Peak Stimulus Has Passed

Doug Nolan

Bloomberg Radio/Television’s Tom Keene, Wednesday June 14, 2017: “Professor, what is the question you want to ask chair Yellen at the press conference here in six minutes?”

Narayana Kocherlakota, former president of the Minneapolis Fed: “I think the question to ask is ‘Why are you continuing to hike rates in such a low inflation environment?’. There doesn’t seem to be any risk to keeping rates low and lots of benefits to it.”

Torsten Slok, chief international economist at Deutsche Bank: “What are their arguments why this move down in inflation is only temporary?”

Bloomberg’s Keene: “Krishna, what do you want to know? Please keep the stock markets up?”

Krishna Memani, chief investment officer of Oppenheimer Funds: “I want to know what would it take for you to get off the path of tightening? What would the data have to show you to get off the path you have set the Fed on?”

Bloomberg’s Keene: “Do you agree with vice chairman Fischer that we are still ultra-accommodative even with the low inflation…?”

Memani: “Yes we are, and there’s no downside because despite ultra-accommodative policies there’s no uptick in inflation. So we can press on the pedal as much as we want without it effecting the economy negatively.”

Bloomberg’s Keene: “Professor, do we have a good understanding of where we are in our technological economy – do you have a belief in the data that the good PhDs at the Fed are coming up with on productivity, on the measurement of price change, on GDP? Do you have faith in the numbers?”

Kocherlakota: “I have faith. It’s definitely a difficult job to be doing – to be measuring productivity in the kind of changing economy that we’re in. But I have faith in that. I look at the data, I try to keep track of not just what’s going on at the aggregate level but individual price changes and I think we’re living in a low inflation world and that gives the Fed a lot more room to stay accommodative.”

Bloomberg’s Scarlet Fu: “Is there any central bank that's doing it right, Torsten? You’re an international economist. Is the ECB doing it better? Is the BOE doing better? Is the Bank of Canada doing it better?”

Slok: “There are important nuances, but I actually think that central banks have done extremely well. They have supported the economy as good as they can; they have invented new tools and instruments. We can debate if they were the right tools at the right time - the right dose. But I still will argue, at the end of the day, that what else should they have done, if we had been sitting in their chairs? I think we would have done the same thing. You can’t invent new tools and [do] Monday morning quarterbacking again without having another framework that's better. This has proven again and again that this was the right way to look at. And you need to come up with some other reason or some other model, and there really is no convincing model other than what the Fed is saying.”

It’s not as if we don’t learn from history. It’s just that more recent history has such a predominant effect on our thinking and perspectives. Nowhere is this truer than in the financial markets.

It’s been going on nine years since the “worst financial crisis since the Great Depression.” 

We’re now only two months from the 10-year anniversary of the Fed’s August 17, 2007 extraordinary measures: “To promote the restoration of orderly conditions in financial markets, the Federal Reserve Board approved temporary changes to its primary credit discount window facility. The Board approved a 50 bps reduction in the primary credit rate to 5-3/4%.”

This extraordinary inter-meeting response to a faltering market Bubble marked the beginning of unprecedented global central bank stimulus that continues to this day. It’s worth noting that the Fed’s August 2007 efforts did somewhat prolong the Bubble. The S&P500 traded to a then record 1,562 on October 12, 2007 (Nasdaq peaked in November). Extending “Terminal Phase” mortgage finance Bubble excess, 30-year mortgage rates dropped below 5.7% by early-2008, down about 100 bps from early-August 2007. And trading at about $72 a barrel in August, crude oil then went on a moonshot to surpass $140 by June 2008.

Memories of the devastating effects of Credit and asset Bubbles have faded from memory. The disastrous aftermath of the Fed aggressively stimulating mortgage Credit - as the centerpiece of its post-“tech” Bubble reflation strategy - has been wiped away by the cagey hand of historical revisionism. The consequences of loose financial conditions – i.e. speculation, malinvestment, maladjustment, deep structural economic impairment, financial system fragility, wealth redistribution – no longer even merit consideration. Instead, it’s accepted as fact that central bank stimulus has been a huge and undeniable success. With inflation so low, central banks “can press on the pedal as much as we want without it effecting the economy negatively.” “There doesn’t seem to be any risk to keeping rates low and lots of benefits to it.” This never has to end.

