Intimidate Nobody

Doug Nolan


Strangely perhaps, but late in the week my thoughts returned to James Carville's 1992 comment: "I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody."

Things have changed so profoundly since then, though I get no sense that many appreciate the momentous ramifications. It seems like ancient history, but the bond market was the king of imposing discipline. Bonds maintained an intimidating watchful eye. No crazy stuff - from politicians, central bankers or corporate managements. The bond market of old would have little tolerance for $1.0 TN dollar deficits, QE or a prolonged boom in BBB corporate debt issuance. Contemporary markets seem to have only a burgeoning desire to tolerate.

July 19 - Reuters (Trevor Hunnicutt and Saqib Iqbal Ahmed): "Donald Trump's comments that a strong dollar 'puts us at a disadvantage' caused an instant fall in the greenback on Thursday and marked another example of the U.S. president commenting directly - and sometimes contradictorily - on the country's currency. Talking directly about the dollar is a break with typical practice by U.S. presidents, who are wary of being seen as interfering directly with financial markets… 'There are certain comments most presidents wouldn't make,' said Michael O'Rourke, chief market strategist at JonesTrading. 'They'd defer monetary policy to the Fed and the dollar to the Treasury secretary. But Donald Trump is not most presidents.'"

July 19 - CNBC (Jeff Cox): "President Donald Trump's move to criticize the Federal Reserve is almost without precedent in a nation that places a high priority on the independence of monetary policy. Almost all of Trump's predecessors steered clear of Fed critiques in the interest of making sure that interest rates were set to whatever was best for the economy and not to boost anyone's political fortunes. The Trump administration, of course, has been anything but typical, and the Trump comments, if anything, were consistent with a president who cares little for convention and is willing to speak his mind on virtually anything. 'Somebody would say, 'Oh, maybe you shouldn't say that as president,' Trump said… 'I couldn't care less what they say, because my views haven't changed.'"

July 19 - Bloomberg (Christopher Condon, Craig Torres and Jeanna Smialek): "President Donald Trump criticized the Federal Reserve's interest-rate increases, breaking with more than two decades of White House tradition of avoiding comments on monetary policy out of respect for the independence of the U.S. central bank. 'I'm not thrilled' the Fed is raising borrowing costs and potentially slowing the economy, he said... 'I don't like all of this work that we're putting into the economy and then I see rates going up.' The dollar relinquished gains from earlier in the day and Treasury yields dropped following the president's remarks."

The 1992 bond market would have recoiled from even the notion of a U.S. President criticizing the Fed, talking down the dollar or kicking sand in the faces of both allies and major foreign holders of our debt. Considering the backdrop, heightened discussion of market complacency is understandable - and long overdue. Why do today's markets - bonds and otherwise - not respond as they would have traditionally? Why is the idea of markets actually imposing discipline turned into such a humorless joke? Discipline? Heck, they don't even react.

From the Fed's Z.1, Total (Debt and Equity) Securities ended this year's first quarter at a record $89.0 TN, or 446% of GDP. For comparison, Total Securities began 1992 at $13.3 TN, or 215% of GDP - only to end the nineties at 360% of GDP ($34.8TN). The Greenspan Federal Reserve championed a historic shift to "activist" central bank management of "market"-based finance. Pure genius and, indeed, miraculous. The economy would massively expand the supply of Credit and equities - and no amount of new supply would slow the dramatic inflation in securities prices. Policymakers found themselves with this all-powerful new lever in which to formulate wealth.

This New Age market finance proved highly unstable. No worries; the Fed would loosen financial conditions with only the wink of a rate cut, as a captive audience of speculators eager to leverage debt securities fixated on every policy twitch. The GSEs were also there to provide increasingly speculative markets a New Age liquidity backstop, with their ballooning balance sheets a harbinger of what was to come from the Federal Reserve and global central bank community. If Fed rate cuts and massive GSE liquidity didn't suffice, there was always government deficit spending and bailouts.

The Federal Reserve and Washington thoroughly abused market-based finance. Along the way, unsound "money" and deeply flawed policy doctrine ensured markets turned increasingly dysfunctional. Not only did they not provide a disciplining mechanism, they became a complicit tool to Washington's power grab. The Treasury market essentially became a bet on prospective monetary policy easing. And as Bubble Dynamics increasingly commanded stock and real estate prices, Treasury bonds essentially became the go-to instrument for betting on (or hedging against) bursting Bubbles. "Excess begets excess." This was especially the case after Dr. Bernanke trumpeted the benefits of "helicopter money" and the "government printing press".

Long before the financial crisis, I argued that "activist" central banking was on a very slippery slope. The evolution of New Age Finance took a giant leap with chairman Bernanke's implementation of zero rates and QE. The Fed's move to reflate the system through inflated market prices essentially ended the securities markets as mechanism of self-adjustment and correction. Market discipline was dead. Today, financial markets now chiefly operate as a tool of government ("government finance quasi-Capitalism").

This complex story turned only more convoluted as the world moved aggressively to adopt U.S.-style policies and, not to be left hopelessly behind, market-based finance. Are the profound changes in monetary management and the rise of the "strongman" politician mere coincidence? I would imagine Greenspan and Bernanke quietly abhor the rise of populism. Do they feel any sense of responsibility?

With central bankers so celebrated for blatantly manipulating markets, of course politicians, dictators and the like would insist on getting a piece of the action. Inflating financial markets became essential to power - economic, political and geopolitical. And as finance became integral to economic growth and the global power play, why not use financial sanctions or the threat of financial repercussions to dictate nation-state behavior? And, over time, attaining financial wealth became an absolute prerequisite for wielding geopolitical power and influence.

