [Laughter]

And thank you to Joel Rosenthal and the Carnegie Council. I was here for the first time 16 years ago as a graduate student speaking about something, which I wish I could remember, and it's interesting that I've come back here over the years to be speaking to you today.

You know, I wrote a few books during the past decade of the 2000s, a decade which I suppose is remaining nameless, although it is becoming known as "the aughts." I think it should really be called "the zeroes."

One of the books I wrote was on religious coexistence between Muslims, Christians, and Jews, called Peace Be Upon You, and then I wrote this book about the relationship between China and the United States—topics which on the face of it have absolutely no relationship to one another. But what's interesting about that, and kind of inadvertent when one looks at one's own career, is that in many ways those are the two issues that have animated a lot of global politics and have led to all sorts of hand-wringing and agitation on the part of people throughout the world, except that the relationship between the faiths, the three monotheistic religions, and the challenge of terrorism, some of which stems from that, is very much an issue of the past.

That doesn't mean that it's not also a crucial issue of the present and the future, but it definitely has its roots in history; whereas the evolving relationship between China and the United States and the evolution of China as an economic superpower is very much in my view the issue of the future. It's both a cliché and a truism that insofar as any of us individually or collectively are trapped in the issues of the past versus focusing on the issues of the future, we do not develop the kind of dynamism and initiative to construct that future.

So part of the concern, and part of the reason why I wrote this book, was a way of saying that while a lot of our public attention has gone to the crisis of 9/11 and beyond, what was happening while that public attention was focused on Iraq and Afghanistan and terrorism and security issues that stem from religious tension was that the evolution of China was happening, if not beneath the surface, then certainly not receiving the kind of acute attention that that conflict was. And some of that is quite understandable. War, death, violence, troops in action, and security have a way of focusing the mind and grabbing attention, whereas fuzzy things like economics and money flows and capital, unless it's a dramatic event like the collapse of Lehman Brothers and are your ATMs going to work tomorrow, don't tend to receive the same kind of attention. It's the historical/cultural equivalent of if it doesn't bleed it doesn't lead—something I know well from having written books, because when I wrote the book on religious coexistence, which was called Peace Be Upon You: The Story of Muslim, Christian, and Jewish Coexistence, while decently received, it didn't get the kind of sales that the publisher would have liked or that I would have liked, because it was about peace, and peace is boring. I mean two people wake up in the morning and they have a cup of coffee and they talk about the weather and they go to sleep—you know, that's peace.

So the paperback version was called Peace Be Upon You: Fourteen Centuries of Muslim, Christian, and Jewish Conflict and Cooperation, presumably under the idea that if we could get the conflict in there you might animate the animal spirits of readers to get them out to buy the book. I suggested that it should have been called "Fourteen Centuries of Muslim, Christian, Jewish Conflict and Cooperation, Anna Nicole Smith, Britney Spears, Madonna, and Branjelina," but that was rejected on the grounds of irrelevance.

So I came to write this current book. Part of that came out of an academic background; part of that came out of a background of managing an investment fund for Fred Alger Management, called the China-U.S. Growth Fund, on Chinese and U.S. companies that were in one way or another benefiting from China's economic growth. Joanne mentioned a couple of those in passing, which I will talk a little bit about as we get further into this.

So a couple of contentions around this. One is that the emerging relationship between China and the United States is the defining relationship of the next generation, and that the emergence of China as a global economic force is the defining global change factor of this part of the century. I was told once that if you're going to make predictions about the future, just don't give dates. So when I say "this part of the century," I'm not entirely clear how long this part of the century lasts, but sort of for now until then.

And that our ability to manage, grapple—"our" in this case the United States, although I suppose you could say "our" citizens of the world—ability to manage this evolution constructively is going to define in large measure whether or not this is a peaceful rise, whether or not this rise is one that enhances global prosperity or triggers a next wave of global tension. I don't have a prediction about that. I simply am saying that as the change factor to be grappled with, how that change is managed domestically, internationally, collectively, I think is going to shape the economic security, and to some degree the security of the United States, as well as that of China, as well as that of the world, and that we are at a particular inflection point.

None of this is to say that the issues that have animated us and continue to animate us in a foreign policy realm about Iraq, about Afghanistan, about the challenges of global terrorism, are not acute and important. It's only to say that that which seems most acute and important right now I don't believe is going to shape our domestic lives nearly as fundamentally as the rise of China, and that even if you believe those things are important, that this is something to be attended to.

Again, what's difficult about it is that there is an amorphousness to it. In fact, what I want to do is to go back for a moment and talk about how this evolved, because I think understanding how it evolved in this particular case is absolutely central to understanding what actually we are in right now and, therefore, what to do about it going forward.

I don't believe that history is predictive. I don't think history repeats itself. I think historians repeat each other. But it can be a source of information and awareness about the path that we're on.

One marker in this, which was unnoticed at the time, was, as Joanne mentioned, the December 2001 joining of China to the World Trade Organization. Now, if you remember, in December of 2001 the attention of the United States was almost entirely on having just sent troops to Afghanistan. And once again, of course, the attention of the United States in a foreign policy context is having just sent troops to Afghanistan.

Even if that had not been the case, a country joining a deliberative body with no geographic center, represented by trade ministers of the world, is not usually the source of Pulitzer Prize-winning journalism or stirring histories. So China's joining the World Trade Organization in December of 2001, even under the best of circumstances, was not likely to be attended by fireworks of "Oh my God, the world has changed."

