Chinese and American cadres in a second-best world

The free market is falling apart. That we all know. Lamentations on the current state of affairs abound. The free market has immiserated the middle class. The free market has created oligarchs. The free market has de-industrialized the Western world. The free market has been gamed by China.

Industrial policy is now in the air. “You started it” fingers are being pointed. Industries are being ring-fenced. Tariffs and subsidies are being threatened and implemented. How did it come to this? Was Marx right? How did the free market fail us so badly? Where did it all go wrong? How right was Marx?  

Sorcerers have crawled out from under rocks to explain the free market’s demise through witchcraft and incantations like multiple equilibria, crowd psychology, behavior economics and, horror of horrors, reflexivity.

And it’s not just markets, it’s the entire neoliberal scaffolding! Populist parties with angry “burn it all down” wings are surfacing across the democratic world. The youth are carrying around dog-eared copies of Das Kapital. And, as if to rub it all in, China just sent its largest delegation in years to Davos.

The biggest error the West can possibly make at this point is to overreact – to throw out the baby with the bathwater. The free market is failing because the West, after the Soviet Union fell apart, consecrated it with undeserved theological reverence.  

The market was never an infallible god at whose altar anyone should ever have worshipped. It is a dirty, messy, imperfect, friction-filled contraption that will grind up fingers and spit out dead bodies if not carefully attended. Well-tended, markets can deliver a 40-fold increase in GDP in four decades, wipe out poverty, put Taikonauts into space and still fail to produce a competent football team. 

In 1956, Richard Lipsey and Kelvin Lancaster published a paper titled The General Theory of Second Best. In elegant simplicity, the paper laid out how, given simple constraints, free markets can deliver outcomes far from optimal. Lipsey and Lancaster managed to flip the tables on neoliberal economics well within the boundaries established by Ricardo, Smith, Mill and Hayek. There was no need to conjure “irrational” black magic behavior or summon treacherous political ideologies.  

The theory of second best states that when even one of the conditions required for the optimal outcome is constrained (an uncorrectable market failure), the next best outcome may require a set of conditions wholly different from (and possibly antithetical to) those required to achieve the first best outcome. And in fact, attempting to keep remaining conditions when just one is constrained may result in very suboptimal outcomes.

For example, while the neighborhood pub may be the optimal Friday night restaurant choice – IPA for Dad, salad for Mom and burgers for the kids – it can become highly suboptimal given a simple constraint. If the pub runs out of IPA on draft and only has bottles, Dad – who hates pub food – is going to be one cranky patron no matter how much mom likes her salad and the kids like their burgers. A completely different restaurant like the pizzeria across the street may become the new optimal – if all concerned get to enjoy themselves – if slightly less so than the pub.

Before being unceremoniously disqualified in 2021, Hong Kong had topped the Heritage Foundation’s rankings as the freest economy in the world for 25 years straight. For years a point of great pride, the Heritage ranking would eventually become a cruel joke.

Imperceptibly at first, and then shockingly, the city ran up against an un-innovative economy, checked-out youth, a great replacement by mainlanders in elite jobs, missing out on the tech revolution, being economically surpassed by not just Shenzhen but also Guangzhou – and, the coup de grâce, the riots of 2019.

Nobody mourned or even protested Heritage’s politically driven disqualification of Hong Kong from its free market rankings. After all, laissez-faire economics had brought disaster to Hong Kong. The proof is right across the border. In no way would Guangzhou or Shenzhen top Heritage’s economic freedom rankings and yet, in the 25 years of Hong Kong’s top placing, they outgrew Hong Kong by 5.3 and 9.6 times (in purchasing power parity terms), respectively.

Using Lipsey and Lancaster’s second-best analysis, Hong Kong was ultimately done in by high property prices and greedy tycoons – a market failure that, in hindsight, perverted the city’s free market. As the city, a legal enclave protected with Western property rights, drew homebuyers from China’s newly minted rich – without adequately building new residential housing – property prices skyrocketed.  

