The Debate Over Renminbi Policy

John Mauldin

Longtime readers know how much I respect and rely on the Gavekal group for thought-provoking research. They have a truly unique organization, one in which even junior analysts can question conventional wisdom and ask uncomfortable questions. Moreover, they aren’t afraid to let the world (or at least their clients) see their disagreements.

Today I have a recent piece in which Louis Gave jumps into the team’s debate over renminbi policy. In true Gavekal style, he openly questions what others in the firm think about China’s currency. I won’t steal any of his thunder but just encourage you to read this piece carefully. It covers a great deal of very important ground.

Louis will have much more to say about China when he speaks at my Strategic Investment Conference in Dallas this coming May 24-27. We’ll also have Gavekal’s other two principals, Charles Gave and Anatole Kaletsky. They rarely all appear in the same place at the same time, so having the three of them together will be a special treat. I’m really looking forward to the good-natured arguments that will no doubt erupt among them. I always learn from their debates.

Speaking of SIC, our early registration period ends this Sunday, Jan. 31, and with it the chance to save $500 off the walkup rate. We’ll soon start promoting the conference more widely, so if you want to get in, you should act quickly. I wish I could tell you about some of the additional speakers we are very close to getting, but until the paperwork is finished you can’t talk about it. You are really going to want to be at this conference. It will be the event of the year. You can find more information and register at the SIC 2016 website.

I am still at the conference in Hollywood, Florida (which is close to Fort Lauderdale). We are staying one more day to have dinner with friends and were thinking that a little beach-time reading would be good. But so much for sunny Florida – this morning saw tornadoes and rain and lots of wind. I could’ve gone back to Texas for that. In theory, I will get to have dinner with my good friend Suze Orman – if her plane doesn’t get stuck on the island where she is because of winds there. I really hope she can hop on over here, because she is just tons of fun to be with.

One of the good things about being at a very large conference like this is that many of the speakers and attendees are friends, so there is a lot of catching up, sharing of notes, and learning opportunities. I fully intend to be in bed by the time you get this issue of OTB, as an early night after the last three really does seem to be the better part of wisdom. You have a great week.

Your finally attacking his inbox analyst,

John Mauldin, Editor
Outside the Box

The Debate Over Renminbi Policy

Louis Gave

One of the core tenets of Gavekal’s philosophy is that we embrace open debate. Rather than concealing the diversity of our analysis beneath a single suffocating “house view”, we strongly believe that conducting our —often animated—discussions about the big topics of the day out in the open adds value for our readers. And few of our recent debates have been as lively as the one over Beijing’s renminbi policy. Joyce’s view is that the Chinese currency is set to weaken this year as Beijing bumps up against the impossible trinity and accepts depreciation as a price worth paying  for interest rate cuts to support growth (see Going Down With The Renminbi). In contrast, Chen Long and Arthur argue that with key financial reforms now in place, the Chinese government is backing away from its policy of renminbi internationalization (see Retreating From An International Renminbi). In true Gavekal style, I would like to take issue with both views.

There are two separate topics here:

1.       Whether the renminbi is likely to rise or fall over the coming years. Right now, this is one of the questions which has got global markets in a panic.

2.      Whether the renminbi will make the grade as a truly international currency.

Of course, you could say that the two are related: for the renminbi to go up, it needs to become an international currency; and to a large extent, there is no doubt that increasing internationalization would lend the currency a nice tailwind, as more and more people, companies, central banks etc. start to save in renminbi. This argument is one of the reasons I have been bullish on the renminbi for the last decade. In my view, as we move from no one in the world saving in renminbi, to perhaps 2%, then 5%, then one day even 10% of the world’s savings (ex-China) being allocated to renminbi assets, the underlying demand for the currency would mean an increasing number of marginal buyers. And more buyers usually mean a higher Price.

A Japanese precedent?

But that is not the only path to currency strength. As Arthur has pointed out, during the 1990s and 2000s, the yen was broadly strong, and Japanese government bonds were the best performing bonds in the world, in spite of a fall in global yen usage, weak domestic growth, short term interest rates that had been cut nearly to zero, and repeated bouts of quantitative easing from the Bank of Japan. This yen strength was the result of domestic deflation, large increases in domestic savings, deleveraging by the corporate sector, and of course a large current account surplus.

In other words, conditions that were not that different from those we see in China today. This brings us back to the first question above: Is the renminbi likely to rise, or fall, over the coming years?

Right now, I think it is fair to say that the consensus view is heavily tilted to the bearish side (when was the last time you met a renminbi bull?). To me this bearish bias underlines a simple reality: Everywhere around the world, we are in the middle of a massive US dollar buying panic. I see signs of this panic everywhere I look, from renewed speculation against the Hong Kong dollar peg (a dud trade if ever there was one), to the recent front page article in Canada’s National Post newspaper advising people to go out and do their grocery shopping now as prices are sure to soar because of the Loonie’s collapse, to the number of people falling over themselves to explain why China—the world’s largest exporter and the country now running the largest trade surplus in history (not just in China’s history, but in the whole of recorded world history) needs a much weaker currency.

Long in the tooth

Meanwhile, what is interesting about this US dollar buying panic is that most major non-US dollar counters (except for sterling) have actually been holding up reasonably well lately. In the midst of this buying panic, the euro has not made new lows, the yen has rallied strongly (granted, the yen always rallies when things are bad in markets) and gold has been hovering between US$1,050 and US$1,110/oz for a while. In short, it feels as if the US dollar’s “strength” may be getting a touch long in the tooth?

Frankly this should not be too surprising. If there is one trade that looks obvious for 2016 it is that the US Federal Reserve will not raise rates the four times it has promised. You can pick your own reason why the Fed will hold back. With the ISM manufacturing PMI below 50, corporate spreads making post-crisis highs, US industrial production in negative territory, headline inflation far below target, US profit margins shrinking, and equities falling, there are more than enough to choose from.

Weak footing

So, given all of the above, why has the renminbi started the year on such a weak footing? Obviously, when a market weakens, it means there must be more sellers than buyers. On the “buyers” side, I tend to think that most potential renminbi buyers are shying away because of the US dollar buying panic mentioned above. But what is probably more interesting is the “sellers” side. From a cursory look at the financial media, you would think that we are at the beginning of a massive exodus of Chinese capital out of China. In short, the bearish argument for the renminbi is simple: the renminbi will go down, and go down a lot, because the Chinese people themselves are losing faith in their own currency.

One can make this argument about any currency. If the British were no longer to trust the pound, then the pound wouldn’t be worth very much. If the Swedes were to decide that they are no longer willing to hold krona, then the value of the krona would crash.

But somehow this argument gains far more media traction when it comes to China. The reason, I think, is that (whether we realize it or not) most of us in the Western world tend to regard the Chinese government as illegitimate, since it was not chosen through elections. And given that the government is “illegitimate”, surely any smart person will seek to ship his or her savings abroad, because an “illegitimate” government cannot have a credible currency.

On-the-ground evidence

My problem with this line of thinking is that there is little evidence on the ground that this is what is actually taking place. Sure, Chinese people have been taking money out of China. But that is nothing new. Ask anyone in Vancouver, Sydney, Auckland, Hong Kong, or Bordeaux. Chinese money has been coming in for years.
Macau was built as one huge conduit to get money out of, and sometimes into, China.

The big question today is whether many more Chinese people are taking their money out, and whether they are doing it on a scale large enough to overwhelm China’s US$600bn trade surplus. The recent contraction in China’s reserves suggests that this is what is happening, and of course this is what the media are latching onto. But I am troubled by the fact that at the anecdotal level, there are few signs of these massive capital outflows. For example, one easy way for Chinese people to send money abroad is through the Shanghai-Hong Kong Stock Connect scheme (which channels funds indirectly into the Hong Kong dollar); but this has barely been utilized. Meanwhile, real estate transaction volumes in the markets typically favored by Chinese buyers—Vancouver, Hong Kong, Macau, Sydney, Auckland—have fallen recently (although prices have proved more sticky). So if the Chinese are shipping their money out of China, where is that money going? In what asset markets can we see volumes and prices rising?