But in the greater scheme of things, oh my God, the world did in fact change, and that was a dramatic inflection point. But even that was simply the most important, I think, statutory moment that helps explain where we are today, that this really began after 1989, and in many ways as a result of how the Chinese leadership managed the political protest at Tiananmen Square.

Now, I think that when people talk about the Chinese-U.S. relationship, certainly my sense of having done enough AM radio and talked around the country is that people are aware that China has evolved as an economic power, they are aware that there is this interrelationship between China and the United States, but if they are aware of it, they are largely aware of it in a negative sense—that China makes cheap goods, tainted drywall, poisonous dog food, lead-tainted toys that kill and imperil the security of our children; they keep their currency undervalued, which undermines the American manufacturing base; they developed a huge amount of reserves based on a devalued currency and flooding the market with cheap goods that leads to the erosion of the American manufacturing base. That narrative, that story, is pretty well ensconced in politics and in popular imagination.

And the Chinese have their own version of this relationship, which is: "We thought that America was a good place to invest. We thought that if we embraced the American model of capitalism we would have a constructive pathway to the future." And, lo and behold, the crisis of 2008 shows just how misguided that was, that once again the West is trying to take China for a naif and a rube and steal money and return nothing, and that the goal long term is to detach from this pathway, go it alone, and once again become the middle kingdom of peace, prosperity, and cultural dominance globally.

So if you talk to the publics of either part of this equation, you don't tend to get a warm and fuzzy feeling about the relationship. You get a really uncomfortable feeling.

In fact, of late the Chinese leadership has become even more kind of contentious and a little bit aggressive. There was a moment at the Copenhagen Summit where a vice minister wagged his finger at Obama for, I think, coming into a meeting, or some aspect of our demands about emissions versus China's.

First of all, it was kind of an astonishing breach of protocol, because vice ministers don't tend to lecture presidents. It's just one of those things in diplomacy. And the fact that it was a Chinese vice minister who—the Chinese, if nothing else, are extremely rigid and respectful of diplomacy. Some of you may have remembered a few years ago when Hu Jintao visited the White House, on the White House lawn. There were a few protocol incidents—what would have seemed to an American audience minor—you know, President Bush grabbed Hu Jintao's elbow because he was making an exit stage left and he was supposed to stay for a photo op; there was a heckler in the background with a sign of "Free Tibet"; and I think there was one other—all of which were seen as less than adept protocol on the part of the United States but no big deal, particularly for those who knew and studied the legacy of George Bush. That was my one real partisan dig for the evening. I'm better now. But for the Chinese this was seen as a very purposeful humiliation and sticking it to the president and kind of trying to show that we were bigger than them.

So for a vice minister of China to lecture the president of the United States was kind of a big deal.

And you've had a lot of comments recently about the currency issues aren't their problem, they're our problem; we should attend to the motes in our own eye before we lecture China; the whole imbroglio between Google and China, another example of "our version of the Internet is our version of the Internet and you have no right to tell us what your version of the Internet is or to impose it upon us, and that this is just another act of cultural imperialism."

But I think in order to understand the way this relationship evolved you have to grapple with the reality that it evolved first because the Chinese wanted it, not because the United States wanted it. And it evolved because in the aftermath of Tiananmen Square the Chinese leadership led by Deng Xiaoping, who authorized the violent suppression of the protest in Tiananmen, are at a crossroads. And they have the example of the Soviet Union very acutely in mind, which is too much political reform will lead to chaos and collapse. And by the way, later in the 1990s they also have the example of post-Soviet Russia, which is too much economic reform will lead to chaos and collapse.

So the Chinese leadership makes this decision, which is: "Okay, we can have political reform or we can have economic reform, but we cannot have neither. So we will shut the door to political reform. You will not be able to speak about your government if you are a Chinese citizen, you will not be able to gainsay what is done, but we will engage in hypercharged economic reform, in the belief that if you can create prosperity and affluence in a market fashion you will maintain stability societally and allow for the continuance of party leadership."

In 1989, if you are China and you decide to embrace the market, as Deng Xiaoping did, embracing the market means that you embrace the United States, because in the 1990s, particularly with the end of the Cold War, the global market is largely defined by global capitalism emanating from the United States and finance capitalism emanating from Wall Street, before "Wall Street" became as much of a dirty word, or rather in an interregnum when "Wall Street" wasn't as much of a dirty word. It kind of comes and goes.

So China begins to woo the United States. At one point, Deng Xiaoping says: "You know, wouldn't it be great if we could have a couple tens of billions of dollars of foreign reserves and be able to sell some products?"

Flash forward 20 years later. China has $2.4 trillion of reserves. It has a $240 billion trade advantage, or deficit in its advantage, with the United States. China now accounts for 10 percent of all global trade, which is getting close to the amount of global trade the United States accounted for at its height in the 20th century.

But in order to get to that point it required China not only to woo American companies but for American companies to invest in China. In many ways, that's the missing part of this story, because beginning in 1989 and stemming through 2008—and you won't be able to find these calculations because they don't exist on any spreadsheet or government data—by my calculations, roughly U.S. companies writ large and some multinationals invested about $1 trillion in China—building factories, or Federal Express buying up airlines in South East Asia in order to build up a network that would allow it to function on the mainland of China.

A trillion dollars for an economy the size of China's in the 1990s, and even into the 2000s, is an extraordinary amount of money. It would have been on percentage terms over that period of time certainly close to $20 trillion if you thought about it in American terms. It would have paid for our health care costs twice. So that's a lot of money.