The tycoons saw to it that Hong Kong would have a continuous housing shortage by hoarding land and lobbying to keep development out of “beloved” country parks and wetlands. This corrupted all economic incentives.

The swashbuckling Hong Kongers who built toy and garment factories in Guangzhou in the 1980s and ‘90s cashed out and became local property speculators, missing subsequent higher-valued-added phases of China’s industrialization. This removed the city from China’s supply chain and aborted a generation of entrepreneurs. Tech was priced out of the city and never got a foothold. Cyberport, one of the city’s many tech/innovation charades, was ultimately a boondoggle to sell luxury housing.

Across the border the semi-planned city of Shenzhen, from acres of toy factories smelling like burning tires, morphed in 25 years to Singapore levels of efficiency and livability. Shenzhen’s economy is well diversified with footholds in technology, manufacturing, financial services and logistics, hosting the corporate headquarters of Tencent, Huawei, Ping An Insurance, DJI and SF Express.  

The many recent travails of the Boeing Company can also be explained by its worshipping at the free market altar in a constrained second-best environment. Passenger airplanes, as it turns out, are not just another product where outsourcing and cost cutting can increase shareholder value. Planes not crashing and not falling apart in the air can be more important than minimizing capital expenditures and cost of goods sold.

When Boeing was run by engineers, it understood that it was operating in a constrained market. There could be no tolerance for product failure. You can’t cut engineering corners to please shareholders. According to various reports, these values were surrendered after the company bought McDonnell Douglas and was infused with the acquisition target’s Wall Street values.

Airbus avoided this trap because it has always been a semi-state-owned company operating under the constraint that its raison d’être is to maintain an aerospace industry in Europe, not shareholder value. As such, this second-best outcome left money on the table but kept planes in the air.

The Ministry of International Trade and Industry (MITI) was the architect of Japan’s postwar economic miracle and operated under second best economic principles. Free markets would not do when the country was constrained by lack of capital, technology and foreign exchange. MITI helped industries by husbanding resources, providing import protection, licensing foreign technology and directing mergers.

The US government neutered MITI in the 1980s with various measures such as the Plaza Accord, sanctions on Toshiba and forcing the ministry to administer humiliating “voluntary” export quotas on cars. By 2001, the once venerable ministry was stripped of its influence and folded into other government organs and Japan’s economy was surrendered to the “benign neglect” of free markets.

The evisceration of Japan’s economic miracle clearly demonstrates that America can operate ruthlessly on second-best principles, if need be. If you got down to it, until the fall of the USSR the US had always operated under second-best principles. Free market neoliberal orthodoxy emerged from The End of History triumphalism of the ‘90s. If you think this piece will devolve into another Francis Fukuyama-bashing exercise, you are absolutely correct.

The Washington Consensus that emerged in the wreckage of the Cold War went on to eviscerate multiple economies in Eastern Europe including Russia. It failed to recognize that free markets would deliver catastrophic results in economies constrained by institutional weaknesses.

Americans tend to be ignorant of their own history and assume the nation was founded after World War II. Especially fatuous End of History fanboys fooled themselves into believing America was founded (or at least re-founded) after the collapse of the USSR.

Alexander Hamilton, a founding father, was a committed practitioner of second-best economic policy.He understood the economic constraints on the new republic and devised an economic plan using tariffs to protect domestic industries, spies to “borrow” European technology and public works projects to build roads and canals for internal trade. This was known as, of all things, the American System.

Like Britain before it, America only became a cheerleader of free trade after its industrial position was secured. German economist Friedrich List wrote of British trade policy in 1841:

It is a very common clever device that when anyone has attained the summit of greatness, he kicks away the ladder by which he has climbed up, in order to deprive others of the means of climbing up after him. In this lies the secret of the cosmopolitan doctrine of Adam Smith, and of the cosmopolitan tendencies of his great contemporary William Pitt, and all his successors in the British Government administrations.

