What needs to happen is to let it collapse, and FORCE these people to create a private sector that actually MAKES something
You are correct, but there are several stumbling blocks. The first and most obvious is that no outsiders are going to invest in Gaza while it is at war with Israel and itself. They will never attract capital other than grants and aid, so there can be no private sector economic development.
A second problem is the uncertainty of how they will manage a private sector economy. For example, even if they did "make peace" if they turn to sharia law there will be no economic incentive for foreign capital because women won't be allowed to drive or eat out with others, locals can't go to bars, and heck, no tourists will go to a place where there are no bars, no women, no good entertainment, no attractions, and the threat of death if you happen to violate some arcane law you aren't aware of (i.e. talking to a woman on the street).
A third problem is the corruption, but this is also mired in a clannish society. There are strong clannish ties - some heavily armed clans - that control everything within a number of city blocks. But if you pay them off, you still need to pay off everyone en route to your "safe zone" or else you can't get to your investment.
When President Bush demanded an end to violence, financial transparancy and the implementation of democratic principles he was 100% correct, but it's not going to happen anytime soon. There is no civilian oversight over the police force - heck, there are already like a dozen different police forces. There isn't a well functioning judicial system... if a clan member is arrested for a crime his clan buddies will burst into court, guns ablazing, and "liberate" him. Lawyers and judges are blackmailed or threatened.
They are so indoctrinated against Israel they cannot see how Israel can benefit them in so many ways. Israel would be their most natural ally, their biggest trading partner, one of the biggest employers, and has decades of experience in running a functional, capitalist democracy from which they can model their own country/society. Sure Israel isn't perfect and the Palestinians aren't Jews, there are cultural differences that will require alterations but there are several principles they must hold sacrosanct in order to succeed.
The only theocracies/dictatorships that are successful in the world are those that have tremendous natural resources like Saudi Arabia, Kuwait, even perhaps Iran to a degree. The Palestinians don't have natural resources to live on, so they have no choice but to develop a skilled workforce and exploit (in the good sense) what they do have. They have access to the sea to develop fisheries, ports of trade, and seaside tourist resorts. They have farmland and can export exotic fruits, vegetables and flowers to Europe. In conjunction with Israel/Jordan/Iraq they could develop a trade route to bypass the Suez (which is too small anyway) from Europe to the far east.
But so long as the lust to "avenge" their myths of past "loss" persist they are sacrificing their present and their future. And to think, Clinton put $30 billion in economic incentive on the table if Arafat would have accepted the Clinton plan (97% of the West Bank/Gaza, land swaps, share of Jerusalem). Imagine what it would be like today if they had accepted that deal 6 years ago. No Palestinian media will put that into perspective. I believe in fact the proposal never got to the Palestinian people - their media kept it from them (controlled by the PA of course). If they had the chance to know about the offer they might have risen to demand acceptance of it.