Gold: Intelligentsia - You're Fired!

By: John Ing
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Trump Cartoon

Former Obama Chief of Staff, Rahm Emanuel, once said, "never let a serious crisis go to waste".

During the 2008 panic collapse, the US government bailed out big business, took over General Motors, fattened the big Wall Street banks and even nationalized mega institutions Fannie Mae and Freddie Mac. As a result, government became even bigger with an insatiable appetite for revenues and to no surprise, the economy remains in a funk. Eleven states in the US now have more people on welfare than they do employed. No wonder there is a populist backlash against Wall Street because today, the "too big to fail" institutions became not only bigger but, "too big not to fail". Since 1997, the six biggest banks in the US and Europe increased their assets almost five-fold. Today the banking sector is at the crux of foreign exchange trading, derivatives and overseas lending. And despite rounds and rounds of rate rigging settlements, Wall Street's complex financial alchemy was again used to disguise their liabilities allowing big business to play an outsized role with trillions of complex structures reducing the clarity where risk lies. The upshot is that these products in Frankenstein-like fashion once turned on their creators in 2008 but today poses a bigger risk - haven't we learned anything?

Americans finally joined the stealth currency war as the strong dollar fundamentals came to an end. The greenback slipped to 15 month lows on the unwinding of carry trades by foreign holders ending a two year rally. Nonetheless a currency war is a zero sum game, going back to the beggar-thy-neighbour policies of the Thirties. Seven years after the financial crisis, the Fed's monetary expansion pumped more than $7 trillion into the financial system in an effort to stimulate lending and revive economic activity. However, instead of a pickup in growth, this cheap money created bubbles in the bond, stock and currency markets while the US national debt jumped to $19 trillion or 100 percent of GDP. Since so much money produced so few results, the Fed's ultra-low bond policy forced investors to chase higher multiple stocks which became more expensive than ever. We believe the damaging ramifications and declining credibility of our central bankers' policies will have a devastating impact on the global economy, raising investor risk.

Negative Rates Brought Negative Returns

It is an upside down world. Negative interest rates delivered an outcome exactly the opposite of what they were intended to produce. Investors greeted negative rates by dumping equities. In imposing negative rates, over half of the Eurozone sovereign debt trades with negative yields.

Noteworthy is that Germany and the Netherlands balked at Mr. Draghi's latest folly, exposing divisions between the savers and the spenders. We believe negative rates are the last arrow in the central banks' quiver of highly unorthodox methods, after quantitative easing (the printing of money to buy bonds) failed to revive a sluggish world economy.

Also running out of options, the Bank of Japan imposed a subzero policy in an attempt to cheapen its currency to lift exports. Instead the yen gained over 10 percent, offsetting any benefits from negative interest rates. Despite experimenting with rates at zero and now negative, Europe is mired in sub two percent growth, Japan is negative and the US economy only grew at a paltry 0.05 percent in the first quarter. Left unsaid is that negative rates squeezes those who borrow, with some, perversely paid to borrow, resulting in even more indebtedness. Investors are not stupid, within this environment, they will hoard cash to preserve capital. After all, why pay to stash one's cash? A safe or mattress may provide security but not surprisingly, gold had its best quarter in 30 years.

How Low Can they Go?

Cheap money has not solved our problems, underlining the limits of central banks' monetary policy. In none of the economies experiencing negative rates has been there been growth.

Negative rates brought negative returns. Every asset class has been scrutinized with past metrics or spreads dismantled. In each country their government intermediaries, the big banks' profits and business models weakened. Lending ironically also stopped. Reluctant to charge their depositors, major bank margins were squeezed and the old banking model was scrapped.

Financial markets also felt the repercussions of subzero rates. What ballasts the US monetary system is debt. In creating credit, the Fed purchased government securities with freshly minted dollars, bidding up bond prices allowing the Fed to push interest rates down such that it amassed a whopping $4.5 trillion of debt versus a pre-crisis average of $825 billion. All this involve risk. According to Bloomberg, the Bank of Japan has become the world's largest hedge fund, purchasing about 90 percent of the Nikkei 225 through ETF purchases. And not surprisingly, Fed Chair Yellen's attempt to raise rates for the first time in over a decade, faltered as she too succumbed to the addiction of cheap money, postponing rate increases, kicking the so called rate increase down the road.

US Real Interest Rates Correlate with Gold
US Real Interest Rates and Gold

As a consequence, governments' propensity to overspend had them confiscate private wealth through direct taxation, and when that failed, inflation and the debasement of money became the policy du jour. Various combinations of revenue enhancements, austerity and monetary policies were unsuccessfully tried to close the budgetary gaps. As a result, the politics of western economies involved scapegoating business using overregulation and overtaxation to disguise governments' ineptitude. Inevitably, the central banks' experimental moves encountered the laws of diminishing returns.

Governments everywhere remain reluctant to reduce spending or deal with their debt relying instead on their central banks to close the gaps through deficit finanicngs. Moreover, politicians everywhere are too weak to solve our economic problems or unwilling to change, preferring the "sunny ways" or the "audacity of hope" type rhetoric instead of the hard truths of realpolitik.

The longer our politicians dither, and leave our central banks' unconventional alchemy to deal with our problems, the greater the damage.

Too Big Not To Fail

Wall Street, one of the beneficiaries of negative interest rates was an easy target for the nonstop populist attacks. And no wonder. Seven years after the biggest financial crisis, Wall Street has gotten bigger, our unelected central banks are in charge and we have a bigger debt problem than before. The disclosure of the Panama Papers showed that business, not only reaped but they were able to sow by setting up offshore companies and for some, reduce their tax bite.

Indeed, in a challenge to the status quo, the popularity of Bernie Sanders and Donald Trump is such that they have captured the mainstream desire for jobs, change, less government interference and the promise to get something done. Wall Street's greed was secondary. The Fed just allowed politicians to postpone the inevitable, mortgaging America's future.

The problem is that governments didn't plug the holes despite the introduction of post crisis financial reform bills like the Volcker Rule and the Dodd Frank Act that introduced, layers and layers of complex regulations and refashioned the global financial markets allowing big business to become even bigger. As an example, the so called "Lender of Last" bill shifted the onus of the next bailouts to depositors and investors reducing the risk exposure of the government, not Main Street. Despite rules to separate the investment banking or trading activities from their traditional commercial arms, in this upside down world, Goldman Sachs has been allowed to become a savings bank, taking deposits from Main Street. Instead of scapegoating Wall Street, more US Real Interest Rates Correlate With Go Bloomberg necessary are structural reforms on government policy and fiscal spending rather than through artificial means. And in this election year, rather than the endless ideological promises to end financial profligacy and reduce debt, concrete plans to make debt reduction a priority is needed. Unfortunately neither presumptive nominees, Clinton nor Trump are fiscal hawks with Clinton a "spender" and Trump, "a serial debtor".

To be sure, America is no longer the superpower it once was after rescuing Wall Street, fighting numerous wars and directing the Fed to revive the economy. As the largest debtor in the world, the United States even lost its financial independence when Saudi pressure threatened to dump $117 billion of US Treasuries, if Congress was to pass the Sept 11 Bipartisan Bill paving the way for an Obama veto. Global central banks sold $225 billion last year and so far $123 billion this year. We therefore need both presumptive nominees to promise to legislate the needed reforms and not give lip service to protect the status quo and vested interests.

Intelligentsia, You're Fired

Investors will have to grapple with a game changing November presidential election. The idea of reality TV mogul Trump winning the presidency sounds fairly ridiculous. Then again, so did the prospect of winning the Republican nomination. Certainly, Mr. Trump's candidacy has broken the two party system. The upcoming election will be an extreme study in contrasts. Mrs. Clinton's strongest suit of government and foreign policy experience is Mr. Trump's weakest. 

Yet Mr. Trump's message of change and honesty is Mrs. Clinton's weakest. At the very least, politics has changed forever and that is a good thing. The roots of political dysfunction go back to the politicization of every decision, broken promises and of course American political campaigns became ruinously expensive and heavily dependent upon the largesse of Wall Street, super PAC groups, and special interest groups.

