‘This Is Something That Traditional Economics Isn’t Prepared to Deal With’ | The Ezra Klein Show

Thanks so much for having us.

Yeah, thrilled to be here.

Um, that's actually a really tough one, which probably says something about this moment in economic history, which is no one really knows anything. Uh, you know, we had these tariffs that came in and everyone was expect—not everyone, but many people were expecting those to have an inflationary effect. We haven't necessarily seen that, even on things like unemployment, but a lot of people have been concerned about a recession for ages now and that just hasn't materialized. I think a lot of the sort of traditional economic thought that should dictate how things develop and unfold isn't bearing out. And so I would describe the economy as unexpectedly chaotic. Perhaps it's just not acting the way a lot of people thought it would in the current situation.

Yeah, there's a layer of policy chaos built on top of an economy which seems surprisingly resilient to that chaos.

I remember Joe Biden recession. There were so many imminent recessions and I think everyone's just very gun-shy right now about calling anything. We also have this sort of weird thing with, you know, understanding the economy is murky in the best of times. Then layer on to the fact that data collection prior to the government shutdown has been getting worse and worse response rates to government surveys. Then you figure, okay, during the shutdown, you know, they impaired the data collection process on top of that. So you have this other multiple—I don't know, error bands is maybe how you would present it—and then the underlying economy itself, let's say we had this clear snapshot, then you have this very strange economy where we know there is this one sector of the economy that's doing absolutely phenomenally well, which is AI and other tech-adjacent things, and then the other areas that probably are sort of stagnating, maybe a little like stagflationary vibes. So even if we had a very clear picture, let's say we had great response rates in all of the surveys and they had been running and we hadn't have a government shutdown, this is just a very strange underlying condition. So levels and levels and levels of uncertainty.

Yeah, absolutely.

Yeah. So, that was a crazy week for obvious reasons. Sort of capital H history being made. I think the surprising thing to everyone was the actual rollout of the tariff announcement and just how unstructured it seemed to be in many ways. In this idea that, you know, we were going to impose tariffs on small islands, um, you know, out in the like in Oceania, who's the penguins, right, and whose only export is like bat guano or something like that. Um, it just didn't make any sense. And you know, markets don't deal with uncertainty at the best of times, and this was like a boatload of uncertainty being dumped onto the market. So, you saw this huge reaction. What was even more surprising is that the market recovered so quickly. We spoke to a lot of businesses back in sort of April and May and asked them, 'How are you dealing with the tariffs?' And we heard, for instance, from a women's clothing company saying, 'It's been absolute chaos. We don't know what's going to happen this year. I'm supposed to be putting orders in for the winter Christmas season. I don't know if I can actually do that with my suppliers in China. I don't know how much to order.' And yet, fast forward to now and things seem to be ticking on relatively well. The big question is going to be whether or not that's an overhang from, you know, earlier periods in the economy. People have already bought a lot of stuff. You know, they stockpiled inventory coming into tariffs. So maybe we're still living through that hangover in many ways. And maybe at some point all that uncertainty, which you would presume would cause businesses to invest less in their own companies, maybe eventually it'll hit.

This is cool, isn't it?

Yeah. I love this.

Yeah, absolutely. So this is a chart of the US average effective tariff rate since the beginning of the year till now. And at the start of the year, I mean, the US was a truly like—it was an open economy. We had very few trade barriers. It was less than 5% on average. Probably looks like it was somewhere close to 2%. Then obviously when we start getting those initial tariffs on Mexico and Canada and then of course Liberation Day in early April, nearly 30% effective tariffs across the board. And then of course we started getting the deals and the carveouts and the bilateral arrangements and we've settled in this area that's a little bit, you know, somewhere between 15 and 20%. But we are now a very high tariff country. I think if you had taken those first numbers seriously, people would have looked at them as like, no, we just can't trade at these levels. With the modifications, they became, I think, tolerable. But I think like the way I've been thinking about the tariffs is this is like on the one hand you might say, okay, tariffs are inflationary, right? They raise the price of goods, that's inflation. Another person might say tariffs are disinflationary. Tariffs are a tax historically and most economists would say that when you raise the tax on things, you're taking money out of the economy. That's disinflationary. So you could actually very—it's kind of, you know, to add to this uncertainty, you could make both arguments. The way I conceive about...