The old military variety appears almost feeble standing next to the contemporary Financial Arms Race. And if you seek dominance - domestically, regionally and/or internationally - you had better get a tight rein on the securities markets - whether you're in Washington, Ankara, Moscow or Beijing. Beijing (and it's "national team") moved ahead in this regard, but it would appear Washington is today keen to play catch up. As market-based finance has commandeered the world, the centers of global power have moved to take command of the markets.

July 17 - Wall Street Journal (Nick Timiraos): "Federal Reserve Chairman Jerome Powell delivered an upbeat assessment of the economy and said it justified continued interest rate increases. But he opened the door to a potential policy shift and outlined risks if escalating trade tensions result in permanently higher tariffs. Mr. Powell has mostly sidestepped recent questions on trade policy because he says it is outside of the Fed's responsibilities. He offered words of caution Tuesday… 'In general, countries that have remained open to trade, that haven't erected barriers including tariffs, have grown faster. They've had higher incomes, higher productivity,' said Mr. Powell. 'And countries that have gone in a more protectionist direction have done worse.' Mr. Powell affirmed the Fed's plans to continue with gradual rate increases…"

I'd be curious to know if it was Chairman Powell's trade comments that provoked the first presidential criticism of the Federal Reserve since Richard Nixon. My hunch would be that the administration is crafting a strategy to direct blame at the Federal Reserve in the event the stock market begins to unravel. I cringed Thursday when Larry Kudlow called out Chinese President Xi as responsible for the lack of fruitful Chinese trade negotiations. Count me quite skeptical that this kind of pressure will prove an adept negotiating ploy.

This game of chicken is turning more dangerous, and perhaps the administration is preparing to scapegoat the Federal Reserve. I personally find the denigration of U.S. institutions most regrettable. The Fed down the road will have enough problems maintaining public trust and confidence. And with short rates not yet even above 2%, the thought that the Fed is already getting pulled into the muck creates a very uncomfortable feeling. My unease only worsened with the President's strong dollar "puts us at a disadvantage" comment.

Am I the only one that finds it ironic that Russia recently dumped most of its Treasury holdings? The administration seems to save its vitriol for countries with large holdings our of debt instruments. Call me old fashioned, but I suggest treating one's creditors with at least a modicum of respect. Ten-year Treasury yields jumped seven bps Friday, as the dollar was being pressured by the President's comments. If the administration has begun buckling in for a dicey game of chicken, it would be wishful thinking not to contemplate Treasuries and the dollar as possible collateral damage.

It was another extraordinary week. I'll leave it to others to get political. Looking at recent developments, one would see strong support for the view that the President is imploding. Or, one wouldn't… Either way, he appears emboldened and certainly in no mood for backing down on anything. Markets just take it all in - and exhale calmly. Securities markets have grown fond of disruption (will tend to keep central bankers in check). The threat of a trade war is tolerable - so long as we don't see an actual smash up. Seems reasonable to assume they're not completely reckless, doesn't it? The President is, after all, keen for higher markets, as are leaders around the globe. Markets are keen to accommodate.

July 20 - CNBC (Tae Kim): "President Donald Trump said the stock market rally since his election victory gives him the opportunity to be more aggressive in his trade war with China and other countries. 'This is the time. You know the expression we're playing with the bank's money,' he told CNBC's Joe Kernen… The president has a big cushion. The S&P 500 is up 31% since Trump's win on Election Day, Nov. 8, 2016, through Thursday… Trump added the market would likely be much higher if he didn't escalate the trade issues with China and the rest of the world. 'We are being taking advantage of and I don't like it,' he said. 'I would have a higher stock market right now. … It could be 80% [since the election] if I didn't want to do this.'"

"Still dancing" - spoken infamously in the Summer of 2007. Summer 2018: "We're playing with the bank's money." "The bank's money" as in "the house's" money at a casino? Or "the bank's money" as in central bank "money"? Either way, it's apparently worth risking…

I'm fond of saying how crazy things get near the end of Bubbles. Convinced this is History's Greatest Bubble, I've been anticipating a pretty astonishing variety of "crazy." Watching this all unfold with increasing trepidation, I sense an important line has been crossed. It's time to retire "crazy" - find a replacement that conjures up something more foreboding - more disturbing. And markets, well, they're seemingly fine with it all. At times almost giddy. And that's the fundamental problem: Dysfunctional markets continue to promote incredibly risky policy behavior - the polar (bear) opposite of imposing discipline.

The central banks' "slippery slope" has led us to an ominous place. "Strongmen" now believe it's within their domain to dictate the markets, interest rates and currency levels. All the while, it's regressed into an unprecedented global Bubble replete with a Global Financial Arms Race.

Markets trade as if they fully expect all governments to absolutely, at all cost, safeguard their respective financial wealth (i.e. Bubbles). Remember "the West will never allow a Russian collapse"? And "Washington will never allow a housing bust"? Global policymakers will never allow another major crisis. Well, let's see how this game of chicken between President Trump and President/General Secretary Xi plays out.


Buttonwood: The index fear

The growth of index investing has not made markets less efficient

It has put a lot of bad money-managers out of business



IN THE autumn of 1974 Paul Samuelson, a prominent economist and Nobel prizewinner, issued a challenge. Most stockpickers should go out of business, he argued. Even the best of them could not always beat the market average. But there was a snag. “If this advice to drop dead is good advice, it is obviously not counsel that will be eagerly followed.” An alternative was needed to set an example. Someone should set up a low-cost, low-turnover fund that simply tracked the S&P 500 index of stocks.