Though viewed with derision, there is a chance for innovation, notwithstanding the resistance from America's political intelligentsia such as the established parties, the mainstream media and the fund-raising machines. We believe Mr. Trump may help reform a broken electoral system by exposing the fault lines within the system. He has built up a tremendous following among the disillusioned voters with establishment politicians. There is no question Mr. Trump's views are hair-raising and undoubtedly divisive. However these days, voters are too complacent, disenfranchised and disinterested, partly because there they see little difference in a politician's promises which is often broken, once elected. Noteworthy amid the derision is that Mr. Trump so far has spent about $40 million in his quest for the presidency. His frugal campaign no doubt is a record and largely because most of it was his own money. Is it possible that once elected, his stewardship of the government's finances could be equally parsimonious? 

That would be innovation and change worth pursuing. Just saying!

The Middle Kingdom Dictates the Gold Price

Of interest is that both presidential candidates are hostile towards China, in particular for alleged currency manipulation. Over the past seven years, there has been a consistent flow of gold from the West to the East. China is the world's largest producer of gold at 460 tonnes and the largest consumer at 1,200 tonnes. However, Chinese mines are short-lived and the deficit grows larger every year.

Chinese state-owned producers are also encouraged to acquire gold assets to close the deficit gap.

State-owned China National Gold recently acquired Eldorado Gold's Jinfeng Bloomberg Mine for $300 million and Eldorado sold its other Chinese mines to Yintai Resources for $600 million (US).

Consequently, China has become a dominant force in the physical gold market. The Chinese central bank also holds 1,808 tonnes of gold reserves up from 600 tonnes in 2009 becoming the fifth largest holder of gold in the world, ahead of Switzerland and Japan. Shanghai has become the hub for gold trade. The Shanghai Gold Exchange (SGE) the official exchange of Chinese gold, recently introduced its own benchmark "fix" denominated in renminbi for gold bullion.

In the first couple of weeks of trading on the SGE, the Chinese fix closely tracked the London Gold Fix. The London Metal Exchange is owned by the HKEX. The world's largest bank, ICBC is a participant in both fixes. The Shanghai Gold Exchange itself has some 55 vaults.

With ICBC purchasing Barclay Bank's 2,000 tonne vault in London, the bank extends its influence from sales to storage.

China Seeks to Set Global Gold Prices
Spot Gold Chart

In the last five years, Comex warehouse inventories have been cut in half as the pool of physical gold dries up in the West. We believe China's gold involvement is part of a major change in the global financial architecture in response to the manipulation and gaming of Western markets as well as China's desire to diversify from the dollar because China has too many dollars. We believe the world's largest trader also wants to make the renminbi a global reserve currency, backed by gold and not by fiat means which can be manipulated. Who is gaming who?

Gold's New Bull Market

The reports of gold's death were premature, very premature. Goldman Sachs even changed their $1,050 per ounce forecast, closing short positions. Half of the Street hates gold, one quarter is indifferent and one quarter likes gold. Everyone however recognizes that all is not right in the world. An old broker adage is that bull markets, "climb walls of worry". Gold's phenomenal rally this year broke three decade old records boosted by worries over the spread of negative interest rates, more cheap money, and a tumbling greenback. What damages trust in the US, damages the whole world. Investors are left wondering whom and what they could trust. Some sovereign wealth funds are stocking up on gold. Gold is an alternative for them. At the very least, Mr. Obama was good for the gold business.

We believe the plethora of both economic and geopolitical uncertainties such as the Middle East quagmire, European dysfunction, Greek default (again), unicorn implosions, Brexit and now a presidential election has contributed to global market volatility. To many (including the mainstream media), gold is just a commodity. It is much more. Gold is a barometer of investor anxiety. Gold maintains its store of value, a value that cannot be weakened by the whims of either central bankers or politicians. While most investors do not fear inflation, they remain surprisingly complacent. Our view is that the resumption in gold's bull market is a prelude to a run-up in core inflation. While the hard asset market has done well, of concern is that the bond and stock markets remain priced to perfection. Ironically if central banks get what they wish for China Seeks to Set Global Gold Prices and inflation picks up because of a lower greenback or higher commodities, that risk is not priced in the market. In an environment of negative rates and falling currencies, there is a shortage of safe havens. Gold is a beneficiary and its super rally in the first part of the year, will be pale if those inflation embers flare up.

The world has been losing confidence in the currencies issued by central banks, and lately the US dollar. Investors are also aghast at the deterioration of the quality of our political leaders.

Investors, like voters everywhere feel disconnected that both our central bankers and politicians just don't get it.

One can detect the decline in confidence in every part of the world. Others like China and Russia already have more dollars than they possibly want. However, US policy has treated them more as enemies than allies or even as equals. As such it is not such a surprise that both countries are hoarding gold to offset American hegemony. We believe they also suspect that the American people will elect an inflationary president and a dysfunctional Congress this November since neither Clinton nor Trump stands for sound money. Mr. Trump, that serial debtor has filed for Chapter 11 bankruptcy, four times. That will be good for gold, but bad for the dollar.

We continue to expect gold at $2,200 per ounce gold.

Recommendations

Finally most gold miners are mining gold at a profit with all in costs (AISC) about 20 percent lower to $1,000 per ounce. Prospects for the industry are bright. Gold shares have more than doubled in the first quarter and the TSX gold weighting was increased to seven percent from four percent. Yet most institutional accounts are underweighted, waiting for the proverbial pullback. Although gold is technically overbought, rather than a pullback we expect a consolidation of the recent move. We believe that we have entered the second leg of gold bull's bull market that began in April 2001 and will continue to rally reaching $2,200 per ounce. We like highly liquid Barrick and Agnico Eagle among the seniors, prefer B2Gold and Eldorado among the intermediaries and McEwen Mining among the juniors

Agnico Eagle Ltd

With eight mines in Canada, Finland and Mexico, Agnico reported a good quarter with strong contributions from open pit Canadian Malartic, Goldex and Kittila. Flagship LaRonde in Quebec which has produced 5 million ounces thus far, increased throughput resulting in improved production. However, higher costs were realized at northerly Meadowbank in Nunavut, offset in part by lower costs from Pinos Altos in Mexico. The company reported that they will produce closer to 1.6 million ounces under $910 per ounce AISC. The company also reported positive exploration results from Amaruq which gives them a better understanding of WhiteTail to be processed likely at nearby Meadowbank, extending Agnico's largest producer's mine life. Of interest is that Agnico has doubled its exploration budget which includes the Canadian Malartic joint venture's nearby deposits as part of the three kilometre mineralized system. Agnico's management is known for its execution, delivery of projects on time and under budget. Agnico-Eagle has in situ reserves of 19 million ounces, a solid balance sheet and is among the few senior producers with a rising production profile. Although the shares have been one of the best performing stocks, we continue to like the shares here.

Barrick Gold Corp.

Barrick, the world's largest gold producer, reported strong results better than Street expectations. Barrick produced almost 1.3 million ounces which resulted in a 24 percent reduction of byproduct AISC to less than $700 an ounce. The almost 400 square mile Cortez district in Nevada continues to be a positive surprise. The Cortez deep underground feasibility expansion was completed, expanding the one million ounce open pit producer. Most important, the company's "back to basic strategy" helped generate positive free cash flow. Barrick is focusing on organic growth from its almost 92 million of in-situ reserves, the longest reserve life in the world. As an example, organic growth will come from Goldrush located six kilometers from Cortez Hill, Lagunas Norte in Argentina and Turquoise Ridge.

Since 2015 Barrick has reduced almost $4 billion of debt. In repairing its balance sheet, it can now focus on the development of its enviable long life core group of mines. During the quarter, Barrick closed its deal to sell Bald Mountain and Round Mountain to Kinross at attractive prices. Barrick has a cash balance of $2.3 billion and less than $200 million of debt maturing before 2018, with $5 billion maturing after 2032. Barrick still wants to reduce debt further.

Possible assets to be sold include Pascua Lama, and 64 percent owned Acacia. Under John Thornton, Barrick has flattened management, established a three person growth group, and repaired its balance sheet. Barrick shares have increased 170 percent since the lows. Barrick is back and looking to the future, we believe Barrick will pursue additional joint ventures, optimize its high quality assets and focus on bringing Barrick into the twenty first century. We continue to like Barrick here.

Centerra Gold Inc.

Centerra reported positive results in part due to a reversal of an inventory adjustment. The Boroo mine in Mongolia has closed so Centerra's output will come from Kumtor in Kyrgyzstan at almost 530,000 ounces annually. Production was lower in the quarter due to lower grades, delays and recoveries. Centerra entered into a five year $150 million revolver with EBRD and signed a $150 million project financing loan facility for Oksut in Turkey. Centerra has a great balance sheet with liquidity of $500 million. However, the company remains locked in a dispute with the Kyrgyz government and that overhang plus harassment has kept a lid on the stock.