Exporters now hedging

This brings me to my next point. Maybe the drop in the renminbi is not primarily linked to the Chinese public panicking over the value of their currency and deciding, en masse, to buy US dollars. Perhaps it has more to do with large numbers of Chinese exporters adjusting their currency exposures and hedging their positions as they have been caught up by the general global US dollar buying panic. To me this seems a much more plausible explanation. And it is one for which there is anecdotal evidence. A number of Hong Kong-based friends in the import-export business have recently told me that they are now hedging their foreign exchange exposure for the first time. If this is what is happening on a general scale—and admittedly it is a big “if”—we should probably not read too much into recent market moves, as they will have been the result of short term panic-buying by corporates, rather than the start of wholesale capital flight out of China.

None of this detracts from the views put forward by Arthur and Chen Long. As they point out, the situation has changed, and it is clear that from now on the PBOC will:

1.       Manage the renminbi more against a trade-weighted basket of currencies (much like Singapore) than against the US dollar, and

2.      Tolerate a greater degree of exchange rate volatility than in the past.

But these are not surprises. They are natural, healthy developments that the PBOC has been telegraphing for years. As I have argued repeatedly over the past year, the days when a simple buy-and-hold strategy could earn you 250bp more in dim sum bonds than in US treasuries, with 2% less volatility, are now clearly over. There was a window of opportunity for quick-footed investors to make easy money with less risk, but it is now closing. From now on, returns in the Chinese bond market will be more volatile. But this volatility will also offer opportunities for sharp investors.

Buy the dip?

This brings me to the next important question. For the past five years, one of the simplest ways to make decent money in Chinese bonds was through a “buy the dip” strategy. Each time the renminbi and dim sum bonds dipped—and they tended to dip together—investors could buy in, confident that the Chinese government would step in to support the market. And why would the government step in? Because of its desire to promote the renminbi as a credible international currency, that could be used for trade financing (to prevent a repeat of the 2009 trade freeze), and one that could be used to denominate central bank reserves around the region and across emerging markets. If as Chen Long and Arthur argue,  we are now seeing a change in this policy to establish the renminbi as an international currency, investors will have to ask themselves whether renminbi bonds are still a good buy-the-dip asset, even as the volatility increases and the dips get bigger.

Now to be sure, there is a lot to dislike about what the Chinese government has been doing lately. Indeed, two years ago, at the Communist Party’s third plenum, foreign investors were given a glimpse of a China that would embrace supply side reforms, deregulate industry, and embrace restructuring. It was easy to get excited. Since then, Beijing’s track record on reform has proved increasingly disappointing. As Arthur has pointed out recently, it feels as if things are going the wrong way fast on the policy front (see China: Still Off Course). The abduction over the holidays of Hong Kong book-publisher Lee Bo, allegedly by mainland security agents, was a deeply shocking development. As Talleyrand said of the Prince de Conde’s murder by Napoleon, “It was worse than a crime; it was a mistake”. One has to wonder what President Xi Jinping was thinking (assuming that the deci sion to kidnap a Hong Kong bookseller was taken at the highest level). How could his stance not have been: “I am the president of China. I am above such trivialities”? Worse, like Henry II, did Xi effectively exclaim: “Will no-one rid me of this turbulent priest?” Either way, such developments bear out Arthur’s case that all is not well in Chinese policymaking circles.

Still, going back to what China’s renminbi policy will be going forward, and whether the buy-the-dip strategy still makes sense, I note that one of the points Arthur makes is that the Chinese leadership is simply too reluctant to let market forces determine either the value of the renminbi or the level of interest rates, for the renminbi to become widely accepted as a credible international currency or bond market.


But there is a paradox here. It is precisely this reluctance to let the market dictate the value of the renminbi or the level of Chinese interest rates that has made the renminbi such an interesting alternative to the US dollar, euro and yen for trade financiers and central bank reserve managers. It was this very reluctance that ensured the success of the buy-the-dip strategy.

Put simply, the only reason foreign central banks were prepared to shift capital into the renminbi, or companies consider financing trade in renminbi, was because there was an implied Chinese government guarantee that the volatility of the renminbi against the US dollar would be confined within “acceptable” limits—an implied guarantee which effectively underpinned the high returns of the buy-the-dip strategy.

Currency basket

The Chinese government’s new “promise” is that this volatility will now no longer be measured against the US dollar, but against a basket of currencies. There are several ways to see this promise:

1.       The first, as Joyce has argued, and as the consensus appears to believe, is that this is a promise that the Chinese government will be unable to keep. In this view, the Chinese government has simply made too many promises for it to keep them all, so some will have to be sacrificed. One of the victims will be its promise for the exchange rate.

2.      The second—and the one I am inclined towards—is that this promise is not surprising. It is consistent with the broad pattern that has been unfolding over recent years, and which continues to point towards the renminbi establishing itself, slowly but surely, as an international currency, with all the normal attributes you would expect of a major currency, including greater volatility than the renminbi has shown in the past. Naturally this process is happening in a very Chinese manner: one small step at a time, and very slowly.

Policy options

To understand why, imagine you are sitting in Beijing and planning how to internationalize the renminbi so that over time, more and more of your imports can be denominated in your own currency, rather than in somebody else’s (somebody you might not be able to trust 100% in a crisis, and somebody you definitely see as a rival for regional geopolitical hegemony). To achieve your objectives, what would you do today?

1.       Your first option is to deregulate interest rates, deregulate the exchange rate, relax capital controls and let prices settle wherever they may. To some extent, I detect in Arthur a sense of frustration that this course of action is not being embraced more openly. Leaving aside the fact that, in terms of Chinese policymaking, such a drastic course of action would be unprecedented, I would question whether, given the current nervous state of markets, such a course of action would be productive. On the contrary, it could easily trigger panic. And if it did end up triggering a panic, would the ultimate goal of moving away from US dollar dependency have been furthered, or undermined? Please don’t get me wrong: I am all for market prices rather than government prices. But this approach reminds me of the story of the American tourist who got lost in the Irish countryside. Spotting a farmer, he asked the way to Dublin, only to be told: “Ah! Dublin is it? Well if you want to go to Dublin, you don’t want to start from here…”.

2.      Your second option is to conclude that you are screwed. Growth is collapsing and you have a debt crisis on your hands. In this scenario your best option is to forget about your international plans and focus on domestic problems. Hunker down, probably devalue the renminbi, and probably forget about your dreams of an international currency. ​To some extent, this is what Joyce has been arguing, and I also get a hint of this line of thinking from Chen Long and Arthur’s most recent report. But if Beijing were really going down this path, then why would policymakers have bothered intervening in the foreign exchange market to the extent that they have over the last six months? If Beijing has cooled towards its internationalization strategy, why would it have bothered with funding the Asia Infrastructure Investment Bank and the Silk Road Fund etc? Why would policymakers bother pretending that the renminbi is moving from being managed against the US dollar, to be ing managed against a basket? An awful lot of money would have been poured down the drain for no good reason.

3.      The third option would be to continue gradually internationalizing the renminbi by slowly increasing its exchange rate volatility, turning the currency into something more than just a US dollar proxy. Of course, the process won’t be linear, but over time the renminbi will increasingly come to resemble a “normal” currency—one other countries feel comfortable borrowing in (note South Korea’s recent issue of panda bonds), and which companies feel comfortable holding as working capital. Personally, I believe Beijing is still following this path, even if recent policy moves have proved disappointing.

As a result, investors have a choice to make. They can conclude that:

a) Beijing is losing or will lose control of its exchange rate in the face of massive capital outflows. To me, this belief is another example of the current US dollar buying panic. While I was very bullish on the US dollar five years ago, it seems to me that in the near future we will get confirmation that the Fed will not be tightening, a policy path which may well shine new light on the growing US twin deficits.

b) Either the Chinese government no longer regards renminbi internationalization as its policy priority, or it is not prepared to pay the price of having a truly international currency. I am not sure I buy into the argument that we have reached the stage at which the Chinese government will have to accept greater market volatility as the price for further internationalization. We may well reach this point one day, but for the time being, as the renminbi continues to build market share, it seems to me that the main concern of investors is whether the buy-the-dip strategy continues to makes sense.

c) The Chinese government still wants to internationalize its currency, if only because Xi is a more nationalist president than his predecessors, and keen to establish China as the unchallenged Asian power as part of his “China Dream”. If this is the case, the buy-the-dip strategy will continue to makes sense over the coming years, even if the dips get bigger, and the volatility greater.