Yeah. Because you're taking money out. You don't have that money to—so it's a tax and so it's disinflationary. I think the way I resolve the tension in my head is not to think about inflation versus disinflation per se, but just to think about this idea we have raised the cost of doing business in the United States. That's—I think we could safely say. So Tracy mentioned we talked to a women's clothing retailer. We were also in Alaska this summer and we talked to this guy who runs—who owns the biggest furniture chain in Alaska, which is really fun. And he was talking about how, okay, we're going to find a company in India that manufactures this couch or chair instead of in China. So they find workarounds, which is why trade hasn't come to a halt. But that company in India, maybe they don't take as many orders as previously because they're worried that by the time that couch gets to the port, that maybe the tariff schedule is going to be different and then the person doesn't want to take the—the importer doesn't want to take delivery of it at the new tariff rate, etc. You know, when it all shakes out, like inflationary, disinflationary, we don't really know, but you like add up all of these factors, it's going to make uncertainty about sourcing decisions. It's going to change your pricing. You don't know about how consistent you're going to access your goods. And so I think in the end it raises the cost of doing business or, you know, it throws sand in the gears, so to speak, of the economy in ways we may not feel for a long time but which may over time sort of degrade the economy or degrade our standard of living.

Why? Uh, it's an excellent question. So one thing I would say is first of all a lot of that hyperbole that we heard about empty shelves and things like that was right after the tariff announcement, right? And so there's still a debate. Had you stuck with those levels, maybe we would have seen that. But even where they settled at the higher rate, actually if you zoom out on that chart and go back to the 1930s, we're at the highest effective tariff rate since the Great Depression basically. So you're right. This is really surprising. I think one of the things that's happening here is there's a tendency to oversimplify, um, I guess, the business environment. You know, people think there's a company in the US that imports stuff from a supplier in China and that's all that happens. That's like the way things actually get into my house. But of course, there are all these middlemen entities in between that process. And so what that means is you actually have, you know, a pretty diverse cushion to absorb some of the tariff costs and maybe even some of the operational issues. So, you know, you'll have the shipping company, maybe the shipping company lowers some of their rates in order to encourage business. You'll have an actual importer who's bringing that stuff and then selling it wholesale. Maybe they'll start reducing their prices to offset some of the tariff rate. And so, if everyone is sort of giving up a tiny slice of that value chain, then the impact on prices can end up being a lot less than you expected. One thing I really appreciated or really realized after the COVID shock specifically, American businesses are really good. Like they're really well-run. Like, oh no, we're going to like figure out a way to turn this restaurant into an overnight commercial kitchen for delivery. And we saw this incredible amount of like resilience during that period. We saw a tremendous amount of like companies figuring out, okay, what do we have and how can we keep operating during these extreme conditions. And I don't know, like I have come out of the last five years with a greater admiration for the creativity and resilience of corporate America to like withstand these shocks and management and executive teams essentially finding a way to very quickly pivot and figure out how are we going to keep running our business under this new uncertainty.

That's right.

But I do think, not to be super negative, but I do think we shouldn't downplay the impact on productivity, right? Because there are a lot of man-hours being devoted to figuring out the tariff schedule, maybe figuring out how to game it a little bit, and then filling out paperwork at the docks and stuff like that. And I don't know about you, but I shop a lot. I bought something from the Netherlands, um, in September and I never got it because the shipper said they couldn't figure out how to mail to the US and who would actually have to pay the tariffs. I ended up getting into a credit dispute with them. Yeah. And anyway, it took up a lot of my time basically. Yeah. I still don't have the item, but...

We get so much content from Tracy. We get so much from Tracy's daily life, we get a tremendous amount.

But that's like one thing, right? So imagine this multiplied by millions of things across various companies. It's a lot of hours, a lot of manpower.

This is the funny thing where I know it's so funny. We're talking about tariffs for all these minutes or for so long as if it was just something that happened. But to your point, there was ostensibly the idea was that it was going to make the economy better. We chose to do it, which makes it very different than the pandemic. Obviously, I have seen no evidence that we have seen some gain from it. None. There has not been some great boon for the American workforce. It's like, okay, we have to, you know, we know that unemployment has been ticking up. Yeah, it is true that revenue had, you know, they're collecting a decent amount of revenue from the tariffs. That is real. But like the idea that that is somehow obviously redounded to the benefit of the American consumer or home buyers or something or whatever made the, uh, you know, our deficits more sustainable per se, I haven't seen any evidence of it. So like in terms of the good, I don't know, like...

