The third great wave

The first two industrial revolutions inflicted plenty of pain but ultimately benefited everyone. The digital one may prove far more divisive, argues Ryan Avent

Oct 4th 2014

MOST PEOPLE ARE discomfited by radical change, and often for good reason. Both the first Industrial Revolution, starting in the late 18th century, and the second one, around 100 years later, had their victims who lost their jobs to Cartwright’s power loom and later to Edison’s electric lighting, Benz’s horseless carriage and countless other inventions that changed the world. But those inventions also immeasurably improved many people’s lives, sweeping away old economic structures and transforming society. They created new economic opportunity on a mass scale, with plenty of new work to replace the old.

A third great wave of invention and economic disruption, set off by advances in computing and information and communication technology (ICT) in the late 20th century, promises to deliver a similar mixture of social stress and economic transformation. It is driven by a handful of technologies—including machine intelligence, the ubiquitous web and advanced robotics—capable of delivering many remarkable innovations: unmanned vehicles; pilotless drones; machines that can instantly translate hundreds of languages; mobile technology that eliminates the distance between doctor and patient, teacher and student. Whether the digital revolution will bring mass job creation to make up for its mass job destruction remains to be seen.

Powerful, ubiquitous computing was made possible by the development of the integrated circuit in the 1950s. Under a rough rule of thumb known as Moore’s law (after Gordon Moore, one of the founders of Intel, a chipmaker), the number of transistors that could be squeezed onto a chip has been doubling every two years or so. This exponential growth has resulted in ever smaller, better and cheaper electronic devices. The smartphones now carried by consumers the world over have vastly more processing power than the supercomputers of the 1960s.

Moore’s law is now approaching the end of its working life. Transistors have become so small that shrinking them further is likely to push up their cost rather than reduce it. Yet commercially available computing power continues to get cheaper. Both Google and Amazon are slashing the price of cloud computing to customers. And firms are getting much better at making use of that computing power.

In a book published in 2011, “Race Against the Machine”, Erik Brynjolfsson and Andrew McAfee cite an analysis suggesting that between 1988 and 2003 the effectiveness of computers increased 43m-fold. Better processors accounted for only a minor part of this improvement. The lion’s share came from more efficient algorithms.

The beneficial effects of this rise in computing power have been slow to come through. The reasons are often illustrated by a story about chessboards and rice. A man invents a new game, chess, and presents it to his king. The king likes it so much that he offers the inventor a reward of his choice.

The man asks for one grain of rice for the first square of his chessboard, two for the second, four for the third and so on to 64. The king readily agrees, believing the request to be surprisingly modest.

They start counting out the rice, and at first the amounts are tiny. But they keep doubling, and soon the next square already requires the output of a large ricefield. Not long afterwards the king has to concede defeat: even his vast riches are insufficient to provide a mountain of rice the size of Everest. Exponential growth, in other words, looks negligible until it suddenly becomes unmanageable.

Messrs Brynjolfsson and McAfee argue that progress in ICT has now brought humanity to the start of the second half of the chessboard. Computing problems that looked insoluble a few years ago have been cracked. In a book published in 2005 Frank Levy and Richard Murnane, two economists, described driving a car on a busy street as such a complex task that it could not possibly be mastered by a computer. Yet only a few years later Google unveiled a small fleet of driverless cars. Most manufacturers are now developing autonomous or near-autonomous vehicles. A critical threshold seems to have been crossed, allowing programmers to use clever algorithms and massive amounts of cheap processing power to wring a semblance of intelligence from circuitry.

Evidence of this is all around. Until recently machines have found it difficult to “understand” written or spoken language, or to deal with complex visual images, but now they seem to be getting to grips with such things. Apple’s Siri responds accurately to many voice commands and can take dictation for e-mails and memos. Google’s translation program is lightning-fast and increasingly accurate, and the company’s computers are becoming better at understanding just what its cameras (as used, for example, to compile Google Maps) are looking at.

At the same time hardware, from processors to cameras to sensors, continues to get better, smaller and cheaper, opening up opportunities for drones, robots and wearable computers. And innovation is spilling into new areas: in finance, for example, crypto-currencies like Bitcoin hint at new payment technologies, and in education the development of new and more effective online offerings may upend the business of higher education.

This wave, like its predecessors, is likely to bring vast improvements in living standards and human welfare, but history suggests that society’s adjustment to it will be slow and difficult. At the turn of the 20th century writers conjured up visions of a dazzling technological future even as some large, rich economies were limping through a period of disappointing growth in output and productivity.

Then, as now, economists hailed a new age of globalisation even as geopolitical tensions rose. Then, as now, political systems struggled to accommodate the demands of growing numbers of dissatisfied workers.

Some economists are offering radical thoughts on the job-destroying power of this new technological wave. Carl Benedikt Frey and Michael Osborne, of Oxford University, recently analysed over 700 different occupations to see how easily they could be computerised, and concluded that 47% of employment in America is at high risk of being automated away over the next decade or two. Messrs Brynjolfsson and McAfee ask whether human workers will be able to upgrade their skills fast enough to justify their continued employment. Other authors think that capitalism itself may be under threat.

The global eclipse of labour
This special report will argue that the digital revolution is opening up a great divide between a skilled and wealthy few and the rest of society. In the past new technologies have usually raised wages by boosting productivity, with the gains being split between skilled and less-skilled workers, and between owners of capital, workers and consumers. Now technology is empowering talented individuals as never before and opening up yawning gaps between the earnings of the skilled and the unskilled, capital-owners and labour. At the same time it is creating a large pool of underemployed labour that is depressing investment.

The digital revolution is opening up a great divide between a skilled and wealthy few and the rest of society
The effect of technological change on trade is also changing the basis of tried-and-true methods of economic development in poorer economies. More manufacturing work can be automated, and skilled design work accounts for a larger share of the value of trade, leading to what economists call “premature deindustrialisation” in developing countries. No longer can governments count on a growing industrial sector to absorb unskilled labour from rural areas. In both the rich and the emerging world, technology is creating opportunities for those previously held back by financial or geographical constraints, yet new work for those with modest skill levels is scarce compared with the bonanza created by earlier technological revolutions.

All this is sorely testing governments, beset by new demands for intervention, regulation and support. If they get their response right, they will be able to channel technological change in ways that broadly benefit society. If they get it wrong, they could be under attack from both angry underemployed workers and resentful rich taxpayers. That way lies a bitter and more confrontational politics.