The following year Vanguard, then a fledgling firm, took up Samuelson’s challenge and launched an index fund for retail investors. It was not eagerly received. Denounced on Wall Street as “un-American”, the index fund raised a mere $17m in the half-decade after its launch.

It has been only in the past two decades that index investing has prospered. Indexed funds have grown around six times faster than those tended by active fund managers who select stocks to buy. Lots of investors now get the average stockmarket return for a fee of as little as 0.03% a year.

Samuelson’s case for an indexed fund rested on the idea that stockmarkets are “efficient”, in that any relevant news about a company’s prospects is quickly reflected in its share price. If there were obvious bargains, a little effort would bring riches at the expense of slothful investors. Yet if more people are buying the index, might the market become less efficient? And might that, in turn, create opportunities for the very stockpickers who Samuelson thought should cease trading? In fact, the opposite is more probable. If index investing has displaced bad stockpickers, as seems likely, it will have made the market more efficient, not less.

A tautology—that the whole is the sum of its parts—is central to an understanding of why this is so. The average investor can do only as well as the stockmarket average. For some investors to beat the market, others must be beaten by it. Stockpickers go to great pains to gather the facts, to assess them and to trade them. And the performance of most mutual funds does not justify these costs. A talented few are able to beat the index, at least for a while. But if they can do so consistently, they will charge a lot to manage your money. And it is always possible that they are lucky and not skilful. The average person will not be able to tell the difference.

Passive aggressive?

A low-cost index fund looks like a sounder bet. As more investors come to that conclusion, what is the effect on market prices? These are set by trades between informed active managers with differing opinions. Index funds are passive. Yet a concern that is often heard is that index investing helps to inflate bubbles, because index funds are forced to put more money into fashionable stocks even as they become more expensive. This rather misses the logic of indexing as a passive strategy. The index weights each stock by its value. If a stock’s price rises rapidly, its weight in the index increases. But its value in the indexed portfolio also increases. No buying is needed.`

A more valid concern is what happens when capital moves to an indexed fund from an active investor who has trailed the market average by shunning fast-rising stocks. The net effect of the switch is to add to the demand for such stocks. The more pension-fund mandates that such “fundamental” investors lose to index-trackers, the greater the chance that bubbles will inflate. Yet it is worth thinking about what would happen if index funds did not exist. Our hypothetical pension-fund trustee might instead switch funds to another active investor, who had done well by betting on recent winners. That would make a bubble far more likely.

Perhaps the growth of indexing has robbed the world of outstanding stockpickers. But it seems more likely that it has put a lot of bad managers out of business, just as Samuelson hoped. And it is not as if the buying and selling of stocks by informed investors with opinions has ceased.

The turnover of stocks has actually increased over time. Active investors are more active than ever.

Why do they bother? If the rise of index investing means less dumb money, then it is harder to beat the market. Yet it goes against human nature for people to think of themselves as mediocre or settling for the average. People will try, even though failure is more likely than success.

Imagine, wrote Samuelson, that a think-tank discovered that one in 20 alcoholics can learn to become moderate drinkers. Even if the finding was well grounded, he argued, the wise clinician should still act as if were false—“for you will never identify that one in twenty, and in the attempt, five in twenty will be ruined”.


Gold And Silver Futures Action Turning Positive

After a brutal few weeks in precious metals, you’d expect trend-following speculators to be heading for the exits. And the most recent gold and silver futures action — aka the commitment of traders (COT) report — shows exactly that. Which is good news.

In gold, speculators – who tend to be wrong at big turning points — cut their net long position by 8%, while commercial traders – who tend to be right at turns – cut their net short positions by about 9%.

These are big moves for a single week and bring both groups closer to levels at which, historically, precious metals start to rise.

gold COT gold and silver futures

Here’s the same data shown graphically. When the two sets of bars converge on the center line, that’s historically a bullish signal. One more week at the current pace and we’re there.

gold COT chart gold and silver futures

In silver, same thing with even bigger percentages: Speculators cut their net long position by 15% and commercials cut their net short position by 9% (though the silver COT report has been tarnished a bit by the fact that it went hyper-bullish in early 2018 but nothing happened).


silver COT gold and silver futures


The past week was generally down for precious metals, so it’s likely that the next report will show current favorable gold and silver futures market trends continuing. Combine this with precious metals’ seasonality – demand rises towards year-end as Asians start loading up for harvest and wedding seasons – and there’s a good chance that the dreary recent action will soon be replaced by something a lot more fun.

Meanwhile, even with precious metals languishing, some of the better junior mining stocks have started to move:

junior miner price moves gold and silver future


This is due in part to their own operational success but also to the fact that big miners can’t find enough new reserves to replace what they’re using up and are now aggressively looking to buy out the best of the rest. See commodities analyst Marin Katusa’s take on this process here, and note his last line: “This makes junior gold miners with high-grade projects that much more valuable.”

And Now, Commence The Currency War

by: The Heisenberg
 
 
Summary

- On Friday, the trade war "evolved" into a currency war, although to a degree, those are two sides of the same coin.

- This is, frankly, all anyone was talking about to close the week, from mainstream media outlets, to analysts, to traders.

- I've included all manner of color from all manner of sources in an effort to shed more light on what's going on and how it's likely to affect markets.

- This is made all the more interesting coming as it does amid the G20 meeting.