The fact that China was able to woo that money is one of the fundamental reasons why China now has the ability to have a $2.4 trillion trade surplus in reserves, why it has become a manufacturing powerhouse, why it's able to build out internal infrastructure, because in many ways China piggybacked on the intellectual property—and we can get to that, to what degree was that piracy or copying—but certainly by the intellectual property of the West, and also consumed the capital in order to build upon itself.

Now, the tradeoff for these U.S. companies was also quite positive, because a lot of the companies that go to China initially in the 1990s or the late 1980s are the companies that are feeling left out of the equation in the 1990s. They're the kind of old-economy companies that everybody in the 1990s was saying were has-beens. They were the people who made stuff that wasn't like cell phones. It's so easy to do that in a talk, but it's a talk about China and that's where all the cell phones are made, including the Apple iPad, which is made by Foxconn Technologies.

So it was the Caterpillars of the world; it was the General Motors of the world; it was Yum Brands, which was then not Yum, it was Kentucky Fried Chicken—all of whom are feeling like the guys in flip-flops and Hawaiian shirts who are getting up on a stage saying, "You know, I have no business plan, I just have a great idea of how we're going to transform the future and make the world seamless," and walked out of the room with $10 billion of start-up capital; versus the other old-economy companies, which are being told routinely that their businesses were archaic, that their product lines were anachronistic, and that they were about to become antediluvian.

China was their 'Hail Mary pass.' They all thought, "we've got to find growth in order to impress shareholders. So we'll go to China because China's saying 'Come here.'"

Companies had been going to China for years and losing money. So the idea of investing in China wasn't necessarily seen as really forward-thinking or what a smart company would do. But a lot of these companies start doing it.

What they do when they do this is not only do they begin to transform China and create a consumer culture, industrial know-how in China—because, again, the story that really hasn't been told about China, and continues to be untold, is how much the evolution of China is a domestic consumption story in China, either the government consuming or people consuming increasingly more, certainly relative to what they had been, not relative to some abstract bar of how much they should.

The example of Kentucky Fried Chicken is the kind of perfect one. So Kentucky Fried Chicken in 1989 is nobody's idea of a cool, sexy, hot, or well-run company. It's a division owned by RJ Reynolds that decides to allow Kentucky Fried Chicken to grow in the mainland, having done okay in Hong Kong and parts of South East Asia, and maybe on the assumption that if you could get a lot of Chinese people to eat greasy fried chicken you could probably get them to smoke.

So it authorizes local managers to grow in China. It gives them a lot of autonomy, because unlike McDonald's, which was much more centralized, Kentucky Fried Chicken was run by franchisees, didn't have a really strong vision. So they allow these mostly Taiwanese and American managers to go and open up a store in Beijing.

They decide: "We're going to throw out the rule book here. We're going to make this an entirely different brand in China. So, first of all, we're not going to call it 'Kentucky Fried Chicken' because that would be as meaningless as calling something 'Newark Fried Rice' in Shanghai." So they call it KFC—which is also meaningless, but at least it's meaninglessly meaningless.

They decide to open up in prime real estate. They rent a 5,000-square-foot store 500 yards off of Tiananmen Square near Mao's tomb, and they spend millions of dollars renovating it. Each floor is adorned with pictures of the United States. One floor has the Statue of Liberty, the Golden Gate Bridge, sort of scenes of American life, because what they're going to do is they're going to brand it as an experience of the market and of modernity. Now, granted, this actually happens right before Tiananmen, so Deng Xiaoping had begun this direction.

They are going to have table service and waiters smiling. And they rebrand the Colonel a little bit, because Colonel Sanders didn't play well to test groups anywhere throughout South East Asia. When the first Kentucky Fried Chicken opens up in Hanoi, there were riots in Vietnam because they thought that the franchise was purposely offending the memory of Ho Chi Minh. He looked a little like a stern grandfather. So they kind of rebranded the Colonel. Now if you look at Colonel Sanders in a Chinese context, he looks a little bit like if Colonel Sanders and Fu Manchu had had an affair.

Because they are able to rebrand this, they are able to charge four times as much money for the same food.

And people flocked there. There are lines around the block. Nobody likes the food, but they say that they think that this is an experience of the modern world. And people keep coming back and coming back and coming back. It's a lot of money for someone in China at the time. It's like a month of disposable income—not a month of income, but it's what you would spend on all your entertainment.

The franchise keeps growing and growing and growing throughout the 1990s. So even though by the middle of this past decade Kentucky Fried Chicken in China represented less than 6 percent of all of Yum Brands' global stores, which includes Pizza Hut, it was 25 percent of their earnings and their revenue.

In the process it became a source of fast food in China. There was no fast food in China under Mao, although I suppose all food was fast because there wasn't much of it and you had to eat quickly. But there were no franchises, there were no restaurants, there was no branding and marketing.

Now, I suppose, from one perspective you could say this is all a negative, right? It was the importation of the worst aspects of consumer culture into a Chinese context. But the world is the world is the world, and that's the world we happen to live in. We can get to whether or not it's the world we ought to live in, but it is the world that we do in fact inhabit.

The transformation of China was a product of a lot of these companies going in and creating these metrics and motifs and ways of acting which were very different than what had gone on in China at any other point in society, and which the Chinese then begin to innovate and adapt in their own context.

You know, what that then created in terms of relationship—it's true—was a lot of Chinese companies also making stuff for sale in the United States. But it's not as if the Chinese woke up and venture capitaled their own factories and figured out what products to make that would be appealing to a U.S. audience. Most of what was produced was produced because American companies set up factories and made stuff that they were making elsewhere.