Emerging economies

Arrested development

The model of development through industrialisation is on its way out

Oct 4th 2014

THIRTY-FIVE YEARS ago Shenzhen was a tiny fishing village just over the river from British Hong Kong. Its inhabitants, like most Chinese, lived in poverty. In 1978 the average income in America was about 21 times that in China. But in 1979 China’s leader, Deng Xiaoping, chose Shenzhen as the country’s first special economic zone, free to experiment with market activity and trade with the outside world. Shenzhen quickly found itself at the leading edge of Chinese economic development, using the same model as Japan, South Korea and Hong Kong itself had done at earlier stages. In the late 1970s China was bursting with cheap, unskilled labour. It opened its doors (a crack, in lucky places like Shenzhen) to foreign manufacturers waiting to take advantage of these low labour costs. Even though wages were at rock bottom, both productivity and pay in urban factories were dramatically higher than in agriculture, so China’s fledgling industrialisation attracted a steady flow of migrants from the countryside.

Over time local production became more sophisticated and wages went up. Industrial cities served as escalators for development, linking the Chinese economy with global markets and allowing incomes to rise steadily. The fruits of this process are clearly visible. As visitors approach the checkpoints between Hong Kong and the mainland, a modern skyline rises on the horizon. Great glass-sheathed skyscrapers reach upwards in central Shenzhen, which boasts some of the world’s tallest buildings. At street level Chinese workers stroll past shopfronts displaying Western luxury brands: Ferrari, Bulgari, Louis Vuitton.

Governments across the emerging world dream of repeating China’s success, but the technological transformation now under way appears to be permanently changing the economics of development. China may be among the last economies to be able to ride industrialisation to middle-income status. Much of the emerging world is facing a problem that Dani Rodrik, of the Institute for Advanced Study in Princeton, New Jersey, calls “premature deindustrialisation”.

For most of recent economic history, “industrialised” meant rich. And indeed most countries that were highly industrialised were rich, and were rich because they were industrialised. Yet this relationship has broken down. Arvind Subramanian, of the Peterson Institute for International Economics and reportedly soon to become chief economic adviser to the Indian government, notes that, at any given level of income, countries today are less reliant on manufacturing, in terms of both output and employment, than they were in the past, and that the level of income per person at which reliance on manufacturing peaks has also declined steadily (see chart 4). When South Korea reached that point in 1988, its workers’ earnings averaged just over $10,000 (in PPP-adjusted 2011 dollars) per person. When Indonesia got there in 2002, average income was just under $6,000, and for India in 2008 it was just over $3,000.

Premature non-industrialisation
Early loss of industry (or, in India’s case, what Mr Subramanian calls “premature non-industrialisation”) is a distressing trend, given the role that exports of goods have historically played in economic development. Productivity in export industries is generally high, otherwise they could not compete in global markets. Over time, productivity in making traded goods tends to rise as firms and workers in the industry become familiar with the technologies involved. Past developmental success stories such as the Asian tigers moved from low-margin, labour-intensive goods such as clothing and toys to electronics assembly, then on to component manufacture and, in the textbook cases of Japan and South Korea, to advanced manufacturing, design and management.

Export success trickles down to the rest of developing economies. Since producers of non-traded goods and services, such as housebuilders and lawyers, must compete with exporters for labour, they need to pay attractive wages. At the same time the chance of well-paid work in manufacturing creates an incentive for workers to move to cities and invest in education. An industrialising export sector is like a speedboat that pulls the rest of the economy out of poverty.

Loss of industry at low income levels, by contrast, caps the contribution that manufacturing can make to domestic living standards. That is no small problem: there is no obvious alternative strategy for turning poor countries into rich ones.

The change in technology’s role in development began in the 1980s. Richard Baldwin, an economist at the Graduate Institute of International and Development Studies in Geneva, explains that for much of modern economic history the driving force behind globalisation was the falling cost of transport. Powered shipping in the 19th century and containerisation in the 20th brought down freight charges, in effect shrinking the world. Yet since the 1980s, he says, cheap and powerful ICT has played a bigger role, allowing firms to co-ordinate production across great distances and national borders. Manufacturing “unbundled” as supply chains scattered across the world.

According to Mr Baldwin, this meant a profound change in what it is to be industrialised. The development of an industrial base in Japan and South Korea was a long and arduous process in which each economy needed to build capabilities along the whole of a supply chain to manufacture finished goods. That meant few economies managed the trick, but those that did were rewarded with a rich and diverse economy.

In the era of supply-chain trade, by contrast, industrialisation means little more than opening labour markets to global manufacturers. Countries that can grab pieces of global supply chains are quickly rewarded with lots of manufacturing employment. But development that is easy-come may also be easy-go. Unless the economies concerned quickly build up their workers’ skills and infrastructure, wage increases will soon lead manufacturers to up sticks for cheaper locations.

From stuff to fluff
Another mechanism through which new technology is changing the process of development is the dematerialisation of economic activity. Consumption the world over is shifting from “stuff to fluff”, reckons Mr Subramanian. People everywhere are spending a larger share of their income on services such as health care, education and telecommunications. This shift is reflected in trade. Messrs Subramanian and Kessler note that, measured in gross terms, goods shipments dominate trade as much as ever. They accounted for 80% of world exports in 2008 (the most recent figure available), down only slightly from 83% in 1980. Measured in value-added terms, however, the importance of goods trade tumbled, from 71% of world exports in 1980 to just 57% in 2008, because of the increasing weight of services in the production of traded goods. Much of the value of an iPhone, for example, derives from the original design and engineering of the product rather than from its components and assembly.

A recent report by the McKinsey Global Institute put the value in 2012 of “knowledge-intensive” trade—meaning flows of goods or services in which research and development or skilled labour contribute a large share of value—at $12.6 trillion, or nearly half the total value of trade in goods, services and finance. Physical assembly accounts for a declining share of the value of finished goods.

The knowledge-intensive component of trade is also growing more quickly than trade in labour-, capital- or resource-intensive products and services. At the same time the dramatic decline in the cost of information and communications technologies has opened up trade in some high-value services. Skilled programmers in India, for example, can sell IT services around the world despite the low overall level of development of the Indian economy.

India has masses of cheap, unskilled labour that ought to be attractive to firms wanting to set up low-cost manufacturing facilities. Yet operating them would require at least some skilled workers, and the rising premium on these created by trade in ICT services makes it uneconomic for many would-be manufacturers to hire the necessary talent. Mr Subramanian and Raghuram Rajan, another Indian economist, have dubbed this the “Bangalore bug”, a reference to the extraordinarily successful ICT cluster in the southern Indian city of Bangalore. But other emerging economies are similarly affected.