Obviously, believers of the third option (and I count myself among them) will note that the recent sell-off is the biggest dip on record, and that it therefore presents an interesting buying opportunity for the renminbi and renminbi bonds.

Under-owned assets

To be fair, this view is driven largely by the belief that renminbi assets remain one of the most under-owned asset classes in the world today and that this “under-ownership” will gradually diminish over the coming years as an ever-growing number of marginal buyers enter the market.

This is the big difference with Japan. In January 1990, Japanese equities were 48% of the MSCI World, and there were seven Japanese financials among the top ten companies in the index. Back then, every equity and every bond manager was long Japanese assets whether he or she liked it or not. This positioning opened the door to two decades in which foreigners sold Japan (and even then, shorting the yen and the JGB market was a poor trade).

Having said that, there is nothing pre-ordained about foreigners buying more Chinese assets. For this to happen, Chinese policymakers need to ensure that the environment is attractive for foreigners to deploy capital. Greater currency volatility would be a deterrent to foreign capital inflows. So would backtracking on supply side reforms, keeping zombie companies alive and kidnapping book publishers. Nevertheless, long term renminbi internationalization remains a powerful tide, and one that I, personally, don’t want to try swimming against. The probability remains in place that over the coming years we will continue to see greater use of the renminbi in international trade, regional project finance, world central bank reserves, and global bond issuance.

The Chances of a Global Meltdown

Investors have reasons to be fearful—but not terrified. Here’s what to expect in the rocky months ahead.

By Gerald O’Driscoll Jr.     

Are we headed for another global financial crisis? The market convulsions of the past week reflected a continuation of a market selloff that began on the first trading day of 2016. Investors have reasons to be fearful—but not terrified.

This year is likely to be one of financial crises in industries and countries around the world.

Whether those turn into a global financial crisis is an open question, and the answer will likely turn on the health of the U.S. financial industry and broader economy. No crisis is global if American financial markets hold up. The best I can foresee, at this moment, is that a true global financial crisis is not likely.

            Photo: Getty Images/Ikon Images 
Pundits are focused on collapsing oil prices, which reflect the technological revolution in production among nimble private producers, combined with weakening global demand for their product. The result has been layoffs in the energy industry, and there will be more. Weak and highly leveraged energy firms have gone bankrupt and more will. But bankruptcy doesn’t necessarily mean that production will decline.

Creditors who lent to these energy producers will suffer losses on their loans, and they too might become financially impaired. If past is prologue, those lenders will be reluctant to fully realize their losses, and they will continue to view future energy prices through too-rosy glasses.

Banks will be reluctant to mark down the value of nonperforming loans and book losses, or even set aside sufficient loan loss reserves. They will instead “extend and pretend”—i.e., extend maturities and pretend they expect the loans to be paid back. Will federal and state banking regulators aid and abet the process? They have in the past, and rumor is that they are already doing so today.

The problem with extend and pretend is that it allows losses to accumulate. When they finally must be realized, they are larger than they would have been, and some financial firms will collapse. This happened in the Texas banking crisis of the 1980s and the nationwide savings-and-loan crisis of the 1980s and ’90s. I am not predicting another banking crisis—but pointing to the folly of extend and pretend.

Regulators need to apply prompt corrective action to overextended lenders. New capital must be injected by investors into solvent banks, but those that are insolvent or too weak to survive must be closed.

In addition to the world-wide oil glut, which will continue in 2016, another important factor in the story is the strong U.S. dollar. The dollar is at a near-term high against an index of other currencies.

This reflects, at least in part, trends in monetary policy. The U.S. Federal Reserve implemented a long-expected, modest increase in short-term interest rates in December, while other major central banks, like the European Central Bank and the Bank of Japan, 8301 -6.25 % are easing their monetary policies. The Fed’s action is seen as a prelude to a series of interest-rate increases. That would further strengthen the dollar.

However, oil is priced globally in dollars. When the dollar is getting stronger, oil becomes more expensive for other countries, who have to sell more of their own currencies to afford it—and this dampens their demand, putting further downward pressure on oil and other commodity prices. In addition, a stronger U.S. dollar makes it more expensive for other countries to buy U.S. goods, lowering U.S. exports.

A strong dollar also means that those who borrowed in U.S. dollars but earn income in other currencies are stressed to pay back their dollar-denominated debts. Emerging-market countries (governments and private borrowers) were heavy borrowers in dollars and are at risk of default on these debts.

In their 2009 book on financial crises, “This Time Is Different,” Carmen Reinhart and Kenneth Rogoff observed that countries are more prone to default on foreign-held debt than debt held by their own citizens. Especially at risk are energy-producing, emerging-market countries as they have been hit by a double whammy: steep drops in the price of their leading export and rising debt-servicing costs in dollars.

I am not going to predict which specific countries are likely to default because there are many variables, including the varying political situations. Default is as much a political decision as an economic necessity. But one country illustrates the ramifications for the U.S. of a default. Brazil is a large, emerging-market debtor. U.S. banks had $89 billion worth of loan exposure to Brazil as of the middle of last year. That debt was likely concentrated in a few large institutions.

The Fed’s monetary policy of extraordinarily low interest rates helped create the asset bubbles in stock and commodity prices that are now bursting. Low rates also distorted investment decisions. I have argued for the Fed’s increasing interest rates much sooner. Now the Fed has made a tentative step forward on rates. It has done so, however, with incredibly bad timing—with the dollar already getting stronger and the global economy weakening. The Fed is worried about energy-industry loans. But how can oil prices recover with a rising U.S. dollar?

In retrospect, the Fed’s rate hike last month will likely be viewed as monetary malpractice. The next hike is on hold, and there is already talk of another round of quantitative easing. None of this is likely to forestall turmoil in credit markets. Investors are wise to be worried, but it’s likely that 2016 won’t be a replay of 2008.

Mr. O’Driscoll is a senior fellow at the Cato Institute and a former vice president at the Federal Reserve Bank of Dallas.

America’s presidential primaries

The brawl begins

Marvel at the jaw-dropping spectacle. Then worry. American politics has taken a dangerous turn

THE muscle-bound rivals have entered the ring. The verbals are at fever pitch. On February 1st Iowans will caucus in the opening round of America’s presidential tussle. Just over a week later, voters will gather in New Hampshire. From there the contest will move on towards Super Tuesday on March 1st, and beyond that to the conventions in July. It is the world’s greatest electoral tournament. It is not going to plan.

Across America, political elites and moderate voters are in a state of disbelief. Hillary Clinton, as much part of the establishment as the Washington Monument, is under pressure from Bernie Sanders, a crotchety senator from Vermont who calls himself a democratic socialist. The sensible squad on the right—“Jeb!” Bush, Marco Rubio, John Kasich et al—have been impaled by the gimlet gibes of Ted Cruz and swamped by the sprawling, tumultuous diatribes of Donald Trump.

The choice was supposed to be between a Bush and a Clinton—more a coronation than an election. Instead, the race for the world’s most powerful office has been more dramatically upended by outsiders than any presidential campaign in the past half-century. America, what on earth is going on?

Bigger and brasher
The United States is not the only country where the establishment is on the ropes. Britain’s Labour Party is in thrall to a man well to the left of Mr Sanders. In the first round of France’s recent regional elections, the far-right National Front won the largest vote. Populists are leading the polls in the Netherlands and running the government in Poland and Hungary. In politically correct Sweden, nativists are polling at 30%.

Like voters across the West, Americans are angry—often for the same reasons. For years a majority of them have been telling pollsters that the country is heading in the wrong direction.

Median wages have stagnated even as incomes at the top have soared. Cultural fears compound economic ones: in 2015 a Pew poll found that white Christians had become a minority in America. And in recent months, fears of terrorism have added a menacing ingredient to the populist brew (see pages 19-21).

Though the trends are common, populism in America is especially potent. Europe has grown used to relative decline. As the sole superpower, America has smarted at the rise of China and the spread of jihadism from parts of the Middle East that it had poured blood and treasure into trying to pacify.

When Mr Trump promises to “Make America great again” and Mr Cruz vows that the sand of Iraq and Syria will “glow in the dark”, they are harking back to a moment, after the fall of the Soviet Union, when America enjoyed untrammelled power.

A second reason is that, in America, outsiders channel popular anger into a political duopoly.

