Matthew C. Klein is the economics commentator at Barron’s. He is also a former writer for the Financial Times, Bloomberg, and The Economist, and was once an investment associate at Bridgewater Associates.

In this discussion with Philipp Carlsson-Szlezak, Chief Economist of BCG and Managing Director and Partner, he discusses his new book, Trade Wars Are Class Wars: How Rising Inequality Distorts the Global Economy and Threatens International Peace (Yale University Press, 2020) by Matthew Klein and Michael Pettis.

This is a transcript of their conversation recorded on June 22, 2020.

Matt, let’s kick off with a high-level summary of the core thesis of your book.

Sure. So a lot of it’s in the title itself. Trade Wars Are Class Wars: How Rising Inequality Distorts the Global Economy and Threatens International Peace. What that means is that when we think of trade conflicts, the default presumption of many of us is that we think about them as being led by governments of countries against other countries. It’s about national interests, it’s about incompatible national characters or geopolitics. Our thesis is that’s not right. If you want to understand what’s going on with trade conflicts and the global economy, you have to understand class conflicts within these countries.

For example, Chinese government policies have been bad for U.S. workers, but they’ve been bad precisely because they’ve also been bad for workers in China. So, in other words, instead of thinking about this as China versus the U.S., it’s much more helpful to think about it as a large group of people in China versus a small group of people in China who are running the government and businesses’ elites. And in many ways, similar conflicts exist in the United States. So, you have complementarities of interests between the workers in the U.S. and China and between elites in the U.S. and China against many of the other people in their own country. That’s really the thesis of the book.

In terms of the economics of your analysis, I think you make a provocative argument. Essentially, you’re saying the U.S. Economy is a deficit economy with a large current account deficit, not because Americans want to live beyond their means, instead you say imports are pushed onto America by surplus countries, specifically China and Germany. And, importantly, you say that’s a structural condition, as inequality in both these countries is so stark that their workers can’t consume what they produce and the excess is pushed onto U.S. import markets. And importantly, their elites are dumping their savings in U.S. financial assets.

Two things flow from that. One is that imports are crowding out U.S. production, and you say the trillions of dollars that flow into the U.S. in financial assets are pushing down interest rates and that engenders financial bubbles and instability. As a result, global imbalances are a burden on the U.S., not a privilege of easy funding from the rest of the world. Is that a fair summary of the economics of what’s in the book?

Yes, absolutely. And of course those two phenomena, the financial and the real side, are necessarily complimentary. They have to go together. It wouldn’t be possible for imports to displace U.S. production and for Americans to keep consuming those imports unless there were also a corresponding amount of debt to finance that spending in excess of income.

Globally the real problem we’ve had is that there is more productive capacity available than is being used. So I’m not going to say that it’s people don’t want enough stuff, there’s plenty of unmet material needs. But there isn’t enough spending to actually generate the demand for those goods to absorb all the productive capacity. And so then the question becomes, who’s going to have the excess production that they can actually sell which will keep their factories running and their people employed? And then who’s going to end up just having a lot of excess capacity as a consequence of this, and then essentially absorbing other people’s excess production at the expense of their own?

And what we’ve seen is that essentially Europe and China — but other countries as well — have ended up being in situations where they have the underconsumption, but they don’t have the underproduction, at least not to the same degree. And they are exporting excess production, predominantly to the United States but to other countries as well.

So, let’s look at China first. Obviously living standards have been rising tremendously there over the last few decades. But your point is they should have risen by much more. So Chinese workers you say are consuming too little. Now, what is the key obstacle here? China has also recognized the need for rebalancing. Where is the “class war”, to use the term in your title, that is an obstacle to that rebalancing? Can you spell that out?

Sure. That’s a great question because as you note, the Chinese Communist Party has basically endorsed the thesis of our book and a lot of specific recommendations we have for them. An interesting question then is why hasn’t there been any progress on this? They have identified these things going back to 2007, at least. My coauthor on this book, Michael Pettis, who is really the China expert, argues that the development model the Communist Party introduced starting in the early 1990s, created an entrenched class of people who ended up benefiting tremendously. Whether it’s real estate developers or provincial local government officials or other kinds of business executives and so forth — those people, because of the wealth that ended up accruing to them, have a very strong incentive to not change the system.