These folks are “charlatans” and “monetary quacks”, terminology pulled from analysis of the long and sordid history of monetary booms and busts. Central bankers are destroying the sanctity of money with no meaningful pushback. And while they risk calamity, pundits claim there’s little risk in zero rates and creating Trillions of new “money.” So long as securities prices are high, all must be well in the markets and with policy.

I am reminded of a parable coming out of the late-eighties commercial real estate boom and bust. A developer walks into a bank hoping for a loan to finance a wonderful new development idea. The loan officer thinks to herself, “This guy is a visionary and surely must know what he’s doing or he wouldn’t be here.” Sitting across the table from the loan officer, the developer is thinking “she’s a whiz with the numbers and wouldn’t think of lending me a dime if this plan doesn’t make financial sense.” So the relationship is cemented, the loan is made and everyone is happy – for a while.

These days, securities markets have raged on the notion of “enlightened” central bank monetary management. Meanwhile, central bankers have viewed robust markets as validation of the ingenuity of both their measures and overall policy frameworks. Everyone is happy - for now.

The crisis put the fear of God into Central bankers back in 2008/09 – and there have been a few unnerving reminders since. It’s difficult to believe most buy into the notion that low inflation ensures there’s little risk associated with sticking with extreme accommodation. Surely they’re familiar with the history of the late-twenties. And I believe there is a consensus view taking shape within the global central banker community that monetary policy should be moving in the direction of normalization. The Fed raised rates this week, and the week was notable as well for less than dovish comments out of the Bank of England and Bank of Canada. And while the Bank of Japan left monetary policy unchanged, there has been a recent notable reduction in the quantity of bonds purchased. This week also saw Finance Minister Schaeuble (among other German officials) urging the ECB to prepare to reverse course.

I do think central bankers would prefer to remove some accommodation – and they won’t this time around be as disposed to flinch at the first sign of a market hissy fit. The Fed has now raised the fed funds rate four times, and financial conditions are as loose as ever. Securities markets have grown convinced that central bankers will not tighten policy to the point of meddling with the great bull market. Such market assurance then works to sustain loose financial conditions, a backdrop that will prod central bankers to move forward with accommodation removal.

I believe passionately in the moral and ethical grounds for sound money. It is a policy obligation at least commensurate with national defense. From my perspective, one can trace today’s disturbing social, political and geopolitical circumstance right back to the consequences of decades of unsound “money” and Credit. At this point, downplaying the risks of ultra-loose central bank policy measures is farcical.

Beyond morality and ethics, there is a more concrete practical issue that seems to escape conventional analysts. Desperate central bankers resorted to a massive “money printing” (central bank Credit) operation at the very heart of contemporary finance. Not surprisingly, years later they remain trapped in this inflationary gambit. They have manipulated interest rates, imposed zero rates on savings and forced savers into the risk markets. After nurturing a $3.0 TN hedge fund industry, monetary policymaking then promoted at $4.0 TN ETF complex. Near zero rates have accommodated an unprecedented expansion of global government and government-related debt. In China, ultra-loose global finance helped push a historic Bubble to unbelievable extremes.

History will look back at these measures as a most regrettable end game to a runaway multi-decade Credit and financial Bubble. When confidence wanes – in the moneyness of electronic central bank “money”; in the ability of central banks to manipulate market yields and returns; in the perception of money-like liquid and low-risk equities and corporate debt; in China – global policymakers will have lost the capacity to control financial and economic developments. It was a epic mistake to embark on almost a decade of central bank liquidity injections to reflate and then backstop global securities markets. To believe that structurally low consumer price inflation justifies ongoing aggressive monetary stimulus is foolhardy.

We’ve entered a dangerous period for the securities markets. Highly speculative markets have diverged greatly from underlying economic prospects. Unstable markets have been fueled by central bank liquidity and the belief that central bankers will not risk removing aggressive stimulus. At the minimum, there is now considerable uncertainty regarding the remaining two main sources of global QE (ECB and BOJ) out past a few months. Meanwhile, the Fed continues on a path of rate normalization, a course other central banks expect to follow. The monetary policy backdrop is in the process of changing. Peak stimulus has passed.

Bull markets create their own liquidity. Especially late in the cycle, speculative leveraging spawns self-reinforcing liquidity abundance. Even with a diluted punch bowl, the party can still rave for a spell. Yet these days the changing backdrop significantly boosts the odds that the next risk-off episode sparks a problematic liquidity issue. It’s been awhile since the markets experienced de-risking/de-leveraging without the succor of a powerful QE liquidity backdrop.