In Europe Mr Trump and Mr Sanders would have their own protest parties, which inevitably struggle to win high office. In contrast, America’s two-party system sucked in Mr Sanders, who joined the Democrats last year, and Mr Trump, who rejoined the Republicans in 2009. If they win the primaries, they will control political machines designed to catapult them into the White House.

And a third, related, explanation is that elites cannot easily manage America’s raucous democracy. Populist insurgencies are written into the source code of a polity that began as a revolt against a distant, high-handed elite. The electoral college devolves power from the centre.

Primaries attract the 20% of eligible voters most fired up by politics. Candidates with money behind them—his own in the case of Mr Trump, someone else’s for Mr Cruz—can sneer at their party’s high command.

Hence populists and anti-establishment candidates make frequent appearances in American presidential races. But as the thrilling spectacle runs its course and voters reluctantly compromise with reality, they tend to fade. That usually happens early (Pat Buchanan, a Republican firebrand who promised a “pitchfork rebellion” in 1996, won the New Hampshire primary, but was out of the race by the end of March). On the rare occasion when insurgents win the nomination, they have collapsed at the general election: Barry Goldwater lost 44 of 50 states in 1964. Those who stand as independents (as Ross Perot did in 1992) have also failed—which would not bode well for a self-financing candidate like Michael Bloomberg.

For the Democrats, history is likely to be repeated in 2016. Even if he wins Iowa and New Hampshire, it is hard to see Mr Sanders thriving as the race moves to the delegate-heavy South. Mrs Clinton has money, experience and support from black Democrats. National polls put her 15 points ahead.

But this time really could be different for Republicans. Goldwater’s surge came late; Mr Trump has mesmerised crowds, and been rewarded in the polls since July. Some Republican grandees who detest Mr Cruz even more than they despise Mr Trump have fallen in behind the billionaire. Perhaps on the day people won’t turn up for either man; perhaps the two of them will throw enough vitriol to destroy each other; perhaps what is left of Mr Bush’s $100m war chest will leave the elite time to mount a counter-attack. As of now, both populists have a chance of taking the fight to the convention and even, barring a backroom establishment deal, of winning the nomination.

The 50:50 nation
That prospect worries this newspaper. Neither Mr Trump nor Mr Cruz offers coherent economics or wise policy. Neither passes the test of character. Yet, merely by being on the ballot in November either would come close to the presidency.

General elections have become 50:50 affairs, determined by a few votes in a handful of states.

Mrs Clinton is not a good campaigner; Mr Trump and Mr Cruz are. In so far as he has policies, Mr Trump borrows freely from right and left. He could win votes by tacking brazenly to the centre. In a close race, a terrorist attack or a scandal near polling day could be decisive.

Pessimism about America is misplaced. The economy is in better shape than that of any other big, rich country; unemployment is low; so is violent crime. But mainstream Republicans have pilloried Barack Obama with such abandon that they are struggling to answer Mr Trump and Mr Cruz. If anyone should regret the spectacle about to unfold, it is they.

The economic losers are in revolt against the elites

Nativist populists must not win. We know that story: it ends very badly indeed
James Ferguson illustration©James Ferguson
Losers have votes, too. That is what democracy means — and rightly so. If they feel sufficiently cheated and humiliated, they will vote for Donald Trump, a candidate for the Republican party’s presidential nomination in the US, Marine Le Pen of the National Front in France or Nigel Farage of the UK Independence party. There are those, particularly the native working class, who are seduced by the siren song of politicians who combine the nativism of the hard right, the statism of the hard left and the authoritarianism of both.

Above all, they reject the elites that dominate the economic and cultural lives of their countries: those assembled last week in Davos for the World Economic Forum. The potential consequences are frightening. Elites need to work out intelligent responses. It might already be too late to do so.

The projects of the rightwing elite have long been low marginal tax rates, liberal immigration, globalisation, curbs on costly “entitlement programmes”, deregulated labour markets and maximisation of shareholder value. The projects of the leftwing elite have been liberal immigration (again), multiculturalism, secularism, diversity, choice on abortion, and racial and gender equality. Libertarians embrace the causes of the elites of both sides; that is why they are a tiny minority.

In the process, elites have become detached from domestic loyalties and concerns, forming instead a global super-elite. It is not hard to see why ordinary people, notably native-born men, are alienated. They are losers, at least relatively; they do not share equally in the gains. They feel used and abused. After the financial crisis and slow recovery in standards of living, they see elites as incompetent and predatory. The surprise is not that many are angry but that so many are not.

Branko Milanovic, formerly of the World Bank, has shown that only two parts of the global income distribution enjoyed virtually no gains in real incomes between 1988 and 2008: the poorest five percentiles and those between the 75th and the 90th percentile. The latter includes the bulk of the population of high-income countries.
Similarly, a study by the Economic Policy Institute in Washington shows that the compensation of ordinary workers has lagged significantly behind the rise in productivity since the mid-1970s. The explanations are a complex mixture of technological innovation, liberal trade, changes in corporate governance and financial liberalisation. But the fact is unquestionable. In the US — but also, to a smaller extent, in other high-income countries — the fruits of growth are concentrated at the top.
Finally, the share of immigrants in populations has jumped sharply. It is hard to argue that this has brought large economic, social and cultural benefits to the mass of the population. But it has unquestionably benefited those at the top, including business.
Despite offering its support for welfare benefits one might think very valuable to the native working classes, the respectable left has increasingly lost their support. This seems to be particularly true in the US, where racial and cultural factors have been particularly important.

The “southern strategy” of Richard Nixon, a former Republican US president, aimed at attracting the support of southern whites, has generated political results. But the core strategy of his party’s elite — exploiting middle-class (especially male) rage over racial, gender and cultural change — is bearing bitter fruit. The focus on tax cuts and deregulation offers little comfort to the great majority of the party’s base.

Mr Trump, Republican ideologues complain, is not a true conservative. That is indeed the point. He is a populist. Like the other leading candidates, he proposes unaffordable tax cuts.
Indeed, the notion that Republicans object to fiscal deficits looks absurd. But, crucially, Mr Trump is protectionist on trade and hostile on immigration. These positions appeal to his supporters because they understand they have one valuable asset: their citizenship. They do not want to share this with countless outsiders. The same is true for supporters of Ms le Pen or Mr Farage.
Nativist populists must not win. We know that story: it ends very badly. In the case of the US, the outcome would have grave global significance. America was the founder and remains guarantor of our global liberal order. The world desperately needs well-informed US leadership. Mr Trump cannot provide this. The results could be catastrophic.


Yet, even if such an outcome is avoided this year, elites have been warned. Those of the right take big risks in cultivating popular rage as a way to secure lower taxes, increased immigration and weaker regulation. Elites of the left are also taking risks if they are seen to sacrifice the interests and values of a struggling mass of citizens to cultural relativism and lax control of borders.

Western countries are democracies. These states still provide the legal and institutional underpinnings of the global economic order. If western elites despise the concerns of the many, the latter will withdraw their consent for the elite’s projects. In the US, elites of the right, having sown the wind, are reaping the whirlwind. But this has happened only because elites of the left have lost the allegiance of swaths of the native middle classes.

Not least, democracy means government by all citizens. If rights of abode, still more of citizenship, are not protected, this dangerous resentment will grow. Indeed, it already has in too many places.

lunes, febrero 01, 2016



Free exchange

All at sea

Ideological divisions in economics undermine its value to the public

DISMAL may not be the most desirable of modifiers, but economists love it when people call their discipline a science. They consider themselves the most rigorous of social scientists. Yet whereas their peers in the natural sciences can edit genes and spot new planets, economists cannot reliably predict, let alone prevent, recessions or other economic events. Indeed, some claim that economics is based not so much on empirical observation and rational analysis as on ideology.

In October Russell Roberts, a research fellow at Stanford University’s Hoover Institution, tweeted that if told an economist’s view on one issue, he could confidently predict his or her position on any number of other questions. Prominent bloggers on economics have since furiously defended the profession, citing cases when economists changed their minds in response to new facts, rather than hewing stubbornly to dogma. Adam Ozimek, an economist at Moody’s Analytics, pointed to Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis from 2009 to 2015, who flipped from hawkishness to dovishness when reality failed to affirm his warnings of a looming surge in inflation. Tyler Cowen, an economist at George Mason, published a list of issues on which his opinion has shifted (he is no longer sure that income from capital is best left untaxed). Paul Krugman, an economist and New York Times columnist, chimed in. He changed his view on the minimum wage after research found that increases up to a certain point reduced employment only marginally (this newspaper had a similar change of heart).

