THE BLOG
09/09/2014 08:17 am ET Updated Nov 09, 2014

China's Potemkin Villages

Getty Images/Vetta

Grigory Potemkin was a successful military leader and sometime lover of his patron Catherine the Great of Russia. But he is known to history primarily for building faux villages along a route the great queen would pass to put on a show of prosperity for her and her royal guests who came from all over Europe.

On August 3, Lesley Stahl of CBS's Sixty Minutes aired a report from China about that nation's obsession for building apartment and condo complexes without end in new cities all over the country, though there are precious few people who can afford to live in them. It is always difficult to glean reliable data from China, but some reports suggest China has invested upwards of $2 trillion in what may prove the most expansive real estate bubble in history.

Beijing has a tiger by the tail. Tens of millions of Chinese have bought condos in these ghost towns as long-term investments. Each condo represents the life savings of a middle class Chinese family. Many millions more Chinese are employed building these vacant edifices and the roads around them that are mostly empty of traffic. The bureaucrats in Beijing do not dare puncture this balloon so it just keeps expanding.

Predictably, the Chinese banking system is heavily over-extended in property. Chinese banks have huge portfolios of non-performing loans that are being swept under the rug because the problem is simply too big to deal with. The Chinese government is pushing forward on interest rate liberalization to inject more competition into the financial sector dominated by state institutions, but this amounts to closing the barn door after the horses have fled.

What we are witnessing is the inevitable day of reckoning between a sclerotic centralized bureaucracy and a runaway free enterprise economy that lacks stabilizing institutions to curb excessive behavior. The bureaucrats in Beijing are trying to control the economy in the old-fashioned communist, top-down way but it just doesn't work anymore. Under communism, for example, food was always a problem. So China subsidizes food production when it isn't needed. The government is sitting on an estimated 150 million tons of grains -- including rice, wheat and corn. The stockpiles are enormous and the excessive food supply will soon begin to rot.

Real estate bubbles and surpluses driven by subsidies are familiar to us but we have a transparent political system built upon democratic processes, the rule of law, a free media and an independent court system that enable us to deal with them. For too long, China has been ruled by a tight inner circle of corrupt party cadres enriching themselves. President Xi Jinping is clamping down on corruption, and that has positive implications, but what China really needs is a transparent political system to tackle corruption based on enforcement of laws, not insider favoritism. Xi is against corruption and must now make major reforms in the Chinese system to provide more transparency and independent legal review.

For many years, I have marveled at the Chinese economic miracle but I have always said it could have setbacks. The property bubble will be major setback that could threaten the regime's survival. The longer Beijing postpones the day of reckoning, the harder it will be.

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Jerry Jasinowski, an economist and author, served as President of the National Association of Manufacturers for 14 years and later The Manufacturing Institute. Jerry is available for speaking engagements. September 2014