According to JPMorgan’s Marko Kolanovic (via zerohedge), an incredible $1.3 TN of S&P500 options expired during Friday’s quarterly “quad witch” expiration. I have always been of the view that derivative trading strategies played a prevailing role in the final speculative blow-off in the big Nasdaq stocks back in Q1 2000. Coincidence that the Nasdaq 100 (NDX) peaked around March 2000 “triple witch” option expiration? After trading at a record high 4,816 on March 24, 2000, the NDX sank below 1,100 in August 2001 before hitting a cycle low 795 on October 8, 2002. Let this be a reminder of how quickly euphoria can vanish; how abruptly greed is transformed into fear; and how rapidly company, industry and economic fundamentals deteriorate when Bubbles burst.

The S&P500 traded to new all-time highs Wednesday, before a resumption of the technology selloff pressured major indices lower. After trading above 12 on Monday and Wednesday, the VIX retreated into Friday’s close (10.38). Such a low VIX reading doesn’t do justice to the volatility that is coming to life below the market’s veneer. The bank stocks (BKX) traded as high as 94.85 at Monday’s open and then retreated to a low of 93.24 before lunch, then traded to 94.93 Tuesday morning and then to 92.59 mid-session Wednesday - before rallying back to 94.78 Thursday and concluding the week at 93.94. NDX traded as low as 5,633 Monday, then rallied to 5,774 Wednesday’s then as low as 5,635 early-Thursday - before closing the week down 1.1% at 5,681.

Thursday trading was the most interesting of the week. At one point, the S&P500 was approaching a 1% decline, with larger losses for the broader indices. The NDX was down as much as 1.6%. Yet despite weak equities, Treasury yields were grinding higher (up 4bps for the session). Both investment-grade and high-yield bonds were under modest selling pressure. Meanwhile, the currencies were trading wildly. The yen reversed abruptly lower, trading in an almost 2% range during the session. It was a market day that seemed to provide an inkling of what a more generally problematic de-risking episode might look like. But it was not to be this time, not with “quad witch” approaching. A significant amount of market “insurance” (put options) purchased over the past month (Trump/Comey/investigation uncertainties) expired worthless.

Returning to earlier, “There doesn’t seem to be any risk to keeping rates low…”, I would point directly to the incredible explosion in options trading (thought it was enormous before!). The VIX is indicative of one of the more conspicuous market distortions nurtured by low rates and central bank liquidity backstops. Anyone not seeing derivatives markets - the epicenter of central bank-induced risk misperceptions and price deviance - as one gigantic accident in the making hasn’t been paying attention.

Clearly, the (distorted) low cost of “market insurance” promotes destabilizing risk-taking and speculative leveraging. Moreover, derivative-related market leverage – in sovereign debt, corporate Credit, equities and commodities – is surely instrumental in what has evolved into a self-reinforcing global liquidity and price Bubble. Furthermore, these dynamics are integral to what has evolved into a major divergence between ultra-loose financial conditions in the markets and a central bank preference for marginally less accommodation.

I have little confidence that central bankers are on top of market developments. I do, however, suspect that they have become increasingly concerned by the markets’ general disregard for economic fundamentals and policy normalization measures. Central bankers over recent years have grown increasingly confident in their extraordinary control over securities markets. At least from the Fed’s vantage point, there must be some reflecting that perhaps markets have left them behind. Fed officials still talk the inflation and employment mandate along with “data dependent.” But they’ve now got at least one eye fixed on the markets.
In contrast to Dr. Kocherlakota, I doubt central bankers have a “good understanding of where we are in our technological economy.” There must be some nagging feelings creeping in – “Are we even measuring GDP correctly? Ditto productivity? Inflation dynamics have changed profoundly – so what effect do our policies really exert these days on consumer prices? Are our economic models even valid? It’s increasingly difficult to maintain faith in what we’ve been doing – this monetary experiment...”

In a period of such profound uncertainties, there’s one thing that is certain by now: central bank accommodation exerts powerful inflationary effects upon securities and asset prices. And for the first time in a while, unstable asset market Bubbles now pressure central bankers to remove accommodation. Sure, they don’t want to be in the Bubble popping business, though when it comes to market Bubbles the sooner they pop the better. Surreptitiously, tremendous amounts of structural damage occur during late-cycle excess. Markets are indicating an initial recognition of structural issues.

Productivity: A Surprise Upside Risk to the Global Economy?