Economists, to be fair, are constrained in ways that many scientists are not. They cannot brew up endless recessions in test tubes to work out what causes what, for instance. Yet the same restriction applies to many hard sciences, too: geologists did not need to recreate the Earth in the lab to get a handle on plate tectonics. The essence of science is agreeing on a shared approach for generating widely accepted knowledge. Science, wrote Paul Romer, an economist, in a paper* published last year, leads to broad consensus. Politics does not.

Nor, it seems, does economics. In a paper on macroeconomics published in 2006, Gregory Mankiw of Harvard University declared: “A new consensus has emerged about the best way to understand economic fluctuations.” But after the financial crisis prompted a wrenching recession, disagreement about the causes and cures raged. “Schlock economics” was how Robert Lucas, a Nobel-prize-winning economist, described Barack Obama’s plan for a big stimulus to revive the American economy. Mr Krugman, another Nobel-winner, reckoned Mr Lucas and his sort were responsible for a “dark age of macroeconomics”.

As Mr Roberts suggested, economists tend to fall into rival camps defined by distinct beliefs. Anthony Randazzo of the Reason Foundation, a libertarian think-tank, and Jonathan Haidt of New York University recently asked a group of academic economists both moral questions (is it fairer to divide resources equally, or according to effort?) and questions about economics. They found a high correlation between the economists’ views on ethics and on economics. The correlation was not limited to matters of debate—how much governments should intervene to reduce inequality, say—but also encompassed more empirical questions, such as how fiscal austerity affects economies on the ropes. Another study found that, in supposedly empirical research, right-leaning economists discerned more economically damaging effects from increases in taxes than left-leaning ones.

That is worrying. Yet is it unusual, compared with other fields? Gunnar Myrdal, yet another Nobel-winning economist, once argued that scientists of all sorts rely on preconceptions. “Questions must be asked before answers can be given,” he quipped. A survey conducted in 2003 among practitioners of six social sciences found that economics was no more political than the other fields, just more finely balanced ideologically: left-leaning economists outnumbered right-leaning ones by three to one, compared with a ratio of 30:1 in anthropology.

Moreover, hard sciences are not immune from ideological rigidity. A recent study of academic citations in the life sciences found that the death of a celebrated scientist precipitates a surge in publishing from academics who previously steered clear of the celebrity’s area of study. Tellingly, papers by newcomers are cited far more heavily than new work by the celebrity’s former collaborators. That suggests that shifts of opinion in science occur not through the changing of minds so much as the displacement of one set of dogged ideologues by another.

Agree to agree
But even if economics is not uniquely ideological, its biases are often more salient than those within chemistry. Economists advise politicians on all manner of important decisions. A reputation for impartiality could improve both perceptions of the field and the quality of economic policy.

Achieving that requires better mechanisms for resolving disputes. Mr Romer’s paper decried the pretend “mathiness” of many economists: the use of meaningless number-crunching to give a veneer of academic credibility to near-useless theories. Sifting out the guff requires transparency, argued John Cochrane of the University of Chicago in another recent blog post.

Too many academics keep their data and calculations secret, he reckoned, and too few journals make space for papers that seek to replicate earlier results. Economists can squabble all they like. But the profession is of little use to anyone if it cannot then work out which side has the better of the argument.


"Mathiness in the theory of economic growth", Paul Romer, American Economic Review, Papers and Proceedings, 2015.
"The macroeconomist as scientist and engineer", Gregory Mankiw, Journal of Economic Perspectives, 2006.
"The moral narratives of economists", Anthony Randazzo and Jonathan Haidt, Econ Journal Watch, 2015.
"Political language in economics", Zubin Jelveh, Bruce Kogut and Suresh Naidu, Columbia Business School Research Paper Number 14-57, 2015.
"How politically diverse are the social sciences and humanities? Survey evidence from six fields", Daniel Klein and Charlotta Stern, Academic Questions, 2004.
"Does science advance one funeral at a time?", Pierre Azoulay, Christian Fons-Rosen and Joshua Graff Zivin, NBER Working Paper 21788, 2015.
Visit our Free exchange economics blog

The Isolated Chancellor

What Is Driving Angela Merkel?

By Markus Feldenkirchen and René Pfister

Photo Gallery: Looking for the Real Merkel                      
Chancellor Angela Merkel spent a decade amassing political capital. Now, with the refugee crisis showing no signs of abating, she has decided to spend it. With her legacy in the balance, she has finally found an issue to fight for. But why now?

On a Sunday evening in early January, Angela Merkel went to a piano concert by Antonio Acunto in the Konzerthaus on Berlin's beautiful Gendarmenmarkt. The program included works from Chopin, Rachmaninoff and Schumann, but the chancellor didn't just come for the music. It was also for a good cause and to show support. The concert was a benefit for the refugees. Her refugees.

Shortly before the concert began, Merkel saw an old acquaintance: Reverend Rainer Eppelmann. In 1990, Eppelmann was head of the Democratic Awakening, a party formed in East Germany soon after the fall of the Berlin Wall, and Merkel was its spokesperson. The party was ultimately folded into the Christian Democratic Union, of which Merkel is now the head.

At the concert, Eppelmann told Merkel how courageous and wonderful he thought her refugee policies were. Given the situation in which Merkel is now in, Eppelmann said, he finds himself thinking often about his favorite quote from the former Czech president and writer Vaclav Havel. "Hope is not the conviction that something will turn out well, but the certainty that something makes sense, regardless of how it turns out."

The concert began and Merkel listened to a melancholic Chopin ballad in G-minor. When the intermission arrived, she jumped up from her chair and walked directly over to Eppelmann.

She asked: "How did that quote about hope go again?"

It is completely unclear how the experiment will end that the German chancellor has forced upon the European Continent, upon her fellow citizens and, not least, upon her party. Her decision late last summer to open the German border to refugees transformed Merkel into a historic figure. It was the most consequential decision of her entire decade in office. The US newsmagazine Time named her Person of the Year and in the fall, she was widely considered to be in the running for the Nobel Peace Prize.

Since then, the mood has shifted, and not just in Germany. To prevent "a rebirth of 1930s-style political violence," New York Times columnist Ross Douthat recently wrote, "Angela Merkel must go."

Within Merkel's conservatives, there are those who have begun envisioning a government without the party's current leader. At the beginning of last week, Transportation Minister Alexander Dobrindt, a member of the Christian Social Union (CSU), the Bavarian sister party to Merkel's Christian Democratic Union (CDU), openly criticized Merkel, something that generally isn't done. In the past, mutiny on the part of government-level ministers has been a sign that a chancellor may soon be forced out of office.

The Rough Draft of Merkel's Downfall

The screenplay for Merkel's downfall hasn't yet been written, but an initial rough draft already exists. CSU head Horst Seehofer intends to heap pressure on Merkel for as long as it takes until she changes course. He isn't trying to push her out of office, but if she doesn't acquiesce, there are some in the conservative camp who could easily imagine Finance Minister Wolfgang Schäuble taking over the reins of government.

It hasn't come that far yet, but a critical mass is slowly coalescing. In a letter to the chancellor last week, 44 conservative parliamentarians voiced their opposition to Merkel's course. On Wednesday, Austria announced the introduction of a cap on refugees. The chancellor is becoming increasingly isolated.

As much as the decision to open the borders itself, what amazes many observers is the stubbornness with which Merkel has maintained her political course. Neither the terror attacks in Paris nor the sexual assaults on New Year's Eve in Cologne -- neither the indignation of furious German citizens nor the warnings from within her own party -- has led Merkel to question her decision to keep Germany's borders open. It seems as though Angela Merkel -- à la Vaclav Havel -- is convinced that her course of action makes sense. No matter how the situation turns out.

"The German people are going to riot. The German people are going to end up overthrowing that woman," Republican presidential candidate Donald Trump predicted in mid-January. "I don't know what the hell she is thinking."

