Monetary Disorder

Doug Nolan

Global Credit, Bubble and market analysis is turning more interesting.

China August Credit data were out Friday. Total (aggregate) Social Financing jumped to 1.48 TN yuan ($225bn), up from July’s 1.22 TN and above the 1.28 TN estimate. New Loans were reported at a much stronger-than-expected 1.09 TN (estimates 750bn yuan), up from July’s 825bn. New loans expanded 13.2% y-o-y. Through August, Total Social Financing is running 18% above 2016’s record pace. Total system Credit growth (“social financing” plus govt. borrowings) appears on track to surpass $4.0 TN. While “shadow banking” has of late been restrained by tighter regulation, household (largely real estate) borrowings have remained exceptionally strong.

It was the weaker Chinese economic data that made the headlines this week. Retail sales (up 10.1% y-o-y), industrial production (up 6.0%) and fixed investment (up 7.8%) were all somewhat below estimates. At the same time – and I would argue more importantly - Chinese inflation is running hotter than forecast. Considering the scope of the ongoing Credit expansion, inflationary pressures should come as no surprise.

September 10 – Bloomberg: “Inflationary pressure emanating from the factory to the world is proving more resilient than economists have anticipated. China’s producer-price inflation accelerated to 6.3% in August from a year earlier, exceeding all but one of 38 estimates… That data… followed 5.5% readings in the prior three months… The surprise strength gives support for global inflation spanning from metals to fuel and shows the effects of resilient domestic demand and reduced supplies of some commodities.”

Up 1.8% y-o-y, Chinese August CPI was the strongest since January. This follows last week’s stronger-than-expected import data. China is demonstrating classic signs of a Credit-induced Bubble economy – one where domestic Credit excesses are seeping into the global inflationary backdrop through commodities and some modest upward pressure on goods and services prices.

It’s now only about a month until the (10/18) start of the National Congress of the Communist Party of China. Financial stability will be a primary focus, though I question whether the party appreciates how unstable things have become. Chinese officials have dabbled with myriad (“macro prudential”) tightening measures. For the most part, stop and go policies have attempted to balance mounting financial risks against a determination to meet growth targets. 

Fatefully, policymakers have been willing to accommodate ever-expanding Credit expansion. And for how much longer?

At this late stage of the cycle, Beijing’s bid to direct finance into productive economic investment will surely achieve about the same results as similar desires during the late-twenties U.S. Bubble period. Officials at some point will need to bite the bullet and rein in system Credit.

It’s the nature of Credit Bubbles that risk rises exponentially during “Terminal Phase” excess. 

In simple terms, the quantity of new Credit expands greatly while quality deteriorates rapidly. 

A hypothetical chart of systemic risk – that had been rising left to right steadily for years - takes a moon shot. A surge in risky mortgage Credit fuels unsustainable real estate inflation, while business borrowings expand rapidly from entities that will struggle with solvency issues as soon as the Bubble falters. The real economy suffers deep maladjustment that remains largely masked so long as rampant Credit growth (and self-reinforcing asset inflation) runs unabated.

Global policymakers have delusions of controlling Bubble Dynamics. Or should I say that the appearance of being able to manage Bubbles creates the complacency necessary for immense, out-of-control Bubble inflations. A dangerous notion took hold that, rather than permitting Bubbles to burst, they will simply be inflated away. Surely part of the underlying angst affecting central bankers (from Washington to Frankfurt to Tokyo to Beijing) these days is the realization that they indeed do not control inflation dynamics. Instead of inflating consumer prices so as to catch up with inflated asset prices, their reflationary measures are exacerbating price instabilities and inflationary divergences.

A key aspect of global Bubble analysis is that inflationary policymaking and resulting monetary disorder have badly distorted economic and financial structures. QE and other monetary inflation were supposed to rectify the dilemma of insufficient “aggregate demand.” Yet all this “money” and Credit sloshing around the global system is creating dangerous market contortions, destabilizing speculation and ubiquitous price Bubbles. China’s financial system is straining under the burden of intermediating $4.0 TN of 2017 Credit growth into perceived “money-like” instruments (that folks are willing to hold).

September 13 – Wall Street Journal (Yifan Xie and Chuin-Wei Yap): “In just four years, a money-market fund created by an affiliate of China’s Alibaba Group… has become the world’s largest, providing millions of the country’s savers a high-returning place to park their money. Now, it is facing pressure from regulators to slow down. Fueled by contributions from some 370 million account holders, the fund, known as Yu’e Bao—which means ‘leftover treasure’—has grown rapidly to manage $211 billion in assets. It is more than twice the size of the next largest money-market fund, a U.S. dollar liquidity fund managed by J.P. Morgan… Yu’e Bao’s assets doubled in the past year alone, and the fund now makes up a quarter of China’s money-market mutual fund industry.”

