Viewpoints

There's an interesting article in today's July 7 South China Morning Post that has far-reaching implications for China’s efforts to stimulate its economy and its imperative to strike a trade deal with the U.S.: "China urged to take bolder steps to tackle price wars, deflation and weak demand". The article reports that China's Central Financial and Economic Affairs Commission, the Communist Party's highest economic policymaking body, has identified "disorderly low-price competition" as a substantial negative, and argued for the need to end the cycle of mild deflation and weak demand.

This officially acknowledges that China's domestic economy remains quite weak, well below where China's leaders’ desire. The article also implies and describes how Chinese leaders rely on central command efforts to manage and guide the economy, rather than market forces. Their policies created the excesses in real estate and China’s economic slump, and are now inhibiting the recovery.

One important issue created by China's weak domestic demand is the admission by its leading policymakers that the trade war with the U.S. imposes a heavy negative weight on China. As the article states, the ongoing trade war with the U.S. "could further intensify China's "involutionary dynamics", an awkward term used to describe what its leaders perceive as intense and self-defeating domestic competition. While its leaders understand that the basics of market supply and demand work to affect economic outcomes, they rely on central control, directives and coercion to achieve desired economic and social objectives. This generates inefficiencies and undercuts the government’s credibility, as Chinese citizens understand the shortcomings of the policies. China is extraordinarily good at certain things—it is a true world leader in efficient manufacturing, with striking advances in high technology, including AI. But its Communist dictatorship that eschews free markets and U.S.-style capitalism undercuts China’s economic performance.

In 2021-2022, I argued that China's strong growth was unraveling, and its economy would weaken sufficiently to challenge its role as global leader of economic growth and trade (China Is About to Fall Into the Middle-Income Trap, October 26, 2022). In 2023, after China's real estate excesses had crumbled and major land developers had filed for bankruptcy, I argued that the Chinese economy would be in the doldrums for many years, similar to Japan's following its asset-price bubble in the late 1980s and the U.S. following its debt-financed housing bubble of the early-2000s (China’s Bill Comes Due, September 19, 2023). All of that is now unfolding, as western companies and nations reduce their supply chain exposures to China.

At least two implications seem clear. First, while China is a tough global negotiator, it clearly would benefit from a favorable trade agreement with the U.S. that would lower tariffs and trade barriers on their imported goods. Doing so would be a plus for China, the U.S. and global trade. Second, similar to Japan's and the U.S.'s historic experiences, China will have to stimulate its domestic economy through increases in deficit spending to lift consumption and businesses. As China stimulates, it will provide interesting investment opportunities in its stock market.

Mild deflation and domestic demand. China is experiencing mild deflation: its GDP deflator has been falling since the third quarter of 2023 and the year-over-year percentage change in its CPI has fallen for four consecutive months (Chart 1). This is a direct reflection of insufficient domestic demand relative to productive capacity. The Chinese leaders’ public allegation that the deflation is due to destructive price competition is misguided by ideology and misleading.

It’s hard to provide a clear numeric analysis because the China’s National Bureau of Statistics (NBS) provides statistical data that are not reliable, and occasionally stops providing the data public, or changes its definition, if the trend of the data is inconsistent with the objectives of the Communist Party. Its official data on GDP growth are far too strong to be realistic with its components and economic logic.

Three trends are clear: 1) China’s mild deflation is a direct result of insufficient domestic demand, 2) the weak demand stems from the earlier excesses in real estate that have unraveled and severely harmed household balance sheets and forced consumers to save rather than spend, and 3) residential real estate remains in the doldrums, with low expectations, despite government efforts to stimulate it.

Prior to and into the Covid pandemic, at the direction of China’s leading economic policymakers, different layers of China’s government pumped up real estate investment through a variety of equity and debt schemes in an ongoing effort to achieve unrealistically high GDP targets. This worked to stimulate robust economic growth and boost local government finances and create an upward spiral in activity, real estate development and prices and household net worth. But the strategy relied on expectations that home values would keep rising. In this regard, the role of home price expectations in China’s real estate boom were strikingly similar to those in the U.S. during its debt-finance housing bubble in the early 2000s, and Japan’s asset price bubble of the late-1980s. Chinese citizens came around to realize the excesses beginning in 2021, and once home price expectations started to erode, they collapsed.