Trump isn't the only one who has questions. Half the world is wondering what is motivating the German chancellor. What's the answer? What's driving Angela Merkel, a woman who gained power by virtue of her implacable pragmatism and who is now governing so unconditionally?

Why has she thus far shown no serious indication that she might shift course on refugee policy despite the fact that her popularity ratings are plummeting and the foundations of her power are crumbling?

Merkel's chief of staff, Peter Altmaier, has a beautiful office in the Chancellery with a view of Berlin's central train station and of the government quarter. But the thick windows keep out the din of the city -- such that the most conspicuous quality of the seat of government is the silence inside.

Altmaier is the voice of Merkel's refugee policy, even if, as the interview takes place, he is suffering from a terrible cold. From Merkel's perspective, Altmaier explains, this is what the world looks like: In order to avoid a humanitarian catastrophe late last summer, she had little choice but to open the borders. Now, the task is that of preventing Europe from falling apart.

Were Germany to now close its borders, it wouldn't just mark a failure for Europe's border-free travel regime known as Schengen.

The refugee flow would also backup across the Balkans and would destabilize the fragile young democracies there.

A Chain of Political Necessities

Greece would become overrun with desperate refugees from Syria and Iraq while Jordan and Lebanon, which are already hosting almost 2 million refugees, could be pushed to the brink of collapse. The alternative is a deal with Turkey, the country through which almost all the refugees have to travel.

That, at least, is the official version. When speaking with Merkel's people, her refugee policies come across as being entirely rational. Like a chain of political necessities.

One reason that Merkel has been able to stay in the Chancellery for so long is that she has never fought for a larger political project. She had no great political goals. She liked playing the role of crisis chancellor, similar to Helmut Schmidt before her. But now, at this late phase of her rule, she suddenly resembles an early Willy Brandt, the visionary.

It's not that Merkel had no convictions when she moved into the Chancellery in 2005. Having grown up in East Germany, she believed in the power of freedom and of the markets. But because voters weren't particularly enamored of her reform proposals in 2005, she dropped them. And early on, she hardly spoke at all about her East German origins or her faith.

That reticence was an element of her success, enabling her to avoid alienating western Germans, atheists and faithful Catholics. Over time, she rose to become the most popular of all politicians in Germany -- and she remained there. Early last summer, she was way ahead in all of the polls and she had collected a significant amount of political capital. The question was if she would ever spend it.

On July 15, Merkel met a 13-year-old girl named Reem Sahwil at a town meeting in the northern German city of Rostock. The girl had fled to Germany from Lebanon four years before but she was now in danger of being deported. "It is really painful to see others really enjoying life when you can't enjoy life yourself," the girl said.

It was the old Merkel who answered. She didn't want to seem heartless, but she also didn't want to make any promises just because she had stumbled into an awkward situation. "(If we would say) you can all come from Africa, and you can all come -- we couldn't handle that," Merkel stammered.

Couldn't handle it. Not long after Merkel finished, Reem began crying and Merkel awkwardly tried to comfort her. In the days that followed, Merkel was accused of being cold-hearted and she was widely criticized on the Internet.

A Lynch-Mob Atmosphere

At the end of August, she and her spokesman Steffen Seibert traveled to Heidenau. The town in Saxony is home to a former DIY store that had been transformed into a refugee shelter -- and in front of which right-wing hooligans had rioted a few days earlier. As Merkel's motorcade pulled up, she was received by a furiously whistling crowd. As she climbed back into her car an hour later, a woman yelled: "Cunt! Get back into your ugly car!" Even much later, Seibert was still talking about the lynch-mob atmosphere.

In the days that followed, something changed in the Chancellery. When Merkel gave her annual summer press conference on August 31, she no longer said that Germany is unable to take everybody.

Neither did she speak of the risk of being overwhelmed, like she had in Rostock. "Germany is a strong country," Merkel said. "The motivation with which we should approach these things has to be: We have handled so much. We can handle it!"

Merkel had decided to fight for an issue. She had saved for so long and carefully protected her power -- now she was intent on spending her political capital. It was only then that the Germans began getting to know the real Angela Merkel.

On Sept. 4, she opened up the border to the refugees trapped in Hungary. Later, she said that she had watched on television as people from Syria had gathered in the Keleti train station in Budapest and were then prevented from continuing their journey. She found it outrageous. Merkel decided to allow the refugees to come to Germany. Three days later, she said she was "a bit proud of our country."

From then on, the numbers of refugees coming to Germany began to climb rapidly. Soon, it was 10,000 per day -- and as the influx grew, so too did the number of Merkel's critics. Bavarian Governor Seehofer said that Merkel had made a mistake that would affect Germany for a long time to come. It was a sentence that helped transform the refugee issue into a power struggle.

Until then, Merkel had always been flexible. She used to be in favor of general conscription, and then she got rid of it. She was against shutting down Germany's nuclear power plants, and then she was in favor. "But she isn't flexible when she is under pressure," says one of her confidants. "Perhaps that is her greatest blemish."

On Oct. 6, she was sitting in a plane bringing her back to Berlin from a trip to India. She could certainly have used a bit of relaxation, but Merkel wanted to explain herself. She could feel that the questions were becoming more pressing and her answers less convincing.

Everything Was Connected

She had a paper brought to her from the cockpit showing the plane's route from Bangalore to Berlin and, surrounded by reporters, her finger wandered across the map, pointing at Saudi Arabia, Syria, Turkey and Germany. For her, it was more than just a piece of paper, it was confirmation of her policies: a clear indication that Germany could no longer simply isolate itself. To Merkel, it showed that everything was connected to everything else.

The Germans may wish for a time prior to the refugee crisis, but that is a wish she cannot fulfill, Merkel said. Of course she could close the borders, but then masses of people would accumulate in front of the barbed wire. The images would be ugly. Germans, she said, can't even stand it when someone is forced to spend the night outside.

She, though, wanted to combat the causes of the refugee crisis at the roots and cooperate with Turkey, Merkel said. As long as she was leading, Germany would not become a country that intentionally chased away people in need. "I will not become involved in a competition for who can treat the refugees the worst," she said. It is a sentence full of pride, and one with a tiny bit of defiance directed at Seehofer as well.

One day later, in an appearance on a popular prime-time political talk show moderated by Anne Will, she repeated her message from the airplane almost word for word. Merkel, for whom almost nothing is less appealing than being forced to talk on television, smiled often during that talk show. On many other issues, you can see by the way she speaks that she doesn't really care about what she's saying.

But on this issue, it is completely different. "She was more passionate than usual," says Will, who has interviewed Merkel several times, in hindsight. During the show, Will says, she often thought to herself: "She seems looser, more unfettered in her choice of words. She seemed at peace with herself, almost gleeful. That was new."

Merkel, of course, also saw the refugee crisis in the light of realpolitik. She has long pursued the goal of stealing centrist voters away from the center-left Social Democrats (SPD). The difficulties the SPD has had in recent years are also a product of Merkel's active involvement in almost all issues near and dear to the left. The CDU has long pursued the goal of ensuring that no party could establish itself to its right on the political spectrum. But, says a close confidant only half joking, "Merkel is the first CDU leader who has pursued the goal of ensuring that no party to the left of the CDU can establish itself."

Yet if it had only been about tactics, Merkel would have abandoned her approach long ago, at the latest when the right-wing populist party Alternative for Germany (AfD) began rising in the polls and her own popularity figures began dropping. There must be a different, more personal motivation, for her unwillingness to change course.

Building a Fence
At the end of October, she went to a summit in Brussels involving the countries along the Balkan Route, the trail used by most refugees to get to Germany. Hungarian Prime Minister Viktor Orbán, who built a barbed wire fence around his country to keep out the migrants, was also there. He saw, and enjoyed, seeing Merkel in a fix. He took the floor and said: "It is only a matter of time before Germany builds a fence. Then I'll have the Europe that I believe is right."

Merkel said nothing at first, a person present at the meeting relates. Only later, after a couple other heads of government had their say, did Merkel turn to Orbán and say: "I lived behind a fence for too long for me to now wish for those times to return." Merkel, the refugee crisis has made clear, has found the courage to justify her politics with her own biography. She no longer wants to be the woman without a face.

"It is an astounding late-life friendship," Klaus von Dohnanyi, the Social Democrat and former Hamburg mayor, says of his relationship with Angela Merkel. They meet regularly, usually together with their spouses, and only rarely talk politics. More often, they chat about concerts they have been to recently, visits to the theater and the natural sciences.

