State Capitalism Does not Work From the Soviet Union to post-Soviet Russia, from Social Democratic Europe to mixed economy China, we see the inherent flaws of systems in which politicians allocate scarce capital

WASHINGTON – Capitalism is flawed, we know this. The 2008 epic, almost terminal, Wall Street financial meltdown demonstrated that in some critical instances the market is not at all “self-correcting”. There will be horrible excesses. There will be bubbles. The idea that the private sector will always be able to price risk correctly is wrong. The idea that impartial and capable watchdogs and regulators will be able to catch problems before they become crises is also wrong.

There is no better system

So, with capitalism we have a most imperfect economic system that can morph into an uncontrollable Frankenstein.

That said, with all its shortcomings, this is the by far the best  system we can have. Empirical evidence shows that all the clever or not so clever alternatives are much, much worse.

Among these, for years it was believed that “Social Democracy”, (the mixed economy model, that is watered down socialism characterized by a happy mix of private enterprises and some government-run economic sectors), had the potential to offer the best of rugged capitalism and benevolent egalitarianism.

State capitalism does not work

Nice idea. But, in practice, abject failure. Simply stated, government appointed functionaries are bad or terrible economic managers. There may be some rare exceptions, but the notion that economic sectors can be run like state bureaucracies is a recipe for bureaucratic allocation of scarce resources, usually in response to political imperatives or pressures. This is most inefficient.

And this is what you get when things are going well.

Built-in waste

When things do not go well, political forces will use economic assets they control by virtue of being in power mostly for political gain, regardless of the economic consequences. Top jobs in state controlled economic sectors become part of the spoils system. Public funds are diverted to support political objectives disguised as “economic investments”. Credit is provided by state-owned banks to friendly state-run enterprises and to private firms that provide political support.

In other words, almost by definition, state capitalism means poor allocation of resources, waste, lack of accountability, corruption and inefficiency. It is good for politicians who use economic assets to reinforce their political base, but it is bad for growth.

The record shows complete failure. The hard core, Soviet-style Communist systems were disasters. But so is every possible European Social Democratic “softer” variation.

France’s “dirigiste” model failed. Italy’s state capitalism failed. Farther afield, South Africa’s state-run sectors are a disaster. The Indian government’s dogged determination to control and regulate everything created gigantic waste, total paralysis and epic corruption.

Is China the bright exception?

But, wait a minute, China is doing well, isn’t it? Isn’t China’s spectacular 30 year journey from under performance to spectacular growth the demonstration that the state can be a capable steward of a major economy?

Well, yes and no. And now, mostly no. Beginning in the 1980s, the Chinese Communist Party leadership was extremely clever in exploiting a unique historic opportunity. The country’s leaders unleashed investments in export-oriented sectors, taking advantage of China’s super abundance of extremely cheap labor.

A combination of smart investments in logistics and infrastructure, plus focus on every possible consumer good sector to be destined to Europe and America, created a remarkable transformation. Tens of millions of Chinese poor peasants went to work in factories. They were paid very little. But it was still better than what they made at home.

With the incredible cheap labor advantage, “Made in China” consumer goods soon dominated Western markets. Indeed, why buy a T-shirt made in North Carolina when the made in China equivalent costs 1/10?

Now it is different

This model worked very well. Until now. Now it is different, simply because the cheap labor advantage has been slowly eroded. China’s incomes are rising. It is becoming a bit harder every day to sell made in China products purely on the basis of lower prices.

As the froth is consumed, we begin to see the blemishes. And they are the typical shortcomings of state-run economies. Yes, in case you forgot, while the Chinese government encouraged the growth of private enterprises, it retained control of key strategic sectors. All banks, financial institutions, energy, telecom, railways, steel and other sectors are controlled by State Owned Enterprises, (SOEs). Many of them are run rather inefficiently. Some lose money.

And here is the problem. As the Chinese government has at its disposal massive amounts of capital accumulated during its fantastic 30 year growth journey, now it is using lots of it to subsidize the under performing, in some cases virtually bankrupt, state owned corporations.

In capitalism we accept failure

In the abhorred capitalist economies, sooner or later we are bound to find out about failed or semi-failed companies. In a statist economy these failures stay hidden. Huge debts are refinanced at friendly rates by state-owned banks, always ready to help SOEs. Local governments that got into debt in order to finance costly or failed projects have the guarantee of a bail out. Nobody goes bankrupt.

China has at its disposal an enormous amount of cash. It can afford all these bail outs, and more. But it is obvious that this is an extremely unproductive use of resources, for no good purpose, except a political one: avoiding the possible negative political reverberations of economic failures.

In a capitalistic economy failures are regrettable; but they are also an indication that the market works. Good performers are rewarded; poor performers go belly up. And, on balance, over time capital will finance more winners than losers. This is how we produce wealth.

Political role of important SOEs

In a mixed economy run by just one party, it is clear that key economic sectors perform a political role. The name of the game is control over society. From this perspective, the real goal is not growth. The primary objective is reinforcing the foundation of political control. And if this requires bankrolling money losing SOEs, so be it.

Unlike semi-impoverished France or Italy, China has plenty of cash. It can afford to burn it. That said, this political allocation of capital aimed at shoring up semi-comatose firms does nothing to produce new wealth. In fact, it destroys it. And even rich China at some point will be harmed by this open-ended, unwise allocation of resources to failed enterprises.

Let’s be clear: China’s economy will not crash. But it will slow down. And, ironically, such a slow down over time may cause undesirable political repercussions.

State appointed managers do not know how to promote innovation

Once you have exhausted the huge competitive advantages of ridiculously low priced goods produced by tens of millions of poorly paid factory workers, you have to move up the value chain. In an ultra-competitive global economy, if you want to stay on top, you have to produce goods and services of superior quality. And this requires smart allocation of capital to promising, innovative companies.

I seriously doubt that this system in which unelected political leaders and bureaucrats decide how to allocate resources is really suited to the task of promoting innovation and competitiveness.

First and foremost Chinese party appointed managers focus on measures that will strengthen the system, rather than real growth. Their policies may help extend the life of the regime, but they will do little to extend the remarkable boom of the past 30 years.

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