Megan McArdle notes that China continues to turn our economic theories upside down.

Everyone–including most of the economists and NGOs–seems to think this is swell.  No fiddling around with archaic, unplanned systems; just figure out what the country needs and do it!

Perhaps it is just my ideological blindness that makes me believe that this cannot, in the long run, turn out well.  But there’s a plausible story that the early boom was mostly a matter of removing distortions (and taking advantage of capital, human and otherwise, accumulated in Hong Kong and China).  Now the government is much more directly picking winners and losers. They’re not trying to manage growth; they’re trying to cause it in places where it shows little sign of happening organically.

My gut response is that China is two fold. First, from the anecdote I’ve head – and I would be really interested in Megan’s take – the Chinese government allows local knowledge to drive particular business decisions.

For example, I remember a story of a small manufacturer in China from National Geographic some years ago. An entrepreneur had been in the brassier assembly business but profits were dwindling. He knew he had to make a move. So he and an associate sat a bra on the table and went through it piece by piece. When they got to the clasp one of them asked, who makes this?

It turns out the claps came from some Western firm. They figured they could undercut this firm and so they set up shop to create bra clasps cheaper than anyone in the world. Within a few years they dominated the market. This is capitalism at its core. A producer with detailed local knowledge specifically looking for an edge. As long as the great industrial plan provides room for this I think the core element of a market economy is satisfied.

Generally speaking I think people focus too much on incentives and not enough on entrepreneurial freedom. Even if the price structure is not accurately conveying all the right information, if I guy with a good idea can make happen then productivity growth can still be attained.

Adam Smith notes a naturally propensity of man to truck, barter and exchange. I think just as important is the natural tendency to Tinker and Tweak. The open source movement shows that a non-trivial number of people will do this at price zero.

Second, the fact that China is in catch-up mode likely makes genuine planning easier. The rough outline of an industrial society are easy to observe after the fact and the planners can emulate that. What I suspect is that the Chinese government will have greater and greater difficulty as it moves to the industrial frontier.

The planners will not be able to guess the next big thing as effectively. Large scale resource allocations will become more common and the central government will begin to weigh on the economy.

However, as long as the spirit of entrepreneurship is alive and individual innovators can tinker and tweak, China will grow. Its just that rather than everyone being all smiles about the central government they will begin to groan and complain.