Dohnanyi knew Merkel's parents and he believes that her Christian roots are very apparent in her approach to the refugee crisis. "She is the daughter of a socialist pastor. And her mother was an extremely devout woman. Such things are deep within you, they don't just disappear," he says. The Kasner family (Merkel is the name of the chancellor's first husband) adhered to a practical form of theology that involved helping the poor, sick and disadvantaged, Dohnanyi says.

Merkel grew up with the tenet that, if a stranger is standing in the rain before your door, you let him in and help, he continues. "And when you let them in, you don't grimace," Dohnanyi says. "Christians don't do that." Merkel herself recently said something similar. "We hold speeches on Sundays and we talk about values. I am the chair of a Christian political party.

And then people come to us from 2,000 kilometers away and then you're supposed to say: You can't show a friendly face here anymore?"

Pastor Eppelmann is likewise convinced that Merkel's approach to the refugee crisis is deeply rooted in her past. "She stands on a solid foundation that was poured in her childhood and youth." He also points out that her childhood home was not a normal Protestant parsonage, rather it was a church-run home for people with disabilities. Angela Kasner grew up surrounded by disabled people who needed to be cared for. "She breathed in empathy like air and oxygen," says Eppelmann.

Later, Eppelmann goes on, Merkel also experienced what it is like to be pushed around by a regime. She initially was not granted a slot at university despite being best in her class. "Such an experience can break a person," Eppelmann says. As such, Merkel can understand what it must be like for people fleeing Islamic State or the regime of Bashar Assad in Syria.

The Protestant Parsonage

The most important element, though, was the evangelical parsonage, emphasizes Eppelmann, who also worked as a pastor in East Germany. One "becomes aware of a certain ethical standards regarding how life should be led." That includes that one shouldn't value oneself more than other people, no matter where they come from, Eppelmann says.

Every day, Jesus and God were discussed in the Kasner household, Eppelmann continues. The daily message was: "Love thy neighbor as yourself. Not just German people. God loves everybody." You should compare the Protestant Church's statement on the refugee crisis with Merkel's words, Eppelmann suggests. "They are virtually identical."

When Merkel spoke to the CDU party convention in the middle of December, her speech was indeed reminiscent of a sermon. She recalled significant CDU achievements from the past, such as binding Germany to the West and reunification, which former chancellors Konrad Adenauer and Helmut Kohl had pushed through against opposition and doubt. Then she presented her own policies as the heir to these miracles of Christian Democracy.

"The founding of the CDU was in reality an outrageous idea," she said. "A party that finds its foundation in C, in the God-given dignity of each individual person. That means that today, it isn't a mass of people that is coming to us. It means they are individuals." When she stopped speaking after an hour, even the doubters and skeptics applauded her speech. For nine full minutes. Only one member of the audience seemed unimpressed: Wolfgang Schäuble, Merkel's finance minister.

Schäuble, despite the sweater thrown over his shirt, is a bit chilly. It is the end of November and Schäuble spent four hours that morning in parliament, where it is always a bit drafty. But he hadn't wanted to leave early. Merkel was delivering her speech on the Chancellery budget and Schäuble didn't want it to look once again as though he wanted nothing to do with her policies.

Only a few days earlier, Schäuble had compared the chancellor to a clumsy skier who triggers an avalanche on a steep slope. It was an image that provided confirmation to those who blame Merkel for the flood of refugees arriving in Europe. In the papers, there were stories claiming that Schäuble was prepared to take over for Merkel if necessary. But is that accurate?

German conservatives believe that only Schäuble would be able to fill Merkel's shoes. He was chief of staff in the Chancellery back when Merkel was still working as a scientist at East Germany's Academy of Sciences. He has also served as interior minister, CDU head and CDU floor leader in parliament. Now, at age 73, he embodies the hopes of those who would like to see the back of Merkel.

Searching for a Cap

Schäuble believes Merkel was right to open up Germany's borders to refugees stranded in Hungary on that night in early September. But he would like to have seen an indication from her at the same time that Germany cannot continue accepting refugees without limits.

In mid-September, he encouraged Interior Minister Thomas de Maizière to demand that a system be created whereby Europe would accept a certain number of refugees -- as a way to cap the numbers coming to Germany. De Maizière took his advice and made the proposal in the form of an interview with DER SPIEGEL that appeared on Sept. 19.

It didn't take long, however, for both SPD head and Vice Chancellor Sigmar Gabriel and Merkel's spokesman Steffen Seibert to distance themselves from de Maizière's proposal, much to Schäuble's chagrin. Not long later, Schäuble had a meeting with Merkel in the Chancellery.

You can't just leave de Maizière fluttering in the wind, he complained. Merkel responded that Seibert had no other choice because the SPD, Merkel's junior coalition partner, would not have gone along with de Maizière's proposal. But SPD voters also want to see a reduction in the number of refugees coming to Germany, which is why Gabriel would ultimately come around, Schäuble insisted. "They wouldn't stick to their rejection for even three days," he said.

In recent years, Schäuble has developed an elder-statesmanlike aura, but when it comes to domestic policy, he was long a hardliner. He believes that Merkel pays too little attention to the sensitivities of the right wing. Had it been up to him, he would have drastically cut benefits available to asylum-seekers while demanding that they pay for at least part of their German lessons. Schäuble is uninterested in the fact that Germany's Federal Constitutional Court ruled a few years ago that the state cannot simply continue cutting asylum-seeker benefits. "I'll throw out any constitutional consultant who says such a thing," he growled to his people.

Schäuble has perfected the art of playing the dissident role without openly contradicting the chancellor. He is a loyalist and a rebel at the same time -- which helps explain his popularity and the fact that he has passed up Merkel in the opinion polls. When he was asked by the Süddeutsche Zeitung newspaper a few days ago whether he follows Merkel in the refugee crisis out of conviction or out of loyalty, he responded: "You can't ask such a question to an intelligent person." It was another typical Schäuble sentence that allows for a number of different interpretations. Of all senior politicians in Berlin, it is Schäuble who is most likely to play Brutus.

Not long after comparing Merkel to a skier who triggered an avalanche, Schäuble called the chancellor to apologize. But as he often does, he threw in a bit of devilish humor. "Comparing you to a skier was wrong, that hardly fits you," he said. One has to remember that two years ago Merkel broke her pelvis while cross-country skiing despite her extremely slow pace. One can definitely not imagine her powder skiing on a steep slope.

But how far will he go? Merkel's people comfort themselves with the fact that Schäuble has never before risked an open rebellion. He didn't attempt to topple Helmut Kohl when the chancellor refused to make way for a younger generation of CDU politicians in the 1990s. And when Merkel kept Greece in the euro zone against his will, he also declined to revolt.

Coldly Rational

Yet even today, it is difficult for Schäuble to accept his position as number two in the party behind Merkel. It was Schäuble, after all, who promoted Merkel to the position of CDU general secretary back in 1998, only to see her replace him as party chair after he stumbled over the same donation scandal that has tainted Kohl's legacy. In moments of clarity, it is clear to him that he is actually too old to take over the Chancellery. On the other hand, though, wasn't Adenauer also 73 when he became chancellor?

Ultimately, everything depends on CSU head Horst Seehofer. Like Schäuble, his political view is generally a coldly rational one, but at times he too sees the world through the lens of past political affronts, the unavoidable product of a long career in the public eye. Recently, Seehofer has been issuing new threats and ultimatums on a weekly basis. He has the reputation of being a flip-flopper, but in the refugee crisis, he has pursued the same strategy from the very beginning. It is a strategy based on numbers: Germany can accept refugees, but a million each year is too many. No chancellor can hold out long against such an influx, Seehofer believes.

"When the situation drifts completely out of control, it will no longer be possible to restrain the political mood in the country." Seehofer uttered that sentence on Nov. 3, 2015. It was a Tuesday and Seehofer was in the Bavarian representation in Berlin. He had spent the previous weekend in the capital for meetings on the refugee crisis.

