Why Dragonomics is Wrong

A colleague recently forwarded me an amusing puff piece from a few months ago on the prospects for China drawn up by Arthur Kroeber at GK Dragonomics, in which he argues that there is nothing to fear from a slowdown as all of the elements of the Chinese growth story remain intact.  While I'm not without my own vested interest here I'd like to address his analysis and in doing so further illuminate my own perspective.  His argument is inconsistent and contradictory, frequently lapsing into broad generalizations extrapolated from top-down aggregates, and evades the fundamental problem at the core of the Chinese economic machine.  In this respect its fairly representative of most of the bull-case arguments floating around as of late, so I figured I'd take a crack at it. 

My issues center around a critical distinction, the importance of which I think is pretty hard to overstate- while China is undoubtedly in need of hard infrastructure in some areas, the real problems that will continue to hinder Chinese development are in the country’s ‘soft’ infrastructure – its political and legal system in general and its capital allocation infrastructure specifically.  This is attributable to the limited liberalization of interest rates, the dominance of finance by state-controlled banks, and the attendant politicization and corruption of capital allocation.  This is a government that has its hands on everything.  Even with efficient capital allocation rapid growth, such as that enjoyed by China in the past decade, is often accompanied by accumulated imbalances and when you wed the captive below-market financing offered through financial repression to China's banking system the results are unlikely to be positive.  Indeed, the past three decades of Chinese banking suggest that when the bill inevitably comes due, the costs will be enormous.