The government scheme unraveled, and left a huge negative gap in China’s household net worth, the largest portion of which was in real estate (estimates ran as high as 75%, more than triple the U.S.’s current 22%). Mirroring Japan in the 1990s and the U.S. following the collapse of its housing bubble, China’s households raised their rate of saving and cut spending to replenish their balance sheets. Many Chinese businesses similarly suffered, including those in land development activities and others that had relied on loans collateralized by real estate. This followed the same pattern as Japan in the 1990s and the U.S. through and following the Great Financial Crisis.

Unlike Japan, which denied it had a problem through much of the 1990s and allowed zombie banks (those that were effectively insolvent) to continue making loans to keep inefficient companies afloat, China quickly acknowledged its problem, but underestimated its severity, and addressed its economic malaise too tentatively. In addition, it tried to directly manage household behavior to try to lift the morbid housing market. For example, some local governments forced select government employees to buy homes while constraining any declines in home prices. Such non-market strategies have had only limited success, harmed credibility and have inhibited rather than facilitated the necessary adjustments that would stabilize real estate and lead to recovery.

One tell-tale indication that the economic recovery is tentative is the ongoing negative expectations of home values. Current data show that residential real estate prices continue to fall (Chart 2) and no leading cities are experiencing an increase in home values while 100% are showing prices that are flat or declining (see Chart 3). Until expectations of home values turn up, households’ propensity to spend will be constrained.

The healthiest way to generate a positive sustained improvement in home values is to stimulate aggregate demand in the economy that boosts consumption and increases jobs that results in rising demand for housing that will absorb excess inventories. This requires a significant increase in deficit spending. Both Japan and the U.S. incurred large increases in government debt and sustained periods of zero interest rates to stabilizing their real estate sectors.

Chinese leaders already face high debt (in various government levels and artificial entities such as Local Government Financing Vehicles) and are reticent to take on more. (Another way to reduce China’s housing excesses would be to destroy a massive number of vacant apartment buildings, but that would harm government credibility and be anti-growth…remember President Obama’s “cash-for-clunkers” which offered financial incentives to people who had their motor vehicles destroyed in an effort to stimulate energy-efficient cars?)

President Trump’s misguided tariffs come at a particularly bad time for China. In 2018, when Trump first imposed high tariffs on China, its economy was strong and its leaders confident. Now, China’s domestic economy is weak. It relies heavily on exports for sustaining growth in its high wage manufacturing sector. It can only sell overseas so many EVs. While China’s exports to non-U.S. trading partners have picked up, its exports to the U.S. have fallen sharply since 2023. Importantly, China relies heavily on its high value-added exports of high-tech materials and components to the U.S., including computer chips and smart phones.

Trump has placed a deadline of July 9 for imposing higher tariffs, but at this writing is indicating that deadline may adjust to August 1. Trump likes negotiating deals and likes to be popular. As I have emphasized, this is a terrible approach to conducting economic policy. But China’s domestic dilemmas make it open to negotiating with the U.S. to lower tariffs and trade barriers. The result—backing off from Trump’s threats and lowering the U.S.’s average effective tariff—would be a positive and is expected within a month.

Is the US economy on the verge of entering a new phase of "American Exceptionalism," or is it approaching the edge of another financial crisis?These two perspectives represent the extreme ends of potential outcomes. Certainly, the economic outlook for 2025 is not grounded in strong fundamentals, as it was in 1995 when America embarked on a long period of "exceptionalism." However, there are some parallels to 2005 (excessive risk-taking and borrowing) that culminated in a significant financial crisis.

Between 1995 and 1999, over a span of five years, the US experienced an average real GDP growth of 4% per year, a feat unmatched since the 1960s. However, even more remarkable than this growth performance was the fact that America settled its "current bills," concluding that period with a balanced budget, and didn't pass legislation that increased future deficits.

In 2025, the US is experiencing minimal growth and facing a budget deficit projected at $2 trillion, suggesting it is not covering its "current bills." Furthermore, Congress's passage of the "Big Beautiful Bill" (BBB) adds an additional $4 trillion over the upcoming decade, leading to an anticipated cumulative annual deficit nearing $25 trillion for the next ten years, as reported by the Congressional Budget Office. When it comes to federal borrowing, 2025 is fundamentally different from 1995 and the years that followed.

However, 2025 resembles 2005. In 2005, American households borrowed trillions to purchase primary and secondary homes and took out additional home equity loans to fund their spending. Likewise, in 2025, the US government is borrowing unprecedented amounts, not only for the present year but also increasingly for the next decade, to maintain and support the economy's growth trajectory.

