George Gilder and Richard Vigilante:

The China Hawks may be getting their wish.

They are on track to see what the world looks like with China poor, backwards, and communist.

The Chinese economy is at even greater risk than the headlines suggest. Western analysts are missing the gravity of the collapse because, just as in their analysis of the U.S. economy, they vastly overestimate the power of monetary policy and government stimulus to affect growth. And they vastly underestimate the true source of economic growth, the freedom of entrepreneurs to create the upside surprises that drive progress.

The financial media are obsessed with two almost irrelevant questions.

The first is the effects of China’s supposed real estate bubble popping.

The second is whether Chairman Xi will do enough to stimulate the economy by opening the monetary floodgates or by giving consumers more yuan to spend.  The Wall Street Journal notes that monetary loosening so far has done little to revive the economy and laments that Xi stubbornly refuses to spread cash via social programs on the grounds that this would be “welfarism.”

Mainstream analysis of the Chinese economy goes wrong for the same reason its analysis of the US economy has gone so badly wrong.

The great lesson from Ronald Reagan’s restoration of the American economy is that what economists misleadingly call fiscal policy always trumps monetary policy.

Monetary policy can provide one background condition for economic growth, stable prices.

What is called fiscal policy really comes down to how much freedom the government allows private businesses to allocate capital and innovate new products, services, and production methods.

The Reagan tax cuts, viewed conventionally as just another form of monetary stimulus, were effective primarily because they freed investors and entrepreneurs to allocate capital into productive investment.   Even the tightening monetary policy of the Fed under Paul Volcker, to the extent it restored price stability, had as its primary effect improving capital allocation.

In the 1970s, with inflation running into double digits and capital gains taxes as high as 35 percent (confiscatory when adjusted for the inflated dollar), real, after tax returns on investment turned negative. Investors preferred accumulating Renoirs and real estate to investing in new enterprises. The Reagan reforms released a flood of capital out of inflation hedges and into the productive economy.

Also crucial were 30 years of relative regulatory restraint starting under President Carter and continuing until the Obama administration, increasing the freedom of entrepreneurs to energize the economy.

What ails the US economy today is not primarily bad monetary policy, neither Fed laxity from 2008 through 2021, nor the tightening since then. Driving slow growth and rising prices are drastic government-imposed inefficiencies especially in the energy and labor markets: too little energy produced and too many Americans still out of the job market.  The devastation of the auto industry by mandates and subsidies for electric vehicles is just the latest wound.

As with establishment reaction to Reagan, the confusion about China’s current problems begins with misunderstanding its prior success. The China Hawks credit the fantastic expansion of the Chinese economy since 1978 to clever Chinese central planning. Bizarrely they imagine that for once, against all precedent and logic, socialism worked. Missing the true source of Chinese prosperity, they now miss the source of its decline.

The real story of Chinese decline is socialist revanchism starting at least a decade ago under Chairman Xi. Chinese state-owned enterprises that had shriveled in previous decades have been massively refunded and subsidized by the Chinese government. According to China-watching economist Nicholas Lardy the effect was to pull China’s national average return on capital down into the low single digits.

Even this, however, was not enough to stall the Chinese economy. Most governments of approximately capitalist nations similarly waste massive amounts of capital, c.f. wind farms and solar farms and trillions in green subsidies of all sorts, not to mention the CHIPs bill, or ethanol, or ….

These inflict grave harm on the economy by diverting entrepreneurial creativity into the destruction of wealth. But if genuine entrepreneurs and the free economy can get the capital they need, they typically more than compensate for government waste.  As Yasheng Huang documented 15 years ago in his great work Capitalism With Chinese Characteristics, the explosive growth of the Chinese economy was driven by the relatively small portion of Chinese businesses most free of government control: smallish rural enterprises and foreign controlled companies operating in China.

As Huang, Lardy, and Nobel Prize winner Ronald Coase among others have shown, it was the unplanned, often extralegal liberation of farmers far from Beijing’s clenched fist that first reinvigorated the Chinese economy. As agricultural productivity increased exponentially, fewer farm laborers were needed. Local prosperity and excess labor spawned tens of thousands, then millions of town and village enterprises, officially “owned” by local governments but actually controlled by local entrepreneurs.

These enterprises were financed in part by informal intermediaries that grew into a “shadow” banking system loathed by the Xi regime as beyond its control. The most visible became Jack Ma’s Ant Financial, which used advanced credit rating algorithms to make millions of sound micro-loans to Chinese businesses and consumers.

In November 2020 Xi shut down Ant’s planned IPO and forced a restructuring that blunted its entrepreneurial style. That was only the most well-publicized attack on the shadow banks, which have been largely neutralized. Though we have no reliable data on the impact on small Chinese businesses the constriction of the shadow sector bodes ill.

The other great source of Chinese economic growth was foreign controlled firms. Foreign Direct Investment is credited even by establishment economists for aiding China’s growth. Its sudden decline amidst US China tensions is always listed as a worrying point by established analysts.

Here again they largely miss the point. As the massive renewed subsidies to state-owned enterprises show, China was not short on capital. It was short on freedom.

As Huang shows, foreign controlled or financed firms disproportionately contributed to China’s prosperity because they were largely exempt from the government interference and corruption that plague most indigenous firms. The importance of this freedom of operation was largely missed, says Huang, because western China watchers vastly overestimated the number of large Chinese enterprises that were actually free from government control.

Formerly state-owned enterprises that were allowed to “go public” and sell shares were often counted by observers as part of China’s private, free economy. In reality, as with public companies in the West, management remained in charge. In these Chinese firms management means the government.

When foreign investors flee China, the capital they take with them is the smallest loss. The real loss is freedom.

If the real estate bubble pops, it will not be because money had been too loose but because the growth needed to sustain that investment didn’t happen.  The people who would have made it happen have been driven away.

The China so hated by the Hawks is imploding. The socialists the Hawks pretended were always in charge have returned with a vengeance. If they are not stopped China and its shrinking population will head back toward poverty and insignificance. The immediate result may be to tip the globe into recession. The long-term results of losing a billion of the most enterprising people on earth back to socialism will be worse.here.