Other advances are eliminating the need for human labour altogether. Walking through an electronics production line at Foxconn’s Longhua campus in Shenzhen, a worker points out places where people have already been replaced by machinery—“to reduce injuries to workers”, he says. Elsewhere on the line he indicates a place where a robot is being tested to take over a range of tasks from humans. Perhaps 10% of the staff at Longhua now consists of engineers working on such automation.

Successful solutions will be rolled out to other Foxconn facilities, says Louis Woo, a special adviser to Foxconn’s chairman, Terry Gou. And Foxconn has even greater ambitions. In Chengdu it is working on a “lights out”, entirely automated, facility which serves a single, as yet unnamed, customer. In fast-developing and rapidly ageing China workers are becoming increasingly expensive, as well as hard to find. Automation provides a means to hold on to work that might otherwise pack up and move to another country.

It also saves a lot of trouble. Vast areas of Foxconn’s Longhua campus are given over to support services for the roughly quarter of a million workers employed there: shops and restaurants, a massive central kitchen with automated rice-cooking equipment, dormitories that house about half the staff, schools for workers’ children and counselling services for distressed employees. Foxconn’s dormitories are ringed with netting, a precaution prompted by an epidemic of suicides by workers that set off a torrent of bad press for the company and its customers. Indeed, notes Mr Woo, it is often customers that are behind the push for greater automation of Foxconn’s facilities.

The falling cost of automation makes the use of robots attractive even in India, where cities are swarming with underemployed young workers. The main reason for that is the country’s thicket of red tape. Mr Subramanian thinks India’s best hope now may be to concentrate on churning out more highly skilled workers, rather than count on manufacturing to mop up its jobless millions.

The rapid growth in emerging economies over the past 15 years was good for many very poor countries in Africa and Central America, but most still grew more slowly than richer developing countries in Asia and South America. Given the institutional weakness, inadequate infrastructure and modest skills base in many of the world’s poorest places, even rock-bottom wages there may be insufficient to attract much manufacturing.

That is a distressing prospect. The United Nations estimates that sub-Saharan Africa’s population will roughly triple over the next half-century, to about 2.7 billion. A development model in which rapidly rising incomes are limited to a highly skilled few is unlikely to be sustainable. Many talented workers are already thinking about emigrating, yet rich economies trapped by growing social spending and shrinking tax bases are more likely to slam their borders shut. Over the past decade or two inequality, despite rising within many economies, has shrunk at the global level, thanks to rapid growth in large emerging markets. But in the absence of a new development model, that happy state of affairs may soon be reversed.

Review & Outlook

The President of Inequality

Policies promoting equality over growth have damaged both.

Getty Images
In the latest grim tiding of the public mood, merely 42% think the American dream that "if you work hard, you'll get ahead" remains true, down from 53% in 2012 and 50% in 2010. According to the Public Religion Research Institute poll last week, the steepest declines in belief in the last two years were among people under age 30 (down 16 percentage points), women (14 points) and Democrats (17).
In other words, the most disillusioned belong to the coalition that elected President Obama. But before giving up on upward mobility, they ought to blame the policies he has enacted. Mr. Obama has been the best President for slow growth and inequality in modern history, as new economic surveys show.


Start with the Census Bureau's annual poverty and income survey, which came out this month. Real U.S. median household income—or the wages earned in the middle of the wage distribution—was $51,939, a 0.3% increase over 2012. But the 2013 figure is still 3.9% lower than the median income when the recession ended in 2009, and 7.9% lower than the median in 2007.
One trick some liberals use to obscure the uniquely bad performance of the Obama years is to go back to the height of the dot-com bubble in 1999 when real income peaked at $56,895 and compare it to 2013. But this conveniently ignores that real median household income rebounded smartly in the middle of the last decade. That rebound occurred after the Bush tax cuts on capital income and marginal income-tax rates became law in 2003.
As the nearby chart shows, incomes fell after 1999 through 2004 but then rose again for three straight years and nearly reached the 1999 level in 2007 at $56,436. The bottom fell out with the 2008 financial panic and recession, as you would expect. But the amazing fact of the Obama years is that incomes did not rebound with the recovery as they have in every other expansion. Only in 2013 did incomes begin to pick up modestly, five long years into recovery.
Even then real median income did not increase in 2013 in 36 states. Instead, the gains were concentrated in metro areas like Washington-Arlington-Alexandria (median: $90,149), San Francisco-Oakland-Hayward ($79,624) and Boston-Cambridge-Newton ($72,907). Wyoming amid the fracking revolution was another standout, with the median rising 5.7%.
This slow, uneven growth has also led to an increase in inequality by the measures the President's favorite economists like to cite. The Census reports that the U.S. Gini Coefficient, which measures income inequality, "was significantly higher" in 2013, rising to 0.481 from 0.476. About 45.3 million people or 14.5% of the population live below the official poverty line, down from 15% in 2012 but statistically the same number of people. Poverty over the prior four years rose to the highest levels since the mid-1960s. The poverty rate was 14.3% in 2009 and 12.5% in 2007.
This month the Federal Reserve also published its triennial Survey of Consumer Finances examining the 2010-2013 period. Overall average real family income rose 4%, but median income fell 5%, "consistent with increasing income concentration." There were essentially no changes for people between the 40th and 90th income percentiles after steep losses from 2007-2010, while median income rose 2% among the top 10% and fell 5.5% among the bottom 40%.
All of this is especially notable because it follows the most sustained policy focus on reducing inequality in decades. President Obama's stimulus spending in 2009-2010 was devoted mainly to transfer payments like Medicaid and jobless benefits. Expanding the number of Americans on food stamps and disability payments have been explicit policy goals. ObamaCare is designed to provide "free" health care to millions of Americans by taxing the wealthy and those who already have insurance.
Mr. Obama has also focused on income redistribution to punish the affluent while financing income transfers. So he cornered Republicans in the 2013 fiscal cliff and succeeded in raising the top income tax rate as well as levies on capital gains, dividends and small-business income.
On CBS 's "60 Minutes" on Sunday Mr. Obama answered a question about economic anxiety by offering another increase in the minimum wage. But the Nancy Pelosi Democrats raised the minimum wage in three stages to $7.25 an hour in 2009 from $5.15 in 2007. If mandated wages are so beneficial to the American worker, where is the evidence?
The Census data show that every income group that was supposed to benefit from the higher wages is worse off than before the minimum wage was increased. This is because the benefits of mandated wage increases for some workers are dwarfed by the overall negative economic trends of slower growth and reduced opportunity.
Another culprit in this skewed economic recovery has been monetary policy. The Fed's QE exertions have been explicitly targeted at raising asset prices, such as stocks and real estate, that are disproportionately held by the affluent. Meantime, Americans without such assets have received a pittance on their savings. The White House has been a stalwart supporter of these Fed policies.