A Yu’e Bao investor provided the salient point from the above WSJ article: “I am not too concerned about what Alibaba does with my money since it’s too big to collapse.” Yu’e Bao these days provides an enticing return of 4.02%, compared to 1.50% for one-year bank deposits and a 3.6% yield on 10-year government debt. “The fund invests most of its money in certificates of deposits issued by Chinese state-owned or state-supported banks.” So, this massive (circuitous) flow of funds to Chinese banks provides liquidity to fund late-cycle lending, including to China’s booming population of “zombie” corporations and uneconomic ventures and enterprises.

September 4 – Financial Times (Gabriel Wildau): “China will impose tighter regulation on ‘systemically important’ money-market mutual funds, potentially forcing Ant Financial’s popular fund to de-risk its portfolio and reduce yields for investors. MMFs have exploded in popularity in recent years, as Chinese investors seek high-yielding alternatives to bank deposits. Total assets reached Rmb5.48tn ($848bn) at the end of June… But analysts warn that even as Chinese investors shift en masse from bank deposits to MMFs, the funds are not subject to the same capital and liquidity regulations as banks.”

The first Chinese mutual fund opened in 2003. Assets were only about $20bn to begin 2013 but have since swelled to $848bn. From the WSJ: “Investors continue to pile in. In July alone, another $114 billion flowed into Chinese money-market funds…”

For investors in Chinese money market funds, various bank liabilities, local government debt, corporate Credit and real estate, confidence is higher than ever that Beijing will not tolerate a crisis. And whether it’s money market assets, Chinese bank negotiable certificate of deposit borrowings, “repo” financing or “shadow banking” more generally, China confronts an unprecedented (and rapidly escalating) risk intermediation problem. For too long Beijing has nurtured the financial alchemy necessary to transform progressively risky Credit into perceived safe and liquid instruments. There will be no unobtrusive approach to reining in the beast.

Before I segue from China, it’s worth noting that China’s currency declined almost 1% this week, a sharp reversal after a rally that saw the renminbi appreciate almost 7% versus the dollar y-t-d. Beijing’s efforts to stabilize its currency proved too successful. I ponder how much “hot money” has over recent months been enticed by China’s combination of high yields and an appreciating renminbi – and what this week’s currency policy adjustment might mean for speculative flows.

September 10 – Wall Street Journal (Lingling Wei): “China is reversing a range of measures it had put in place to support its currency, a response to a recent surge in the value of the yuan that has hurt Chinese exporters and added to the country’s economic headwinds. Starting Monday, the People’s Bank of China will scrap a two-year-old rule that made it more expensive for traders to bet the yuan will fall in value... The move, which ends a deposit requirement on trades called currency forwards, will make it less expensive for companies and investors to buy dollars while selling the yuan. That would put some pressure on the currency to decline, traders and analysts said. The step will ‘fend off macro-financial risks,’ said the central bank notice…”

On the subject of China, unstable Bubble Finance and newfound regulator zeal, how about bitcoin?

September 15 – Bloomberg (Olga Kharif and Belinda Cao): “Bitcoin’s meteoric summertime surge risks coming to a painful end as Chinese policy makers move to restrict trading amid growing warnings of a market bubble. The biggest cryptocurrency dropped as much as 40% since reaching a record high of $4,921 on Sept. 1, cutting about $20 billion in market value. The collapse extended to as much as 30% this week since China began sending stronger signals of a clampdown on Sept. 8, making this the biggest five-day decline since January 2015, when it traded at around $200.”

Historians will surely look back at this period and struggle to understand why global central bankers after all these years were so reticent in reducing extraordinary monetary stimulus. Bitcoin and the cryptocurrencies have gone parabolic. U.S. and global equities grind further into record territory; global bond prices are indicative of one of history’s greatest financial Bubbles; real estate prices continue to inflate in most markets globally; debt issuance is on record pace and financial conditions remain incredibly loose virtually everywhere.

A few – not necessarily market-friendly - headlines worth pondering: “UK inflation rate rises to 2.9%”; “Euro zone wage growth surges, making ECB taper more likely”; “Bank of Canada open to alternatives to inflation target”; “Inflation data prompt rethink on US rates”; “Inflation is heating up with some help from the hurricanes”.

Recent inflation readings have generally surprised on the upside, including those in China, UK, U.S. and India. The GSCI commodities index gained 2.2% this week to trade to highs since April. Crude (WTI) was back above $50 this week. While down this week, the Industrial metals have been on fire. Meanwhile, Harvey and Irma will now make U.S. economic and inflation analysis even more of a challenge. Interestingly, market probabilities for the Fed to boost rates again before year-end have increased to almost 50%.

Global bond markets have begun taking notice. UK yields surged a notable 32 bps this week to 1.32%, near a seven-month high. Ten-year yields were up 10 bps in Canada to an almost three-year high. Australian 10-year yields were up 16 bps to 2.74%, near the high since March. Sweden saw yields jump 13 bps to 0.85%, the high since January 2016. German bund yields rose 12 bps to 0.43%.