Now again, whether or not this trend benefits simply American capital at the expense of American labor is an interesting question. But it's undoubtedly true that those trends had been in place long before China is on the horizon, because before China it was Mexico and it was Ross Perot railing against NAFTA as creating that giant sucking sound that was going to lead all jobs to go south. And before Mexico it was Taiwan and South Korea. So the move of labor to lower-cost areas has been going on for decades and is not a product of China, even though China is the latest iteration of it.

This is often now seen as a system that undermines the American manufacturing base and enhances the competitive abilities of China. But in my view it's also a system essentially of capital and ideas in motion in a way that national statistics do an extremely poor job of encapsulating.

That much-vaunted trade deficit figure of $200-300 billion a year assumes that every dollar of trade with China is a dollar that leaves the United States and goes to China. But if 15 percent of that trade deficit is Walmart sourcing its goods, a lot of that money doesn't go to China. It goes, yes, to Walmart; it goes to people working in the Port of Long Beach offloading the goods; it goes to Burlington Northern Railroad, which Warren Buffett just bought the rest of, shipping those goods throughout the country. It doesn't all go in that direction.

It's not even clear, in fact, where things are actually made, even though they always get ascribed to one country or another, because if GE makes a washing machine in a plant in northern China with polymers and plastics that have been initially made in Malaysia and circuit boards that are produced in Taiwan and some cloth that was sourced from Cambodia with initially having been grown in Texas, that then gets assembled partly in a plant in southern China, and then gets shipped to a plant in northern China via Hong Kong, where it then counts as a Chinese export to Hong Kong and a Hong Kong export to China, and then it gets sent to the United States, where was that thing made by a company whose shares trade on the New York Stock Exchange? Or if it's a BlackBerry phone and you have the same thing, it gets sent to the United States for a company that's incorporated in Canada whose shares trade on the New York Stock Exchange.

So national trade statistics do a very bad job capturing those realities.

They also do a very bad job capturing capital in motion. And again, you could really see this more as a system.

I want to do kind of a brief thought experiment and talk very, very quickly, partly for effect. The numbers I'm going to give aren't actual but they are representative.

One of the only sources of growth from about 2003 to about 2008 that Wall Street investment banks saw, other than creating mortgage-backed securities, was the possibility of doing banking and loan and lending and underwriting business in China, because by the World Trade Organization China had to allow these to come in.

So in around 2003, Morgan Stanley, seeing potential to do lots of underwriting business of dynamic new Chinese companies that want to list their shares or former state-owned Chinese enterprises that have reformed enough that they can then turn to Western capital markets for an infusion of capital, Morgan Stanley decides to invest $5 billion in one of China's banks. Which it does. One of these banks then takes that $5 billion and disburses a series of loans, some of them to government-sponsored projects to build infrastructure (roads and rail and urban infrastructure to create a competitive domestic economy) and some to build some factories. Those factories then may make goods that in turn get exported to the United States.

So Morgan Stanley gives $5 billion to a Chinese bank, which then gives $5 billion to a variety of projects, including companies that then sell goods to the United States. Americans then buy $5 billion of goods based on that $5 billion of funding, which leads to $5 billion of foreign reserves being built up in China. China then needs to do something with those reserves because it's got a closed currency account, and it invests $5 billion of that with the U.S. government.

Comes to the fall of 2008 when the financial system is imploding. Morgan Stanley, like the rest of the investment banks, needs money because it needs to survive. So it turns to the U.S. government for an infusion of capital so that they don't go out of business. The U.S. government then gives Morgan Stanley $5 billion. But of course where is that money going to come from? It needs to float some issues of Treasury notes to the public, which it does. The major foreign buyer of those Treasury notes is the government of China. So the government of China buys $5 billion of U.S. Treasury notes in order for the U.S. government to give Morgan Stanley $5 billion, which in turn gives $5 billion to Chinese banks so the Chinese banks can give money to Chinese factories who could then sell goods to the United States, could then create currency deposits in China, so that China could then loan the U.S. government money in order to bail Morgan Stanley out.

Come the spring of 2009, Morgan Stanley needs to pay the government back because it doesn't like owing the U.S. government money. So it decides to issue shares to the public in order to pay the U.S. government back $5 billion. Then, on a Sunday, so that people wouldn't notice, the largest buyer of that issuance is the government of China in the form of the Chinese Investment Corporation. So the Chinese Investment Corporation gives Morgan Stanley $5 billion so that Morgan Stanley can give $5 billion back to the U.S. government so that the U.S. government can service the loans of the Chinese government which had lent it $5 billion because those factories that Morgan Stanley had given $5 billion to have produced a series of products that they could sell to American consumers.



ZACHARY KARABELL: The point of that is that what can be seen as a trade deficit and a current account and a drain of capital from one direction to the other can just as well be seen, because everything I just said is—I mean there are actual numbers, and it's more like $4 billion, but it's about right—all of that is true. I didn't make any of that up. That is, in my view, a system of capital in motion.

So what can be seen as this negative weighting between states can just as well be seen as a system that's evolved. The problem is our ability to measure that system, both in terms of the data that we have and in terms of our frameworks, is limited, because we still all conceive of things in terms of a nation-state and our economy and their nation-state and their economy.

And the Chinese do the same thing. This is not like an American issue per se. This is an issue of how do we all perceive of systems and capital and the world, and we still perceive of them as starting from the nation-state.