Well, there's also a major policy tension, right, where Trump was claiming that this isn't going to have an impact on prices. Your prices are going to stay the same. It's not going to slow down the American economy, etc. But then he was also arguing that this was going to be a huge revenue generator for the US government. You can't have both, right? You can't charge people a bunch of money and raise a bunch of money and expect not to be taking people's money, right? It has to come from somewhere.

Yeah. So it is true that competing with China is one of the few areas of bipartisan agreement at the moment. I think everyone feels this sense of competition, but what China has actually been really good at is creating ecosystems for certain products and industries. So for instance on the rare earth side of things, you know, we hear all the time that rare earths are a major choke point for the US and there are worries that China is going to cut off supplies. The way China has approached that industry is they have mining extraction—again, probably benefits from a lack of environmental regulation—but they've also built manufacturers and then they have a very vibrant, you know, EV industry, computer industry that's built around that rare earth supply and is there to offtake the supply, to actually consume it. It's very hard to replicate those types of ecosystems on a short time frame.

Well, we don't know. That's the thing, like we don't really know where the White House stands on the—the question you posed is the entire trade war about isolating China? Because that was sort of one view. The US is not the only country where people have very serious concerns about manipulation or the effect that Chinese manufacturing has on their own national champions and so forth. Like all the anxieties that we have in the US, they're shared by plenty of other countries, and not just Europe, elsewhere in Asia, South America, so forth. But like we don't really know. Like there are China hawks in the administration that clearly feel like, oh, this is like an existential threat. Trump himself is like—Trump, who arguably more than any American of the last decade or whatever is responsible for the sort of massive national turn towards, uh, on China, may be one of the least hawkish members of the administration when it comes to China. He clearly has a lot of admiration for Xi Jinping. I think he likes him. Um, like he may think it's unfair, but he clearly like does not hold it against China. He clearly sort of admires the fact or appreciates the fact that the various strategies that the country has undertaken were done in pursuit of the national interest, which he seems to, uh, think. So I don't think we actually know. And again, if you're going to do this isolate China strategy, then you really—or I would say intuitively—you want to have as much trade as possible with the non-China world. Really like destroy any barriers. And we've, you know, this is a bipartisan thing. You know, the most frequent guest on our show who's been on more than any other time, the economist Brad Setser, he's been talking for years about how, you know, the US and Europe really need to form some coherent trading block such that the economies have the market scale to compete with China, but we haven't done that. So, I don't think really we know where this administration views these sort of tensions with China in part because I think it's divided.

I mean, I think there's definitely an element of erraticism. Is that a word? Erraticism when it comes to the Trump administration's policy, and it gets back to that tension, you know, between alleged policy goals. Again, if you're really worried about the US deficit, are tariffs the best way to actually generate money for the US government? Probably not. Which then begs the question of, well, why are we doing this? I guess if you were going to be very, very cynical about it, you could argue that Trump really likes deals because it gives him those short-term wins and those short-term headlines, right? People forget things fairly quickly when it comes to the news flow. And so if all they see is the US strikes a deal with China, um, you know, the US is bringing China to the negotiating table, people forget all the chaos that it took to actually bring us to that moment. I do think with China in particular the rare earths thing was really important. I think there was a sort of...

Sure. So basically China said, okay, you're going to tariff us at 50% or whatever. We're going to cut off the supply of magnets that are used in lots of batteries, um, computers, things like that. And I think that sparked an element of panic among the type of people that Trump listens to. Right. So we're talking business executives who are thinking, well, this is an incredibly important component for my particular business. I can maybe get some of it from elsewhere in the world, but certainly not at the cost and scale that I've been getting it from China. So, China has done a phenomenal job of basically putting itself right in the middle of a crucial choke point for the entire global economy. And they were able to use that to their benefit to reduce the tariffs. They didn't get them all to zero, but they brought them down a lot.

I mean, I think look, I do think Tracy is absolutely right that, um, the rare earth specifically, to some extent because of our vulnerability there, may have undermined the entire like prosecution of the trade war, so to speak, because it's so specific. But to your—like—and so arguably, yes. I think though, to your question though, I think that offers such an important insight into how he thinks. The idea of like a strategy or a policy is abstract, right? Whereas a deal is him—a deal is something that he could shake the hand of someone else, that is real, that is tangible to him. Whereas yes, whereas all this other stuff, what we call what is our long-term strategy, it's abstract, it's depersonal, it's not the way—I do not think this is the way Trump conceives of government.