Ten-year Treasury yields rose 15 bps this week to 2.20%. Two-year Treasury yields jumped 12 bps to 1.38%, quickly closing in on early-July’s multi-year high of 1.41%. Five-year Treasuries were under heavy selling pressure, with yields jumping 17 bps to 1.81%. Meanwhile, currency trading continues to indicate underlying instability. Two currencies popular in speculative trading strategies – the Japanese yen and British pound – both posted big moves this week. The pound surged 3.0%, while the yen sank 2.7%.

September option expiration helped U.S. equities push higher into record territory. There was likely a decent amount of hedging (North Korea, Trump, etc.) in September derivatives. Then we saw hurricane Irma bearing down on Florida, with the potential for a catastrophic direct hit on Miami. Markets were also concerned that North Korea might follow up last week’s nuclear test with another ICBM launch on Saturday. When the worst fears didn’t materialize over the weekend, equities rallied big on Monday as hedges and short positions were unwound.

The fact that markets continue to so readily disregard risk is consistent with Bubble Dynamics. 
We’ve seen it all before – except never on a such an all-encompassing, multi-asset class and global basis. I would argue that bond yields have been held artificially low by a combination of complacent central bankers, mounting geopolitical risks, Trump uncertainties and the general view that equities and risk markets have become increasingly vulnerable. There is at least some indication that global central bankers are becoming a little less complacent.

Switching to autopilot

The Fed prepares for its balance-sheet—and its board—to shrink

The next chairman will have to decide how many assets to shed

NINE years ago, in the autumn of 2008, the Federal Reserve was fighting a financial collapse. To stave off disaster, it lent aggressively—to banks, to money-market funds, even to other central banks.

As a result, its balance-sheet ballooned. At the start of September 2008, the month when Lehman Brothers collapsed, the Fed’s assets totalled $905bn (at the time, about 6% of GDP). By December they had more than doubled in size, to $2.1trn. That was only the start. As its emergency lending unwound, the Fed began purchasing government debt and mortgage-backed securities (MBSs), in an attempt to support the real economy. Three volleys of so-called “quantitative easing” (QE) eventually swelled the balance-sheet to $4.5trn by 2015.

On September 20th the Fed will probably announce that it is putting QE into reverse. It does not intend to sell its assets. Rather, as its securities mature, it will stop reinvesting all of the proceeds. The permitted monthly “run-off” will gradually rise until it reaches $30bn for Treasury bonds, and $20bn for MBSs and housing-agency debt (see chart). The process will not be entirely predictable. Treasuries mature on a known date. But how fast the MBS portfolio shrinks will depend on how many Americans move house or refinance their mortgages (which in turn largely depends on interest rates).

Exactly how QE worked—and hence the effects of unwinding it—remains a little mysterious.

The consensus, however, is that asset purchases brought down long-term interest rates, and that the first programme, which began in 2009, had the biggest impact. Fed economists recently estimated that, combined, all the programmes lowered the ten-year Treasury yield by one percentage point.

So as the balance-sheet shrinks, this effect might be expected to go into reverse and interest rates to rise. But there are three reasons to doubt this. First, economists have speculated that some or even all of QE’s potency came from its influence on traders’ expectations for short-term rates. For example, when markets threw their so-called “taper tantrum” in mid-2013, after then-chairman Ben Bernanke said that asset purchases would be reduced, they were agitated in part by the prospect of faster interest-rate rises.

This time, however, there is little scope for the markets to change their assumptions about the path of rates. The Fed has clearly signalled its intentions in advance. Once balance-sheet reduction has started, it will “run quietly in the background”, according to Janet Yellen, the Fed’s current chairman. In any case, markets today view interest-rate rises and balance-sheet reduction as alternatives rather than complements, according to Daan Struyven of Goldman Sachs.

Second, markets have been relatively stable as the Fed has signalled its balance-sheet strategy.

The ten-year Treasury yield is 2.1%, almost as low as it has been at any point in 2017.

Prospects for tax cuts and new infrastructure spending seem to have moved the markets more than have the Fed’s prognostications. Perhaps earlier QE announcements had an unusually large impact because markets were dysfunctional at the time; today, by contrast, traders can shrug-off balance-sheet policy.

Finally, the run-off will be gradual. Even if the Fed hits its redemption cap every month, it would take eight years to offload all its mortgage-backed securities. This is important if, as many traders believe, it is the flow of central-bank transactions more than its stock of assets that determines prices. (If the stock—which economists emphasise—matters more, the eventual impact on MBS markets looks unavoidable, since the Fed owns 21% of the market.)

The Fed will almost certainly shed its entire mortgage portfolio eventually. Few economists think it should meddle in housing markets in the long term. But how much of its Treasury holdings is sold depends on where the Fed wants its balance-sheet to end up.

That question will probably be resolved by a new chairman, and an almost entirely new Fed board, next year. After the departure of Stanley Fischer, the vice-chairman, in October (see Free exchange), the board might be left with just three members, rather than the intended seven—an unprecedented situation. A perverse effect, besides the higher workload, is that it could make it hard for board members to confer privately. Any two would constitute a quorum.