Now, assuming that this system is in motion and assuming, which I know is a debatable point, the presence of this system in my view created more global stability and liquidity than would otherwise have been the case at the heart of the financial crisis. Now, there are many people who will say that the financial crisis fundamentally was caused by imbalances in the global system, the greatest imbalances in the global system stemming from the Chinese-U.S. relationship. I don't agree with that perspective. I think those who word it "imbalances" are a little bit like your friend in Southern California who's always calling you up saying, "The big one is coming, the big one is coming. I'm on the National Earthquake Center and I'm seeing little tremors and I'm telling you it's going to happen. Any day now it's going to happen."

There are a lot of people who have been railing against global imbalances and the sense of this relationship between China and the United States was distorting the economic system.

So it's like that friend who calls you up, and then one day a small meteor hits Southern California. He calls you up and he says, "You see, I told you so." In many respects the implosion of the financial system, while it may have been somewhat enabled by the liquidity created by this relationship, in my view is much more a function of bonds and derivatives created on the basis of the U.S. housing market, and that the presence of the China-U.S. relationship ultimately created much more ballast of the global system, a fact which I think many more people now are signing on to, particularly seeing how much China has become, much to people's consternation and surprise, a source of stability globally in the past year, without which things might have been much worse.

Now, clearly, this has been a disruptive relationship to the U.S. economy and disruptive to the U.S. perception of itself, and in fact to our ability to continue to generate the level of domestic affluence commensurate with our needs and desires. So the argument here is not that this is an unalloyed good thing. The argument here is that this is an unalloyed thing, that it is a reality, and that judging it negative or positive will not change the reality.

There is a lot of talk today about a mutual desire for a divorce, that both sides have come to the conclusion that this is an unhealthy relationship. One radio interviewer began his interview with me saying that many have likened the relationship to that between a junkie and his dealer, that China is continuing to facilitate American overconsumption.

Another issue that one could take issue with, because it's not clear that the issue has been American overconsumption, nor is it that there is Chinese underconsumption. It's true that the figures look that way, but of the 70 percent of the U.S. economy that's domestic consumption, about half of that is consumption that people have to do, it's not discretionary; it's health care costs and food. Of the 35 percent of the Chinese economy that's domestic consumption, it doesn't include the fact that people save more in China because they have to pay for their health care costs. So there is lots of misalignment of statistics that leads to facile generalizations that don't hold up under scrutiny.

But there's a lot of talk now that this was an unhealthy relationship that's heading for a divorce. Maybe. I think now the question is: Okay, now where is this heading?

First of all, it's much more like a 19th-century marriage than a 21st-century marriage. Both sides can be unhappy, discontented with their relationship, engage in mutual recriminations, but it's really difficult to get divorced. And, as much as China wants to talk about creating a new global economic system, having gotten into bed with the dollar in the first place, they have to come home to the dollar in the second.

This says nothing about the long term. I want to talk about what is the long term. I see two pathways here.

One pathway is that as this relationship between the United States and China evolves and as China continues to emerge, it becomes somewhat like a European Union, which seems highly unlikely today. But if you talk to a French winemaker or an Italian urban dweller or a German burgher in 1965 and ask them if 40 years hence unelected bureaucrats in Brussels would be making key economic decisions about their interest rates, their currency, and their government spending, that too would have seemed, particularly in the context of European history, ludicrous. So the fact that an EU-like pathway seems unlikely now does not say that it is impossible. A couple things mitigate against this.

One is at least the European Union is the product of conscious desires on the part of elites, whereas the relationship between China and the United States has evolved largely without anyone in China or in the United States knowing it, wanting it, or intending it. If it is a superfusion, as I argue, it's an inadvertent one and in many ways an unloved one. It's difficult to create a cohesive set of governing institutions without people actually wanting this thing to exist and then have it be governed.

But it is certainly possible that as these two societies continue to evolve together that they will be forced to work together in ways that neither particularly likes but that both see as in their interest.

This is not to say that the European Union is a perfect model, but it has created a level of stability and prosperity for 340 million people, all of whom have the month of August off. So that is, on the balance of human history, not a bad thing.

The other pathway is a more troubling one, and that is that as this relationship evolves, it recapitulates the relationship between the United States and Great Britain in the first half of the 20th century, except in this case the United States plays the role of Great Britain and China plays the role of the United States.

In February of 1946, after the British had fought two wars against what it believed to be the proximate threat of both imperial and then Nazi Germany, it turns to the United States, which had been its closest ally, which had provided it with untold billions of dollars in funding (which is equivalent to trillions now) for a loan because it was unable to meet its short-term commitments, having had its coffers depleted by the war. And the United States say "No." The British come back in February of 1946 and say, "If you refuse to give us the $5 billion loan we need, we will default on our obligations, and that will not be good for the international system."

The Americans come back and they say, "Fine, you can have the money, but under two conditions: (1) you abide by Bretton Woods and you make the dollar and not the pound Sterling the global currency of reference, and (2) you end the system of imperial preferences," which had allowed Britain to trade with India and South Africa and Australia in a preferential fashion. Basically, the Americans say to the British, "You can have the money but you cannot have your empire." That then begins a cascade of dominoes that fall rather quickly, such that within a few years Britain's empire is ended and it enters decades of doldrums.

Now, there are worse things than to be Great Britain. It was a lot of fun to be in London in the swinging 1960s. It's a lovely country. But there are better things as well.

We are nowhere near in the China-U.S. relationship, given Chinese holdings of U.S. debt, to a 1946 moment. The problem is we don't know how far along that path we are, and we won't know how far along that path we are until it's too late to get off of it.