One of those meetings was a 10-hour marathon with Merkel in the Chancellery, along with Chief of Staff Altmaier, conservative floor leader Volker Kauder and Gerda Hasselfeldt, who is head of the group of CSU federal parliamentarians from Bavaria. The Bavarians were trying to convince the others of the necessity of capping the number of refugees coming to Germany, but Merkel and Altmaier were having none of it. In the end, they agreed that the number of refugees coming to Germany had to drop. Merkel herself wrote down the decisive sentence.

"The chancellor herself retrieved the paper. It was a formulation marathon," Seehofer said afterwards. "At the moment we are very pleased with the paper," he added with a crooked smile. The formulation represented his first small victory in the battle with Merkel. For Seehofer, the struggle isn't just about refugee numbers. It is also about the future of the CSU, which has always derived its disproportionate power from the fact that it consistently wins absolute majorities in Bavarian state elections. "The CDU can afford it if its support slides below 40 percent. But for us, it is existential," Seehofer says.

From Seehofer's perspective, Merkel committed her cardinal sin when she opened the doors to the refugees trapped in Hungary. That night, she tried to reach Seehofer by mobile phone. But he was sleeping and didn't answer -- at least according to his version of events. When she finally got through to him the next morning, she knew the precise time she had tried to reach him the night before. It sounded as though she had a bad conscience.

'A Very Receptive Country'

"We won't be able to handle it," Seehofer said of the number of refugees now making their way to Germany.

"I'm saddened to hear you say that," Merkel responded.

Looking back, Seehofer says the chancellor made a huge mistake despite having the best intentions. From his perspective, it would still have been possible to impose order on the situation later. One could have declared that the opening of the border was a humanitarian exception. But when Merkel defended her decision at a press conference on Sept. 7 with Vice Chancellor Gabriel, she said something different. "Germany is a receptive country," she said.

Seehofer has a theory about dealing with political mistakes: Problems are not the consequence of erroneous decisions, but of the inability to rapidly correct them. "Often, politicians are doomed by the beta mistakes," he says. It becomes particularly problematic, he says, when the initial mistake is justified with a political philosophy. For Seehofer, Merkel's fatal philosophy her idea of a Wilkommenskultur, of welcoming the refugees.

He says he doesn't think Merkel consciously intended to put her position at risk. "She is of an age when you no longer give up power willingly. She might cook for her husband every now and then, but politics is her life," Seehofer says. The beginning of the end for every chancellor, he says, is when the distance to the party's grassroots begins to grow. Helmut Schmidt fell when he agreed to allow NATO to station nuclear missiles in West Germany, he notes, and Gerhard Schröder fell when he cut unemployment and retirement benefits.

Merkel, he continues, is certainly able to correct her mistakes. He leans back and thinks back to 2004, a time when conservatives in Germany were bickering about far-reaching reform plans -- plans that Seehofer felt were neo-liberal aberrations. When Merkel came within a hair's breadth of losing the 2005 election, she simply discarded her reform plans. "There was no official funeral," Seehofer says. Were Merkel to now correct her course in the refugee crisis, Seehofer says she wouldn't admit it. "She would never say that it had been wrong."

It may be that Merkel never admits to making mistakes. But it is more likely that she is convinced she is doing the right thing. And that, in part, has to do with people like Hassan Alasad. He's wearing a dark blue sweater-vest over a light blue shirt and sitting in a shelter in northwest Berlin. Two mobile phones are lying in front of him. He takes one of them and begins swiping through photos. Of course he still has it: He will always have it with him, for his entire life.

The photo, which transformed the Syrian refugee into a symbol, shows him next to the chancellor smiling into the mobile phone camera. It is perhaps the most famous selfie of 2015 and it was quickly shared around the world. It became symbolic of Germany's efforts to welcome the refugees -- efforts that are now synonymous with Merkel's name and that have led her to the low point of her political career.

'An Amazing Feeling'

It was Sept. 10 when Merkel visited the shelter, where Alasad still lives. She seemed so friendly, so approachable, he now says, that he spontaneously asked her for a selfie. Back home, Alasad explains, it was impossible to ever approach those in power. In 12 years, he never even shook hands with the mayor of his own hometown. "Then, I had only been in Germany for just a couple of days and the chancellor comes by in person to greet us." Alasad shakes his head and laughs. "That was an amazing feeling."

Friends from around the world called him after the photo began to go viral: from Dubai, from Belgrade and even from Afghanistan. It was printed in countless newspapers and Internet sites. He saved almost all of them in his mobile phone.

"I thought Germany was a paradise," Alasad says. "The most orderly country in the world. A country with structures." His vision of Germany is everything that his homeland doesn't have.

Before bombs destroyed his office and warehouse, Hassan Alasad was a businessman. He didn't want to leave Syria, but he felt useless there, a feeling he had had for quite some time. When he and his brother went to a lake one day and airplanes dropped bombs that ripped apart friends and acquaintances, they decided to leave Syria.

On Jan. 5, Merkel was in the lobby of the Chancellery to listen to the Sternsinger children's choir as she does every year in early January. She sang along with the boys and girls to a Biblical song called "We Saw His Star in the East." At one point, it looked almost as though Merkel had to wipe away a tear from the corner of her eye.

Then she held a brief address. She noted that people now see the Sternsinger, who go from house to house singing carols on the Epiphany, as cultural heritage. But in actuality, she went on, it is a Christian tradition. The motto of the Sternsinger is respect, and respect is also anchored in the German constitution, where it says that human dignity is inviolable, she said.

But that doesn't just apply to Germans and Europeans. "Rather it also applies to all people -- to every person as God's creature." Her approach to the refugees, it seemed, hadn't changed with the New Year.

Still, since that November day she spent with Seehofer in the Chancellery, the situation has become more acute almost by the day. The number of refugees arriving in Germany has dropped slightly, but that could change again soon once winter storms subside. Seehofer has continued steering his party into a conflict with Merkel and since the sexual assaults on New Year's Eve in Cologne, the hate felt in broad swaths of the populace for Merkel's refugee policies has only intensified.

No Mood to Admit Defeat

"We have to continually urge each other on so that we can change things for the good," Merkel told the Sternsinger. It was a touching sentence. Merkel is doing her best to fight against the growing numbers, particularly since Cologne, of those who would like to see her fail -- and against the increasingly sneering sentiment that her approach was a naive attempt to make the world more humane.

Her confidants these days are in no mood to admit defeat. At most, they will own up to minor mistakes: the tweet sent out by the Federal Office for Migration and Refugees on August 25, for example, which gave the impression that Germany was opening its doors to all Syrian refugees.

But it is obvious to all that Merkel has lost control of refugee policy. There is a discrepancy between that which she feels is right and the side effects these policies are having on her country. It seems as though she is playing for time, but the game doesn't look to be turning in her favor.

Angela Merkel wanted to give Germany a friendly, humanitarian face. And it worked for a few weeks. But now, the German face has become a grimace. It is no longer the unburdened, smiling face of Merkel, but that of the grim Pegida marchers and AfD populists. In fact, AfD has ridden its refugee opposition to unprecedented opinion poll highs of over 10 percent in recent surveys.

Merkel is disappointed that her party and the German people ultimately declined to follow her lead.

But she herself failed to link her message of welcome together with a solid plan for at least halfway controlling the influx of refugees. That is ultimately what caused the mood in Germany to shift, what triggered opposition in the rest of Europe and what propelled the right-wing populists to unprecedented heights. That is also on Merkel.

The Greatest Surprise of All

Even Hassan Alasad, Merkel's selfie partner, now has a different image of Germany than he did four months ago. Although there is nothing that would get in the way of him being officially recognized as a refugee -- which would allow him to work -- he still hasn't received his papers.

Each week, he stands in line in front of the relevant office, but thus far his efforts have been in vain. The officials have no time for him and are completely overwhelmed. Were Merkel to drop by for another visit, he says he would ask her what's wrong in her country.

It could still be that Merkel will find her way back to her old pragmatism and will pursue the Plan B of turning back most refugees at the Slovenian border. Such a plan would allow the continuation of border-free travel in the Schengen Zone, but it would mean that people would be stranded in the Balkans or in Greece -- and Germany would contribute to Europe showing its ugly face.

"I would feel terribly sorry for her as a person if she were to get into a situation where she was forced to abandon her convictions and her past," says Eppelmann. "But if it came to that, she would step down first."

Among all of the surprises that Merkel has sprung on the Germans in the past several months, that would be the greatest one of all.