Any nation that by means of protective duties and restrictions on navigation has raised her manufacturing power and her navigation to such a degree of development that no other nation can sustain free competition with her can do nothing wiser than to throw away the ladders of her greatness, to preach to other nations the benefits of free trade and to declare in penitent tones that she hitherto wandered in the path of errors and has now for the first time succeeded in discovering the truth.  

This “clever device” was employed by American policymakers as they engaged in what List and his modern champion, economist Ha-Joon Chang, called “kicking away the ladder.” We are now certain that karma exists because the new champions of free trade, sending the biggest delegation to Davos and most vocally opposing the tariff curtain descending on the world, are … you know who.

The major criticism of the theory of second best, and why it was never considered for the Nobel Prize, is that it’s a party pooper. The theory comes in, points out all the flaws of existing economic policy and then shrugs its shoulders and leaves, relieving itself of the responsibility of figuring out what the right policies are.

In 2007, Richard Lipsey published an update to his original paper titled Reflections on the General Theory of Second Best on its Golden Jubilee, saying:  

Practical policy advice requires more parochial objective functions than community welfare; must rely on formal and appreciative theory, empirical evidence, and large doses of judgment; and should concentrate on making piecemeal improvements in context-specific situations.

What that means is: You are on your own. Once a market is constrained – and all markets eventually are – there is no magic formula to figure out next steps. It requires extensive data, analytical rigor, deep theoretical knowledge, appreciation of uncertainty, trial and error and so on – exactly the skills required of a cadre in China’s Communist Party.    

What exactly is a cadre? Nowadays, it only seems to be applied to Chinese government officials. Neither of the dictionary definitions, “a small group of people specifically trained for a particular purpose” nor “a group of activists in a communist or revolutionary organization” is satisfying.

The Mandarin word for cadre, 干部, has a connotation of action from the character 干, meaning to do, to act, to undertake. It is difficult to think of cadres in China as mere bureaucrats. The government expects much more from them than formulating and promulgating policy. They are expected not only to formulate policies but also to drive outcomes, whatever they may be – clean up a stream, shut down germanium exports, increase university enrollment, build high speed rail.

Because cadres in China are expected to be action oriented, like MITI officials in their heyday, optimal second-best outcomes become targets to be met rather than end products of rearranged policies.

The most famous American cadre-driven undertaking is either the Manhattan project or the Apollo program – it‘s a tossup between them. Both of these endeavors were assigned to doers – Leslie Groves, Robert Oppenheimer, Abe Silverstein, James Webb – and both succeeded spectacularly.

There have been various others like DARPA or Sematech but, over the years, cadre-style active management in the US has fallen to the wayside as The End of History zeitgeist decided that passive noninterference espoused by the Washington Consensus would surely produce superior results.

This pits America’s entrepreneurs against China’s entrepreneurs and its cadres.

As superhuman as Elon Musk may be, Tesla’s profitability was questionable until it built its gigafactory in Shanghai. China’s cadres moved heaven and earth to install 1.8 million EV charging stations across the country versus 128,000 in the US. In 2023, China accounted for 58% of global EV sales compared with 12% in the US. And, as of the fourth quarter of 2023, BYD surpassed Tesla as the world’s largest producer of fully electric vehicles under the leadership of its equally superhuman but far less obnoxious founder, Wang Chuanfu.

It has always been a second-best world and the US will be operating with a handicap if it continues to cling to End of History fantasies. America’s entrepreneurs are no match for China’s entrepreneur/cadre partnership. Gina Raimondo and her bureaucrats at the Department of Commerce may be a start but, so far, they are still bureaucrats and not cadres and Huawei’s running circles around them.

Bringing back American cadres like Leslie Groves, Robert Oppenheimer, Abe Silverstein and James Webb may be necessary if the US wants a shot at remaining first-best in a second-best world.

‘Han Feizi’ is a Beijing-based financial industry veteran.