The issue as far as I'm concerned is not how does China evolve. China is going to do what China is going to do, and it is largely going to do what it's going to do regardless of whether we like it or not and whether we try to contest it or not.

It is the first time in the past 60 years that there has been an economic force in the world that is significant enough in its own right that it is neither coercible nor changeable by the desires or actions of the United States, nor is it susceptible to military action. I think it's highly unlikely that this tension, if it exists, ever takes a military dimension, because China is not even trying to compete with the United States militarily. In fact, they would love to see the United States continue to spend $600 billion a year on aircraft carriers and divisions, because they're not even attempting to build those up. They're just going to spend $60 billion a year on cyber-warfare, taking advantage of the weapons of the weak to prevent the weapons of the strong from doing the damage that they can.

So China's going to do what China's going to do. The question is: What is the United States going to be? Because if one assumes, as I do, that China's evolution is a fact, much as the evolution of the United States from the late 1890s through the middle of the 20th century was a fact, not a fact without great internal turmoil—so simply saying, "Well, China may be headed for a real estate crash" or that "the resource intensivity of China's industrial growth will lead to untenable spikes in the price of oil and copper and industrial materials that will then put a crimp on it" or that "there's too much loans being given in China to support the actual activity"—the fact is all of that could be true and the trajectory can still be incredibly rapid relative to the rest of the world, just as the trajectory of the United States from the 1890s to the 1940s was incredibly strong, even with the Great Depression. In fact, if you want to do a little historical rhyming again, China has emerged from this past economic crisis much stronger, just as the United States emerged from the Great Depression in World War II much stronger relative to the rest of the world.

Insofar as the United States remains innovative, dynamic, compelling, and a market that is both consuming and producing ideas that are tractionable and competitive, that relationship will continue, because right now China is not even trying to innovate at the level the United States is doing less of. I mean even less innovation and research in the United States is more than China is doing or aspires to do, because they're in the build-it phase, they're not in the creative phase. That won't last forever.

But it is a competitive advantage and it is a window that hasn't yet shut. So the more that our economy remains dynamic and innovative and creative and that we think about creating the markets and the products and the ideas and the worlds of tomorrow, the more that we will remain as competitive and dynamic, and therefore a necessary partner, just as the more China continues on its path it will remain a vital source of both market and ideas and capital for the United States.

Whether or not we are able to embrace that without perceiving it as a relative decline is a much more troubling question. And whether or not we will be able to act with the urgency that the rise of China demands is an equally troubling question.

For instance, in the area of green technologies, China decides "We're going to spend $20 million a month on green technology because we recognize that the environmental path of 1950s-style industrialization will be untenable sooner rather than later." For the next ten years China is on a path where they are going to use more and more coal and more and more industrialization, so they had better take that time while things are getting worse to lay the groundwork for things to be better and spend on solar and spend on wind and spend on everything else. Whereas we talk about green energy but it takes us 18 months to put $20 billion in toto, on the books, and another 18 months to disburse it.

Now, people will say, "Well, you know, we have a democratic system, and that means that we have to deal with all the inefficiencies of democracy, and China has the advantages of being an autocratic system." To which the answer is: "So? That's the world we happen to be living in. They have the advantages of an autocratic system."

Will we be able to act with urgency in the face of that? And that I think is the open question, and one that I don't think is answered, although I don't think the current seeds and signs are particularly hopeful. But we're not there yet, and this relationship is still far too interdependent for either side to do anything other than wish it weren't, which is a good opportunity to act with the urgency the moment requires, because I think still if that is done this relationship can continue to be mutually constructive. But if we don't, in my view, China will continue to do what China does, and the competitive ability of the United States to meet that will decrease and become increasingly difficult.

So it's a fascinating moment. I think it is as dramatic as if we had been talking about the rise of the United States 100 years ago, and how the United States, in particular, grapples with that I think will be the defining issue of what the domestic prosperity of this country is for the next generation or two.

Thank you very much for coming. We have some time for questions.

Questions and Answers

QUESTION:What are your views of a possible, although counterintuitive, new superfusion between Japan, China, and Taiwan?

ZACHARY KARABELL: It's a good question. Clearly, there is a fusion going on between Taiwan and China. There were some question marks about four or five years ago, but both Taiwanese politics and Taiwanese society have become so intertwined economically with China, to the point where most of its technology manufacturing has gone to the Greater Shanghai area, a lot of the capital infusions that haven't been American have been Taiwanese in the Chinese economy. I think there is an increasing recognition on the part of Taiwan that its economic future really lies with a fusion with mainland China. Whether or not that takes the form of the Hong Kong system—i.e., some autonomy with some joint integration—who knows? But it's on that pathway.

Japan is a really interesting one. Japan's economic growth for the past few years has been totally derivative of China. So when China was buying - because Japan imports [sic - exports?] more to China that it imports from China, so that China has a negative trade balance with Japan, because it sends power equipment and earth movers and high-end steel to China. So when China is building and buying, Japan is doing okay, and when China isn't, Japan collapses.

The problem, of course, is that Japan hasn't solved any of their domestic consumption issue. It's almost entirely dependent on how does China grow or not grow. There is much less willingness to cast their lot with China because of the historical pride and tension.

So I wouldn't hold one's breath about that kind of fusion between Japan and China, except for the fact that already Japan's growth is derivative and dependent on China. So there is a kind of de facto. But it is much less clear, particularly ten years down the line, if China does, which it's likely to do, make a lot of the stuff that Japan is making. It's not clear what Japan adds to that equation, because it's not really a market. I mean for all the discomfort of the United States being a market, the fact that it is such a vibrant market—even in a hobbled state, China's trade with the United States dropped 10 percent this year, so it's about where it was in 2007 or mid-2008, which is extraordinary if you think about what's going on in the world. Japan doesn't offer that. So I don't see that as much.