As house prices declined, the excessive risk-taking and leverage by households resulted in a series of adverse effects on the financial markets and the economy. While the federal government has more borrowing options and capacity compared to the private sector, it is not limitless.

In 2009, Kevin Hassett, who is the White House Director of the National Economic Council, co-authored an article titled "The Deficit Endgame" for the American Enterprise Institute. In this article, the authors noted "countries most at risk of defaulting on their government debts were those heavily dependent on foreign capital flows to finance their government deficits." The authors also that high levels of domestic debt could and have led to defaults.

The US fits both of these descriptions; it is heavily reliant on foreign capital and operates with a current debt-to-GDP ratio well above the thresholds that have led to previous sovereign defaults in other countries.

Financial markets currently perceive a very small risk of the US entering the "default bucket," unlike with other countries with a similar debt profile. However, the potential for another credit downgrade might change this view or at least raise funding costs. In April, S&P Global Ratings, mentioned that "the outcome of forthcoming fiscal negotiations...will be a key factor in our assessment of the US fiscal profile." The approval of "BBB" by Congress represents "fiscal expansion" as opposed to the "fiscal consolidation" typically preferred by credit ratings, which increases the likelihood of a credit downgrade.

Two decades ago, the notion that home prices might fall was unimaginable for households, as a nationwide decline had never happened, nor did they anticipate challenges in refinancing their debt. Similarly, it's difficult to envision the US government being unable to roll over its debt. However, this scenario can occur at any time, often triggered by factors like the financially reckless 'Big Beautiful Bill'.

Last month, we had the opportunity to travel to China as part of a high-level UK delegation of companies and policymakers.

Over two weeks—starting in Beijing and traveling by bus, train, and plane—we visited Shandong and Zhejiang provinces. Along the way, we engaged with senior government officials and met with dozens of leading Chinese companies operating in energy, AI, robotics, healthcare, and biotech.

Three Key Takeaways

1. China Is Back in Business

As we’ve written before, a primary concern post-COVID wasn’t just economic indicators—it was the deep sense of risk aversion that had taken root in the corporate sector. Years of regulatory crackdowns, state intervention, and surveillance had stifled the entrepreneurial energy that once propelled China’s meteoric growth. Even financially strong private enterprises were hesitant to act.

The turning point came in February, with DeepSeek. President Xi Jinping—ever the pragmatist—appears to have recognised that revitalising the economy, pushing forward with “Industrial Revolution 4.0,” and achieving “common prosperity” were not possible without the private sector. DeepSeek, a symbol of private-sector innovation, marked a pivotal moment. The publicised meetings between Xi, senior officials, and industrial titans sent a clear message: the private sector is once again central to China’s economic vision.

This shift was palpable during our visit. The government is stepping back from direct economic management and focusing instead on creating strong incentives for investment. Priority sectors include next-gen technology, biomedical innovation, EVs, advanced materials, smart equipment, and clean energy. The goal is to harness AI and digital tools to modernise manufacturing across all company sizes.

2. Geopolitics and Trump’s Trade War Are Reshaping Alliances

Europe is looking East. As we’ve previously argued, Europe stands to lose the most from a Trump 2.0 presidency. His aggressive trade policies, unilateral stance on Ukraine, and NATO funding demands have strained transatlantic ties. Europe can no longer rely on the U.S. for security or technological leadership.

China, on the other hand, is indispensable—especially if Europe is to meet its net-zero goals. China leads the world in green technologies: from EVs and batteries to solar, wind, and energy optimisation. Chinese firms produce 70% of global EVs and 80% of batteries. A new EV rolls off the line every 76 minutes—built by just 100 people and robots. Xiaomi’s YU7 EV can charge from 10% to 80% in 12 minutes, delivering 620 km of range in just 15 minutes of charging.

The AI gap with the U.S. is narrowing, and China’s expertise in applying AI to manufacturing and energy optimisation is advancing rapidly. China is also home to some of the most cost-competitive manufacturers in the world. One standout was Unitree, a robotics firm we met that sells factory-ready robots for as little as $16,000.

Engagement is becoming essential. While national security concerns persist, economic cooperation with China is becoming a necessity for Europe. Meanwhile, China is actively courting new partners. Across dozens of business meetings, Chinese firms were eager to collaborate, expand overseas, and welcome UK investment.

Foreign companies remain vital to China. We were told that foreign firms account for 13 million jobs, a third of tax revenues and exports. In Beijing alone, there are 49,000 foreign enterprises from 16 countries. New foreign-funded company registrations rose 16% year-on-year in 2024.