And contrary to perceptions we have about China being a sort of very centralized system, and becoming more centralized under Xi Jinping, generally speaking it’s actually not. A lot of policy is administered at the provincial or semi-local level, and provinces are the size of European countries, if not bigger. A lot of power is diffused, so, it’s actually hard, relatively speaking, for the center to get what it wants on specific things and there are trade-offs they have to make. They might have some priorities and other priorities get subordinated and that’s a lot of the reason why, even people at the top, recognize the unsustainability of this model. Wen Jiabao famously said — and I think it was in 2007 — about how their growth was unsustainable and unbalanced and talking about all these things. They haven’t really been able to make as much progress as they should.

Moving on to Germany, the other empirical case study in your book, and another major surplus country. The conventional wisdom on Germany’s surplus would be a mix of technological prowess and cultural traits of thrift and fiscal discipline, to stereotype this a little. I believe you used the word “nonsense” at some point, instead you put it down to stark inequality in Germany. Just like with China, can you zoom in on the political economy and nail down the “class war” that you think underpins that imbalance in Germany?

Sure. Just to start off why I don’t think it’s about culture or anything like that — throughout the 1990s, Germany basically had a balanced current account with the rest of the world. Did German culture dramatically change in the 2000s? That doesn’t seem to be true. And then you can also break down what sectors are contributing: households, businesses, and the government. And household savings really haven’t changed much in Germany over time as the surplus rose. What actually changed was you had a massive decline of business investment and you had a massive increase in business profitability. So those two things interacted and that was what really drove the change in the trade and current account balance in the early 2000s.

That was a reaction to a couple of things. Throughout the ’90s, after German reunification and after the fall of communism in Central and Eastern Europe, and the integration of some of the CE4 economies of Czechoslovakia, Hungary, Poland into German and European supply chains — you had a situation where a lot of German companies were: A — losing money on operations and B — had a really attractive opportunity to move factories just a couple hundred miles to places that basically had not been part of the European economy until very recently. It was a very artificial division of where they were cut off, and also a lot of those people even spoke German. So, it was very easy for them to move.

What ended up happening was you had a sustained decline in employment in the West in the ’90s. The reunification didn’t work out nearly as well as people thought or hoped it would. You have this massive job loss. The people who are the most successful in Germany were from the southwest industrial heartland: the Stuttgart-Frankfurt area. They decided this was a chance for them to cut back on the German social security system. Unemployment benefits and retirement benefits had been extended to the East to discourage people from migrating to the West. They didn’t think it would be that expensive, and then it became very expensive. That was the underlying pressure for fiscal policy change. But even before that, you had wage cuts and a lot of Germans losing their jobs, as they were outsourced. Once you have the tech bust in early 2000s in Germany businesses essentially said, “Well, we’re not going to invest anything at home.”

But German businesses have, because of their past investments abroad, still ended up making a lot more money. Their profitability rises pretty dramatically. The net operating surplus of German companies, as a share of net value add, essentially the capital share, it went from like 25% to about 37% in the span of 10 years. It was pretty much just a straight line upwards. Now it’s come down a bit since then, but that coincides with dramatic stagnation in German wages — in fact a decline in real terms. Also the growth of the surplus, the trade surplus, which in fact, basically maps onto this increase in profitability. Because essentially if you’re selling mostly abroad and your customers are growing more than domestic demand is growing, then you’re going to sort of mechanically see an increase in your profitability because you’re not paying your workers any wages.

And that’s in aggregate what happened to the German economy. It’s not really anything about technology or superior productivity in Germany. Those aren’t the reasons why they have a surplus. That should be rewarded with higher wages for Germans, higher consumption, higher living standards, but that’s not what happened. You have wage stagnation, you have, in fact, contrary to the stereotype, infrastructure quality in Germany is quite poor. I mean, maybe it’s better than the U.S. but the train systems, the roads, the internet, all those things are much better in many other countries. And these are the kinds of costs being paid by ordinary Germans, even as very wealthy Germans have done quite well.

Moving on to the U.S., I think here it’s interesting to hear how you reconcile the fact that there’s stark inequality also in the United States. And yet the way it translates here is we’re seeing a massive deficit, not a surplus. How do you reconcile that seeming contradiction?

Yes, it’s a great question. Essentially there are countervailing forces at work. On the one hand, in a lot of ways, you look at the U.S. and you look at the changes in policy in the U.S., they’re very similar to both the situation in Germany and the changes in Germany. And so the interesting question is why did you have different outcomes? And I think a lot of it has to do with the sort of structure of both the U.S. financial system and the global financial system.