Nonetheless, we believe that a rapprochement with the government is inevitable. Down here, the shares remain cheap.

Detour Gold Corp.

Intermediate gold producer, Detour reported positive cash flow and a new life of mine (LOM) production plan with Detour West (Block A) which extended the life of the open pit mine in northern Ontario. Detour is one of the largest Canadian gold producers with less than 20 percent of its property explored. Of interest is that recent exploration at Detour West resulted in better grades. The company has optimized improvements at the mill averaging 54 kptd which is close to nameplate. Detour also extended its electricity contract to December 2024 under favourable terms at 4 cents a kw allowing a reduction in costs. Detour produced 505,000 ounces last year and will increase production to 570,000 ounces at AISC about $930 per ounce.

Detour paid down $124 million of debt but will have to refinance about $300 million of convertibles next year. The key for Detour however is to process more material and improve grade to make money. Detour has some 16.4 million ounces of in situ reserves, a rising production profile, conservative management and we like the shares here.

Goldcorp Inc.

Goldcorp reported surprisingly improved results producing 784,000 ounces at AISC of $836 per ounce. Production was lower due to a lower grade cycle at Red Lake and Penasquito with AISC of $1,000 per ounce. Cash flow was negative for another quarter. Eleonore in northern Quebec continued a slow ramp up with results weaker than expected suggesting a continuous dilution problem. Goldcorp's flagship polymetallic Penasquito in Mexico had a scheduled shutdown as well as a lower grade cycle resulting in a 30 percent reduction in output. Results will again be adversely affected this year and in fact, the Penasquito pyrite leach plant expansion might be shelved because of costs.

Goldcorp's main drawback is growth, particularly since Ontario-based Cochenour and Borden Gold were to help extend Porcupine and Red Lake mine lives as well as boost production. Both projects were downgraded from development suggesting their reserves remain elusive. So much money, so few ounces. Goldcorp's other problem is that its pipeline is somewhat bare. To replenish that pipeline, Goldcorp spent $400 million to buy Kaminak's Coffee project in the Yukon. Coffee is a high grade three million ounce project with a feasibility study but there is a need to spend $300 million excluding hundreds of millions for a road and infrastructure. We believe newly minted CEO, David Garofalo will have his hands full since more shoes are expected to drop as he optimizes existing assets, shed underperforming, higher cost operations and replenish Goldcorp's pipeline. We prefer Barrick here.

Iamgold Corp.

Iamgold reported yet another off quarter despite producing about 191,000 ounces from four mines at AISC of $1,084 per ounce. Main assets Essakane and Rosebel's costs were lower however free cash flow was negative as Iamgold loses money on just about every ounce it produces. Although Essakane in Burkina Faso performed well, producing 88,000 ounce at AISC of $1,116 per ounce, lower grades in the quarter and a need for waste stripping hurt costs. At Westwood in northern Quebec, rehab work is continuing but there's still a need to spend about $50 million in development work with production not expected until 2019 at the earliest. Iamgold has a declining production profile, mediocre pipeline and thus cash preservation as well as harvesting existing mines remain priorities. We do not see much here. Sell.

McEwen Mining Inc.

Junior producer, McEwen Mining produced almost 38,000 ounces in the first quarter with earnings of almost $20 million. Importantly McEwen reported positive free cash flow in the quarter with AISC at $903 per ounce. The Flagship El Gallo mine in Mexico cash cost was $432 and AISC was $532 pe ounce due in part to a contribution from copper. At the San Jose mine in Argentina, all in cost was about $938 per ounce allowing a $2.6 million dividend contribution to results. McEwen's guidance was increased to 100,000 ounces at 3.3 million ounces of silver or 144,000 gold equivalent ounces at AISC of $935 per geo. Rob McEwen owns 25 percent of McEwen and the Company has a stellar balance sheet with no debt and liquidity of $46 million. We like McEwen here for El Gallo, pristine balance sheet, a wide US following and McEwen's penchant for growth.

New Gold Inc.

New Gold has four operating mines in mining friendly jurisdictions like British Columbia, Mexico and Australia. New Gold reported a strong quarter producing almost 91,000 ounces which was in line with guidance. The New Afton Mine in BC reported higher recoveries and mill throughput. New Gold also produced 25.4 million pounds of copper in the quarter, above expectations. Nonetheless, New Gold reported flat results. Grade was key. Looking ahead, Cerro San Pedro in its final year of mining, is to be replaced by Rainy River next year. At its AGM, New Gold reported that Rainy River development was on track and more than 30 percent completed. Financing for Rainy River has now been completed and the threat of equity dilution has been removed. New Gold also hedged 270,000 ounces in 2016. Given New Gold's geographic profile, and with Rainy River production less than a year away, we like the shares here.

Primero Mining Corp.

Junior producer Primero 's two mines in Mexico and Ontario reported losses due to higher costs at 100 percent owned San Dimas in Mexico which produced 20,000 ounces at 2,500 tonnes per day. Overall, cash flow was negative in the quarter with Primero only producing about 36,000 ounces at a whopping AISC of $1,555 ounce. With net debt at about $95 million, the Company repaid $48 million. Black Fox development continues but it seems that the Black Fox underground development is very slow. Reserves and development work remains a problem as overall grade declined. Finally the dispute with Mexican tax authorities over San Dimas is still unresolved which is an overhang. Primero has total liquidity of $71 million against $75 million of convertible debentures due in 2020. Importantly, silver produced at San Dimas is subject to a silver purchase agreement with Silver Wheaton, so margins are tight. We would switch into McEwen Mines here.

Yamana Gold Inc.

 Yamana reported positive cash flow in the quarter on earnings of $0.03 per share producing 308,000 ounces in the quarter at AISC of $804 per ounce. Lower output from El Penon and Chapada was offset by contributions from Canadian Malartic production and Jacobina.

Nonetheless Yamana is still stuck with high cost Brio Gold which was to be spun off but rejected by the Street. Yamana's balance sheet is laden with some $1.7 billion of debt grew again with the recent acquisition of RGM in Brazil for $47 million which will be lumped in with Brio's assets. On a positive note, Daniel Racine was elevated to COO which will result in some improvement of the operations of Yamana's array of assets. Given, Yamana's debt laden balance sheet (finance expense alone was $47.6 million versus $11.2 million) and flat production profile, the shares are a sell candidate.

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Rise of the Populists

Austria a Step Ahead in Europe's Race to the Right

By Hasnain Kazim, Katrin Kuntz, Walter Mayr and Barbara Supp
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Austria's mainstream parties long believed they could keep the far right under control. On Sunday, though, a right-wing populist could become the country's president. What went wrong? The answer has implications for all of Europe.

For someone who, it is said, wants to fundamentally change the country, Norbert Hofer seems quite relaxed. He is sitting there sipping his tea with a smile on his face and talking about all that he wants to accomplish should he be elected president of Austria.

It is a recent Friday morning, shortly before an important press conference, but Hofer is not to be rushed. His ornate office is located on the second floor of the parliament building in the heart of Vienna, where he -- for the time being -- occupies the position of third president of the Nationalrat, Austria's parliament. On May 22, though, he is seeking to make history. Were he to win the second round of presidential elections on that day, he would become the first candidate ever from the right-wing populist Freedom Party of Austria (FPÖ) to move into the Hofburg Palace, the former imperial seat that now serves as the office of the country's president.

If he wins, and his chances are good, Austria would have a president who is "decisively opposed to forced multiculturalism, globalization and mass immigration." He has blasted his opponent, Green Party candidate Alexander Van der Bellen, as a "fascist, green dictator."

As in Germany, the position of president in Austria is largely symbolic despite being the country's highest representative. But there are key differences. For one, the president is elected by popular vote, giving the office holder the kind of electoral legitimacy that the president of Germany does not have. For another, the Austrian president is commander in chief of the country's military. Beyond that, though, were Hofer elected, he would have political power domestically as well.

Hofer says he doesn't understand all the agitation surrounding his candidacy and all the talk of a "presidential putsch" from editorialists and experts on the constitution. He doesn't understand the concern that he, a candidate from the far right, would be in a position to dismiss the government, dissolve parliament and name a new chancellor of his choosing. The Austrian constitution gives the president the ability to do all of that, in theory. Thus far, though, no president has ever sought to exploit the full extent of those powers.