 
On Thursday evening, I went to great lengths to explain the market significance of Donald Trump's landmark interview with CNBC's Joe Kernen, in which the President criticized Fed policy.
 
In that linked post, I outlined the three key reasons why Trump is concerned about the prospect of further rate hikes from Jerome Powell. Those three reasons are:
  1. Fed hikes imperil the stock market rally
  2. Fed hikes have the potential to slow down the U.S. economy
  3. Fed hikes drive the monetary policy divergence between the U.S. and its trade partners wider, thus pushing up the dollar and softening the blow of the tariffs on America's trade partners
Minutes after I finished that post, the PBoC weakened the yuan fixing by the most in over two years. The offshore yuan immediately plunged, trading through 6.83 to the dollar. The news rippled through markets and the headlines came in fast and furious.
 
There are times when I feel like it's necessary to convey to readers here that certain things are not open to interpretation and this is one of those times. That fixing was a signal to the Trump administration that China read his comments about the Fed as a sign that he not only understands the extent to which the policy divergence between the Fed and the PBoC is helping to weaken the yuan and thereby shield the Chinese economy from the tariffs, but also that Beijing believes Trump intends to try and ameliorate that situation by expressing his displeasure at Fed policy.
 
I detailed that extensively in my Thursday evening post, citing the following comment from Trump's CNBC interview:
China's currency is dropping like a rock [and] our currency is going up, and I have to tell you it puts us at a disadvantage [on trade].
On Friday morning, Trump made it explicit. The full version of his interview with CNBC aired and in it, the President said he is "ready to go to $500 billion", a reference to the prospect of imposing tariffs on everything China exports to the U.S. Those are his words, not mine.
 
Hours later, on Twitter, Trump said this in a tweet:
China and the European Union are manipulating their currencies and interest rates lower, while the U.S. is raising rates while the dollar's gets stronger and stronger with each passing day - taking away our big competitive edge.
Then, in a followup tweet, he said Fed hikes are threatening to derail U.S. economic momentum:
Tightening now hurts all that we have done.
There is nothing ambiguous about that, and it simply isn't possible to interpret it any other way. Donald Trump is advocating for a weaker dollar (UUP) and rate cuts in order to ensure that hawkish Fed policy doesn't end up softening the blow from the tariffs.
 
"Currency War Erupts, Threatening to Ripple Across Global Markets", the title of Bloomberg's feature story on Friday afternoon reads. Here are a couple of quick excerpts just to kind of drive home what I was trying to say on Thursday evening:

The currency war has arrived. 
As the world’s two largest economies open up a new front in their increasingly acrimonious game of brinkmanship, the consequences could be dire -- and ripple far beyond the U.S. and Chinese currencies. Everything from equities to oil to emerging-market assets are in danger of becoming collateral damage as Beijing and Washington threaten the current global financial order.
Obviously, this has massive market implications and the timing couldn't be worse, coming as it does ahead of the G-20 meeting of finance ministers in Argentina. The following headline ran on the Terminal late Friday, and it speaks volumes:
 
FED'S POWELL DECLINES TO TAKE QUESTION AT G-20 IN BUENOS AIRES
On Friday morning, in the first post of the day over on my site, I used the following chart to illustrate how the offshore yuan was whipsawed by the CNBC interview on Thursday afternoon, the CNY fixing early Friday (in Asia), intervention on the part of a policy bank in China that was seen by traders selling dollars at 6.81 and the "$500 billion" comment CNBC ran some three hours prior to the open on Wall Street:
 
(Source: Heisenberg)
 
That was before the tweets excerpted above, which, once they hit, catalyzed a sharp selloff in the dollar.
 
Want to see something amusing? Roughly six hours after I posted that chart, Goldman was out with a new note called "Trade war evolving into currency war" and it contains the following visual which they call "Chart of the week":
 
(Source: Goldman)
 
Does that look familiar to you? Yeah, it looked familiar to me too.
 
In any event, here's what Goldman's FX team had to say in the note about the market implications of everything that's happened over the past 24 hours:
The evolution of the conflict to more directly focus on FX would be consistent with how major trade disputes have played out in the past—often involving negotiated Dollar weakness—as well as the Administration’s goal of reducing the US trade deficit. We do not think the President’s comments on the Fed affect the outlook for US monetary policy. However, they could impact how other countries are approaching trade disputes, either by bringing them to the negotiating table or affecting currency policy directly. For FX markets, we think the latest developments imply: (i) that the correlation between trade tensions and FX will change, such that an escalating conflict may not result in consistent USD gains; (ii) that other reserve currencies, particularly EUR and JPY, should find support, and (iii) that CNY will be more stable, as the US could interpret further depreciation as a form of retaliation.
Other analysts had varying takes, but they all have one thing in common: skepticism about the durability of the dollar rally in light of Trump's comments and now explicit rebuke of further rate hikes from Jerome Powell. Here's one example from BNP:
Trump’s recent comments about a strong USD putting the US at a disadvantage and accusing China and the European Union of currency manipulation suggest it will be more difficult for the USD to extend gains as trade tensions escalate, unless US officials at the G20 meeting this weekend attempt to dial back his comments and reiterate the United States’ strong USD policy.
This is made all the more interesting by that fact that in the week through Tuesday, net long positioning in the dollar rose for a fifth straight week to nearly $20 billion:
 
(Goldman)
 