QUESTION: As you pointed out, China is going from a simple type of manufacturing base to one of high sophistication and basically getting it from the U.S., because they're investing in the United States with Chinese companies, either partially or solely owned by the government, and they're taking our technology, and we are training their people to be our competitors. Could you comment on where we're going, simply because we haven't got enough capital in this country to do the research and development that the private sector needs to grow, and we have a terrible job shortage and are losing our technical primacy? Could you comment on that?

ZACHARY KARABELL: On the first part, I would say we probably do have enough capital to engage in research. We just aren't using it in that direction.

QUESTIONER: [Inaudible]

ZACHARY KARABELL: Right. I mean there are a lot of constraints on our ability to utilize the capital we have as constructively.

But we also have cultural constraints in how we're using it versus how we're not. I mean you could make, I think, a pretty good argument for if we spent more money on research and development and on the next wave of things we'd probably also be creating more jobs long term, including government putting money in those directions—which we're trying to do, but it's a very slow, arduous, inefficient process. Again, not the best competitive advantage.

On the issue of to what degree is China essentially piggybacking and taking and draining from us in order to build, yes, there is in the past ten years a fascinating and disturbing global shift of capital, which is kind of an allocation of our money to the rest of the world, whether it's our money to China in the form of us buying their stuff or our money to resource-producing parts of the world in the form of purchasing oil and commodities, which has meant that the result of the crisis of the past year has been it's been a really bad time to be American labor, it's been not such a great time to be American capital, and it has been a really great time to be Chinese and Indian and Brazilian and Chilean and Australian and lots of other things. I mean they're going to write the history of the past year as the great—I don't know—what's the opposite of the Great Recession?—you know, "their great recession, our great advantage."

But on the competitive thing, to me what it is is a call for that a kind of innovation, because the amount of time that Americans in particular spend agonizing over the theft of intellectual property, the degree to which American companies go there and then like two weeks later they're making our stuff, kind of misses the point. I mean in an information technology world where ideas are relatively porous, most companies can't maintain an information advantage even with intellectual property regulations domestically, whether it's biotech and drugs having four or five years of patent and the fact that an Israeli company named Teva can back-engineer any drug anyway and generics are being produced hither and yon. It requires increasing effort to maintain that anyway.

Most companies now are saying, "Look, we've got like five years once we turn an idea into a product before that product can be made by somebody else without us seeing any money on the basis of it."

In China, rather than spending time focusing on "Oh my God, they're stealing our intellectual property," most companies that are quietly doing this kind of recognition that "Okay, we've got about five years. So if we partner with a Chinese company, whether we're GM or GE or anybody else, we've got five years where they're going to work with us." Often, these deals now require the transfer of intellectual property as part of the deal, which is the reason why you've got five years to innovate the next product, because the Chinese aren't even trying to innovate the next product. As long as you maintain that edge, you maintain the viable reason for being in that market, and if we don't maintain that edge, we have no viable reason for being in that market. That's just the imperatives of that.

I think some good companies are recognizing that, and I think a lot of them are still stuck in the "Wouldn't it be great if there were enough lawyers to enforce intellectual property?"

You know, the Chinese will enforce intellectual property when there are enough Chinese companies innovating who don't want other Chinese companies stealing from them. Until that happens, they're not going to do it.

QUESTIONER: We've exported jobs.

ZACHARY KARABELL: Well, again, I would say that we've been in long process of exporting jobs to other parts of the world and that a lot of the source of job destruction has also been efficiencies and technology. It's easier to rail against another country than it is to rail against a computer. There's a lot of drives that go into that.

QUESTION: Yesterday's New York Times had two seemingly contradictory articles relative to this. One was claiming that Europe is seemingly fracturing and fragmenting and breaking up and that the G8 is becoming irrelevant and there needs to be much more weight given to the developing nations, and therefore there's got to be G20 or maybe G30 or whatever. The same paper had an article saying that really the only two powers that matter in the world economy are China and the United States and there's got to be a G2.

I wonder whether any combination of these is likely to have an impact on the Chinese government, because its policies clearly are mercantilist, it clearly is following the practice of beggar thy neighbor in terms of its trade and currency policies.

At some point I wonder whether the leaders themselves might feel that it is in their own interest, not because the United States is pushing them or anyone else is pushing them, but it is in their own interest to accommodate the needs of their partners, whoever they are, rather than impoverishing them according to a mercantilist system.

ZACHARY KARABELL: Perhaps we should have a comment like, "Wow, I could have had a G8!"

I don't agree with the latter part of your contention, that it's a beggar-thy-neighbor policy. I think in fact between 2005 and 2008 China allowed its currency to appreciate nearly 20 percent and was on a pathway of a gradual appreciation of its currency, because it's very much in the Chinese government's interest to increase the purchasing power of China and of Chinese consumers. Although one of the consequences of that would be, if you really do see an appreciation of their currency, a desire then to utilize that money both in terms of domestic consumption but also purchasing assets and purchasing things elsewhere, including investing in the United States. When China has invested in the United States, some of those have been greeted with a sort of xenophobic paranoia that "Oh my God, China's going to come," and this is a sign of weakness rather than a sign of this is the kind of system we've created. There are echoes of the Japanese buying Pebble Beach and Rockefeller Center and Sony Pictures, all of which turned out to be such stellar investments. [Laughter]

So I think China actually does see it in its interest to gradually alter this balance, because I do think the Chinese are aware that you cannot endlessly beggar your neighbor without impoverishing yourself and that their pathway is deeply entwined with global prosperity, a fact with which they are uncomfortable, not at ease, and have their own cultural desire to, not beggar thy neighbor, but really go alone, build a market and shut off. That's the kind of Chinese cultural legacy. Although their investments in Africa and in Latin America in order to get resources comes from a kind of "Okay, we need to be enmeshed in this world because there's a lot that this world has that we need in order to continue to grow, including agricultural commodities and industrial commodities."