Even if the Senate soon confirms Randal Quarles, the president’s nominee to be vice-chairman for bank supervision, three slots would still be open. The vacancies give President Donald Trump latitude to reshape the central bank, and hence, indirectly, its balance-sheet. For now, they increase the power of the five presidents of regional Fed banks who, with the board, vote on monetary policy. They tend to be more hawkish than board members (perhaps because, unlike the board, they are not appointed by politicians).

In February Ms Yellen’s term will expire. Until recently, the favourite to replace her was Gary Cohn, Mr Trump’s senior economic adviser, whose views on monetary policy are not clear. But Mr Cohn has reportedly fallen out of favour with the president, after criticising his response to a white-supremacist march. That might have boosted Ms Yellen’s chances of reappointment.

But she, too, has risked the ire of the White House, with a robust defence of financial regulations that Mr Trump wants to loosen. (Her backers hope that a recent breakfast with Ivanka Trump, the first daughter, helped to curry favour.)

The obvious beneficiary of these setbacks is Kevin Warsh, an ex-banker who served on the Fed’s board during the financial crisis and was a confidant of Mr Bernanke. Unfortunately, Mr Warsh’s skills at making friends seem stronger than his monetary-policy acumen. During the financial crisis, he fretted needlessly about inflation. His criticism of asset purchases from 2010 onwards have not aged well. And his muddled writings on monetary policy betray his lack of economic training.

Under Mr Warsh, the Fed might shed assets, especially MBSs, faster. Worryingly, it might also hesitate to use QE again if, as is likely, interest rates hit bottom once more during a future recession—especially if Mr Trump appoints other QE-sceptics, such as Marvin Goodfriend, a professor at Carnegie Mellon University, to the board. Ms Yellen, despite her efforts to shrink the balance-sheet now, would be a better firefighter come the next conflagration.

Islamic State's Demise

A Terror Group in its Death Throes?

By Christoph Reuter

 Photo Gallery: IS Has Its Back Against the Wall

Islamic State has lost an enormous amount of territory in both Iraq and Syria and many of its leaders are dead. Yet even as the terror group appears to be breaking apart, attacks are being carried out in its name in Europe. What's next for IS?

Few in the West are familiar with the city that Iraqi Prime Minister Haider al-Abadi ordered to be invaded 10 days ago. "You either surrender, or die," he said in a televised speech, a combative appearance during which he wore the black fatigues of the notorious anti-terror units. The town is called Tal Afar, located west of the recently liberated city of Mosul, and it is one of the last Islamic State (IS) strongholds in Iraq.

Tal Afar is essentially one of two IS hometowns, having produced several high-ranking members of the terrorist organization. Even under Saddam Hussein, the city was something of a laboratory of hate. The Turkmen majority here mistrusted the Arab minority, yet the Turkmen community included both Sunnis and Shiites, allowing Saddam to play them off against each other. Sunnis, for example, were allowed to pursue a career in the secret services and enrich themselves at the expense of their neighbors.

When IS conquered Tal Afar in June 2014, the group murdered or expelled all Shiites. In response, notorious Shiite militias have been insisting that they be allowed to fight on the front lines during the battle for the liberation of the city, where around 10,000 of the once 200,000 residents are still holed up.

The war, in other words, is also a battle for revenge. And Tal Afar is the next round.

Islamic State's "caliphate," which Abu Bakr al-Baghdadi proclaimed in July 2014 and which once stretched from al-Bab in northern Syria to Tikrit in Iraq, is now history. The area under the terrorist group's control has shrunk dramatically. IS has lost Mosul in Iraq. It has been pushed out of Sirte in Libya and lost control of almost all of its oil wells. Soon, the group will also be forced to surrender Raqqa in Syria.

Between 80 and 90 percent of the group's top leadership is dead, having been neutralized in the last three years primarily by U.S. drones and missiles. Among the dead are the five most important IS commanders who, starting in 2012, planned and carried out the conquering of northern Syria. Today, the group no longer has a centralized military chain of command -- each unit is fighting on its own. Unsigned orders are jotted down on slips of paper and delivered via courier.

No Verifiable Connection

In Europe, meanwhile, more terror attacks are being committed in Islamic State's name, and in Islamic State's spirit, than ever before. In this year alone, there have been attacks in London, Manchester, Paris, Stockholm, Saint Petersburg and Istanbul. And that was before 15 people were killed and almost 100 injured in the attacks earlier this month in Barcelona and Cabrils. IS claimed responsibility just hours after the violence.

As upsetting as each individual attack is, it is grotesquely simple to drive vehicles into crowds of people, fire a Kalashnikov into dancing crowds or stab people with knives. The Barcelona attackers were so unsophisticated that they weren't even able to use gas bottles as bombs.

There is, in other words, no comparison to Islamic State's 2013 ability to import hundreds of tons of explosives from around the world into Syria across the Turkish border.

Furthermore, there is no verifiable connection between the perpetrators in Spain and the IS leadership in Syria or Iraq, and IS claims of responsibility have not included any proof of such a connection. The group has long since set in motion a wave of terror, and Islamic State is no longer necessary to keep it going. But the intended effect of the attacks is consistent with the IS mission: that of stoking hatred and resentment against Muslims in the West as a way of driving a wedge into European societies -- and driving Muslims in Europe into the arms of the terrorist group.