Census data like this used to get banner headlines, but these days they barely get media notice. Perhaps it is too embarrassing to point out that the policies flaunted to reduce inequality have presided over so much more of it. Instead, liberals use the fact of flat or falling incomes to call for more of the same policies that have resulted in flat or falling incomes. By making equality a higher priority than economic growth, Mr. Obama has reduced growth and increased inequality.
What's needed now is a return to policies that put growth as the country's highest economic priority. The wealthy may get richer as a result, but so will the middle class and poor who haven't benefitted from Mr. Obama's focus on inequality.
The good news is that the public may be ahead of the politicians in seeking this change, and it is certainly ahead of the media. A survey this year by the Global Strategy Group found that by 59% to 37% Americans prefer a political candidate who focuses on economic growth to one who focuses on fairness. Thus is Mr. Obama creating, albeit unintentionally, a new opening for the politics of growth.

Read This, Spike That

The Cracks in the Economy

Several articles show that a positive jobs report and 5.9% unemployment don’t tell the full story.

By John Kimelman

Updated Oct. 3, 2014 5:06 p.m. ET

Investors woke up Friday morning to great news about the economy.
The U.S. Labor Department reported that employers added 248,000 jobs last month, about 30,000 more than economists expected. In addition, job numbers for previous months were revised upward.

And the jobless rate fell to 5.9% last month from August’s 6.1%. The stock market rallied modestly on the news.
But those encouraging headline numbers don’t reveal the extent to which problems remain with the economy.
As a piece in points out, there are a slew of other data points that aren’t as encouraging.
For example, average hourly earnings were down a penny in September to $24.53, bringing the year-over-year growth rate down to 2%. And the much-discussed labor-force participation rate, instead of going up, ticked down slightly from 62.8% to 62.7%.
Recent headlines have been pointing to economic warning signs in the form of sliding energy prices due to weak demand from a weakened China, weak manufacturing, and a fall-off in new home construction, in part because of cash-strapped younger people.
It’s small wonder then, according to Fortune’s Chris Matthews, that a “whopping 72% of Americans believe we are still in a recession,” according to a recent poll from the Public Religion Research Institute.
It’s easy to conclude that Americans who talk to pollsters about the economy are simply misinformed about the economy or simply have a negative bias. But the lackluster income numbers support their distress.
As Matthews puts it, “The total number of jobs created, which had been a good enough metric to estimate the state of the economy, just isn’t cutting it anymore. The number we need to be looking at, which is also released in the monthly Employment Situation Report, is income. And unlike the jobs picture, there’s been little to no improvement when it comes to average hourly earnings.”
Matthews points put that since the current economic recovery began, average hourly earnings have only kept up with inflation. “And without rising incomes, there’s little reason for people to feel like their lives are getting better or for the economy to grow at a faster rate.”
Another interesting piece by Matthews seeks to get to the heart of economic woes that have prevented the housing industry from recovering more robustly since the end of the financial crisis. 

“According to Jed Kolko, chief economist at Trulia, all of this can be laid at the feet of the Millennial generation; or, to be more specific, the fact that members of that generation can’t find jobs,” writes Matthews. “In a report released on Wednesday, Kolko points out that while home prices, existing home sales, and the foreclosure rate have more or less recovered to their pre-bubble norms, two measures—new home construction and youth unemployment—show where the recovery has come up short.”
As Kolko writes, these measures “connect the housing market to the job market,” because youth employment creates demand for housing, and demand for housing creates good paying, middle-class jobs that can help further spur economic and wage growth.
The Fortune article concludes, “Housing prices have recovered, but no amount of home price appreciation can solve the fact that young people don’t have jobs, and the ones they do have aren’t paying well enough for them to form households of their own.”
Indeed, the extent to which many Americans are not engaged in the labor force is referred to by economists as “slack.” In a column that appeared this week in the New York Times, Jared Bernstein, a senior fellow at the Center on Budget and Policy Priorities in Washington and a former chief economist to Vice President Joe Biden, writes that as long as this slack exists, the Fed will move cautiously in raising short-term rates despite the positive headline job numbers.
“There are at least two special factors that are distorting the unemployment rate’s signal,” writes Bernstein. “First, there are over seven million involuntary part-time workers, almost 5% of the labor force, who want, but can’t find, full-time jobs. That’s still up two percentage points from its pre-recession trough.”
Bernstein writes that the second factor masking the extent of slack as measured by unemployment has to do with participation in the labor force.
“Once you give up looking for work, you’re no longer counted in the unemployment rate, so if a bunch of people exit the labor force because of the very slack we’re trying to measure, it artificially lowers unemployment, making a weak labor market look better,” he adds.
When American’s get a collective pay raise and young folks can afford to move out of their parents’ basements en masse, we’ll have real reason to celebrate about the economy.

lunes, octubre 06, 2014



China’s Inscrutable Contraction

Kenneth Rogoff

OCT 3, 2014

CAMBRIDGE – While virtually every country in the world is trying to boost growth, China’s government is trying to slow it down to a sustainable level. As China shifts to a more domestic-demand driven, services-oriented economy, a transition to slower trend growth is both inevitable and desirable. But the challenges are immense, and no one should take a soft landing for granted.
As China’s economy grows relative to the economies of its trading partners, the efficacy of its export-led growth model must inevitably fade. As a corollary, the returns on massive infrastructure investment, much of which is directed toward supporting export growth, must also fade.
Consumption and quality of life need to rise, even as China’s air pollution and water shortages become more acute in many areas. But, in an economy where debt has exploded to more than 200% of GDP, it is not easy to rein in growth gradually without triggering widespread failure of ambitious investment projects. Even in China, where the government has deep pockets to cushion the fall, one Lehman Brothers-size bankruptcy could lead to a major panic.
Think of how hard it is to engineer a soft landing in market-based economies. Many a recession has been catalyzed or amplified by monetary-tightening cycles; former US Federal Reserve Chairman Alan Greenspan was christened the “maestro” in the 1990s, because he managed to slow inflation and maintain strong growth simultaneously. The idea that controlled tightening is easier in a more centrally planned economy, where policymakers must rely on far noisier market signals, is highly questionable.
If one were to judge by official and market growth forecasts, one would think that the risks were modest. China’s official target growth rate is 7.5%. Anyone forecasting 7% is considered a “China bear,” and predicting a downshift to 6.5% makes one a downright fanatic.


lunes, octubre 06, 2014



Gold Is Against The Ropes

  • Gold is now sitting at support.              
  • Common trend extrapolation has everyone looking lower.                
  • Upcoming week's expectations.

