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It's China's totalitarian bubble that's bursting

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Chinese flag

Every economy and every market needs its bulls and bears. It needs an open push-and-pull and free flowing information about companies and economic trends. China doesn't have that, has never really had that, and now the curtain is coming off all the things Beijing does to window dress its economy and its markets.

The warning bells started to really sound much louder earlier this summer when the Chinese government began a series of new rules and even arrests to stem short selling. Some of the moves were justified, as many of those short sellers were likely acting fraudulently. But the chilling effect on all short selling was clear. And now, the government has taken it one step further by arresting hundreds of alleged "rumor mongers" who just happened to be talking or posting negative comments about China's stock turmoil or economic challenges like the recent chemical factory explosion at Tianjin. No word yet on what happens to Chinese people spreading positive rumors about their markets and economy.

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CNBC's Bob Pisani summarized the Chinese government's edicts beautifully in his note to his colleagues in the newsroom this morning. It read: "(This is) the message. Invest or perish. Stay long. Selling is a crime. Welcome to the new open market system."

But it would be a mistake to think this is only about shady market and economic window dressing, because these are all just the symptoms of the real disease. China's market troubles are rooted in politics and not economics. It takes a totalitarian government like China's to even think it can kill off the truth about its economy and asset holders from selling off stocks forever. The bubble that you hear bursting isn't just the Chinese real estate bubble, manufacturing bubble, oil consuming bubble, or even its stock buying bubble. The bursting bubble is the misbegotten notion that China's demographic numbers, economic potential, and work ethic could somehow overcome an inherently repressive regime and government-manipulated market. It can't.

Why is the bubble bursting now? Again, it's not just about the natural economic ebb and flow. China's government is going through some unusual turmoil of its own recently. Xi Jinping is being called the "paramount leader" because he now holds the offices of General Secretary of the Communist Party, President of the People's Republic and the Chairman of the Central Military Commission. This gives Xi more power than his two predecessors and like all dictators who strive to consolidate their power even more, it's more an outward sign of weakness and fear than strength. Xi also started ordering the arrests of several high ranking members and former members of the Chinese Politburo late last year. Foreign and domestic investors usually react bearishly to these kinds of moves, and it's no different for China despite a decidedly delayed effect.

Does this mean China's repressive regime is in trouble of being overthrown? No. I don't see any evidence of that, and that's not the point. But what is being overthrown now is the aura the leaders in Beijing undeservedly acquired as some kind of economic supreme beings.

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Even if all of these moves are being made to cover up an economic slowdown, the political problem is worse. That's because if things do start to improve in China, how will we ever really know for sure? A totalitarian state, no matter how efficient, no matter how awash in resources, can never really be healthy economically.

But so many of China's promoters and detractors haven't been able to see this very simple truth. Investors have too easily been eager to accept Beijing's stimulus spending and questionable economic data and used them as a reason to keep buying. New York Times columnist Thomas Friedman famously gushed back in 2010 about how great it was that China's totalitarian government could instantly ban environmentally unfriendly plastic bags, as if any government having the power to ban something that was legal a minute beforehand could possibly be a good thing for an economy. And demonizing figures like Donald Trump have fallen for it too, decrying the Chinese for unfairly creating a booming economy at America's expense even as China's boom is ending and was never as great as it was cracked up to be in the first place.

Does this mean China is not an economic power? Of course China has tremendous economic value, but there's an economic growth premium that comes with a functioning democracy and a reasonable assumption that a democratic rule of law exists. Until China has those things, its assets should be bought and sold at a significant discount to defray the inherent risk of being tied to an unpredictable and repressive regime.

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U.S. investors seem to be waking up to that fact over the past few weeks. Hopefully, they'll also wake up to the fact that it's trends like these that prove the United States economy and markets must continue to lead the world economy and financial systems. Too many of our political leaders, including President Obama, have been all too eager to push America out of the leadership role internationally whether it's Asia, the Middle East, Europe, or the financial markets the world over. Recent events in all those arenas prove it's far too costly for the U.S. to take a backseat. We cannot allow China, Russia or any other non-free nation to set the tone throughout the world. Otherwise, you get crazy moves in the market like what we're seeing now. Otherwise, it's just too dangerous for our wealth and our freedom.

Commentary by Jake Novak, supervising producer of "Power Lunch." Follow him on Twitter @jakejakeny.