The FPÖ candidate does admit, however, that he reserves the right to intervene. "Of course, if a government has been in office for years and the situation in the country is becoming worse and worse, then it will be dismissed in the end."

Things haven't gone that far yet, but the chancellor is already history. On May 9, Chancellor Werner Faymann of the Social Democratic Party of Austria (SPÖ) stepped down unexpectedly.

It was the most recent climax in an ongoing development that has rocked the foundation of Austrian postwar political certitude. Since World War II, cooperation between the SPÖ and the center-right Austrian People's Party (ÖVP) has formed the backbone of the country's stability.

Should Norbert Hofer be elected president, it would be a further milestone in that erosion: In the first round of elections on April 24, he won fully 35 percent of the vote.

From Outrageous to Reality

All of Europe is looking this week to Austria, this small country in its midst where an eventuality considered by many to be outrageous may soon become reality. This reality, though, comes in the guise of a harmless, friendly face. Norbert Hofer is a 45-year-old trained airplane technician from the state of Burgenland, just southeast of Vienna. He is the father of four and his wife, his second marriage, is an elderly care professional. Hanging above his desk in parliament is a framed image of Article 1 of the constitution, which says of the Austrian Republic: "Its law emanates from the people."

Will the people of Austria really elect a right-wing populist to become their highest representative on Sunday? Is Austria in the process of becoming part of that group of European countries, along with Hungary, Poland, Finland and Switzerland, where the right-wing is already part of the government? And if so, how long will it take before the new right-wing movement tears Europe apart?

If one looks geographically at the congratulatory messages the FPÖ candidate Hofer received following his triumph in the first round of presidential elections, a checkered pattern of new European nationalists emerges. Marine Le Pen from the French party Front National was first, followed by the Lega Nord of Matteo Salvini and Forza Italia, under the leadership of former Prime Minister Silvio Berlusconi. From the Netherlands, congratulations came from PVV head Geert Wilders and from Germany, plaudits were sent by the right-wing populists from the Alternative for Germany (AfD). The right wing in Europe is becoming organized and developing contacts across the Continent. The election on Sunday is far more than just a purely Austrian affair.

Across Europe, large, mainstream parties are losing power and influence. It has happened in Spain, France and Germany, but nowhere has the phenomenon been as dramatically visible as during the first round of the presidential elections in Austria. Hofer came in first place followed by Green candidate Van der Bellen. An independent candidate came in third place. Only then did the candidates of the SPÖ and ÖVP -- the two parties that currently form the governing coalition -- follow in fourth and fifth place. Together, they didn't even managed 23 percent of the vote.

Both parties are in turmoil. After Faymann's resignation, the SPÖ scrambled to quickly find a new chancellor, ultimately choosing an outsider: Christian Kern, head of the Austrian national railway. At the ÖVP, meanwhile, the days of the party's leader Reinhold Mitterlehner are likely numbered, with Sebastian Kurz, Austria's young foreign minister, standing by to take over.

Lessons for Europe

The setbacks for the ÖVP and the SPÖ have been dramatic. Into the 1970s, the two parties enjoyed four times the support they did in the first round of this year's presidential elections, with the SPÖ experiencing a brief period during which it received over 50 percent of the vote.

These days, though, three out of four blue-collar workers in the country cast their ballots for the FPÖ. The right-wing populists are even ahead among labor union members.

What went wrong in Austria and its approach to the right-wing populists and their voters?

More importantly, are there lessons to be learned for the rest of Europe, particularly for Germany, where the country's political establishment is slowly getting used to the presence of the AfD?

The history of the FPÖ in Austria is a long one, meaning the country has experience with the question as to whether right-wing populists should be approached with rejection or acceptance.

Both the ÖVP and the SPÖ have, in the past, chosen acceptance. In 2000, the ÖVP formed a governing coalition with the FPÖ at the national level. And in Burgenland last year, the SPÖ joined the right-wing populists in the state government, despite the fact that a 1986 party resolution enjoined the Social Democrats from ever cooperating with the Freedom Party. With the prospect of new parliamentary elections approaching, it is fair to ask whether the SPÖ would be willing to join the FPÖ again.

The political duel looks like this: On the one side stands Hofer, a 45-year-old who wouldn't turn heads on the street -- a smiling, friendly man who talks rapidly. His campaign posters read: "Your homeland needs you now!"

On the other side is the 72-year-old Alexander Van der Bellen, the long-time head of the Greens whose appearances are professional but who has thus far seemed shaky on the campaign trail, depending on the day. After a serious illness that kept him away from the large political stage for years, he is now trying to make a comeback. He enters the final round of voting on May 22nd with a 14 percentage point deficit in the polls. His campaign posters read: "Those who love our homeland don't divide it."

In a debate between the two candidates held on Austrian public broadcaster ORF shortly after the first round of elections, Van der Bellen seemed polite. Indeed, he was so reserved that one commentator wondered if the Green candidate was aiming to form a coalition with the FPÖ candidate. "We are once again of the same opinion, Mr. Hofer," said Van der Bellen. In response to a question as to why he was suddenly talking so much about the "homeland," the Green Party leader said: "One can always learn something new." He seemed tame and harmless. Yet he is the candidate tasked with defending the political mainstream.

Can it really be that Austria is preparing to hand over the presidency to the right wing without a fight?

A further debate, held on Sunday evening, delivered a different impression. The two candidates were seated at a table in a sparsely decorated studio for a discussion free of rules and with no previously agreed list of issues for discussion. There wasn't even a moderator. The result was the kind of childish name-calling one might expect from a school playground. It was not a good look.

A Bit Eccentric

From the outside, the situation in Austria is vexing. It is a small country of not even 9 million residents -- and one that has long been allergic to suggestions from Germany, its large neighbor to the northeast. The country does not want to be treated like a little brother; it wants to be taken seriously as a political partner.

Germans, though, tend to see Austria more as a vacation destination than as a political entity: A bit eccentric perhaps, but full of attractions. It has transformed its history into a spectacle: The Austro-Hungarian Empire, Empress Sisi and Franz Joseph I., the "good emperor," who is once again being celebrated on the 100th anniversary of his death.

Austria has Mozart, the Spanish Riding School, apricot dumplings and the Burgtheater. It has the deep, with Sigmund Freud and his psychoanalysis, and the morbid, with the Imperial Crypt and the Central Cemetery. It has its coffee houses, where comfort meets depression and grumpiness. It has the mountains to climb and the lakes to swim in.

It is so beautiful in Austria. It is so beautiful in the state of Carinthia.

It is also beautiful in Grosskirchheim, a small municipality of 1,374 residents in the Möll Valley, a place of weathered farmhouses, tangy air and mountains with a dusting of snow. Little streams bubble through the meadows, the buttercups are in bloom and bubbly wine is being served in restaurants -- but dark thoughts are in the air.

In a wood-panelled parlor, Mayor Peter Suntinger has set out a Bible, a book about Islam and a further volume with the title: "The Koran, God and I." In addition, he has put on display colored printouts of the asylum-seeker IDs and passport photos belonging to seven refugees from Syria who now live in the village. He wants to show everything that is going wrong in Austria -- and in Europe at large.

Wearing a blue doublet, the balding, 51-year-old mayor has a mistrustful, cagey expression on his face. His greeting is brief.

Protecting the Homeland from Islam

Suntinger, a member of the FPÖ, proudly claims to have once stood atop the Grossglockner, Austria's highest peak, together with the late FPÖ leader Jörg Haider, who died in late night car crash in 2008.

He tells the story as though it were a religious experience.

Suntinger is a farmer, a mountaineer and the father of two. In the last municipal elections in 2015, he was elected with around 80 percent of the vote. There was no other candidate.

His lecture on the state of the world begins. "Essential to the Koran is that the woman is a subject -- and that in the 21st century," he says, before reading out suras pertaining to sexuality and identifying women as a "place of sowing of seed."

"The Koran sees only dead Christians as good Christians," he says. Europe only makes sense, he goes on, "if it focuses on preventing the Islamization."

He then presses his index finger onto the identification photo of one of the Syrian women. He says: "That is supposed to be the mother." Impossible, he says, the children are much too old.

"The West is colliding with the East!" Suntinger calls out. "The people have to wake up!"