In a title fight, when one boxer has been terribly bludgeoned and is being pushed back on the ropes, the ref often steps in to call the fight. We are now witnessing such a situation in the metals world, but there does not seem to be a red to step in. Gold is on its own.

Since the highs of 2011 - the so called hey-day for gold - it was the heavy-weight champion of the world. Everyone who attempted to short gold was dealt fast knock-out punches, just like Mike Tyson's opponents in the late 80's. No short traders could stand in the ring with it.

But, in 2011, gold clearly lost its edge. It was dealt its own knock out blow. In 2012, it attempted a come-back, however, in April of 2013, it was dealt yet another knock-out blow. So, in 2013, with the gold-bug world in its corner, it attempted yet another come-back. Everyone was so convinced that this comeback was for real, and it would regain its heavy-weight glory. But, of late, it has been bludgeoned again, and is up against the ropes. Will October of 2014 deal it a final knock-out blow?

Just three months ago, I remember standing alone against a tide of extreme bullishness in gold. I was staunchly retaining the position that lower lows will be seen in the metals. Yet, everyone else seemed so confident that we were on our way to higher highs. Many even went so far as to ridicule my expectation, and warn me that my short trade would be stopped out for a nice loss.

Now, amazingly, everyone seems to be convinced that gold will be dealt a final death blow. I am being sent daily emails about other analysts now calling for sub-$700 levels on gold. But, one cannot blame them for such expectations. 95% of analysts and just about 100% of investors engage in what we normally refer to as trend extrapolation. And, this is why the herding principle works so well.

Many look at the trend as it currently exists, and simply expect it will continue indefinitely into the future. Very few are able to identify points at which a trend can change. And, those that attempt to do so often lack the tools and ability to do so on a consistent basis.

So, I have to ask you, how difficult is trend extrapolation? Simply draw a trend channel and follow it. It is the crudest form of analysis and works very well during a strongly trending market. But, it will never be able to identify the point at which a trend changes until after the fact. And, why would you need to read an analyst to provide you with a lot of technical-speak to simply provide you with trend extrapolation?

Well, I would say that such analysis is far better than what I consider driving a car, while looking out the back window. Yes, I am referring to fundamental analysis which has only hurt most investors over the last 3+ years in the metals market.

In my humble opinion, I believe that, as more and more study is conducted into investor psychology and the social aspect of economics, we will ultimately abandon the use of "fundamental analysis" as the main research tool in identifying market direction. In fact, many noteworthy scholars and economists have begun to recognize that using fundamental analysis to determine market turning points is akin to driving a car blindfolded, while facing the rear window.

As an example, in a paper written by Professor Hernan Cortes Douglas, former Luksic Scholar at Harvard University, former Deputy Research Administrator at the World Bank, and former Senior Economist at the IMF, he noted the following regarding those engaged in "fundamental" analysis for predictive purposes:

The historical data say that they cannot succeed; financial markets never collapse when things look bad. In fact, quite the contrary is true. Before contractions begin, macroeconomic flows always look fine. That is why the vast majority of economists always proclaim the economy to be in excellent health just before it swoons. Despite these failures, indeed despite repeating almost precisely those failures, economists have continued to pore over the same macroeconomic fundamentals for clues to the future. If the conventional macroeconomic approach is useless even in retrospect, if it cannot explain or understand an outcome when we know what it is, has it a prayer of doing so when the goal is assessing the future?

I think all those that are intellectually honest understand the severe limitations in using fundamental analysis for prognostication purposes in a non-linear market, such as the metals. And, this applies to stocks, as well as the overall economy, with the best example I have seen to date being the case of AAPL stock.

For years, AAPL's stock kept driving higher and higher. Its fundamental picture was as rosy as could be. However, as we approached the 700 region, and as almost all analysts joined the consensus of AAPL heading to levels exceeding 800, those of us who understood sentiment were looking for a market top. Unfortunately, the great majority did not see it coming, and many lost a lot of money when AAPL topped right when a small number of us expected.

So, why is tracking sentiment more effective than fundamental analysis?

Fundamental analysis is generally defined as a method of evaluation that attempts to measure "value" by examining related "current" economic, financial and other qualitative and quantitative factors. Fundamental analysts will utilize "current" macroeconomic factors (like the overall economy and industry conditions) and company-specific factors (like financial condition and management).

Therefore, market fundamentals are the existing conditions of a market based upon historical data. In order to utilize this information for predictive purposes, economists will employ a form of trend extrapolation. This effectively presumes that the current market conditions will continue indefinitely into the future, until they do not. This is possibly the crudest form of linear extrapolation. But, can it really foresee turning points in a non-linear environment? If we wait for the underlying "fundamentals" to change, are we not already within a different trend within the market that is now changing underlying fundamentals?

The common perception in the market is that the news causes changes in market psychology and fundamentals, which then causes changes in prices. But I believe that the correct, more consistently applicable premise is that market psychology and sentiment are the causes of news events and changes in prices, whereas fundamentals are purely lagging indicators, and the result of psychology and sentiment changes.

Bernard Baruch, an exceptionally successful American financier and stock market speculator who lived from 1870- 1965, identified the following long ago:

All economic movements, by their very nature, are motivated by crowd psychology. Without due recognition of crowd-thinking ... our theories of economics leave much to be desired. ... It has always seemed to me that the periodic madness which afflicts mankind must reflect some deeply rooted trait in human nature - a trait akin to the force that motivates the migration of birds or the rush of lemmings to the sea ... It is a force wholly impalpable ... yet, knowledge of it is necessary to right judgments on passing events.

During his tenure as chairman of the Federal Reserve, Alan Greenspan testified many times before various committees of Congress. In front of the Joint Economic Committee, Green- span noted that markets are driven by "human psychology" and "waves of optimism and pessimism." Ultimately, as Greenspan correctly recognized, it is social mood and sentiment that moves markets. I believe this makes much more sense when deriving the causality chain.

During a negative sentiment trend, the market declines, and the news seems to get worse and worse. Once the negative sentiment has run its course, however, and it's time for sentiment to change direction, the general public then becomes subconsciously more positive.

When people become positive about their future, they are willing to take risks. What is the most immediate way that the public can act on this return to positive sentiment? The easiest is to buy stocks. For this reason, we see the stock market lead in the opposite direction before the economy and fundamentals have turned. This is why R.N. Elliott, whose work led to Elliott wave theory, believed that the stock market is the best barometer of public sentiment.