 
Late Friday, CNBC reported that according to a White House official, the President is "worried" about the prospect of the Fed raising rates twice more in 2018 and in an interview with Fox News, OMB Director Mick Mulvaney said the following about Trump's thinking on monetary policy:
[He’s] frustrated that every time things seem to start getting a lot better, the Fed pumps the brakes.
Hopefully, you now understand why I spent so much time walking readers here through this situation in the post linked here at the outset. This is, not to put too fine a point on it, a very big deal.
Depending on how China responds, it's possible that we could end up reliving what played out in August of 2015, when the PBoC's overnight devaluation triggered turmoil across the global, culminating in an outright meltdown on August 24. If you don't believe me, just ask former Goldman Chief FX strategist and current Chief Economist at the IIF, Robin Brooks. Here's Bloomberg summarizing his take (this is from the same Bloomberg post linked above):
China’s shock devaluation of the yuan in 2015 provides a good template for what the contagion might look like, according to Robin Brooks, the chief economist at the Institute of International Finance and the former head currency strategist at Goldman Sachs Group Inc. Risk assets and oil prices would likely tumble as worries about growth arise, hitting currencies of commodity - exporting countries particularly hard - namely, the Russian ruble, Colombian peso and Malaysian ringgit - before taking down the rest of Asia.
The question here for China is whether and to what extent they are willing to risk capital flight in order to protect the economy by letting the yuan weaken further against the dollar. The 2015 experience gave Beijing a template for how to control that risk. That certainly seems to suggest they feel more comfortable letting the currency weaken knowing they could, for instance, deploy the counter-cyclical adjustment factor which they rolled out last summer when the yuan was pushing 7.00. One source close to the matter told Reuters the following about that earlier this month:
Currently, the pressure is not as big as in 2015 [and] if the depreciation trend continues like this, they could take some measures, including reviving the counter-cyclical factor, rather than heavy spending of foreign exchange reserves.
Meanwhile, in a Twitter post, the above-mentioned Robin Brooks reminds you that while capital flight is the worry for China, the concern for the U.S. is simply the S&P rally:

China's Achilles heel in a currency war is resumption of capital flight, which in my opinion will become an issue again as $/CNY gets near 7.00. The US' Achilles heel is the SPX, which in 2015/6 tumbled when the RMB fell, on global growth worries. Whose Achilles heel is weaker?

Good question. And it's about to be the question, now that the trade war has, to quote Goldman, evolved "to more directly focus on FX".
 
And with that, I'll leave you with one last indelible visual which I highlighted here earlier this week in a post that is looking pretty prescient about now.
 
(Deutsche Bank)


Inside China’s Dystopian Dreams: A.I., Shame and Lots of Cameras

By Paul Mozur

A video showing facial recognition software in use at the headquarters of the artificial intelligence company Megvii in Beijing.CreditGilles Sabrie for The New York Times


ZHENGZHOU, China — In the Chinese city of Zhengzhou, a police officer wearing facial recognition glasses spotted a heroin smuggler at a train station.

In Qingdao, a city famous for its German colonial heritage, cameras powered by artificial intelligence helped the police snatch two dozen criminal suspects in the midst of a big annual beer festival.

In Wuhu, a fugitive murder suspect was identified by a camera as he bought food from a street vendor.

With millions of cameras and billions of lines of code, China is building a high-tech authoritarian future. Beijing is embracing technologies like facial recognition and artificial intelligence to identify and track 1.4 billion people. It wants to assemble a vast and unprecedented national surveillance system, with crucial help from its thriving technology industry.

“In the past, it was all about instinct,” said Shan Jun, the deputy chief of the police at the railway station in Zhengzhou, where the heroin smuggler was caught. “If you missed something, you missed it.”

China is reversing the commonly held vision of technology as a great democratizer, bringing people more freedom and connecting them to the world. In China, it has brought control.

Megvii employees at the company’s offices in Beijing.CreditGilles Sabrié for The New York Times


In some cities, cameras scan train stations for China’s most wanted. Billboard-size displays show the faces of jaywalkers and list the names of people who can’t pay their debts. Facial recognition scanners guard the entrances to housing complexes. Already, China has an estimated 200 million surveillance cameras — four times as many as the United States.

Such efforts supplement other systems that track internet use and communications, hotel stays, train and plane trips and even car travel in some places.

Even so, China’s ambitions outstrip its abilities. Technology in place at one train station or crosswalk may be lacking in another city, or even the next block over. Bureaucratic inefficiencies prevent the creation of a nationwide network.

For the Communist Party, that may not matter. Far from hiding their efforts, Chinese authorities regularly state, and overstate, their capabilities. In China, even the perception of surveillance can keep the public in line.

Some places are further along than others. Invasive mass-surveillance software has been set up in the west to track members of the Uighur Muslim minority and map their relations with friends and family, according to software viewed by The New York Times.

“This is potentially a totally new way for the government to manage the economy and society,” said Martin Chorzempa, a fellow at the Peterson Institute for International Economics.

“The goal is algorithmic governance,” he added.

    Police officers wearing A.I.-powered smart glasses in Luoyang. CreditReuters

The Shame Game

The intersection south of Changhong Bridge in the city of Xiangyang used to be a nightmare. Cars drove fast and jaywalkers darted into the street.

Then last summer, the police put up cameras linked to facial recognition technology and a big, outdoor screen. Photos of lawbreakers were displayed alongside their names and government I.D. numbers. People were initially excited to see their faces on the board, said Guan Yue, a spokeswoman, until propaganda outlets told them it was punishment.

“If you are captured by the system and you don’t see it, your neighbors or colleagues will, and they will gossip about it,” she said. “That’s too embarrassing for people to take.”

