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Could Capitalism Bring Out the Good China?


Or will recovery crack under communism's pressure?

I had a very interesting conversation with a reader who responded to my article entitled The Next Great Bubble: China. He argued that there's something very important and intangible economists cannot measure: the will of people. That will becomes even stronger when the country's past is ridden with political and economic misery.

Think of Germany and Japan after World War II: Their economies were in shambles, but human capital and ingenuity played a much larger role in their recovery than the traditional capital. In other words, economic models at the time would have predicted that those economies wouldn't recover as fast and as well as they did, as they wouldn't have accounted for the human factor - the raw (and very selfish) drive to succeed.

The reader was making the argument that because of its poverty-stricken past (like Germany and Japan had) after World War II, the Chinese people's ingenuity will put their economy on a tremendous growth trajectory. I thought it was a very interesting observation, though I never really made the argument that China would fail and go back to the pre-80's or 90's era. My argument was that all good things need time to rest, which is why economies have normal cyclicality (periods of expansion followed by recessions). Chinese growth was very high for a very long time; it needs a good rest, which it never gets because its government is afraid of civil unrest, and so spends money at a very fast pace.

Misery alone is not enough. Japan and Germany recovered and blossomed because those were capitalistic societies. In fact, their success is a triumph of capitalism. China is toying with communism (socialism) and capitalism at the same time. Unfortunately, in a time of crisis, if a choice presents itself, government will chose the path of least resistance - in this case, communism (socialism). (Just think of what our government is doing today.) But the more difficult and correct choice (at least in the short run) is creative destruction: capitalism.

Russia is a good example. The same Japan/Germany-after-WWII argument could have been made about Russia in the early 1990's. It had a very educated population that saw plenty of misery. For a while, Russia was going the right direction, but the crisis of the late 1990's shifted the country back from democracy and capitalism toward a more command-and-control economy. This conversation made me realize that Chinese success in the future (beyond the short run) will depend on the market system it chooses. Capitalism will let human ingenuity bloom, where communism will just crush it.

In investing, it's important to think unconventionally, to consider not only obvious risks but the ones hiding just around the corner. For many investors, it's a foregone conclusion that China will consume more stuff (energy, materials, industrial goods) in the future. Therefore, many argue that one should buy what China needs - the stuff.

But this investment thesis will only work out if China sticks with capitalism - if the current crisis doesn't push it toward the path of the least resistance: communism.

I therefore want to issue this warning: If I were to follow the "buy what China needs" investment, I'd watch political developments over the next couple of years very closely.
No positions in stocks mentioned.

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