Let's look at the same change in positive sentiment and what it takes to have an effect on the fundamentals. When the general public's sentiment turns positive, this is the point at which they are willing to take more risks based on their positive feelings about the future. Whereas investors immediately place money to work in the stock market, having an immediate affect upon stock prices, business owners and entrepreneurs seek loans to build or expand a business, which take time to secure. They then place the newly acquired funds to work in their business by hiring more people or buying additional equipment, and this takes more time. With this new capacity, they are then able to provide more goods and services to the public, and, ultimately, profits and earnings begin to grow - after more time has passed.

When the news of such improved earnings finally hits the market, most market participants seem shocked that the stock starts to move up strongly (even though the stock likely bottomed well before the public takes notice when the investors effectuated their positive sentiment by buying stock), and they simply attribute the stock's rise to the announcement of positive earnings.

There is a significant lag between a positive turn in public sentiment and the resulting change in the fundamentals of a stock or the economy, especially relative to the more immediate stock-buying activity that comes from the sentiment change. This is why fundamentalists can be left holding the bag at the top of a market, when the news and fundamentals look the most attractive, right before the market begins to dive, as sentiment turns in the opposite direction well before the fundamentals.

This lag is a much more plausible reason as to why the stock market is a leading indicator, as opposed to some form of investor omniscience. This also provides a plausible reason as to why earnings lag stock prices, as earnings are the last segment in the chain of positive mood effects on a business growth cycle. It is also why those analysts who attempt to predict stock prices based on earnings fail so miserably. By the time earnings are affected by a change in social mood, the social mood trend has already been negative for some time. And this is why economists fail as well - the social mood has shifted well before they see evidence of it in their "indicators."

In 1996, Robert Olson published a study in the Financial Analysts Journal in which he studied the effects of herding upon "expert" fundamental analysts' predictions of corporate earnings. After studying 4000 corporate earnings estimates, he arrived at the following conclusion:

Experts' earnings predictions exhibit positive bias and disappointing accuracy. These shortcomings are usually attributed to some combination of incomplete knowledge, incompetence, and/or misrepresentation.

Mr. Olson's article suggests that "the human desire for consensus leads to herding behavior among earnings forecasters," with the herd always looking for the current trend to continue unabated and indefinitely. But, those that have experience in the non-linear work of the stock market understand that the most bullish calls by these "expert fundamentalists" almost always come at the top of a market or stock.

So, allow me to apologize for my digression and ranting, but I have seen so many articles coming out of late that are extremely bearish on gold that it has even shocked me. If you remember, as we came into 2014, I wrote that this would likely be the year we see bullishness for metals die. And, it sure seems like we are witnessing exactly that now. And, yes, I think it will get even worse at the lower levels I expect. In fact, when we start seeing multiple articles claiming that gold is not to be touched as the bull market is clearly over, that will likely be when we have hit bottom.

Now, moving on to the current state of the gold market. While I correctly expected that gold would not break down yet below its 2013 lows this past week, we clearly did not get the bigger bounce I had wanted to see. Gold was clearly much weaker than I had expected. But, we have now made it into October, and, as I said last week, it is during this month that I think we have the potential to see gold break down below its 2013 lows.

I also owe everyone an apology. In the GLD, there is one thing I did not take into account. Although I have written before about how toxic the GLD is for long term investors, I did not take into account one of the reasons I noted it was so toxic - the loss of value inherent in the fund itself, irrespective of what the price of gold does. So, while gold has not yet touched its 2013 lows, the GLD has, due to this inherent loss of internal value. Therefore, it will actually take a strong break down below 113.50 to signal that we are on our way to our lower degree targets sooner rather than later.

Ultimately, I still would like to see a corrective bounce back to at least the 118 region before we set up to drive down to much lower lows in GLD. I can even see an "evil" set up which marginally breaks below the 2013 lows to run stops on traders, and then shoot back up in this corrective bounce I would like to see. It would stop many people out of their long positions and then cause them to chase the run up in price, at the same time that shorts begin covering. Both of these scenarios would leave a vacuum underneath the market which would support a strong drop later this month.

October 2, 2014 10:59 pm

Dwindling US inflation casts shadow

U.S. Federal Reserve Chair Jane Yellen (L) walks with European Central Bank President Marlo Draghi at the Jackson Hole Economic Policy Symposium in Jackson Hole, Wyoming August 22, 2014. REUTERS/David Stubbs (UNITED STATES - Tags: BUSINESS POLITICS)©Reuters
Market expectations of US inflation have slid to levels rarely seen over the past decade, overshadowing the outlook for growth for the world’s largest economy and posing a challenge to central bank policy makers.
With Japan and the eurozone pushing for weaker currencies to boost their struggling economies, a strengthening dollar since the summer has cut inflation pressures for the US. That raises the prospect of global disinflationary forces swinging back and forth between regions, reinforcing the current cycle of low interest rates and lacklustre growth.
“Investors are beginning to realise that, contrary to their confident actions and assurances, the Fed and the European Central Bank have failed to prevent a dreaded replay of Japan’s deflationary template a decade earlier in the west,” said Albert Edwards, strategist at Société Générale.

The Fed will get its latest reading on the health of the jobs market on Friday, with the release on non-farm payrolls data for September, expected to show 215,000 new jobs and a steady 6.1 per cent unemployment rate.

Some Fed officials are starting to think about the strength of the dollar, and the broader weakness of the global economy, as a threat to the US growth outlook. Fed chairwoman Janet Yellen warned of “a number of risks to the global economy” in her most recent press conference.
“Given the relative movements of exchange rates, it seems likely that our net export position is going to be a challenge for those of us in the US,” said Charles Evans, president of the Chicago Fed, on Monday.
He questioned whether the US can decouple from weak growth elsewhere in the world. “It would be pretty surprising to have a very strong economy in an otherwise weak world economy,” he said.

The US central bank follows a dual mandate of maximum employment and stable prices, which it defines as 2 per cent inflation. Since late 2008 the Fed has undertaken several rounds of bond purchases designed to stimulate the economy, boost job creation and firm up consumer prices.

While employment has steadily improved over the past 18 months, the inflation outlook has lagged behind the Fed’s target, with consumer prices recently retreating anew due to a stronger currency and lower commodity prices.

Now as the Fed looks to formally end quantitative easing this month, a key market measure of inflation expectations that is followed by the central bank has dropped back to 2.17 per cent, near levels that in the past provoked aggressive bond purchases from the central bank.

Alan Ruskin, strategist at Deutsche Bank, said the drop in inflation expectations “is bound to gain some attention among US officials, especially if it shows persistence at levels near 2 per cent”.

