The 'Third Way' Bubbles Are Bursting

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When the financial crisis hit three years ago, many gleeful leftists assumed that the long-anticipated failure of the free-market system had finally come and that this crisis would do for capitalism what the fall of the Berlin Wall did for communism. In fact, it is not capitalism that is failing.

We are beginning to see this in Europe, where the debt crisis is a crisis of the welfare state. I think we are also about to see it, possibly in a more spectacular way, in another leading example of a capitalism-socialism hybrid: the so-called "state capitalism" of China.

As the global recession began, the government of China chose to weather the economic storm by followed the same rotten advice we were getting back here: the Keynesian idea of "stimulating" the economy with borrowed government money. They just took that idea more seriously.

Three years later, we're starting to get an idea of the results of China's "stimulus." Niall Ferguson has coined the perfect term for it: "a real-estate bubble with Chinese characteristics." It's a take-off on the Chinese regime's description for its not-quite-socialist, not-quite-capitalist system: "socialism with Chinese characteristics."

The Chinese government launched its stimulus by ordering local government to massively increase their funding on public works projects and real-estate development. Local officials, who rake off kickbacks from every deal they set up, were all too happy to comply. Chinese law limits the ability of local governments to borrow money, but then again, the law doesn't mean too much in China. So local officials set up nominally independent corporations to take on debt that doesn't have to be declared on the government's own balance sheet. China analysts call them LGFVs, for Local Government Finance Vehicles, but here in America we have a different acronym for the same set-up. We call it FNMA. This debt is backed by collateral in the form of local government land holdings. But to make the collateral sufficient for such large loans, the value of the land was preposterously overstated.

And what sorts of things are being built in this real-estate bubble? The LA Times reports on the massive "face projects" (we would call them "vanity" projects) undertaken by corrupt local officials.

"Take the poverty-stricken county of Dancheng in central Henan province. Officials there spent $1.3 million on a sightseeing rail line with a replica steam-powered train, although there's little to see but farmland. The locomotive overturned on its first day in operation last year. It's now sitting idle at a park.

"In the remote city of Ganzhou in southern Jiangxi province, officials splurged on a $45-million mechanical clock tower touted as the largest in the world. But so far there have been few visitors; officials haven't finished paving a road to the site."

One Chinese official, Cheng Siwei, has already gone ahead and laid it all out there explicitly: "Our version of the US subprime crisis is the lending to local governments."

On top of corrupt lending to local governments there is the newer phenomenon of "unofficial shadow banking," i.e., black-market banking. A lot of this lending is coming from non-banking firms who are looking for a way to prop up their profits as China's industrial production slows. Thus, "More than a quarter of Yangzijiang Shipbuilding Holdings' pre-tax profits came from lending, according to its recent second-quarter results. SG [Research] highlights that in several non-banking Chinese companies' recent half-year accounts, such peripheral operations have accounted for one-third of profits." And as China's central planners impose loan quotas and other regulations intended to curb excess lending to the private economy, the demand for unregulated loans from these black-market banks increases.

What could possibly go wrong? Exactly what you would expect. The Asia Times reports on the next logical step: Chinese businessmen fleeing the country, abandoning their businesses, and presumably absconding with funds, because they can no longer pay back the ruinous interest rates on their black-market loans.

China's problems have already gotten large enough that the current debate among observers is over whether the country's economy will experience a "soft landing" or a "hard landing." A Yale professor makes the case for a "soft landing," but notice that he does so entirely by reference to big macroeconomic forces and the official policies trumpeted by the central government. But any discussion of China's economy has to take into account its lawlessness and corruption. The central government doesn't have the ability or the will to exert as much control as it pretends to have. That makes a hard landing a lot more likely.

It's not just China that is on the cusp of a crisis. The current era is a crisis for "state capitalism" and welfare-statism in all of its forms. It is a crisis for any system that has tried to carve some sort of "Third Way" between capitalism and socialism.

This is true of the other great recent example of "state capitalism," Russia. Leon Aron recently described how Vladimir Putin's death grip on the country has suppressed all economic activity other than state-controlled oil production. How badly has Russia decayed? The core of its ability to project power globally, its submarine fleet, is shrinking because Russia cannot produce new submarines fast enough to replace the old ones as they fall apart.

Events in China and Russia lead Michael Shuman, in his "Curious Capitalist" blog at Time, to conclude that "state capitalism" is about to be revealed as a failure. He quotes Arkady Dvorkovich, an adviser to Dmitri Medvedev, who says that those who admire state capitalism "don't know what they're saying. This way of doing things has exhausted all its potential, so we need to change policies."

As for the other main contemporary variant of "Third Way" statism, one need look only at the growing crisis in Europe to see the results of borrowing money to feed the ever-expanding benefits of a generous welfare state.

It turns out that this was the real legacy of the fall of the Berlin Wall. Back in 1989, it seemed that capitalism had indisputably triumphed over socialism. But the elites in government, academia, and the media could not accept that conclusion. Instead, they responded by trying to find a Third Way between capitalism and socialism. This was the legacy of Bill Clinton in America and Tony Blair in Britain, and it was the pattern for the policies of the European Union. The idea was to accept many aspects of capitalism, such as financial markets and the relatively free flow of capital, but to try to harness these capitalist institutions to pay for a bloated middle-class welfare state.

That was the dominant response in the West. Elsewhere, first in China and then in Russia, the response was "state capitalism," a Frankenstein-monster hybrid that allowed a large measure of freedom for the economy, except where an authoritarian regime decides to exert control over key companies and industries and to favor the interests of its cronies.

I'm beginning to suspect that the credit "bubble" is one of the hallmarks of such a system. It reflects the hybrid nature of the system. It is a system that still has property rights, private savings, financial markets, and ambitious individuals exuberantly reacting to price signals in a frenzy of activity. But behind that is the "management" of government, which serves to distort those price signals and misdirect trillions of dollars of private economic activity. The government decides that housing, for example, or "green energy" is an industry to be supported with cheap credit, loan guarantees, and subsidies, making it seem artificially profitable and leading investors to pour more money into these activities than the economy can actually support over the long run.

Or European governments decide that Greece should be allowed, through the mechanism of the Eurozone, to issue its debt at the same low interest rates as Germany. And then they decide, when the financial crisis hits in 2008, that European banks should increase their reserves by loading up on the "safe" debt of European governments. Or in China, the corrupt incentives driving government officials--who don't need to fear the scrutiny of a free press or the accountability of free elections--encourages unsustainable borrowing and out-of-control real-estate speculation. All of these bubbles are bursting or are about to be burst.

The big story of the past few decades is still the genuine advance of capitalism and its enormous economic rewards. This wasn't all, or even mostly, a bubble. But the attempt to create a Third Way redoubt to retain some elements of socialism led to the creation of a false superstructure of economically unsustainable activity, hidden by the government's distortion of price signals and magnified by the private activity of financial markets acting on those signals.

If we don't want this to happen again, we have to learn the lessons of the collapse of the Third Way, and we have to be willing to follow the process of elimination to its logical conclusion. If socialism has failed, and so has the Third Way between capitalism and socialism, that leaves us with only one system left: capitalism.


Robert Tracinski is senior writer for The Federalist and editor of The Tracinski Letter.

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