Thus far, Europeans have proven to be astonishingly resilient to the terror, even if the end is not yet in sight. Nobody has yet figured out, after all, how to put a stop to this wave of attacks, given that the only thing attackers need to strike the West is a vehicle of some kind.

The increase in attacks in Europe is far from surprising. The more quickly IS loses territory, the less the group has to lose. It can now launch terror attacks at will.

More Experienced and More Competent

Does this, then, mean that Islamic State is facing its demise? One should be careful with such a verdict. Islamic State seemed to be at an end once before. Seven years ago, the U.S. military along with Iraqi security personnel had almost completely destroyed the organization's leadership. In June 2010, U.S. generals announced that the group, which at the time was still called Islamic State of Iraq, had been devastated. But the Americans had merely accelerated a generational change among the group's leadership, paving the way for the organization to become the monster that began terrorizing the world in 2014.

The group's new leaders had been part of the IS chain of command for some time and were both more experienced and more competent than most of those who had been killed. Until then, though, their rise had been blocked by a flaw they all shared: They had all been officers in Saddam Hussein's intelligence services and military. They were experts in military leadership, intelligence agency structuring and strategic planning. In short, they were the kinds of people who knew how to build up a state.

The terror militia's rapid advance in 2014, extensive planning for which had been conducted in secret, was their work. Islamic State's ideological façade may be similar to al-Qaida's, but the two groups are fundamentally different. The core of the successful IS strategy in Iraq, Syria and Libya was infiltration, lightning attacks and, afterward, keeping a tight grip on the conquered territory by terrorizing the populace. Islamist propaganda was merely the means chosen to legitimize the incursions and to attract volunteer fighters from around the world.

Their strategy would have worked if IS could have managed to hold on to the territorial gains it initially made. What, though, might follow the group's most recent collapse?

Expert predictions range from the premature proclamations of victory coming from the Iraqi prime minister to assumptions that IS will continue to operate as a terrorist group and focus its violence on attacks in the West. There is even a theory that the group consciously accepted the Mosul defeat as a way to recruit new followers.

Even if IS has lost control of its largest cities, which had functioned as symbols of the group's strength, it still rules over a significant swath of territory. It is currently fighting on around 11 different fronts and is not withdrawing from any of them without putting up a powerful fight.

In Syria, it is still holding on to the fertile and densely populated Euphrates valley between the city of Deir al-Zor and the Iraqi border, an area to which many IS leaders are thought to have withdrawn.

Down on the Agenda

The narrow valley would actually be easier to conquer than the cities, but it is located far from where Kurdish militias are operating as they attack Raqqa with U.S. support. Furthermore, the topography of the valley is advantageous for IS: Both sides are flanked by steppe land and desert, making it easy for the terrorist group to quickly pull back.

Perhaps most importantly, though, fighting Islamic State is well down on the agenda of Syrian ruler Bashar Assad and his Russian and Iranian allies, despite all their claims to the contrary.

The jihadists have simply been too beneficial to Assad, allowing him to appear as the lesser of two evils in the eyes of the world.

In Iraq, too, the terrorist army continues to maintain its hold on a vast territory beyond the now embattled stronghold of Tal Afar: the district of Hawija, a region of more than 40 square kilometers of fertile land located southwest of Kirkuk, home to several towns, around 100 villages and tens of thousands of residents.

Hawija was one of Islamic State's first strongholds in Iraq -- and will likely be the last one to fall. The district is a microcosm that reveals both the terror organization's decay as well as its resilience. DER SPIEGEL informants in the region have been supplying information for months, including reports of the erosion of discipline among fighters and leadership in addition to massive disputes between competing factions.

The Hisbah morality police, which conducts patrols in IS-held territories, and the group's secret service organization Amniyat both try to prevent civilians from fleeing the region, for example. Without a human shield, after all, it would be more difficult to defend the region. IS fighters on the front lines and observation posts, by contrast, earn significant sums of money by allowing civilians to pass through or by smuggling them through the minefields themselves.

"There were 200 of us in our group," recalls one person who fled the IS-controlled area. "The IS man who took us out embraced the guards at the checkpoint. They knew each other." In the towns and villages, say eyewitnesses, IS members organize the smuggling operation even as IS commandos immediately take people into custody on even the slightest suspicion that they are preparing to flee.

Scorched Earth

Despite all of that, Islamic State continues to have a tight grip on Hawija. When the security chief for the town of Abbasi was murdered at the end of June, IS fighters made hundreds of arrests and killed seven of their own people, including two town commanders. The end of IS control in Hawija still seems a long way off, but even here, the group's demise doesn't lie too far into the future. Cities and villages will be destroyed and women and children will likely be sent as suicide bombers into Iraqi lines -- while Iraqi troops are likely to shoot prisoners dead. IS leaves behind scorched earth -- if it goes down, everything else must go down as well. It is a taste of the apocalypse, consistent with the constant claims being made by IS propaganda.