China’s new surveillance is based on an old idea: Only strong authority can bring order to a turbulent country. Mao Zedong took that philosophy to devastating ends, as his top-down rule brought famine and then the Cultural Revolution.

His successors also craved order but feared the consequences of totalitarian rule. They formed a new understanding with the Chinese people. In exchange for political impotence, they would be mostly left alone and allowed to get rich.

It worked. Censorship and police powers remained strong, but China’s people still found more freedom. That new attitude helped usher in decades of breakneck economic growth.

Today, that unwritten agreement is breaking down.

China’s economy isn’t growing at the same pace. It suffers from a severe wealth gap. After four decades of fatter paychecks and better living, its people have higher expectations.

Tourists waiting to visit the Mao Mausoleum in Beijing, under a pole holding 11 surveillance cameras.CreditGilles Sabrié for The New York Times


Xi Jinping, China’s top leader, has moved to solidify his power. Changes to Chinese law mean he could rule longer than any leader since Mao. And he has undertaken a broad corruption crackdown that could make him plenty of enemies.

For support, he has turned to the Mao-era beliefs in the importance of a cult of personality and the role of the Communist Party in everyday life. Technology gives him the power to make it happen.

“Reform and opening has already failed, but no one dares to say it,” said Chinese historian Zhang Lifan, citing China’s four-decade post-Mao policy. “The current system has created severe social and economic segregation. So now the rulers use the taxpayers’ money to monitor the taxpayers.”

Mr. Xi has launched a major upgrade of the Chinese surveillance state. China has become the world’s biggest market for security and surveillance technology, with analysts estimating the country will have almost 300 million cameras installed by 2020. Chinese buyers will snap up more than three-quarters of all servers designed to scan video footage for faces, predicts IHS Markit, a research firm. China’s police will spend an additional $30 billion in the coming years on techno-enabled snooping, according to one expert quoted in state media.

Government contracts are fueling research and development into technologies that track faces, clothing and even a person’s gait. Experimental gadgets, like facial-recognition glasses, have begun to appear.

Judging public Chinese reaction can be difficult in a country where the news media is controlled by the government. Still, so far the average Chinese citizen appears to show little concern. Erratic enforcement of laws against everything from speeding to assault means the long arm of China’s authoritarian government can feel remote from everyday life. As a result, many cheer on new attempts at law and order.

“It’s one of the biggest intersections in the city,” said Wang Fukang, a college student who volunteered as a guard at the crosswalk in Xiangyang. “It’s important that it stays safe and orderly.”

At the Shanghai headquarters of the artificial intelligence start-up Yitu, a network of cameras linked to a facial recognition system monitors employees and can track their movements in the office.CreditGilles Sabrié for The New York Times



The Surveillance Start-Up

Start-ups often make a point of insisting their employees use their technology. In Shanghai, a company called Yitu has taken that to the extreme.

The halls of its offices are dotted with cameras, looking for faces. From desk to break room to exit, employees’ paths are traced on a television screen with blue dotted lines. The monitor shows their comings and goings, all day, everyday.

In China, snooping is becoming big business. As the country spends heavily on surveillance, a new generation of start-ups have risen to meet the demand.

Chinese companies are developing globally competitive applications like image and voice recognition. Yitu took first place in a 2017 open contest for facial recognition algorithms held by the United States government’s Office of the Director of National Intelligence. A number of other Chinese companies also scored well.

A technology boom in China is helping the government’s surveillance ambitions. In sheer scale and investment, China already rivals Silicon Valley. Between the government and eager investors, surveillance start-ups have access to plenty of money and other resources.

In May, the upstart A.I. company SenseTime raised $620 million, giving it a valuation of about $4.5 billion. Yitu raised $200 million last month. Another rival, Megvii, raised $460 million from investors that included a state-backed fund created by China’s top leadership.

At a conference in May at an upscale hotel in Beijing, China’s security-industrial complex offered its vision of the future. Companies big and small showed off facial-recognition security gates and systems that track cars around cities to local government officials, tech executives and investors.

Private companies see big potential in China’s surveillance build-out. China’s public security market was valued at more than $80 billion last year but could be worth even more as the country builds its capabilities, said Shen Xinyang, a former Google data scientist who is now chief technology officer of Eyecool, a start-up.

“Artificial intelligence for public security is actually still a very insignificant portion of the whole market,” he said, pointing out that most equipment currently in use was “nonintelligent.”

Many of these businesses are already providing data to the government.

Mr. Shen told the group that his company had surveillance systems at more than 20 airports and train stations, which had helped catch 1,000 criminals. Eyecool, he said, is also handing over two million facial images each day to a burgeoning big-data police system called Skynet.

At a building complex in Xiangyang, a facial-recognition system set up to let residents quickly through security gates adds to the police’s collection of photos of local residents, according to local Chinese Communist Party officials.

Wen Yangli, an executive at Number 1 Community, which makes the product, said the company is at work on other applications. One would detect when crowds of people are clashing. Another would allow police to use virtual maps of buildings to find out who lives where.

China’s surveillance companies are also looking to test the appetite for high-tech surveillance abroad. Yitu says it has been expanding overseas, with plans to increase business in regions like Southeast Asia and the Middle East.

At home, China is preparing its people for next-level surveillance technology. A recent state-media propaganda film called “Amazing China” showed off a similar virtual map that provided police with records of utility use, saying it could be used for predictive policing.

