The System Xi Cannot Afford to Break

Everybody knows Communist countries can’t get rich. So, we tend to tell ourselves a story about how China got rich, a story people may find comforting at first but over time becomes enraging.

The story is that China got rich by stealing. It sounds right. It preserves our assumptions. If Communist China is succeeding, it must be cheating. Take away the cheating, and the whole thing falls apart.

The problem is—it’s not true. Yes, we have all read the rants about China stealing $200 billion, $600 billion, a trillion dollars a year in intellectual property.

It is nonsense on two counts.

First, the two aging studies everyone quotes to this end are both embarrassing fictions, as Richard demonstrated in Reason Magazine last year.

The second reason is even more important. IP theft—stealing the recipe—just does not get you very far. Blueprints can be copied. But the ability to build, to scale, to improve yields, to iterate under pressure—that comes from doing. It comes from the learning curve.

China didn’t steal its way to prosperity. It learned its way there. In the “Information Theory of Economics,” which we espouse, wealth is knowledge, information is surprise, money is time, and growth is learning. Summing up the learning are “learning curves,” in which prices drop by around 25% with every doubling of total output.

That’s how enterprise works. The recipe is rarely the secret. The process is the point.

China plugged itself into the process. Under Deng Xiaoping, it opened up enough to allow capital, technology, and know-how to flow in and allowed entrepreneurs enough freedom to turn learning into wealth.

Somewhat confusing is what partial liberalization created: two Chinas.

There’s Party China: centralized control, surveillance, political authority, and not a small dose of paranoia. Party China put Hong Kong news tycoon Jimmy Lai in jail for 20years for promoting democracy.

And there’s the Free China that makes things work: reasonably free markets, uniquely entrepreneurial venture capitalist mayors, local problem-solving, a gazillion engineers, and the factories and supply chains they built.

One controls. The other produces.

For years, many in the West assumed Free China would eventually transform Party China into something like a liberal democracy. Because that has not happened, the same folks now tend to take the opposite view: Party China is all powerful and fully in control of Free China.

That view is just as wrong, not because Party China would not like to control Free China, but because it cannot.

Xi’s constraint

By the time Xi Jinping came to power, China had become impossible to run from the top down. In a sense this has always been true. The closest the regime ever came to complete control was within its first 10 years—and at least 40 million peasants starved to death.

Mao shrugged off the 40 million. Xi can’t follow Mao’s pattern because Free China has gotten too rich and Party China depends on the money. China cannot be a world power if it destroys the economy of Free China.

That Xi knows this became clear during Covid. China imposed sweeping lockdowns—an extraordinary display of state power. Then in the face of massive resistance, Xi did what Mao—and even Deng, who ordered the massacre in Tiananmen Square—never would have done—backed down.

Not because the Party lost political control. It didn’t. But because the wealth of Free China was imperiled. Supply chains broke, factories missed targets, food shortages hit neighborhoods, local enforcement began to look fragile.

The cost of pushing further became too high. Xi backed off. The great lesson: Party China is powerful and ruthless. But it is not unconstrained.

Americans should be able to see this. We are used to sorting regimes from people. We do it with Iran. We do it with Cuba. We hate the governments, but we don’t hate the people.

Increasingly, however, Americans do hate China. We hate it for its success—all of which comes from Free China. In America, that success breeds fear, anger and, most dangerous of all, envy, the root of all evil, the most original sin.

Wars are rarely the product of dispassionate calculations. They happen when countries hate each other. Wars erupt when we make rivals against whom we should strive to emulate into enemies we seek to kill.

Leaders in both American parties speak in increasingly absolute and fiery terms, whipping up American anger. Crucial to this anger is the pretense that there is only one China, Party China, which became rich and powerful by cheating. Refusing to acknowledge the role of freedom—and millions of Chinese entrepreneurs emulating America—U.S. political hacks feed our rage.

Party China rules. When it feels threatened, it lashes out. When Alibaba founder Jack Ma criticized the regime’s financial bureaucracy, Xi drove him into exile and nearly destroyed his company. Xi taught Ma a lesson: Free China makes the money; Party China makes the rules.

Still, Party China has learned some lessons as well. Without Free China, Party China would be left poor and weak. There is only so hard Party China can push.

For investors, there is also a lesson. China builds value. The Party decides how much of it you keep.

That doesn’t mean “never invest in China.” It does make it necessary to distinguish, when possible, enterprises Party China will likely ignore from those likely to provoke the Party’s rage.

In upcoming issues of the Gilder Technology Report, we endeavor to do just that.