That doesn't, however, mean that the entire IS is interested in perishing. Islamic State is made up of diverse groups: In addition to the devout and the "martyrs," who would rather die fighting than give up, there have always been the opportunists, who were more interested in money and power. For as long as IS continued to win on the battlefield, these fault lines remained largely invisible. Now, though, amid growing pressure, the situation is changing. In Mosul last fall, it became apparent that many IS fighters were leaving the city even as others were arriving, knowing full well that they wouldn't escape with their lives.

IS could have surrendered Mosul, saving both the city and the lives of thousands of its own fighters. But it didn't, instead accepting military defeat in order to further stoke the hatred between Sunnis and Shiites. Doing so made Sunnis the targets of revenge attacks and placed them under a general suspicion of all being terrorists.

Now, the same Shiite militias who liberated Mosul are systematically destroying Sunni towns like Diyala, Babel and Tuz Khurmatu. They are abducting young men, who are never seen again, driving out their families and stripping down factories. Even those who fled Islamic State are finding no protection with the group's enemies. Many of the hundreds of thousands of displaced people are prevented from traveling to Baghdad or southern Iraq. They are stopped at the heavily guarded district borders and left to vegetate in miserably supplied camps.

Dysfunctional and Corrupt

The investment in hate and retribution is a strategic constant for the Islamic State. Even Abu Musab al-Zarqawi, founder of al-Qaida in Iraq, which preceded Islamic State, began targeting the Iraqi Shiite majority with terror in 2003 instead of seeking to attack far-flung enemies in America and Europe.

The calculation is a simple one: Shiite reprisals would drive Sunnis directly into the arms of Islamic State. And that is exactly what happened in 2014. In Mosul, Tikrit and elsewhere, many Sunnis welcomed the IS invaders as liberators.

This time, nothing will stand in the way of the victors' excesses following their defeat of the terrorist group. Particularly given that in recent years, the Shiite militias have transformed into a frightening, multinational shadow-army that fights in both Syria and Iraq and is made up of recruits from Pakistan and Afghanistan in addition to Hezbollah supporters, all controlled by Iran's Revolutionary Guard.

The Shiite-dominated government in Baghdad, on the other hand, is so dysfunctional and corrupt that it can't even provide for its own people, much less the Sunni population. In one of the most oil-rich countries on earth, one-third of the population lives below the poverty line and the state can't even afford to pay many of its civil servants. There likewise aren't plans or money yet for the reconstruction of Mosul. And that will ensure that hate will survive, as will the thirst for revenge. A new generation of jihadists will emerge -- there is, after all, no shortage of rage.

One thing, though, is irreplaceable: the entire generation of military and secret service leaders that IS made more powerful than ever before. At the peak of its powers, the organization controlled 100,000 square kilometers of land with several million residents. A vast apparatus kept this new empire in operation.

But the proclamation of the caliphate also made Islamic State vulnerable. Its visibility turned it into a target. In August 2014, when Washington finally joined the battle against the terror organization, an escalation began that the IS could only lose. The execution of American and British hostages along with the terror attacks in Europe and Turkey did nothing to discourage the countries belonging to the anti-IS coalition. On the contrary. Declaring war on the entire world may have been good for IS from a PR point of view, but the caliphate had no response to the airstrikes that followed.

Taken Out of Harm's Way

Some have nevertheless continued to fight. But others have not. Shortly after the beginning of the year, a group of junior commanders and small elite units vanished without a trace. Islamic State declared many of them dead, saying that they had fallen victim to various airstrikes. But Western intelligence agencies know from sources deep within Islamic State roughly where some of the terrorists are. "We know of at least two or three cases where the person in question wasn't present at the site where they allegedly died," says one European intelligence officer.

That would seem to indicate that they were discretely taken out of harm's way.

In late March, the IS news channel Aamaq sowed panic among the residents of Raqqa when it announced that the Tabqa Dam upriver from the city had been bombed by the Americans and was about to burst. All residents were called on to flee immediately, which they did. The city emptied out within just one day. Just hours later came the order to return: The dam, it was said, wouldn't break after all. IS knew that the dam wasn't in danger of breaking, so why did it knowingly spread the false rumor?

According to an IS fighter from Raqqa who fled in early April, the mass evacuation was a well-planned diversion. "It allowed the leadership to leave the city without exposing them to drones," the man told DER SPIEGEL at the end of May. The evacuating civilians had been used as a human shield.

As early as the turn of the year, IS leader Abu Bakr al-Baghdadi was to be brought to Syria by way of the village of Asaviyah, southwest of Hawija. IS had already assembled a number of fighters there at the end of October. The trip was made in secret, but IS bragged afterwards that they had brought their leader to safety.

The U.S. government confirmed Baghdadi's departure from Iraq weeks later. But when Baghdadi's death was reported for the umpteenth time in early July, the news was based on just a single source: Within IS, rumors were circulating that the Islamic State leader was no longer alive. The report could be accurate -- or it could have been purposely planted to relieve pressure on Baghdadi.