“If there are anomalies, the system sends an alert,” a narrator says, as Chinese police officers pay a visit to an apartment with a record of erratic utility use. The film then quotes one of the officers: “No matter which corner you escape to, we’ll bring you to justice.”


A video showing facial recognition software in use at the Megvii showroom in Beijing.CreditGilles Sabrié for The New York Times

Enter the Panopticon

For technology to be effective, it doesn’t always have to work. Take China’s facial-recognition glasses.

Police in the central Chinese city of Zhengzhou recently showed off the specs at a high-speed rail station for state media and others. They snapped photos of a policewoman peering from behind the shaded lenses.

But the glasses work only if the target stands still for several seconds. They have been used mostly to check travelers for fake identifications.

China’s national database of individuals it has flagged for watching — including suspected terrorists, criminals, drug traffickers, political activists and others — includes 20 million to 30 million people, said one technology executive who works closely with the government. That is too many people for today’s facial recognition technology to parse, said the executive, who asked not to be identified because the information wasn’t public.

The system remains more of a digital patchwork than an all-seeing technological network. Many files still aren’t digitized, and others are on mismatched spreadsheets that can’t be easily reconciled. Systems that police hope will someday be powered by A.I. are currently run by teams of people sorting through photos and data the old-fashioned way.

Take, for example, the crosswalk in Xiangyang. The images don’t appear instantaneously. The billboard often shows jaywalkers from weeks ago, though authorities have recently reduced the lag to about five or six days. Officials said humans still sift through the images to match them to people’s identities.

Still, Chinese authorities who are generally mum about security have embarked on a campaign to persuade the country’s people that the high-tech security state is already in place.

China’s propagandists are fond of stories in which police use facial recognition to spot wanted criminals at events. An article in the People’s Daily, the Communist Party’s official newspaper, covered a series of arrests made with the aid of facial recognition at concerts of the pop star Jackie Cheung. The piece referenced some of the singer’s lyrics: “You are a boundless net of love that easily trapped me.”

In many places, it works. At the intersection in Xiangyang, jaywalking has decreased. At the building complex where Number 1 Community’s facial-recognition gate system has been installed, a problem with bike theft ceased entirely, according to building management.

An outdoor screen in Xiangyang displays photos of jaywalkers alongside their names and I.D. numbers. The idea is to embarrass offenders into compliance.CreditGilles Sabrié for The New York Times



“The whole point is that people don’t know if they’re being monitored, and that uncertainty makes people more obedient,” said Mr. Chorzempa, the Peterson Institute fellow.

He described the approach as a panopticon, the idea that people will follow the rules precisely because they don’t know whether they are being watched.

In Zhengzhou, police were happy to explain how just the thought of the facial recognition glasses could get criminals to confess.

Mr. Shan, the Zhengzhou railway station deputy police chief, cited the time his department grabbed a heroin smuggler. While questioning the suspect, Mr. Shan said, police pulled out the glasses and told the man that what he said didn’t matter. The glasses could give them all the information they needed.

“Because he was afraid of being found out by the advanced technology, he confessed,” said Mr. Shan, adding that the suspect had swallowed 60 small packs of heroin.

“We didn’t even use any interrogation techniques,” Mr. Shan said. “He simply gave it all up.”



Carolyn Zhang contributed reporting from Zhengzhou.


A Stock Market Crash With Chinese Characteristics

By Nathaniel Taplin



SHANGHAIED
Change from a year earlier. Stocks look more aligned with fundamentals this time
*For all A-shares.

Source: Factset, Wind Info, CEIC



One might think that a “socialist market economy” would feature markets that are less prone to booms and busts than the U.S. Not exactly.

As longtime China watchers know, the country’s still-immature markets are in many ways more bubble-prone than their Western counterparts, thanks to heavy involvement from retail investors who often take cues from government policy, rather than quaint notions like earnings. Tanking Chinese stocks—the Shanghai Composite is now down nearly 25% from its January peak—could therefore be taken as a meaningless signal. That would be a mistake: this year’s selloff reflects real worries about Chinese growth and financial stability. 
The slowdown is still at an early stage, but is poised to deepen in the second half—adding to headwinds for global stocks that are already under assault from rising trade tensions.


The last time Chinese stocks popped, in early 2015, was a classic example of Chinese market dysfunction. Corporate earnings and the economy were faltering, but the central bank was aggressively pushing down borrowing costs: retail investors took this as a green light to make massive leveraged stock bets, helping the Shanghai Composite to double in six months. When rules on margin borrowing were tightened in mid-2015—and everyone suddenly remembered that the real economy was still in the doldrums—most of those gains evaporated.


GRINDING LOWER
Change from a year earlier

*Average of change in metals, power, steel, cement and glass output.
Source: CEIC

The bull market in Chinese stocks, which started in 2016, had better fundamental economic support—but that support is now eroding. While services still look healthy, industrial profit growth peaked in the third quarter of 2017. A spring bump in investment and industrial output, thanks to the end of winter pollution controls, looks unlikely to last—since 2014, property investment has never risen faster than overall credit growth, which is now slowing sharply. Exceptionally weak May credit and investment data was one trigger for the current selloff.

Exports are also under pressure, even before President Donald Trump’s tariffs have really hit. Weakening export momentum is one reason the yuan, now down 3% against the U.S. dollar since the end of May, has sold off so sharply in recent weeks. Both China’s official purchasing managers index and Caixin’s privately compiled index showed export orders declining in June—the first simultaneous contraction since October 2016. The yuan’s abrupt weakening also risks renewed capital outflows at a time when the Federal Reserve is in full tightening mode.