The problem is that when it becomes an issue of pride, it becomes a non-starter. So every time Americans get up and say, "You're playing unfair; you must revalue your currency," that's almost the guaranteed worst possible pathway to working constructively.

Part of what China's evolution demands is that the modes of public diplomacy are very different. You know, Americans tend to get out and make strong statements of principle, of an ideal version of the world that we wish to be in, and then end up being much more pragmatic, and potentially hypocritical, in actually dealing with the real world in private. The Chinese tend to be completely anodyne in public and only really engage in something serious in private.

So the public face of things is not the right venue to engage China, but it's the way in which we are accustomed to engaging. That's a real inhibition on both sides, because it leads to the inability to actually constructively discuss something, because we think if we do it their way we are weak and they think if they do it our way they are weak.

That is, I think, a difficult navigation. But again, it is something that we're going to have to get used to, because there's a lot of commonality there. It's often difficult to get to that.

This includes things like values and rights. I mean there is an assumption that China is just going to wake up in the next couple of years and, because they are prosperous, they are going to become democratic. And again, we'll see. But one of the great tests of the next ten years is going to be: Is this particular historical pathway that the West took—whereby liberalism, democracy, capitalism, and affluence were all part of the same magical broth—are those just a particular pathway based on a couple of hundred years of history? Do they represent anything eternal about human beings, or do human beings just need to be able to better themselves and the lives of their families and have some sense of personal autonomy, but don't necessarily need to vote and don't necessarily need to publicly speak about their government?

The test for China is going to be a decade from now, when the kids who grow up in China, who grow up in this world as normal—because if you're anyone over 20 in China, you have more personal freedom and affluence than you ever thought you'd ever have. You can own an apartment; you can travel; you can buy stuff; you can buy cars, you can buy Maseratis if you have the money, you can dream about buying Maseratis if you don't; you can play video games for ten hours—I mean good things and bad things that you couldn't do. But the generation that grows up with this as normal, are they going to like it, are they not going to like it; are they going to be like the 1960s generation in the United States, which grew up with greater affluence and security than any generation ever and we're pissed as hell? Is that going to be China? I don't know.

I know that's a bit tangential to what you were asking, but it kind of gets to the assumptions that we enter that relationship with and that they enter it with are often just that, assumptions about how the world is and should be. The more that we can actually just deal with the world as it is rather than the world as we think it is or should be, the more ability we're going to have to work constructively together.

QUESTION: Can you comment at all on the relationship of the Russian economy and the Chinese economy? Where is it going?

ZACHARY KARABELL: I think Russia really is a commodity basket case, meaning Russia survives when the price of oil goes above $80 a barrel and everyone needs iron ore and bauxite and all these other things, because Russia is engaged in absolutely no internal development other than being able to generate income based on its ability to sell, largely to China. So again, much more even than Japan, as goes China so goes Russia.

In fact, Russia is eventually still on a pathway toward complete Venezuelization, to make an adjective out of Venezuela. They don't invest in their own future production. The money kind of disappears into some pit of who knows where it goes.

So Russia is going to be big because it's big, but I don't see it as having much vitality in the future.

QUESTION: Would you please evaluate the significance of China's billion-plus population, in the sense that they can keep producing millions of Ph.D.s, anything they want. So potentially they're a threat. On the other hand, they have a huge rural population that they have to feed and whatever. And then, how do you compare this with India also?

ZACHARY KARABELL: It's a great question.

One, China has enough people who are still in poverty in rural areas that it can continue even as it moves up the value chain of a more wealthy middle class. It has a huge internal market of low-cost labor, which will be exhausted at some point, but not for decades.

Now, there are questions about China's demographic path and that, because of the one-child policy for the past years, that China will begin to age before it has become affluent enough, and that that will undermine it. All I can say about that is that every demographic projection and consequences thereof since Malthus have been wrong - which doesn't mean that they will not eventually be right; it just means that there's no great reason to believe that the perception of demography being destiny will hold any more substance in the future than it has in the past.

What's interesting about India, of course, is India has a more favorable demographic curve, in that it has young people now who will become wealthier and support an aging population. But India is still a much more internal economic story. China is a much more integrated economic story with the world.

I imagine we could be sitting here in years talking about India as an integrated economic story, but that lies—India has taken the path of "We will develop internally before opening up to the world commercially." China has taken the path of "We will open up to the world commercially in order to develop internally." Those are two different pathways, both of which seem to be viable right now and not competitive. So I think there is a lot to be said of both the demographic paths here. I don't think either is going to imperil this development, certainly not in the next decade or so.

I do want to end with one exhortation, which is that you buy a book, which is not a selfish exhortation because an author wants to be able to sell books. It's because books are one of the only things that are still actually made in the United States. So if you want to support the future vitality of this economy and this system, please buy a book, buy two, buy three—not for me, but for your country.

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