If you're going to ask us to explain it, we're going to struggle. See, you know, the David Sacks argument is that the important thing is that Nvidia, the American chip company, remains the dominant infrastructure for the development of AI. And I don't find that to be completely unreasonable. I don't find that to be a completely absurd argument. So there's the—on the one hand, dominance of AI. The question is like, well, who is developing? Who is at the front? Who is at the edge of developing models, right? That's certainly one way of measuring who is at the frontier of AI. But I think it's totally—it does not strike me as per se crazy to redefine the question of the AI race as who has the—on what, on whose chips and on whose software architecture will all AI models be built in the future. I don't have like a view on like which is right or wrong. I'm just saying it does not strike me as necessarily absurd, that view, that it is a win if everyone is using the chips of an American design. On some level, I disagree with the view, but I don't think it's absurd.

I mean, I think that's right. And I doubt anyone in the Trump administration was like, 'Okay, we need to change our approach right now. We've had this big, you know, realization.' Um, what I would say, if you think about how China views the sort of technology competition with the US, the thing that comes up quite a lot domestically in China is, have you guys read The Three-Body Problem? Or okay. There's a pretty good Netflix... I started it. Uh, very brief synopsis, but, um, you know, aliens are threatening Earth and basically all of humanity comes together at some point and develops technology to get rid of the aliens. It definitely does, but you know, we don't have that much time, so I'm shortening. But like in China there's this idea that, you know, you can think of it as a Sputnik moment or whatever, but if the US completely cuts off the country from global technology, then China is going to accelerate its own technological development and basically do everything that the rest of the world does probably more cheaply and at better scale. And so that—that was a concern that we saw starting to bubble in the Biden administration when they toughened up the initial chips development. You know, we—or sorry, when they toughened up the initial restrictions on chips, we saw China start to, you know, allegedly produce some pretty advanced things. So I think there is a concern there that if you press too hard, China is just going to double down on its own development.

Yeah. Okay. This is US real GDP growth contribution from tech capex. And as you might expect, uh, technology-related, AI-related capex has become a much more important driver of GDP growth. I can't tell on this particular chart, but I heard 40% of US growth in 2025 is estimated to be coming from AI, which is more than the growth we're getting from consumer spending, which is pretty phenomenal in the context of the US economy. I would also just add, right before we came in here to record, I saw a number from Standard Chartered, they were saying two-thirds of US growth this year is coming from AI. And you know, you never want to be too dependent on one particular industry. You especially don't want to be too dependent on an as-yet-unproven technology in a highly cyclical industry for your growth.

Yeah. Um, gigantic computers basically, you know, huge complexes that are as large as Central Park somewhere in like near Abilene, Texas or whatever, where it's these mammoth, um, what—data centers that are these assets that are a combination of real estate. So, they're a real estate play. They're high-tech plays because they're filled with those Nvidia chips or other chips and so forth. They're huge energy consumers or increasingly energy producers in their own right. So, whether you know—because it takes a while to get anything access to the grid, they'll have a natural gas facility producing energy on the campus directly. And so it's this extraordinary buildout all over the country of these data centers, which of course become very political and very important to the economic growth, etc. When I look at that chart, contributions from tech capex, you know, the really important thing is since basically 2008, 2009, 2010, this handful of tech companies have been where a lot of the action is for growth, particularly for growth and income and making money in the US economy. These companies used to just, uh, you know, they did not have to—they mostly just spent on labor. Their main cost was their software engineers, etc. And everything else was like pretty cheap because cloud compute was pretty cheap, etc. But they're famously like asset-light, as they say. So the big story, the other big story of this chart, setting aside the sort of US GDP component, is the degree to which these very important companies for the US economy have suddenly become like big spenders on stuff in a way that they never had any history before. And so you see these companies, they're taking out more debt or they're coming up with these special financing vehicles where there's sort of this, you know, it's off-book and suddenly we're like, uh, you know, there—the yeah, these off-balance-sheet arrangements to finance these things. So there is this fundamental restructuring, I would say, of like the P&L and the balance sheet of these big companies that is novel in their corporate history, and that's really a story of the last two or three years.