On the U.S. side, you have a system where the financial markets and bankers in the U.S. are and very historically have been adept at being able to innovate and create new kinds of credit instruments and direct them to customers. If there’s a demand for a new kind of bond or stock or whatever, they’ll find ways of generating it. And people say, “Oh, they want tech stocks.” They’ll generate all sorts of tech IPOs, maybe good or bad. People say, “Oh, we want safe mortgage bonds.” Wall Street can come up with ways of doing that. So that’s one thing.

A parallel to that is that the U.S. legal system is generally very open to global investment coming in and very protective of the rights of investors in a way that in some other countries might be harder for you to buy things, or it might be trickier. Also, English makes it very easy because everyone knows English.

And that’s why the U.S., like the UK, which is another example, can accommodate a lot of financial inflows from the rest of the world. So basically, if you have a rich person in China, or Africa, or Saudi Arabia, or wherever, they can say, “Okay, well, I know I can get a bank account in New York or a condo in Miami.” It’s going to be much more attractive to you than a lot of other options you’re going to find. So, to the extent that the U.S. becomes the magnet, that’s part of it.

Now, of course, this is also rolled up with the dollar as a global currency. That’s not unique to the dollar but the dollar is predominant. I think in many ways, it ties from all of these things. For example, if you’re a manufacturer in Thailand and you want to trade with a manufacturer in Vietnam or something, you’re both going to do the trade in dollars because it’s easier for you. That’s where your end customers are.

And therefore, if you think about it that way, then if you want to save some extra money, because of future costs, you want to save it in dollars. So that creates another reason why you have this sort of global demand for dollars. Part of it is that a lot of rich people in the U.S. can recycle it internally in a way that doesn’t necessarily happen in places like Germany or China, because of the way the financial system works.

Then the other thing is that you have this massive amount of money coming in from the rest of the world. And those flows are so large, and the U.S. financial system has historically been so effective at accommodating those flows that even though we should be a surplus country based on the internal income dynamics — we’re not.

So, you’re pointing to the dollar’s reserve currency status, the U.S.’s unique role in the global financial system. And yet I think we need to also ask, and you address that in your book, can we prove, or at least is there strong indication to answer the question of whether these flows are unsolicited or solicited? Whether there actually is pull for all that financial capital flowing to the U.S. or whether it is pushed into the U.S.?

This is the great question. We know that the transactions occurred, but who’s driving it? So the best we can do is look at it and say, “Well, what’s happened with the prices?” We know the quantities. So, what about the price? If the U.S., for example, were desperate for outside money, then you would expect that to show up in a whole bunch of different asset prices. But interest rates have to go up to attract money. You have to pull it in. Basically, you want to make investment attractive. And so, the way to make it attractive is you raise future expected returns, the way you raise future expected returns is you lower the prices of all your assets.

But that’s not what happened in the U.S., interest rates went down. Currency was basically flat. I mean, yes, there was a depreciation from 2000 to 2008, but on average, the currency was still, the dollar was much more expensive than it was in say the mid ’90s. Stock prices basically were quite elevated. Anything you can think of really. Obviously real estate was going up. So that seems to me to suggest it was an unsolicited inflow, push from the rest of the world, rather than being pulled in.

Now turning to the future, Matt, what can be done about this? China’s surplus has grown. Germany’s surplus that used to be pushed onto the rest of the Eurozone is now pushed onto the rest of the world. But ultimately there isn’t a way of telling other countries how to manage their income distribution. So what are some of the things that you think are most attainable in solving this intractable problem?

So that’s a great question. I don’t know. I mean, we have recommendations in the book for what we say is the optimal solution. The optimal solution is that in countries, such as Germany and China, that they do things that raise the incomes of the people who live there, which is good for them. And also will happen to, as a nice side benefit essentially, absorb some of the excess production and therefore help solve the general problem. How can people outside those countries really get them to do anything? And I don’t know. I mean, that’s a challenging question. The constructive solution is what I just said. The destructive solution, but potentially more effective at getting results, is essentially for the U.S. and other countries in a similar situation to refuse to accept the inflows from surplus countries.

And there are a variety of ways of doing this. I think the most effective way of doing it would be some sort of capital controls. And you’ve seen this a little bit in some countries, Australia and New Zealand and Canada, when it comes to housing. But housing is one thing and that’s an obvious situation where it’s just harmful for the local economy to have just foreigners bidding up houses that nobody’s living in. But if you want to be comprehensive, you’d really go after all foreign investment.

