The Chinese turmoil roiling markets right now presents a fresh and profound challenge to the world economy: For the first time, a giant, non-European superpower threatens world financial stability and the powers that be seem at a loss. If the IMF and World Bank have stumbled with Greece, how are they going to get a hold on the stock market travails of Communist China? What tools do we even have to affect how it plays out?I have long noticed that people confuse the temporary evidence of effervescence with underlying productivity and this confusion arises from failing to take into account BOTH the costs and the benefits of any particular action. You can conquer a territory and fill up your coffers with looted gold but unless your economic system has changed, your underlying productivity has not changed at all. You have inflated the appearance of prosperity without actually creating the sustaining mechanism of continued prosperity. If you want continued prosperity, you have to keep feeding the beast with new conquests. At some point, you run out of wealthy regions to capture and you are left with a system that is still low on productivity. That's when empires, countries, and economies collapse.
But if the particulars are novel, in the bigger sense this is a movie we’ve seen before. Though China has been the global economic star of the last low-growth decade, it remains a totalitarian dictatorship, with its economy shrouded in state secrecy. What we’re encountering in this crisis is the spectacle of a closed society colliding with the forces of complex, free-market capitalism. If we look beyond China, we can find a long history of these collisions, dating back hundreds of years, as both closed societies and capitalism evolved and became more complex. And the history has a clear but unsettling lesson to offer: When such a collision happens, it’s a moment to genuinely worry.
Since the dawn of capitalism, closed societies with repressive governments have — much like China — been capable of remarkable growth and innovation. Sixteenth-century Spain was a great imperial power, with a massive navy and extensive industry such as shipbuilding and mining. One could say the same thing about Louis XIV’s France during the 17th century, which also had vast wealth, burgeoning industry and a sprawling empire.
But both countries were also secretive, absolute monarchies, and they found themselves thrust into competition with the freer countries Holland and Great Britain. Holland, in particular, with a government that didn’t try to control information, became the information center of Europe — the place traders went to find out vital information which they then used as the basis of their projects and investments. The large empires, on the other hand, had economies so centrally planned that the monarch himself would often make detailed economic decisions. As these secretive monarchies tried to prop up their economies, they ended up in unsustainable positions that invariably led to bankruptcy, collapse and conflict.
The US government has been doing this at a social policy level for decades. It understandably wants people in the low productivity (poor) income quintiles to become middle class. Instead of focusing on how to equip them with the cognitive and non-cognitive skills that will allow them to become more productive (the ticket into the middle class), the government has instead focused on giving people the trappings of the middle class. It fails to recognize that the trappings of the middle class are only the outward manifestation of productivity, not productivity itself (which arises from cognitive and non-cognitive attributes).
The principal examples are homeownership and private university education, those archetypal milestones to the middle class. The government has worked hard (but disastrously and ineffectively) to make those hallmarks of middle class equally accessible to all, not realizing that these are consumption goods resulting from middle class behaviors, not the actual causes of middle class prosperity.
At a national level, what drives prosperity? Transparency, Trust and Competition - the constituent ingredients to the elixir of modern, liberal economies. Reduce or remove any one of these and the tap of prosperity, innovation and growth slowly closes.
Anyone can, for a period, look like they are producing a lot, as long as they hide the costs. What Western economies achieve is growth through productivity and they do that through a system of Transparency, Trust and Competition. A system like the Soviet Union (with low Transparency, Trust, and Competition) can grow and look like it is successful because it is able to hide the costs. The Soviet Union was fundamentally a failure because they were exploiting resources, first Human and later Natural (such as oil and gas), without ever acknowledging the costs. A productive, efficient system, such as in a Western economy can only grow when both sides of the equation are taken into account, the costs and the benefits. 15th century monarchical Spain, 17th century monarchical France, 20th century Soviet Union and 21st century China are all systems with low Transparency and Trust. Spain, France and China at least had some forms of competition, China especially. In fact, there has been a twenty year background discussion about when the conflict between the unleashed forces of market competition would finally come to a head with the political disposition to low Transparency and Trust. Perhaps now is that moment.
There is no historical example of a closed imperial economy facing large capital-driven, open states and sustainably competing over a long term. That is not to say that China isn’t an economic powerhouse and a remarkable site of energy and potential. It is certainly both. But we also know Chinese debt — as secret as the state likes to keep it — is enormous, and that its financial system is like any other bubble. It is predicated on inflated earnings reports and expectations. The great “Beijing Consensus,” China’s absolute commitment to showing 8% growth every year, is unsustainable, at least through legitimate means. And without it, China is beginning to look like an enormous totalitarian ponzi scheme — a phenomenon common enough in world history, but extremely dangerous be near in the long run.For Americans, the saving grace is the relative insularity of our continental economy. Yes, we are a global economic behemoth, but compared to most other countries, particularly in Europe, a relatively small portion is actually traded globally. A slowdown in China hurts us but wounds others with more trade dependent economies.
UPDATE: A very current example of the consequences of eating the seed corn and never addressing real productivity: Printing Money Goes Haywire in Venezuela by Megan McArdle