Biding Its Time

So, what comes next? For as long as the group has enough jihadists willing to fight to the death and enough kidnapped child soldiers, it will likely continue to let one village after the next be destroyed in murderous battles. But IS has long since evacuated parts of its leadership, its elite fighters and its immense gold reserves, much of which was plundered in 2014 from Mosul. It has done so in order to continue fighting where it has always been most mobile: underground.

There, it will reorganize, bide its time and then pop up under a different name and perhaps with a different profile.

The decisive trigger for IS to once again begin operating in the open in 2013 was the prospect of establishing its own state. How good are the chances, then, that it will return once again? The Islamic State brand has been exhausted, but it is still useful for propaganda purposes. Nothing triggers U.S. drone attacks as reliably as the black-and-white IS flag.

Furthermore, the conditions in the Middle East -- the deep distrust between Shiites and Sunnis, the wars and the lack of state control -- are perfect for the rise of a new group of Sunni fighters. Starting in 2010, IS leadership had the patience, the ideas and the discipline to take advantage of those conditions to create the most powerful terror organization in the world.

Today, that leadership no longer exists. As such, the decisive question is: Has a sufficient number of competent commanders and planners managed to stay alive, or are there enough able replacements, to keep IS together underground?

If so, then one European intelligence agent -- a man who intensively monitored the climb of Islamic State even before 2014 -- might ultimately be right. "They always had a Plan B, a Plan C and a Plan D," he says. "There is no reason why they won't surprise us once again."

The mysterious rise in shares of the Swiss National Bank

A recent surge in the central bank’s stock has puzzled investors

by: Ralph Atkins in Zúrich

Not just over-ambitious hikers in the Swiss Alps have suffered altitude sickness this month. Shareholders in Switzerland’s ultra-conservative central bank have experienced a similar sensation.

The price of a share in Swiss National Bank in August rose above SFr3,000 ($3,143) for the first time — more than double the level of a year ago and 50 per cent higher than as recently as mid-July.

That it is possible to buy shares in a central bank might come as a surprise to the outside world. In fact, the Swiss National Bank was founded as a joint-stock company in 1907 and its shares trade on the Swiss stock exchange. Some 48 per cent of the shareholders, with 25 per cent of the voting rights, are private. The rest are owned by Swiss cantons, cantonal banks and other public sector organisations.

The SNB is not unique: other countries in which central banks have private shareholders include Japan, Greece and Belgium.

Harder to explain, however, is why the price of SNB shares has risen so steeply this summer. “Institutional investors do not invest in them, so there is no demand for analysis or coverage,” says Andreas Venditti, bank analyst at Vontobel in Zurich. “Since the impact of even small financial market moves on its financials is so huge, it would be difficult to do a reliable earnings estimate.”

What might seem the most obvious explanation — a likely sharp rise in SNB profits this year — is almost certainly wrong.

In its battle to prevent a stronger franc hitting the country’s exporters, the SNB has intervened heavily in currency markets, selling francs and swelling its foreign currency holdings to almost SFr700bn at the end of June, of which 20 per cent was invested in equities.

But lately the Swiss franc has weakened significantly against the euro, increasing the local value of its foreign currency holdings — and the potential profits it will report.

Shareholders, however, will not benefit from the extra money rolling into the SNB. Since 1921, dividends have been fixed by law at a maximum of SFr15 per share.

Instead, other theories are circulating in Switzerland for the recent share price spike. One is that German investor newsletter Actien Börse encouraged a buying spurt after likening the shares in July to ultra-rare “Blue Mauritius” 19th century postage stamps. Trading in the 100,000 SNB shares is thin, so even modest buying or selling leads to significant price swings.

The largest private shareholder is Theo Siegert, a German businessman whose directorships included seats on boards at Merck and Henkel. The SNB annual report shows he held a 6.7 per cent stake at the end of last year. But he has not spoken publicly about his trades — and this week said he would not break his reticence for the Financial Times.

Another theory is that investors are speculating they might be bought out. Central bank buybacks have happened before. In the early 2000s, the Basel-based Bank for International Settlements — which acts as a bank to central banks — bought out its private shareholders so it could focus on its public service functions, rather than the interests of financial investors.

Back then, private BIS shareholders received SFr25,000 per share — roughly three times the price they were trading at before the initial announcement.

The SNB’s public role is subject to furious debate in Switzerland — especially whether its massive foreign currency reserves should be used to create a sovereign wealth fund similar to Norway’s oil fund. But so far the idea of buying out private shareholders has not featured in the discussions.

There is a more straightforward explanation, however, for why SNB shares have become more attractive, leading to a higher price.

SNB shares should be regarded, not as equity stakes, but as an alternative to ultra-safe government bonds, says Alexander Koch, economist at Raiffeisen bank. Given central banks cannot go bankrupt — they control money creation — a share in the SNB is like a perpetual bond with a fixed coupon.

At a price of around SFr3,000 the yield is only about 0.5 per cent — but that still compares favourably with the yield on a 10-year Swiss government bond, currently about minus 0.15 per cent. “If you treat them as bond substitutes, then there is quite some premium,” says Mr Koch.

