Edward ChancellorWhat explains the rise and fall of nations? The late economist Mancur Olson argued that economies are progressively captured by special interest groups intent on taking an ever larger slice of the pie for themselves. Their selfish actions may actually cause the pie to shrink in size. A grand historical drama plays out as the leading nation becomes increasingly sclerotic and is overtaken by a more dynamic upstart.

Many people believe the United States suffers from this type of sclerosis and that China is better placed to respond to the challenges posed by the global economic crisis. This view, however, ignores the deep-rooted corruption in the Chinese body politic, a problem so great that it poses a serious threat to the Middle Kingdom’s rise to economic primacy.

One doesn’t have to look far to find gross examples of rent-seeking in the U.S. Lobbyists twist Washington politicians around their fingers. Investment banks, unashamed by their role in precipitating the financial crisis, have skillfully evaded any serious regulation and are back to their old ways. Public sector unions fiercely protect their generous entitlements at the risk of bankrupting state and municipal finances. Other “distributional coalitions,” as Olson calls them, are seeking to mop up stimulus dollars and keep out foreign competitors.

China, by contrast, is seen as an example of latter-day enlightened despotism. Apparently unfettered by special interest groups, Beijing has acted boldly to maintain its prodigious rate of economic growth. At a time when the financial system in the West remains under threat from “financial weapons of mass destruction,” Chinese regulators have recently moved to restrict the use of derivatives for speculative purposes. If only the decadent U.S. could respond with such decisiveness.

The China dreamers, however, are turning a blind eye to the corruption that plagues the country. China recently slipped to 79th place in Transparency International’s Corruptions Perceptions index, below Burkina Faso.

Minxin Pei of the Carnegie Endowment provides an analysis of the problem in his 2006 book, China’s Trapped Transition: The Limits of Developmental Autocracy. The sale of public offices, or maiguan maigjuan, is commonplace, he says. The legal system is not independent from the executive branch of government. At the local level the judiciary is often ill-trained and corrupt, which means that property rights are not secure.

The commercial banking system remains under political control. As a result, capital is misallocated. In the early 1990s banks funneled cheap loans to state-owned enterprises. The resulting losses were vast — an estimated 40 percent of loans were later deemed nonperforming — and were socialized by a government bailout. Whatever profits these loans generated remained in private hands.

Beijing has decentralized many powers since Deng Xiaoping’s reforms commenced three decades ago. This has been beneficial for economic growth. However, it has also created the opportunity for local elites to line their pockets.

China is an example of “decentralized predation,” according to Pei. In the southwestern city of Chongqing, the recent trial of an owner of illegal casinos involved more than 9,000 suspects and 50 public officials, according to The New York Times. One member of the local judiciary was discovered to have buried $3 million in cash in his fish pond. Protesters outside the court complained that they had been taken forcibly from their homes, which were later demolished for redevelopment. “The bandits used to live in the mountains,” lamented one local interviewed by the Times. “Now they live in the Public Security Bureau.”

A key measure in China’s stimulus package has been the explosion of bank lending, which expanded by 30 percent in the first half of the year. This creates a great opportunity for self-enrichment by the local elites. Money has flowed primarily into infrastructure projects; but, as Pei observes, “in China you don’t rob a bank, you rob infrastructure.” Profits are generated through land seizures for development, the use of inferior building materials and the failure to build according to ­specifications.

Local governments have set up development companies to undertake infrastructure projects, funded with bank loans. However, reports suggest that these loans may be passed back to the local government. Such off-balance-sheet public financing is common in China, Pei notes.

The credit explosion in China has fueled speculation in commodities, stocks and real estate. A recent report by Independent Strategy, an investment consulting firm headquartered in London, describes state-owned enterprises passing on loans to affiliated “window companies,” which have been using the money to acquire properties in Hong Kong. After a purchase, writes Independent Strategy, the window company “goes to a local HK bank and raises a mortgage. That’s when the chips are cashed into foreign currency, and god knows what happens to the proceeds next.”

The last two economic superpowers — Britain in the 19th century and the U.S. in the 20th century — rose to prominence on the backs of strong institutions that protected property rights and encouraged wealth creation. In neither country was government corruption extensive enough to hold back economic growth. Today the U.S. may face a challenge from vested interests, but at least the Constitution and the courts still protect property rights. A free press ensures that corruption is exposed. If the politicians are too venal, they can be kicked out.

None of this is true of China. Wu Jinglian, the country’s most respected economist and the architect of Deng Xiaoping’s reforms, recently warned that corrupt bureaucrats were pushing the state to take a larger economic role so they can cash in on their positions through payoffs and bribes. “I’m not optimistic about the future,” Wu told the Times. “The Maoists want to go back to central planning, and the cronies want to get richer.”

There is no doubt that the Chinese are a clever and industrious people. They are also very numerous. However, those who believe that the 21st century belongs to China should heed the words of Adam Smith: “Great nations are never impoverished by private, though they sometimes are by public prodigality and misconduct. The whole, or almost the whole public revenue, is in most countries employed in maintaining unproductive hands. . . . Those unproductive hands . . . may consume so great a share of the whole revenue, and thereby oblige so great a number to encroach upon their capitals, upon the funds destined for the maintenance of productive labour, that all the frugality and good conduct of individuals may not be able to compensate the waste and degradation of produce occasioned by this violent and forced encroachment.”

Edward Chancellor is the author of Devil Take the Hindmost and a senior member of GMO’s asset allocation team.