A bottom-up look at major industries around the world reveals significant potential for productivity growth.

By Matthew Tracey, Joachim Fels 
May 2017

Is productivity dead? It is no secret that global productivity has languished in the post-financial-crisis years – with precious little evidence of a turnaround. If robust productivity growth were indeed a relic of the past, the long-term consequences for investors would be profound: Lower-for-even-longer interest rates would prolong the pain for yield-starved savers, pension funds and financial institutions; equity markets might underwhelm in a low-growth world; and PIMCO’s New Neutral might begin to look permanent.

But what if amidst all the doom and gloom there were a productivity-revival story in its infancy? That world would look starkly different. Imagine: World growth stages a comeback, interest rates normalize to the benefit of fixed income investors globally, and fears of secular stagnation give way to a renewed optimism in our future economic potential.

The productivity question couldn’t be more important. After all, there are only two ways to grow an economy: boost productivity, or grow the labor force (demographics). And we’re certainly not going to get much help from demographics. Fortunately, the upside potential for global productivity is growing (or, in economist-speak, productivity’s “right tail is getting fatter” – referring to the rising probability of a positive surprise in the range of outcomes). You might never recognize productivity’s upside potential, however, looking through the lens of macroeconomics alone. So let us look instead to microeconomics (sacré bleu!) for insights. Our thesis in a nutshell: Don’t rule out a global productivity rebound in the coming years that ushers in “old normal” (4%+) global growth. While a strong rebound is not PIMCO’s baseline view, it’s a tail tha t is fattening – and the microeconomic catalysts may have arrived.
Productivity optimists versus pessimists: clash of titans

Labor productivity – or GDP per human hour worked – is in the dumps. Throughout the entire post-financial-crisis period we’ve observed declining productivity growth in economically significant countries worldwide (see Figure 1).

Productivity pessimists typically blame secular stagnation for the slump. Here, the arguments fall into two camps. “Demand-side” secular stagnation devotees, notably Larry Summers (a guest speaker at PIMCO’s upcoming Secular Forum), suggest that a chronic deficiency of aggregate demand and investment is responsible for the dismal productivity growth we’ve seen in recent years … and that absent a rebound in demand, we’re doomed to more of the same. Meanwhile, “supply-side” secular stagnationists such as Robert Gordon believe innovation today isn’t what it used to be and that productivity gains from the computer revolution (formally, the “information and communications technology” or “ICT” revolution) have mostly run their course. Thes e supply-side pessimists argue that today’s innovations are mostly non-market – namely they help us enjoy our leisure time, but that’s about it (think iPhones loaded with fancy new apps). Gordon himself has suggested that “The future of technology can be forecast 50 or even 100 years in advance” and that he sees nothing on the horizon that will rival the breakthroughs of the past (see references list at the end of this paper – Gordon 2014).

Yet it is hard to look around and not see promising new technologies everywhere: self-driving cars, drones buzzing overhead and “smart” everything, to name just a few. Enter the techno-optimists: people who argue we’re on the cusp of radical breakthroughs that will drive huge gains in productivity and living standards. In our increasingly knowledge-based economy, they suggest, we’re moving from a zero-sum game of trade in goods to a positive-sum game of trade in information and ideas – with exponential benefits that our brains are not wired to foresee. (If you want to become a techno-optimist, read “Abundance: The Future Is Better Than You Think,” by Peter Diamandis and Steven Kotler.)

And so the debate rages on. It is certainly true that many consumer inventions – Facebook, Fitbit, Apple Watch and the like – don’t help workers produce more output per hour on the job. But what if these same underlying technologies (big data, microsensors, ever-smaller computers) join forces in less obvious ways to revolutionize the way firms, and whole industries, operate? And, we ask, is the future actually as predictable as Gordon would have us believe? Legend holds that an 1876 internal memo from Western Union, the telegraph monopolist, read: “The telephone has too many shortcomings to be considered as a serious means of communication.” Well, we all saw how that turned out.

Bottom line: Rapid innovation – as Robert Solow might say – is everywhere except in the productivity statistics. So what gives? Macroeconomics may not have the answer. As Dr. Olivier Blanchard reminded us during our May 2016 Secular Forum, we macro folks actually know very little about productivity. So let us turn, instead, to microeconomics.