Still, the data shows a recent cooling in inbound FDI. Post-pandemic uncertainty, domestic policy shifts, and geopolitical tensions—especially Trump’s trade war—have caused FDI flows to drop to $18 billion in 2024, their lowest since 2009 (Figure 1). It's no wonder China is accelerating reforms to attract foreign investors and level the playing field.

This is extremely embarrassing and a deceptive act by the WSJ editorial team. The current budget baseline relies on what is explicitly stated in the tax code, not on assumptions. According to the existing tax law, individual tax rates are set to return to pre-2017 levels in 2026. That is a fact. Where is written that "Congress was never going to allow" individual tax rates to revert back to pre 2017?

If the "Big Beautiful Bill" (BBB) is projected to save $500 billion over the next ten years, as stated by the WSJ editorial team, then why does the BBB include a provision to raise the debt ceiling by $5 trillion? The WSJ editorial team, similar to members of Congress, is currently engaged in using deceptive "budget math".

However, this will not fool global investors or credit rating agencies, who will soon confront a US debt approaching $50 trillion.

The Federal Reserve Bank of Philadelphia’s state coincident indexes in May were generally lackluster. In the one-month changes, Kentucky’s index did rise a reasonably hefty .71 percent, and Indiana, Idaho, New York, and South Carolina had increases above .5 percent. In contrast, 10 states saw declines. These were spread across the nation, with Massachusetts down .52 percent. Over the three months ending in May seven states were down, with Massachusetts on the bottom (down 1.0 percent) here as well. Indiana’s 1.71 percent was the largest gain, while 6 other states had increases above 1 percent. Over the last twelve months, Massachusetts, Michigan, and Iowa were down, and seven others saw increases of less than one percent. No state had an increase higher than four percent (Idaho was up 3.62 percent), and only four were at or higher than three percent.

The independently estimated national estimates of growth over the last three and twelve months were, respectively, .62 and 2.40 percent. Both measures appear to be a bit weaker than the state numbers would have suggested.

State real GDP growth rates in 2025:1 were weak, ranging from -6.1% in Iowa and Nebraska to 1.7% in South Carolina. Farm output is estimated to have dropped sharply in the nation’s midsection, which explains very weak numbers in the Plains (in reality, of course, excluding seasonal adjustment, farm output is minimal in that section in the winter and estimates are problematic). Other areas were soft, most notably the Pacific Coast and the Northeast (a pronounced drop in financial output weighed heavily in New York, for instance). It is, of course, a bit hard to blame losses in output in Plains state agriculture on the surge in imports, which adds further to the puzzle of understanding the national GDP decline.

Personal income was stronger with growth rates ranging from Washington’s 3.2% to North Dakota’s 12.7%. In this case, the Plains states were the leaders, greatly aided by higher federal payments to farmers. Increases in transfer payments were unusually rapid, in part reflecting the annual Social Security COLA, as well as ACA tax credits.

In recent months, I’ve been exploring how deep structural constraints—on labour, capital, and above all, energy—are reshaping the world economy. What’s become increasingly clear is that we’re moving away from the familiar rhythm of demand-led recoveries and into something more constrained, more structural. Growth isn’t just slow—it’s bumping up against hard supply-side ceilings. Some of those were pandemic-induced. Others were physical. Many, increasingly, are ecological.

Arguably at the heart of that shift is energy. Not as an afterthought or cost input, but as a binding constraint. As I’ve written before, energy isn’t just another factor of production. It’s the factor that makes all other inputs productive. Without energy, capital is idle, and labour is inert. But to understand the full extent of this transformation—and where it’s leading—we need to look beyond energy itself, to the natural systems that support it.

State labor markets were very little changed in May. No state reported a statistically significant change in jobs. Three states (Iowa, Massachusetts, and Virginia) had statistically significant increases in their unemployment rates, while two (Indiana and New York) had statistically significant declines. None of these moves were larger than .2 percentage points. The highest unemployment rates were in DC (5.9%), Nevada (5.5%), Michigan (5.4%), California (5.3%), and Kentucky (5.0%), though Kentucky’s rate is not deemed statistically different than the national average of 4.2%. Hawaii, Montana, North Dakota, South Dakota, and Vermont had unemployment rates under 3.0%, while South Dakota’s 1.8% was yet again the lowest in the nation.

Puerto Rico’s unemployment rate was unchanged at 5.5% and the island’s job count moved up by 2,000.