By that point, his presentation was only 10 minutes old.

The economy of the Möll Valley was long dependent on mining and agriculture, but is now trying to attract tourists -- foreigners with money -- as well. As part of that effort, Suntinger has overseen the several-million-euro construction of a new recreation park, complete with a hall where you can shoot at virtual deer. "It's a big hit," says Suntinger. "Because of the overpopulation of foreigners, many more people have weapons here."

When Suntinger says foreigner overpopulation, he means migrants -- and he would like to keep them away. Because as the FPÖ says: "Protect the homeland from Islam."

Mountains and Cows

One year ago, someone from the Netherlands, who owns an empty pension in the municipality, wanted to provide shelter to 29 refugees, but the town was able to prevent it. The vote in the municipal council was 14 to one against the foreigners. Not only that, but someone threw a firework onto the pension's terrace and the Dutchman's hearing was damaged in the explosion. He then sold the place and moved away.

Now, a seven-member Syrian family lives in a former rectory on the hill above town and they generally stay out of sight: Fatima, Madiha, Mohamed, Amina, Anes, Boshra and Bashar, from Damascus. They have learned a bit of German, with their first words being "excuse me," "mountains," and "cows." "It is beautiful here," says Fatima up in the rectory. "But so quiet."

Down below, in the parish hall, Suntinger says: "Islamization is the great danger."

That things will improve and remain the way they always were, that was the promise made by Jörg Haider back when he was governor of Carinthia, the state in which Grosskirchheim is located. "Jörg dares to do things" was once Haider's campaign slogan, a perfect slogan for a populist. He came from Carinthia and used it as the base for his climb to the chairmanship of the FPÖ, transforming it into the state's most powerful political party by 1999. It was also here, in 1991, that he praised the "Third Reich" for its "decent job creation policies."

Haider drove the state of Carinthia to ruins and led his party into several scandals, but nevertheless brought the FPÖ a measure of acceptance. After Haider died in the 2008 traffic accident, almost 30,000 people showed up to his funeral in Klagenfurt. His charisma still holds sway in the Möll Valley.

He was a master at winning people over, many in Grosskirchheim still say today. Others note he was a great friend and keen observer of human nature. He wasn't shy about becoming one with the people, they say.

It has now been 30 years ago since Haider ended up at the top of the FPÖ, the party that was founded 60 years ago, initially providing a political home mostly to members of the country's far-right fraternities, known as Burschenschaften, and to ex-Nazis -- though many of them also joined the SPÖ and ÖVP.

Austria is a country where the "greatcoat of silence" was draped over the past for far too long, as author Karl-Markus Gauss once wrote. One of the founding myths of postwar Austria is that the country was not first-and-foremost an accomplice of Nazi Germany, but rather that it was the first victim of Hitler's aggression.

The Nazi Past

Early on, Austria's national consciousness was extremely fragile. Shortly after the war, fully half of the population saw themselves as being part of the German nation. The result has been that, even today, the majority of the population closes ranks in the face of massive assaults from abroad. That was the case in 1986, when the Nazi past of Austrian President Kurt Waldheim -- a former UN general secretary -- came to light. And that was also the case when Haider's FPÖ became part of the federal government and was faced with widespread outrage from Europe and further afield.

The chameleon-like Haider represented the transition from Nazi brown to the modern right wing. He proved attractive to large segments of the rural population but also to blue collar workers in the cities. He was able to present himself as a modernizer while at the same time appealing to the old Nazis; as the child of Nazi parents, he had the far-right vocabulary down pat.

Yet even Haider, who, starting in 1986, led the party to unprecedented popularity and, ultimately, into the federal government, proved too objectionable. He declined to represent the party on the national stage and wasn't part of the team when Wolfgang Schüssel, then head of the ÖVP, put together his governing coalition with the right-wing populists. The coalition didn't last long, partly due to the steady stream of provocations delivered by Haider from the sidelines, but it was important in that it showed the FPÖ could play in the top league.

When Schüssel went into a coalition with the FPÖ, the outcry from Europe was deafening and the Continent sought to sideline Austria with diplomatic sanctions, even declining to invite the country's foreign minister to certain events. It looked as though Europe were ready for a fight, but then it lost momentum. The pressure faded and Europe resigned itself to Austria's new government.

But the outcry was loud in Austria as well, at least among artists and intellectuals. One of those who made his voice heard at the time was theater director Martin Kusej, who is from Carinthia. In an essay, he decried the "friendly, open men and women" of "the horror called homeland." The party, he wrote, "will be everywhere." Today, Kusej is art director at the Residenztheater in Munich and, looking across the border to his home country, he sees a friendly, open man by the name of Hofer, who wants to become the president of Austria.

Kusej is broad-shouldered 55-year-old who still looks like the athlete he once was. He is from an agricultural region in southern Carinthia and is known for his coarse, sometimes brutish, staging. But he has a softer image of his homeland and the malaise it triggers.

Pre-Democratic Austria

He too says that Carinthia is beautiful. So beautiful that he can sometimes hardly stand it. In the autumn, there are always "two or three weeks where the low, late-afternoon light breaks particularly elegantly on the mountain formations or becomes entangled in the dying, colorful leaves on the trees. It is so outrageously beautiful that a heavy ring of iron forms around your heart. I have to leave quickly." He has found a literary quote from Haruki Murakami describing the feeling as "a groundless sadness called forth in a person's heart by a pastoral landscape."

The difficulty that Kusej had with his homeland during his childhood, though, had far less romantic origins. It came from the fact that he and others with Slovenian names were frequently singled out for abuse.
 
Still, he is uninterested in joining the standard chorus of anti-Austrian critique, in part because it is never fair to blame an entire country for a political development. But he is happy to talk about his experiences with politics back home. "Voting for a party means trying to get the maximum advantage for one's self," he says. It is an economy based on one's party membership and everyone, he said, internalized that view of politics. If you needed a job, were building a house or wanted a fishing license: "The party -- for many years it was the SPÖ -- took care of it.

And when the FPÖ came to power promising to put an end to it, everything just became worse."

He says that some aspects of Austria seemed pre-democratic. In Germany, he says, "you go to the authorities and have rights. In Austria, you are a supplicant." That, he says in his Munich office, "is why everybody in Austria, myself included, uses a title, no matter how farfetched."

They think such a title will guarantee them better treatment. They think that if a policeman sees "professor" or "engineer" in your identification, "they will have a certain reluctance to bite." It is an approach that sees authority as something that can both mete out punishment as well as offer protection. There is a desire, he says, for this authority "to be embodied in an omnipotent leader, a good leader, a ray of light. A good emperor."

Pre-democratic thought, a yearning for the ray of light -- that accelerates the rise of figures like Haider, and like Hofer. Theater can react to such a thing. Theater provides a free space where a world can be created to come to terms with such developments -- a space where hyperbole is allowed.

But is that freedom now under threat? In Vienna, a right-wing extremist group stormed the performance of Elfriede Jelinek's work "Die Schutzbefohlenen" (The Subjects). Kusej says that he has nasty visions when he thinks about it. He sees violent hordes marching through the streets "like in pre-fascist times."

Headscarves and Dreadlocks

"Pessimistic, perhaps," he says with a smile. Kusej says he is beset by the special Austrian form of pessimism that is combined with faith. "When you envision something particularly bad, there is always the hope that perhaps it won't be so bad after all."

Austria's governing parties, by contrast, are currently learning that things can also be even worse than the most dyed-in-the-wool pessimist might predict. For decades, the ÖVP and SPÖ have divided power and posts between them. Since the end of World War II, the two parties have governed the country in a coalition government, apart from three interludes. They watched the rise of the right-wing populists but continued to take their own primacy for granted -- particularly when the FPÖ, consumed by scandal, split in two in 2005 and plunged into the opposition, hardly able to attract 3 percent of the votes.

Now, though, you can head out to the Viennese working-class district of Simmering, in the southeast of the capital, to hear how things have changed. It is a diverse, slightly decrepit area with lots of social housing. The women wear headscarves or dreadlocks and one sees men with completely pierced and tattooed faces. If you want Wiener schnitzel, you have to go to the Ünlu Kebap diner and for punschkrapfen, that Austrian, pink-glazed delicacy soaked in rum, you must go to Yildiz Bakery.

It is here where Norbert Hofer achieved his best result in Vienna, with 41.2 percent.