You know, there's a lot about the AI boom, the AI race that, you know, probably intuitively sort of reminds me in many dimensions of the sort of race to build a nuclear bomb. Okay. So, first of all, I'm not sure where that was going, but I didn't quite see that. So, um, you know, someone once described to me OpenAI as being like—it's like the Manhattan Project except the goal is not to build the—because you know the big fear is that AI, as many people in the space fear, is like you're going to have this like runaway AI that kills us all, right? So it's like how do we like build something that doesn't kill everyone. It's very existential, right? That's exactly it. So there's that, there's this fear of like who is going to get there first, there's the US versus China, etc. I think there is something similar going on with the way companies feel about being part of the—buying into AI as products, etc. That this technology is going to be so powerful, it's going to be so important that even if you can't articulate why you need to be adopting it for your company, you better like have an AI project. You better have an AI experiment going on because the stakes are so high for whoever figures out a way to like plug AI into their business, reduce labor cost, get more productivity and so forth, that the gains are going to be so great that you literally just can't afford to not be investing in it. From a consumer experience, I think like, you know, you listen to someone like Mark Zuckerberg, he clearly thinks that. I think you look at every other company, it is this fear. And I do think it's worth pointing out there are examples, you know, clearly engineers use AI coding all the time, other companies are figuring out a way—we did an episode with the CEO of a firm and he was talking about how AI allows them to see like companies that are misstating what they do in their terms of service. So it is true that already companies are figuring out ways to deploy these tools, but I really do think there's a tremendous amount of fear driving this at both the hyperscaler level and the customer level that someone else is going to figure something out.

That they're sort of acting as if it's a race to the finish line and so all that matters is being in front. But if that's not true, then actually there's like way overinvestment.

And then there's this phenomenon where it's like while we're on the race to create superintelligence, we're going to create these sort of, you know, slop apps that everyone has. Like so, uh, Meta has the Meta AI which is sort of like Instagram except it's all AI-generated garbage and ChatGPT is Sora which is a little bit better I think, but you know, whatever, it does not feel like a—it does not feel like a way station on the path to superintelligence when you see them rolling out these things and as you mentioned starting to look more and more like traditional software businesses that just sort of like plug into various layers. So I agree. I think it's like very muddled and I don't think we know yet what—whether these—I'm sure there's a mix within the companies, right? I'm sure there are people like, no, we are here to build superintelligence and there are probably others who are like, we are here—we are here to build enterprise software and build a subscription.

I was just about to say, first of all, if you couch everything in existential terms, then you know the limit on your capital expenditure is basically infinity. So that's part of what's happening here. There are two approaches to building out AI at the moment, and I call this the coffee pod theory of AI. America is building really expensive cappuccino machines that it thinks are going to produce the most amazing cup of coffee that the world has ever known. And because of that, everyone in the world is going to want to buy one of these cappuccino machines. That is not the only way to approach AI development or the AI business model. China has taken a very different approach. Again, China is doing the Nespresso coffee pod version of AI technology. They're producing something that's relatively cheap, something that's pretty standardized, and something again that it sees the entire world being a market for. I don't think we yet know the answer which particular model is business model is going to win out. But then you mentioned capitalism on the customer side. We're also seeing this dynamic, this narrative dynamic where, you know, late-stage capitalism, it's kind of hard to boost returns forever. And so now this new lever has appeared. It's called AI. And all you have to do is pull it, or at least put out a press release saying that you're pulling the AI lever and, you know, cutting workers and saving a bunch of money, and you'll see your share price go up. And I think that's pretty important. Like, investors are still responding very well to any utterance of AI in a business press release. There may come a moment where people are actually like, wait a second, we want to see the cost savings, but it's not happening yet.

Tracy said it, so I'm going to make her answer. I have no idea. I'm going to flip. It's all on Tracy. Tracy's the one who mentioned it.

I mean, okay, it's a little bit of an intellectual crutch. I will give you that because we're basically always living in late-stage capitalism, right? Late-stage capitalism is now. But I think if you look at our existing situation, it's this relentless search for growth. And a relentless search for growth is also something that is in many ways very unique to America. Other countries, I hate to keep talking about China, but other countries take a different approach, right? So in China, we've seen China take the lead in a number of strategic industries, which you know counts as growth, but that growth hasn't translated into huge returns for investors. So if you look at a line of the Shanghai Composite, it's been going sideways for many, many years. China is willing to make that trade-off. You know, we're going to develop important industries and give people jobs and maybe, you know, shareholders just aren't going to make that much money off of it. In the US, it's pretty much all about shareholder return and getting that line going up forever. And our political economy is basically built on that entire system of if you put your money in the S&P 500, you'll probably have a decent retirement, and so everyone will be fine.

Yes. And also late-stage capitalism implies that there's an end at some point, and I'm not sure there is.

Bloomberg chart. I recognize it from a distance. I know this chart from a distance.