Now, I don’t think that’s the ultimate solution to this because really what you would do is redirect the underlying problem to somewhere else. Maybe you’d redirect it back to where it came from and that forces domestic reforms…that would be sort of the ideal. Or it just gets dumped on a third party. So I don’t think that’s sufficient. I think ultimately you have to address this problem of insufficient incomes for people who are being paid less than they produce. That’s the real problem. Raising global spending to absorb global production because, anything else you try to do is just going to redirect it elsewhere.

Apart from redirecting the problem, are we not playing with the architecture itself? So if we started talking about capital controls, sending some of those flows in other directions, that really goes to the heart of how the global financial architecture is built. The reserve currency status, welcoming those flows. I mean, those are more far reaching consequences than just a fix to the volume of inflows.

That’s true. And I mean, arguably, that would actually be a good thing. One of the points that we make is that the architecture has evolved. It’s not as if the U.S. dictated to the rest of the world and everyone is forced to use the dollar. That’s a common misconception. I mean, clearly it’s not better for most Americans. It’s better for some Americans, but for most Americans it’s not better. These are the function of choices of people outside the United States. The Bretton Woods system at the end of World War II — formally back when that dollar was deliberately placed in the center — was a time when the U.S. accounted for half of the global economy. And now the U.S. is about a quarter of the global economy. Relative to the rest of the world, the U.S. has fallen in size pretty dramatically. From one-to-one to one-to-three.

And so that means that the relative impact of changes in foreign demand for U.S. dollar assets or foreign, for that matter desire to borrow a dollar, or whatever — is larger. If it were something that U.S. was comfortable with in say the 1950s, and it turns out we’ve talked about this in the book that even if you go back to the 1950s, it was sort of tricky to balance the domestic needs of the U.S. national system with the global needs of the U.S. financial system. It was hard then, it’s going to be significantly harder now. I don’t know if the U.S. economy is going to keep shrinking relative to the rest of the world or not, but even if it stays the same size, it’s going to be difficult to maintain.

So, some kind of change in the architecture would be helpful. Whether that means going back to Keynes’s idea of having an international currency specifically for foreign trade, or if the Euro area, for example, were to make certain institutional reforms. Basically the ones we talk about and the ones I should stress that are fundamentally good for Europeans, that would make the Euro, among other things, more attractive as an asset for people outside the Euro to hold.

There are a variety of possibilities. You could have a sort of a multi-currency framework or you have a new international currency, but the current system of the dollar being at the center is very difficult for the United States to maintain. The rest of the world is going to be paying a price for it because we just choose to do what we want, or the U.S. pays the price or some combination where no one is very happy. So reform of that architecture is I think, necessary.

So as a final question, Matt, I noticed the book stops short of linking geopolitical dynamics and the risk of armed conflict. Global imbalances are a trade theme, a finance theme, but ultimately it’s also the foundation of geopolitics and the risks that lie there.

Yes. So, I think that’s valid. I mean, sort of the subtitle of the book, and it’s sort of an implied threat, is that if the global economic financial system does just break down and degenerate into anarchy, then it seems likely given historical precedent that the risk of an actual armed conflict between states goes up and certainly any goodwill you have between countries and governments would go down in this situation. And we’ve seen that in Europe. I mean, no one is talking about a shooting war between Southern Europe and Northern Europe, but clearly the sense of goodwill and belief in a shared project was definitely eroded over time through the sort of experience of the past 15 years.

It’ll be interesting to see how some of that’s changing in response to the coronavirus crisis. At least my reading of the attitudes with the way Germany has responded with more spending. Then there are other countries where it seems like it has not, the Netherlands, for example. But this idea of when you perceive these economic conflicts that have to do with the distribution of income as being about countries versus countries, that is going to naturally generate a lot of hostility. And that hostility might not immediately lead itself into armed conflict, but it certainly makes it relatively more likely than if you think that you’re actually on the same side of things. And I think that that’s definitely a risk.

So, does it have to lead to war? No, but, are the precedents for the total breakdown encouraging? No, they’re not encouraging either. So I think that there’s definitely a risk there. I think it should be one of the reasons why policy makers should really focus on trying to solve this problem.

Matt, thank you very much for sharing your thoughts today.

Thanks so much for having me.