Maria and Karl are sitting at the bar of an Austrian restaurant located on the main street of Simmering. It is noon on Sunday and blue smoke wafts through the room -- smoking is still allowed in many restaurants and bars in Vienna. She was a housewife her entire life while he worked for Opel until he retired five years ago. The two order their third round of beers. Back in October, they voted for the FPÖ candidate Heinz-Christian Strache in the Vienna city council election, they say. "And now Hofer." They see him as "smooth" and as "a young man who wants to change things." What exactly? "That Austria remains Austria."

Ali too, who came from Turkey to Austria when he was five and who has now lived in Vienna for 32 years and become an Austrian citizen, has high hopes for Hofer. "He's great," Ali says in the mobile phone shop where he works. Great? Really? From the perspective of an immigrant?

"There are more and more coming and they get everything handed to them while I had to work hard for years." Even so-called guest workers and their descendants have praise for the FPÖ.

Standing Up to Berlin

That is not completely Hofer's doing. Hofer, in his office in parliament, seems friendly, but he is adamant about what he has to say. He has used a cane since a serious paragliding accident in 2003 that almost left him paralyzed. He merely grins at the accusation that he is, despite his personable nature, merely a "wolf in sheep's clothing." And what about his recently purchased Glock-26 pistol?

He says he's not planning on using it in the presidential office. What about his connection to a German nationalist Burschenschaft -- one which views the Austrian state as a fiction -- in his home village of Pinkafeld? Hofer says he is merely an honorary member. And his widely quoted answer given during a televised interview when asked about the powers of Austrian president? At the time, he said: "You will be surprised to see how much is possible." Now he says it just slipped out.

Regarding Europe, Hofer says that "those issues that can be decided in the member states must once again be allowed to be addressed and decided there." He adds: "I think, for example, that Marine Le Pen is a politician with whom such goals can be implemented together." Le Pen is the leader of France's right-wing populist party Front National.

Hofer is convinced that if he and the rest of the FPÖ were to hold power in Austria, the EU would cease bowing to the will of the Germans. The FPÖ presidential candidate, to give an example, sees the demand issued by Sigmar Gabriel, head of the Social Democrats in Germany, that "all democratic forces" must form a front against Hofer" as inadmissible meddling. "We are not taking orders from Berlin," he says.

The Front National, on the other hand, provides the Austrian right-wing populists with a kind of blueprint. Marine Le Pen has turned her back on open anti-Semitism -- primarily embodied by her father and party founder Jean Marie -- and is now trying to appear modern. It is a path that is appealing to Hofer's FPÖ as well.

The party is currently under the leadership of Heinz-Christian ("HC") Strache, who took over from Jörg Haider in 2005. It was Strache who chose Hofer as the party's candidate for tsidency and when Hofer takes the stage wearing his preferred dark suit, as he did on May 1 in a packed beer tent in Linz, Strache is sitting in the audience, wearing his knee-length lederhosen and matching vest. A trained dental technician, Strache spent his youth in the far-right milieu, taking part in militia training exercises. He initially attracted attention for his relentless election campaigning against immigrants in addition to the rigid organizational structure he imposed on the nationalist camp. Now, the FPÖ leads the nationwide public opinion polls in the country with 34 percent.

Austria for the Austrians

Hofer, his candidate, employs a gentler speaking style, but is just as far to the right as Strache.

He is fully devoted to his party, including to people like the FPÖ Vienna city council member who in 2013 demanded: "Now it's time to take out the clubs for all asylum frauds, criminals, illegal foreigners, criminal Islamists and leftist screamers!" Hofer was largely responsible for the party's 2011 platform, called "Austria First." It offers a look at the country as the FPÖ wants it to be.

That Austria is "not a country of immigration" and should focus primarily on its own citizens -- and not on those that do not possess an Austrian passport. Social housing, for example, should be reserved "to cover the housing needs of Austrian citizens," the platform reads.

Voters should also be asked to take part in national referendums, as in Switzerland. The homeland is to be loved and traditions maintained, because "those who value their own culture and homeland" can "defend themselves as needed against other cultures should they display an aggressive character that seeks to push aside our own culture."

The problem, the party consistently makes clear, is the foreigners, particularly Muslims. It is a message with which the FPÖ scores points among many of those Austrians who are fearful of losing their place in society and of being overrun by foreigners. The message does not do as well among the prosperous and the generous.

But Strache has secured a further triumph: The support of Ursula Stenzel, a distinguished presence who can be found in the Hotel Sacher. She has everything that a Viennese lady should have: a refined upbringing, blonde hair perfectly coiffed and held in place with a liberal dose of hairspray, carefully chosen gold jewelry and the ability, even during the tensest moments of conversation, to graciously balance her cup of coffee. She is, she says, "hopelessly bourgeois."

Before she joined the FPÖ list in 2015, she was a presenter on the main news show of public broadcaster ORF and, after that, head of the ÖVP delegation in the European Parliament.

Starting in 2005, she spent 10 years as chairwoman of District 1 in Vienna, which encompasses the very heart of the city. Now, she serves as "a bourgeoisie icebreaker, I'm aware of that," says Stenzel. She also says that the chemistry between herself and Strache is excellent.

The FPÖ is doing all it can to make headway within both the propertied upper class and the petit bourgeoisie without losing sight of its traditional, German-nationalist far-right wing.

Strache says he imagines the division of tasks as follows: He himself is responsible for the rough stuff, with his "husky eyes." The rest is covered by Norbert Hofer "with his deer eyes."

Green Party Confusión

Meanwhile, the Van der Bellen camp has had difficulty finding the right strategy for confronting the right wingers. The Green Party candidate said on television that he is hoping for a "grassroots movement." He promised that he would do all he could "within the framework of the constitution" to prevent a possible Chancellor Strache should it come to that -- if the FPÖ were to win the next parliamentary elections.

Despite all the calls from the anti-fascist camp for voters to avoid casting their ballots for the far right on May 22, though, Van der Bellen has avoided accusing the FPÖ of having right-wing extremist tendencies. His PR advisors have warned that doing so could trigger even more people to side with the FPÖ against such an onslaught.

But the Green candidate has also shown a more aggressive side. During a breakfast debate just over a week ago, he earned from Hofer the comment: "Herr Doctor, you are so angry today."

And during the tête-à-tête on Sunday, Van der Bellen warned that the coming vote was a "decision between a cooperative style and an authoritarian style." A Gallup survey is forecasting a close race, but prior to the first round, the polling company also predicted that Van der Bellen would do better than he did -- and Hofer worse.

What, then, can be done to ensure that Van der Bellen does in fact become Austria's next president?

Even André Heller, a leading member of the candidate's support team, doesn't know for sure.

Heller, who splits his time between his estate near Marrakesh and his Vienna apartment, turned away from the SPÖ eight years ago when Faymann became prime minister. The Social Democrats, he says -- a party that has even forgotten how to "take the hardships in social housing seriously" -- are themselves to blame for their own disaster. "That's why it is deceptive and even embarrassing to only attack Mr. Strache."

Although he is a Social Democrat himself, Vienna Mayor Michael Häupl agrees, saying that after decades of power, the SPÖ has forgotten how to "understand the language of the suburbs." That he is one of the most powerful members of this quarrelsome party, and yet is willing to say such a thing, is yet another example of the crisis in which the SPÖ finds itself.

Vienna's Powerful Mayor

It is 11:08 on this Thursday morning when the door to Häupl's office swings open. A man in a slim-cut, conservative suit steps out and says: "Good day, I am Christian Kern." It is a polite greeting, but somewhat unnecessary. Only seconds before emerging from the office, he had learned that he was to become Austria's next chancellor, replacing Faymann. He is hardly an unknown.

Kern is head of Austria's state-owned railway, an elegant-looking gentleman with a past that is indispensable for the Social Democrats: He grew up the son of a working-class family in the Simmering district of Vienna and became a member of the SPÖ early on. Within the powerful union wing of his party, Kern is considered modern but moderate -- someone who might be able to pull the party out of the swamp.

But how could the proud Austrian Social Democrats have fallen so low? The man whose office Kern has just left should know: 66-year-old Michael Häupl, who has been mayor of Vienna since 1994. For decades, he has pulled the strings for the Austrian Social Democrats.