The share price’s jump in the past month or so makes sense when it is considered that since the financial crises of 2007-2008, there has been a significant risk of the SNB missing dividend payments. It happened in 2013 when the SNB scrapped a profit distribution after racking up big losses on its gold portfolio.

Mr Koch notes that biggest recent moves up in the SNB share price were in mid-July, when the Swiss franc started depreciating, and again in early August, after the SNB published data showing the value of its foreign currency reserves. “The risk of no payment has declined dramatically,” he says.

Investors might also consider SNB shares as “havens” at times of geo-political turmoil; in the past their price has sometimes moved in line with gold. That theory suffered a setback this week, however. When North Korea fired a missile over Japan, the gold price rose — but the SNB share price fell slightly from its recent dizzy heights.

Tax Reform and Budget Deficits in America

Martin Feldstein
. State budget negotiations


CAMBRIDGE – The Republican Party’s leaders in the United States House of Representatives have been hard at work for more than a year designing a major reform of personal and corporate taxes. With an election looming in 2018, the House Republicans are determined to deliver a reform package and send it to the Senate for enactment.
This reform will be very different from the last major tax overhaul enacted back in 1986. The Tax Reform Act of 1986 focused on the personal income tax, lowering the top rate from 50% to 28% and cutting rates for lower-income taxpayers. The revenue loss was offset by changes in tax deductions and other accounting rules, producing a reform that was revenue neutral at each income level, even without taking into account the effects of lower tax rates on increasing economic growth and taxable incomes.
In the 30 years since 1986, the tax rates for high-income taxpayers rose significantly, from 28% to 39.6%, with an extra 3.8% tax on these taxpayers’ investment income. A detailed study by the Congressional Budget Office (CBO) of taxes between 1979 and 2013 concluded that while the effective tax rate fell in every quintile of the income distribution, it rose well above that 35-year average for taxpayers in the top 1% of the income distribution.
The House Republican plan would cut the top tax rate back to 30% or lower, with comparable reductions for those now facing lower tax rates. The new tax law might also follow the Canadian example and eliminate the estate tax, while imposing a tax on capital gains accrued before the taxpayer’s death. To offset some of the resulting revenue loss, the new law might eliminate tax deductions for state and local taxes, and tax some of the fringe benefits that are currently excluded from taxable income.
The big difference between the House Republicans’ plan and the 1986 tax reform is that the current proposal would also address the tax treatment of corporate profits and other business income. The statutory tax rate on corporate profits is now 35%, the highest in the OECD. The new legislation would reduce that rate to 25% or less, spurring a shift in capital flows away from investments in housing and agriculture, and toward domestic corporate investment.
The new tax law is also likely to boost domestic corporate investment by changing the tax treatment of the profits of US corporations’ foreign subsidiaries. Under current law, a subsidiary pays tax on profits to the government of the country where those profits are earned.
It can then invest the after-tax profits anywhere in the world outside the US. But if it brings those funds back to the US to invest or pay dividends to shareholders, it must pay the full US corporate tax rate, with a credit for the tax already paid to the foreign government.
This penalty on repatriating funds causes US firms to leave those after-tax profits abroad. The US Treasury estimates that American subsidiaries’ offshore investments stand at more than $2.5 trillion.
This method of taxing the profits of foreign subsidiaries is unique to the US. Every other industrial country uses what is known as the territorial method, in which profits of foreign subsidiaries can be brought home with little or no extra tax. By shifting the US toward such a system, the Republican proposal would stimulate repatriation of some of the funds that have been accumulated abroad, as well as increased inflows of future foreign profits.
What does all this mean for the budget deficit? The CBO estimates that the deficit will rise from 3.4% of GDP to more than 4% over the next ten years, even with no change in tax rules.

The direct impact of lowering tax rates on personal income and corporate profits will be to reduce tax revenue and increase the budget deficit. But this will be offset by limits on personal tax deductions and exclusions, and the lower tax rates on personal income will boost taxable incomes as individuals increase earnings and compensation shifts from fringe benefits to taxable cash. Likewise, the move to a territorial tax system will raise taxable profits, especially in the short term, as companies repatriate some of the existing stock of overseas funds.
Although the net tax changes may widen the budget deficit in the short term, the incentive effects of lower tax rates and the increased accumulation of capital will mean faster economic growth and higher real incomes, both of which will cause rising taxable incomes and lower long-term deficits.
There is an important legislative reason why the projected budget will return to surplus in the future.
The Republicans have only a very small majority in the Senate, where the filibuster rule requires a three-fifths majority to pass most legislation, giving the Democrats the ability to block the Republican tax agenda. But an exception allows tax and spending bills to be passed with a simple majority if the resulting budget returns to surplus after ten years. By designing the tax and spending rules accordingly and phasing in future revenue increases, the Republicans can achieve the needed long-term surpluses.
As a result, I am optimistic that a tax reform serving to increase capital formation and growth will be enacted, and that any resulting increase in the budget deficit will be only temporary.