The Fed follows a specific measure that looks at five-year inflation expectations that start five years from now. The so-called five-year into five-year break-even rate loiters at 2.15 per cent, near the low from September 2011 and just above the financial crisis nadir of 1.95 per cent seen in December 2008.

Mario Draghi, president of the European Central Bank, said on Thursday that eurozone inflation expectations, as measured by the region’s five-year, five-year inflation swap rate, were still below the ECB’s target, but close to 2 per cent.

Beyond the energy and global growth story lowering US inflation expectations, the Treasury inflation market has also been influenced by the travails at Pimco. Bill Gross, the former manager of the Total Return Fund, was an advocate of inflation-protected bonds and the tens of billions of outflows from Pimco during September has compelled investors to pre-empt sales by the investment firm.

The Fed watches inflation expectations closely and similar drops were a factor in its decision to launch QE2 in 2010 and the so-called Operation Twist in 2011. They are particularly important to certain Fed officials, such as James Bullard of the St Louis Fed, who are otherwise inclined towards early rate rises.

Copyright The Financial Times Limited 2014.

lunes, octubre 06, 2014



Can Your Gold Be Confiscated?

  • There is a heated debate about confiscation.
  • Let's look at history as a guide.
  • Will it also affect your safety deposit boxes?

There is a major issue that is often debated amongst gold investors. And, it relates to the government's ability to confiscate gold owned by the public.

This issue often leads to heated debate, and, unfortunately, most of the debate I see on this matter is not supported by facts. Rather, arguments on the side of confiscation not being a possibility for which one must plan is often an emotional response which is quite tantamount to covering your eyes and muttering to yourself "it simply can't happen."

Many quote the famous words of Winston Churchill "Those who fail to learn from history are doomed to repeat it." However, if one delves further into where this astute phrase originated, you are led back to George Santayana (1863-1952), who likely "borrowed" it from Edmund Burke (1729-1797), a British philosopher, who stated that "Those who don't know history are destined to repeat it." But, I digress.

I would suggest we learn a little history before we can begin discussion of whether or not you have to be concerned about your gold being confiscated.

On April 5, 1933, President Roosevelt signed United States Presidential Executive Order 6102, "forbidding the hoarding of gold coin, gold bullion, and gold certificates within the continental United States." This was followed up by Presidential Proclamation 2039 which forbade the holding of gold or silver coin, bullion or currency under the penalty of law.

However, Order 6102 specifically exempted "gold coins having recognized special value to collectors of rare and unusual coins."

At the time, the United States was still under the gold standard, and Roosevelt felt the enactment of this Order was a necessary step to allow the Federal Reserve the ability to act in a somewhat unfettered manner to stem the tide of deflation through further money printing. To quote Irving Fisher from that period of time, "after a wave of bank failures . . . both banks and their depositors began raiding each other in a cut-throat competition which more than defeated the new issues of Federal Reserve notes."

The main point that many gold enthusiast point towards is that the confiscation Order was enacted during the time when the United States was still on the gold standard, and the government needed to control the gold in order to control monetary policy. So, of course, those that maintain the perspective that we will not face confiscation again appropriately note that, since we are no longer under the gold standard, the government does not have the same incentive to confiscate the public's gold.

However, I believe this is a very narrow reading of history, as well as a narrow perspective of the true purpose behind the enactment of this confiscation Order. I submit to all those reading this article another, more broad, perspective to take away from the enactment of such an Order. Does Roosevelt's signing of this Order not tell you that the government will go to whatever lengths it needs in order to maintain itself and an orderly society? Does it not tell you that if the government will deem it necessary to confiscate gold in the future for whatever purpose it deems necessary for the common good at the time, it will do so?

Remember what Franklin said in his autobiography: "So convenient a thing is it is to be a reasonable creature, since it enables one to find or to make a reason for everything one has a mind to do." And governments are not beyond such "reason."

While I will not harp on this issue any further, I suggest you consider this perspective a little more carefully, rather than "reason" that since we are no longer on the gold standard, the government will never confiscate gold again. I think too many proffer a public perspective based upon this over-simplified understanding of history and they are doing metals investors a serious disservice.

Furthermore, while there was an exemption to this order for those coins that retained independent numismatic value beyond the value of the actual gold itself, there is no guarantee that, should any future Order be enacted again, we will have a similar exemption; although, it is a reasonable expectation. For this purpose alone, I think it behooves all metals investors to have some allocation of their overall gold holdings in coins with independent numismatic value, especially those that view gold as "insurance."

In fact, in speaking with fellow Seeking Alpha contributor and precious metals broker Doug Eberhardt of Buy Gold and Silver Safely, Doug stated that "premiums for rare and semi-numismatic coins are at historic lows relative to their past. The risk is less when investing in these coins when you are paying lower premiums." So, it would seem that, should you consider adding this type investment to your overall gold portfolio, we are approaching an ideal time to so.

Before I conclude this article, I also want to address the related issue of safety deposit box seizures. It seems that there is a common belief that the government can simply seize all safety deposit boxes, which then makes any gold you have stored therein subject to government confiscation. However, there is only some truth to this perspective, again, based upon history.

During the 1930's, as thousands of banks failed during the massive deflationary spiral experienced by the United States, the Treasury came into possession of the safe deposit boxes located in these failed banks. So, one had to come to the US Treasury to claim the contents of their deposit boxes. Now, if one stored gold in the deposit boxes at one of these failed banks, then they were required to turn that gold over to the Treasury when they opened the deposit boxes.

So, if one is to learn a simple lesson from history, you would need to see several factors being in place before you would not be able to collect your gold from your bank deposit box. First, a confiscation order would have to be in effect. Second, the bank in which you store your gold would have to have failed and come under the control of the US Treasury.

Many of you are probably saying to yourself that you can now be much more comfortable with leaving gold in your safe deposit box at your bank since banks are not failing and there is no foreseeable confiscation order being proposed. Well, let's think about this. Gold is wanted by most as protection against systemic failure, whether that be governmental or financial. But, once the system does fail, only then do we begin to see confiscations and bank failures. So, the events that will have you seeking safety in your gold are the same events that can potentially prevent your access to your gold, or can even separate you from your gold.

So, I will leave you with one final quote from Franklin, which I sincerely hope you take to heart with regard to storing your gold:

"By failing to prepare, you are preparing to fail."

Hong Kong erupts even as China tightens screws on civil society

By Simon Denyer

September 30  

Chinese leaders unnerved by protests elsewhere this year have been steadily tightening controls over civic organizations on the mainland suspected of carrying out the work of foreign powers.