It is Häupl who chose the unsuccessful chancellors Viktor Klima, Alfred Gusenbauer and Werner Faymann, even though he himself -- a man who is both down-to-earth and well educated -- would have been the more promising candidate. And it is interim party leader Häupl who, on this morning in his office with its view of St. Stephen's Cathedral, sets forth the party's new direction. When it comes to the vital refugee question, he describes the future under newly installed Chancellor Kern like this: "Our fundamental principle of humanity combined with order hasn't changed," Häupl says. "But we do want to know who is coming to us."

How will the SPÖ deal with the FPÖ? Häupl is known in Vienna for his folksy style and his hardline against the far right, but he has begun waffling on the issue. We must find a compromise, he says, "between political reality and our party platform." The proposal made by the head of the Carinthia chapter of the SPÖ, he says, is worth considering: namely that binding criteria be established for coalitions with all parties, and not just for the FPÖ.
Estrangement from the Mainstream

That is akin to a step-by-step retreat. And the bulky Häupl, who in a previous life in science became an expert on the cranial kinesis of geckos, doesn't deny it. He would like his party to be untainted and patient, moving slowly but tenaciously in the right direction. You can't simply rely on the dogmas of yesteryear, Häupl says.

The debate, in any case, has been reopened. And there are many in the party who view the SPÖ coalition with the FPÖ in Burgenland not as a misstep but as a model for the future.

Burgenland is the easternmost and least populated state in Austria, and the coalition, in which the right-wing populists are the junior partner, has been in office for almost a year. Presidential candidate Hofer, who is from the Burgenland town of Pinkafeld, helped midwife the coalition.

Hans Niessl, the Social Democrat who has governed Burgenland for the last 15 years, is considered a pragmatist and a man of the people. He has no ideological reservations about having the tightly hierarchical FPÖ in his state's government.

Niessl can count on the support of Austria's senior-most union leader, who recently called for the center-left to take a new approach to the FPÖ with the words: "You can't just shove the 35 percent who voted for Hofer into the right wing." More importantly, though, Niessl can invoke a famous precedent: that established by Bruno Kreisky, the four-time Austrian chancellor and the unchallenged political icon of the postwar period. Until 1971, Kreisky's socialist minority government was tolerated by the FPÖ and its then-leader, a former SS Obersturmführer (roughly equivalent to a lieutenant colonel). The arrangement granted the FPÖ a certain amount of legitimacy in the eyes of many.

"We are the successors of Bruno Kreisky," is the unblushing claim now made by FPÖ head Strache. The Freedom Party, he says, is a new Volkspartei, a term used to denote large parties representing a huge swath of the electorate. The FPÖ, he says, represents "the center of society."

These days, it is becoming clear just how large, and likely lasting, the estrangement has become between voters and those parties, like the ÖVP and SPÖ, that were once defined by the term Volkspartei. Their old mistakes have continued through the decades and new ones have joined them.

Both the center right and the center left have underestimated the electorate's anger that has built up as a result of their almost God-given claim to leadership in Austria.

Simple Solutions

The situation has been made worse by the fact that mistrust of those in power has been growing not just in Austria, but in all of Europe. That mistrust can be summed up in three overarching complaints: We are being steamrolled by globalization; nobody is listening to us; and the market economy benefits others.

But the FPÖ is listening and is quick to offer simple solutions: Close the door. Shut out the migrants.

Both the SPÖ and the ÖVP found in the first round of the presidential elections that it doesn't help to simply parrot such answers. They copied the immigration policies proffered by the FPÖ and tightened the country's asylum policies to such an extent that those policies hardly have an application any more. But they were heavily punished by the voters anyway. Why should voters choose a copy when they can have the original?

It has become apparent that this opponent cannot be defeated with imitations. It may, however, help to listen to the voters, even those who have been lost, to take their concerns seriously and to provide their own answers that are more intelligent than those coming from the FPÖ.

Why, though, didn't the SPÖ immediately throw their weight behind Van der Bellen and against Hofer following the first round of elections? Some critical, despairing Social Democrats give the following answer: "When you only managed to get 11 percent, what can you really tell the voters?"

But there are also other reasons as well that reach far into the past. One of those who has long considered the question is Josef Haslinger, a political essayist and author. He is also president of the German PEN Center and primarily known for being the author of "Opernball," or "Opera Ball," a German-language novel dealing with right-wing terrorism.

Haslinger can be found in his garden house in the Grinzing district of Vienna when he is not in Leipzig carrying out his duties as professor of literary aesthetics. On a recent Friday after the first round of voting, Haslinger was wondering how many Austrians would "come to their senses" and resist Hofer, particularly among Social Democrats. In an essay, he addressed the question as to "why Austrian Social Democrats have for decades served as accessories to the FPÖ." One answer can be found the early 1930s.

'Engraved in Their Memories'

It was a time when the Christian Socialists and the Social Democrats engaged in a brief, but bloody civil war. Both parties were banned -- the Nazis and the Social Democrats. Some socialists, including the later Austrian Chancellor Bruno Kreisky, sat together with a Nazi in the same prison cell.

For the Social Democratic movement, says Haslinger, "the awareness that they were not defeated by the Nazis, but by the political mainstream, has been engraved in their memories for decades."

Haslinger wrote early on about the Nazi past of then-Austrian President Waldheim and published an essay called "Politics of Emotion," that still provides a foundation for the present-day debate.

Haslinger wrote about Haider, organized demonstrations and repeatedly took political sides as an intellectual and as PEN president. And now, in his garden house surrounded by nature with Vienna behind it, the issue is once again at the forefront. Do demonstrations help? Calls to action? Podium discussions?

"It would be nice," Haslinger says, "if it weren't the same old people" -- people like himself -- "standing behind such a movement." The call came and he signed. But there isn't nearly as much outrage today as there was in 2000, when the FPÖ joined the government.

Perhaps that is because the shock isn't as great as it would be in Germany, for example, were the AfD to win an election. Over the years, Austria has slowly gotten used to the FPÖ. The taboos have shifted.

It used to be that no one admitted to having voted for the FPÖ, Haslinger says. "I didn't know a single FPÖ voter." And today? "Today I know one. Quite well, actually." And? "We have been talking about it since."

What else can one do other than talk, write and produce words?

A short walk leads to the Grinzing cemetery, where the famous singer Peter Alexander is buried as is the late publisher of the newspaper Kronenzeitung. So too is the writer Thomas Bernhard, who's grave Haslinger visits regularly.

Thomas Bernhard is resting under thick and well-tended greenery. Sometimes his grave is vandalized by unknown idiots, but on this day everything is quiet and peaceful. There he lies, unaware that his saying about punschkrapfen is once again being quoted: that Austrians are a lot like this Austrian national treat -- red on the outside, brown on the inside and always a bit drunk.

Another tidbit making the rounds again these days is from the satirist Karl Kraus, who once called Austria the "testing grounds for the end of the world." Or the old saw from playwright Johann Nestroy, who decried the "grief" that "constantly shines through our threadbare warmth and friendliness."

But perhaps the best bon mot comes from the writer and translator Hans Weigel. He once said of his country: "Please don't think evil thoughts about the Austrians. They have enough of those themselves."

Up and Down Wall Street

Fed Stuck in a Time Warp

As was the case a decade ago, the Federal Reserve is preparing for rate hikes. And as was the case then, the yield curve is sending a warning.

By Randall W. Forsyth
.

          Photos: Chris Kleponis (Greenspan); Frank Polich (Bernanke)/Bloomberg News 


Isn’t this where we came in?
 
The weekday version of Up and Down Wall Street started on Barrons.com 10 years ago this week, and the remarkable thing is what hasn’t changed in the past tumultuous decade.
 
As in 2006, the Federal Reserve is in the early stages of raising its policy interest rates—after a period of unprecedentedly low short-term rates, which were put in place to counter the impact of a plunge in asset prices. The subsequent rate hikes were supposed to mark a return of normality and allow an elongation of the recoveries in the economy and the stock market.
 
As things turned out, instead of a soft landing there was a crash. And although the current expansion is about to enter its eighth year, the economy continues to feel the effects of The Great Recession.        
 
In addition to the calendar, these recollections were brought to mind by central bank officials’ strong suggestions that second interest-rate hike of the current cycle will be on the table at the June 14-15 meeting of the Federal Open Market Committee. Minutes of the April 26-27 confab, released Wednesday, underlined that message offered by a number of Fed district bank presidents.
 