     An investor watches stock prices at a brokerage in Beijing on July 6. Photo: Reuters 


That all sounds rather worrisome—but the downturn this market drop is signaling might not be as ugly as the last in 2015, when housing prices dipped sharply and steel firms defaulted in droves. China’s enormous housing inventory overhang has dropped by about a third since early 2015. And Beijing also imposed tough new controls on capital exiting the country following the market mayhem of that year. More cash trapped in China chasing fewer empty houses raises the probability of a less severe Chinese housing downturn this time around.

Still—if housing prices do start falling rapidly, or if a lot of capital starts finding ways out through the cracks, investors should prepare for stormy weather. China’s central bank has begun intervening in onshore markets again to support the yuan. If large-scale intervention continues, the resulting pressure on domestic money supply could trip up China’s heavily indebted developers and industrial firms, or cause funding difficulties for smaller banks. Recent moves to lower borrowing costs—and reports that tighter rules on bank wealth management products have been delayed—hint that some policy makers are getting nervous that China’s “deleveraging” campaign risks going too far.

A stock market crash—so far much smaller than in 2015—is something China can likely handle. More ructions in its fixed income and currency markets, this time with the Fed deep into its tightening cycle and little relief in sight, would be far more worrisome.

America’s Decline Never Seems to Arrive

Our institutions show an unrivaled capacity for weathering disruptive change.

By Walter Russell Mead


This year’s Independence Day does not find the nation in the most celebratory of moods.

With one of the most polarizing presidents in American history poised to make the most consequential Supreme Court choice in decades, trade wars looming on all sides, a moral and humanitarian crisis on the southern border, and at least one member of Congress calling for mobs to harass administration officials on the streets, the atmosphere in Washington could hardly be more tense. Some speak of a “cold civil war” between red and blue.

Meanwhile, the values that have defined U.S. foreign policy since World War II are shuddering and shaking. As China and Russia seek to pull down the pillars of American strength, it is unclear whether President Trump is committed to the institutions and alliances that have kept America great for so long—or whether his ill-judged attempts to reform the global system will bring it down in ruins. Some leaders in Asia, Africa and even Europe are beginning to wonder whether China’s authoritarian technocracy is a better governance model for the 21st century than America’s chaotic democratic system.


America’s Decline Never Seems to Arrive
Photo: istock/getty images


Uncertainty about the future is not new to the U.S. “A republic, if you can keep it,” was Benjamin Franklin’s famous account of the product of the Constitutional Convention. Our national anthem begins not with a triumphant assertion but an anxious question: Is the American flag still flying as night gives way to dawn?

That anxiety intensified as American power grew. Fear of decline has been an American obsession since the end of World War II. The political scientist Andrew Hacker published “The End of the American Era” in 1970; Charles Kupchan used the same title for a 2002 book; and in 2011 Stephen Walt used it again for an influential article in the National Interest. From Paul Kennedy to Fareed Zakaria to Henry Kissinger, some of the most acute foreign-policy thinkers have from time to time perceived the signs of decline.

And yet somehow, the flag has continued to fly. Why does American power look so fragile and remain so resilient? One reason is that the U.S. emerged just as the pace of human history was accelerating. In the mid-18th century, the Enlightenment and Industrial Revolution unleashed ideas and technologies that would transform the world. Modern capitalism exploded into being. The social turmoil, geopolitical instability, and technological change now battering the global system are only the latest stages in a long process whose end we can’t yet see.

The U.S. has stood the challenge better than most. Now in its 230th year, the American political system is one of the world’s oldest. But the revolutionary force of capitalism isn’t finished with us. The social and political changes of the 21st century challenge the institutions that humanity so painstakingly assembled in the second half of the 20th. Across the globe, societies must renew themselves as the information revolution reshapes the way people work, think, interact and engage in politics.

This is doubly hard for the U.S., which must not only reform its own domestic institutions but also act as custodian of a world system under strain from globalization, technological disruption and great-power rebalancing.

As Franklin well knew, there are no guarantees that the American experiment will work. Yet he and his fellow Founders designed a system of government to weather the stress and the strain of revolutionary times. The strength and flexibility of Madisonian federalism have enabled the American system to flourish amid more than two centuries of successive upheavals. 
But constitutions, however elegant, can’t breathe life into dead polities. It is the union of sound institutions with a strong national spirit—ordinary Americans’ patriotism, democratic faith and enterprising ambition—that has made America such a force in the world.





Noisy extremists on the political fringes notwithstanding, that spirit still rules in America today.

As long as it does, the country will continue to astonish the world with its creativity and its capacity for renewal. For now, at least, we can still answer Francis Scott Key’s anxious question in the affirmative: our flag is still there.


Walter Russell Mead is the James Clarke Chace Professor of Foreign Affairs and the Humanities at Bard College, a Distinguished Fellow in American Strategy and Statesmanship at the Hudson Institute, and The Wall Street Journal's Global View columnist. He formerly served as the Editor-at-Large for The American Interest, where he directed the popular Via Meadia blog.Professor Mead currently serves as a Richard von Weizsäcker Fellow at the Bosch Stiftung, and previously was the Henry A. Kissinger Senior Fellow for U.S. Foreign Policy at the Council on Foreign Relations. The author of God and Gold: Britain, America, and the Making of the Modern World (2008), Professor Mead is also the United States book reviewer for Foreign Affairs. Professor Mead is an honors graduate of Yale College, as well as a founding board member of New America and a board member of Freedom House.