Microeconomics: a right-tail picture of global productivity

When we look at the state of industry in 2017 from the bottom up – sector trends down to company-level innovations – we see a global economy with underappreciated potential. A productivity-driven return to “old normal” 4%+ global GDP growth may lie within reach in the coming years, based only on the spread (“diffusion”) of existing technologies.

How? A handful of technologies have emerged that are radically changing the way firms do business. These technologies – offspring of the computer revolution – include artificial intelligence (advanced robotics), simulation, the cloud, additive manufacturing (3D printing), augmented reality, big data, microsensors and the “internet of things” (web connectivity of everyday objects). These technologies are now being used, in many cases for the first time, in synergy with one another. Together, they enable businesses to experiment more effectively, better measure their activities in real time, and scale their innovations – and those of their peers – faster. (See the works of Erik Brynjolfsson and Andrew McAfee for more.) Here’s the key: Smarter experimentation plus faster scalability of winning ideas can speed up the diffusion of best practices from productivity leaders to laggards. And global “catch-up” potential is huge, especially in emerging markets (EM).
The productivity gap between leading, “frontier” firms and all others has widened dramatically in recent years – see Figure 2. (Note: This gap does not merely reflect productivity differentials across industries.) The gap cannot widen forever; inefficient and unproductive firms can play defense for a while – creative destruction takes time – but eventually they will converge toward the frontier or exit. This growing divergence between leaders and laggards represents strong pent-up productivity gains waiting for a catalyst (… read on!).

So there’s potential for catch-up … but why now?

Two logical questions: Haven’t computers, the internet and automation been around for years? Why should we expect a productivity rebound anytime soon? One key reason: cost. Productivity-enhancing technologies exist today that haven’t yet been put to use because their cost outweighs their perceived economic benefits. That’s changing.
Case study: advanced robotics

Take robotics. Costs continue to fall while performance improves – making automation more and more competitive with human labor. In many industries, companies are nearing an inflection point where they can earn an attractive return on an investment in advanced robotics systems (Sirkin et al., Boston Consulting Group 2015). “Generic” robotics systems capable of many different types of work cost, today, about $28 per hour, already below the typical hourly human wage in a number of industries. By 2020, the cost of advanced robotics is expected to fall to $20 per hour or lower – below the average human worker’s wage. The Boston Consulting Group projects that growth in global installations of advanced robotics systems will accelerate from 2%–3% per year today to about 10% per year over the next decade. The result: robust productivity gains in the industries that can take advantage.

Sound fanciful? This isn’t the stuff of theory or hope. A major German shoe manufacturer, for example, is building its first factory on German soil in 30 years; the 50,000-square-foot facility will rely on robots and customized automation to slash logistics and supply-chain costs – and free up hundreds of factory workers to focus on higher-skill tasks. And the world’s two biggest airplane makers also are incorporating advanced robotics into their production processes. To date, both companies have built planes mostly by hand. But going forward, taking after the auto industry, they will use robots, drones and higher-skill human labor to boost production efficiency – a response to years of order backlogs and surging (unmet) demand. Why now? Because these technologies are now priced low enough that they become accretive to earnings – and therefore are poised to transform these companies’ business models (Wall 2016).

And now smaller firms are joining in. Until recently, advanced robotic systems were too complex and too expensive for small firms – but it now generally takes only a few months for small- and medium-sized enterprises (SMEs) to earn a positive return on their investment in these technologies. Greater adoption by SMEs, most of which do not operate on the productivity frontier, will help speed up technological diffusion – a catalyst for faster aggregate productivity growth. (Note that SMEs account for about half of total employment in the United States.)
Pent-up productivity growth: examples from industry

Advanced robotics in shoe and airplane production is just the beginning. We may be approaching similar tipping points in other industries as well. McKinsey & Company, in a 2015 study authored by James Manyika and others, offered projections of global sector-level productivity growth potential through 2025 based on anticipated diffusion of known technologies and existing best practices. (Take the numbers themselves with a grain of salt; productivity trends are notoriously difficult to forecast.) Here are some of McKinsey’s industry-level estimates of potential annual productivity growth:

  • Agriculture: 4%–5%. Big data and cutting-edge microsensors can team up to create “precision agriculture” techniques that improve real-time forecasting, production tracking and micro-optimization of irrigation and fertilization. The result? Rising crop and meat yields – and less waste.

  • Automotive: 5%–6%. Big data, simulation and robotics can drive rapid improvements in operations – and force smaller manufacturers to merge, exit or adopt current best practices (the sector, globally, remains highly fragmented). Within parts supply, the industry’s largest segment by value added, advanced robotics may just be reaching the point of economic viability for second- and third-tier suppliers.