Those signals will be amplified Thursday by two of the most influential members of the FOMC, Fed Vice Chair Stanley Fischer and New York Fed President William Dudley. And on May 27, the one voice that counts the most, that of Fed Chair Janet Yellen, will be heard at a speech at Harvard University.
 
Ahead of the pronouncements of other Fed presidents, and after the release of the April FOMC minutes, the probability of a 25-basis point (one-quarter percentage point) increase in the federal funds rate target range at next month’s meeting, to 0.5%-0.75%, increased to 30%, from 16% shortly before, according to Bloomberg’s analysis of the fed-funds futures market. Just last Friday, the probability of such a move was put at just 4%.
 
What’s changed? Apparently, mainly the markets. Even though the FOMC minutes noted that indicators of domestic demand had been “disappointing,” the panel explained the shortfalls as reflecting “possible measurement problems and other transitory factors.”
 
But financial conditions improved, with higher equity prices, tighter credit spreads and a weaker dollar. So, with continued improvement in labor markets, the dollar no longer rising and oil prices no longer falling, inflation was on track to move back to the FOMC’s 2% target.
 
If—and this is a big if, as Peter Boockvar, chief market analyst at Lindsey Group, emphasizes—economic data line up as the Fed expects, that would leave open the possibility of a hike at next month’s FOMC meeting, according to the April meeting minutes.
 
In that case, the May employment data, due to be reported June 3, will figure greatly in setting the odds of a move at the coming Fed policy-setting meeting, writes Joshua Shapiro, chief U.S. economist at MFR Inc.
 
That said, the improved odds of a June hike largely reflect the rebound in risk markets—higher equity prices, higher oil and other commodity prices, lower bond yields and, especially, a less-strong dollar. But those improvements are the result of the a shift in Fed rhetoric, says Steve Blitz, chief economist of ITG Investment Research.
 
 
The FOMC, ironically, didn’t acknowledge that the improvement of market conditions was the result of Fed officials’ own pronouncements, Blitz adds. The officials also ignore the impact of their previous statements talking up rate hikes in 2014-15, which Blitz says contributed to slower growth subsequently.
 
For the proverbial person from Mars, who is blissfully ignorant of the economic theories and models of the Fed’s reaction function, there seems a simpler explanation.
 
The Fed would like to move the fed funds rate target away from zero—but only when the asset markets allow. Last December, when initial liftoff took place, the Standard & Poor’s 500 hovered around its historic peak near 2100. At that point, expectations of four rate hikes in 2016 were “in the ballpark,” in the words of Fed Vice Chair Fischer last January.
 
The stock market then swooned into correction territory, with the S&P 500 falling close to 1800 in early February. Circumstantial evidence points to some accommodation, with the Fed backing off from the full slate of expected rate hikes. More important, the dollar’s rise was arrested, which in turn boosted commodities and especially oil. For the capital markets, high-yield bonds rebounded, a welcome improvement in this highly energy-dependent market.
 
What’s striking is the Fed officials’ current underestimation of the impact of their words and actions, as happened a decade ago. The clearest signal then was the flattening of the slope of the yield curve—the graph of bond yields of increasing maturity. As pointed out on numerous occasions in this space back then, the failure of long-term interest rates to follow short-term rates higher implied that investors anticipated weaker economic conditions ahead. That is the classic portent of a flatter yield curve.
 
The current curve, as defined by the spread between the yields on two- and 10-year Treasuries, is the flattest since November, 2007, according to the St. Louis Federal Reserve. The S&P 500 peaked in the preceding month, and the simmering credit crisis exploded in 2008.
 
Former Fed Chairman Alan Greenspan called the situation a “conundrum.” His successor, Ben Bernanke, pointed to a global saving glut, which depressed long-term bond yields. Neither recognized the more mundane but more dire implications from yield-curve flattening, however.
 
While most economists now assert that the economy will motor through a Fed rate hike or two, MFR’s Shapiro thinks a June increase could be the last, not just the second, in a long series. “A weakening labor market and an overall market fraying around the edges will keep the Fed on hold for the balance of the year before further weakness leads to easing moves in 2017,” he writes.
 
Let’s simplify the FOMC’s reaction function further. If the S&P 500 is around 2100 when the FOMC meets in June, the panel will hike rates. The likely subsequent negative stock market reaction (plus renewed dollar strength) would likely put further Fed rate increases on hold.
 
So, a decade on, the markets remain dependent on the Fed. What’s changed is how dependent Fed policy is on the markets’ actions.


Ending the Fed’s Inflation Fixation

The focus is misplaced—and because it delays an overdue interest-rate rise, it is also dangerous.

By Martin Feldstein
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The primary role of the Federal Reserve and other central banks should be to prevent high rates of inflation. The double-digit inflation rates of the late 1970s and early ’80s were a destructive and frightening experience that could have been avoided by better monetary policy in the previous decade. Fortunately, the Fed’s tighter monetary policy under Paul Volcker brought the inflation rate down and set the stage for a strong economic recovery during the Reagan years.

The Federal Reserve has two congressionally mandated policy goals: “full employment” and “price stability.” The current unemployment rate of 5% means that the economy is essentially at full employment, very close to the 4.8% unemployment rate that the members of the Fed’s Open Market Committee say is the lowest sustainable rate of unemployment.

For price stability, the Fed since 2012 has interpreted its mandate as a long-term inflation rate of 2%.

Although it has achieved full employment, the Fed continues to maintain excessively low interest rates in order to move toward its inflation target. This has created substantial risks that could lead to another financial crisis and economic downturn.

The Fed did raise the federal-funds rate by 0.25 percentage points in December, but interest rates remain excessively low and are still driving investors and lenders to take unsound risks to reach for yield, leading to a serious mispricing of assets. The S&P 500 price-earnings ratio is more than 50% above its historic average. Commercial real estate is priced as if low bond yields will last forever. Banks and other lenders are lending to lower quality borrowers and making loans with fewer conditions.

When interest rates return to normal there will be substantial losses to investors, lenders and borrowers. The adverse impact on the overall economy could be very serious.

A fundamental problem with an explicit inflation target is the difficulty of knowing if it has been hit. The index of consumer prices that the Fed targets should in principle measure how much more it costs to buy goods and services that create the same value for consumers as the goods and services that they bought the year before. Estimating that cost would be an easy task for the national income statisticians if consumers bought the same things year after year. But the things that we buy are continually evolving, with improvements in quality and with the introduction of new goods and services. These changes imply that our dollars buy goods and services with greater value year after year.

Adjusting the price index for these changes is an impossibly difficult task. The methods used by the Bureau of Labor Statistics fail to capture the extent of quality improvements and don’t even try to capture the value created by new goods and services.

The true value of the national income is therefore rising faster than the official estimates of real gross domestic product and real incomes imply. For the same reason, the official measure of inflation overstates the increase in the true cost of the goods and services that consumers buy. If the official measure of inflation were 1%, the true cost of buying goods and services that create the same value to consumers may have actually declined. The true rate of inflation could be minus 1% or minus 3% or minus 5%. There is simply no way to know.

With a margin of error that large, it makes no sense to focus monetary policy on trying to hit a precise inflation target. The problem that consumers care about and that should be the subject of Fed policy is avoiding a return to the rapidly rising inflation that took measured inflation from less than 2% in 1965 to 5% in 1970 and to more than 12% in 1980.

Although we cannot know the true rate of inflation at any time, we can see if the measured inflation rate starts rising rapidly. If that happens, it would be a sign that true inflation is also rising because of excess demand in product and labor markets. That would be an indication that the Fed should be tightening monetary policy.

The situation today in which the official inflation rate is close to zero implies that the true inflation rate is now less than zero. Fortunately this doesn’t create the kind of deflation problem that would occur if households’ money incomes were falling. If that occurred, households would cut back on spending, leading to declines in overall demand and a possible downward spiral in prices and economic activity.

Not only are nominal wages and incomes not falling in the U.S. now, they are rising at about 2% a year. The negative true inflation rate means that true real incomes are rising more rapidly than the official statistics imply.

The Federal Reserve should now eliminate the explicit inflation target policy that it adopted less than five years ago. The Fed should instead emphasize its commitment to avoiding both high inflation and declining nominal wages. That would permit it to raise interest rates more rapidly today and to pursue a sounder monetary policy in the years ahead.


Mr. Feldstein, chairman of the Council of Economic Advisers under President Ronald Reagan, is a professor at Harvard and a member of the Journal’s board of contributors.