The campaign aims to insulate China from subversive Western ideas such as democracy and freedom of expression, and from the influence, specifically, of U.S. groups that may be trying to promote those values here, experts say. That campaign is long-standing, but it has been prosecuted with renewed vigor under President Xi Jinping, especially after the overthrow of Ukrainian President Viktor Yanukovych following months of street demonstrations in Kiev that were viewed here as explicitly backed by the West.

The tensions have been heightened by pro-democracy demonstrations in Hong Kong, and on Monday, Beijing warned other nations not to intervene in protests there. Chinese news media suggested that Western civil society organizations have had a hand in promoting unrest there.

In its tightening of control, China appears to be taking a page from the playbook of Russian President Vladi­mir Putin, who oversaw a crackdown on Russian non-governmental organizations (NGOs) two years ago that has sapped their ability to effect change.

The question now is whether the demonstrations in Hong Kong will accelerate Beijing’s campaign, at least on the mainland.

“Xi Jinping has clearly shown he is fond of Putin,” said Xiao Shu, a visiting fellow at Columbia University and a former newspaper columnist. “Xi doesn’t want to go back to Mao’s path, but he doesn’t agree to Western democracy, either. So Xi will follow the third path — Putin-style democracy, a controllable democracy — by shutting down the NGOs that are not submissive and supporting NGOs that are useful to government.”

As a result, it was a long, hot summer for members of China’s beleaguered NGO community, marked by many invitations for a “cup of tea,” as the gentle or not-so-gentle interrogations by security services are euphemistically known. Surveillance and suspicion are regular facts of life for anyone trying to strengthen civil society in China, but this year the questioning has taken on a different tone — more frequent, often more aggressive and particularly focused on foreign sources of income, activists say.

“There has been an increase in the number of meetings, and an increase in the number of departments who want to speak to you,” said a manager at an international NGO, who spoke on the condition of anonymity for fear of inviting trouble. “The questions have become more pointed. ‘So what are you really doing?’ That’s the question you get all the time.”

NGOs have been asked to declare foreign sources of income, while academics have faced similar scrutiny over research projects financed with Western money. Groups working in health, on LGBT rights or even on women’s rights say their problems have mounted this year, especially if they get money from the United States.

“The target is not the money, it is the NGOs themselves,” said Cheng Yuan, the Beijing and Guangzhou bureau chief for the Equal Rights Trust, or Yirenping, an anti-discrimination group. “The government wants to control NGOs by controlling their money.”

China, like many less-than-democratic governments, watched in dismay as popular uprisings known as the Color Revolutions spread across Ukraine, Georgia and Kyrgyzstan in the 2000s and the Arab Spring unfolded in the Middle East in 2011. Ever since the 1989 Tiananmen Square protests, the government has been determined to prevent people from organizing themselves into any kind of group — political, religious or rights-based — that might threaten the Communist Party’s hegemony.

One foreign policy expert, who spoke on the condition of anonymity to discuss a sensitive subject, said Putin had called Xi to share his concern about the West’s role in Ukraine. Those concerns appear to have filtered down into conversations held over cups of tea in China, according to civil society group members.

“They are very concerned about Color Revolutions, they are very concerned about what is going on in Ukraine,” said the international NGO manager, whose organization is partly financed by the National Endowment for Democracy (NED), blamed here for supporting the protests in Kiev’s central Maidan square. “They say, ‘Your money is coming from the same people. Clearly you want to overthrow China.’ ”

Congressionally funded with the explicit goal of promoting democracy abroad, NED has long been viewed with suspicion or hostility by the authorities here. But the net of suspicion has widened to encompass such U.S. groups as the Ford Foundation, the International Republican Institute, the Carter Center and the Asia Foundation.

A documentary produced in association with China’s National Defense University accused those U.S. groups of incitement, sabotage and covert subversion here. In June, the Maoist Web site Utopia recommended the swift arrest of Western-influenced officials and intellectuals, while the party’s premier think-tank, the Chinese Academy of Social Sciences, has even come under extraordinary criticism from within the party for supposed “infiltration by foreign forces.”

Some activists say the latest investigations could simply be an effort to map and understand the growing NGO sector, ahead of legislation that would regulate the sector and is said to be in the works. But others say they are part of a broad crackdown on freedom of expression under Xi. An official notice briefly posted on a local government Web site in Shanxi province said that the investigation of foreign NGOs had come at the behest of Xi’s newly established National Security Commission.

Just as Putin’s Russia is reported to be considering measures to isolate its citizens from the global Internet, in an apparent imitation of China’s “Great Firewall,” so Xi appears to be learning from Russia’s experience in “sovereign democracy.”

In July, Wang Haiyun, vice chairman of the China Research Institute of China-Russia Relations, argued that his country should follow Russia’s example in forcing foreign-financed NGOs to register as “foreign agents.”

“We can learn from Russia and introduce a ‘foreign agent law,’ so as to block the way for the infiltration of external forces and eliminate the possibilities of a Color Revolution,” he wrote in the Global Times newspaper.

China boasts more than half a million registered NGOs, and many more unregistered bodies. Small, local groups working on environmental, education or health issues have been able to make progress here, by complementing what the government can provide rather than challenging the Communist Party’s ultimate control. But any group that grows too large, or talks the language of citizens’ rights, risks uncomfortable scrutiny.

The demonstrations in Hong Kong, which has maintained a measure of self-rule, are likely to reaffirm for Chinese leaders the dangers of relaxing any control.

For NGOs on the mainland, there are some clear red lines, with issues around democracy, ethnic minority rights or religion particularly sensitive, and any attempts to organize public protests especially dangerous. But in other areas, the red line is deliberately fuzzy, and often shifting.

In May, Yirenping’s attorney Chang Boyang was arrested and subsequently denied access to legal representation. The group, whose offices have since been raided twice by police, said his detention “appeared to have been motivated solely by his work on behalf of individuals exposed to discrimination in China, including women, migrant workers, people living with HIV/AIDS or hepatitis B or C, and other vulnerable individuals.”

Yirenping’s Cheng said some NGOs are now refusing to accept foreign money, especially from sensitive groups. “But if NGOs turn to domestic money, they have to sacrifice some independence, since most domestic money comes from the government,” he said.

Yu Fangqiang, executive director of Nanjing-based Justice for All, said attempts to cut off foreign funding would damage civil society, limit its diversity and ultimately rebound on the party. “Social conflicts will become worse, and more protests will show up,” he said.

But China’s leaders may see a different lesson arising from Hong Kong — that tolerance of political diversity opens the door to foreign antagonists, and that just leads to trouble.

Xu Jing contributed to this report.