  • Food processing: 3%. Mechanization and automation can drive robust productivity gains, mainly in EM countries where food and beverage production is still relatively labor-intensive.

What about notoriously low-productivity service industries? Boosting productivity growth in services will be critical given these sectors’ rising share of global employment. Here, we see new hope for productivity gains through catch-up, consolidation, or exit – mainly due to the huge productivity gap between leaders and laggards (as shown previously in Figure 2). But again we ask: Why now? Greater use of computers, web technologies and analytics (the stuff manufacturers adopted long ago) is opening up services to greater competition – both domestically and internationally through global trade. (As evidence, consider that across countries, the value-added share of domestic services in gross exports has been increasing at a faster and faster clip as services become increasingly tradable. The “micro-multinationals” are coming.) Bottom line: In services, productivity gains through basic IT and digitization may still be in their infancy .

Now for a couple of service sector examples from McKinsey’s 2015 study. Below are their industry-level estimates of potential annual global productivity growth through 2025:

  • Healthcare: 2%–3%. Big data and simulation may produce gains through “smart” care, while basic IT improvements could drive time and cost savings. (Nurses, for instance, currently spend only one-third of their time on actual patient care. And imagine what happens when more doctors learn to use FaceTime for remote consultations.)

  • Retail: 3%–4%. Global retail is ripe for creative destruction (consolidation, exit, or catch-up) given massive productivity gaps between retailers within countries and between retail sectors across countries (e.g., Japanese retail productivity is only about 40% of the U.S. level). The catalysts for change? In the McKinsey scenario, advanced analytics and big data will drive improvements in lean-store operations and supply-chain management. Competitive pressures are mounting, notably from the continued rise of e-commerce (80% more efficient than modern brick-and-mortar yet still only a small fraction of total retail activity – about 10% in the U.S.). “Modern” (i.e., large, as in not your local mom-and-pop) brick-and-mortar formats themselves are three times as productive as small, traditional stores – yet modern brick-and-mortar businesses are rare in much of the emergin g world (where they represent a 25% – and often lower – share of total retail employment).

We could go on. Could government services, notoriously far behind the productivity frontier, be next in line for an upgrade? (For color, see Glaeser et al. 2016.) Evidence is trickling in that municipalities are turning to big data to better track their performance and provide public services more efficiently. And then there’s the education system ...
From micro gains to macro growth?

Could industry-level productivity gains boost global productivity growth in aggregate?

In our view, this (right-tail!) possibility is rising. And the microeconomic experts at McKinsey would seem to agree. In their 2015 report they draw from a collection of industry studies to project productivity growth through 2025 at the sector level – and then extrapolate these sector trends to global labor productivity growth in aggregate. McKinsey forecasts 4% potential annual productivity growth through 2025 – a jolt higher from the 2%–2.5% post-financial-crisis global average. (The forecast considers the G-19 countries plus Nigeria.) Note: This 4% forecast is based only on the diffusion of existing best practices and known technologies – i.e., before giving any credit to unknowable future innovations. As the study suggests, “Waves of innovation may, in reality, push the frontier far further than we can ascertain based on the current evidence.”
Three productivity scenarios and their investment implications

Broadly, we envision three possible scenarios for global productivity. The first is that our weak-productivity status quo – call it secular stagnation – persists. We all have a sense of what this paradigm means for economies and markets because we have been living through a version of it for years. The future effect of secular stagnation on interest rates is ambiguous – though we note that a continued global trend toward populism, absent a productivity rebound, could put a higher inflation term premium in nominal yield curves (causing curves to steepen).

The other two (more optimistic) scenarios both involve a productivity rebound; the resulting economic gains, however, manifest differently between them – and that’s because productivity growth can occur in two ways. Either innovation reduces required inputs for a given output (through efficiencies and cost savings), or innovation boosts output for a given input.

Productivity rebound scenario 1: ‘Technological Unemployment’

Under “Technological Unemployment,” innovation drives robust productivity growth through firm-level operational improvements and cost savings while chipping away at the demand for human labor. Productivity gains therefore come mostly from a reduction in (human) hours worked – mechanically, this is the denominator in the productivity calculation (output divided by total hours).

Consider the potential long-term economic and market impact of “Technological Unemployment” (note, we’re speculating and simplifying a lot here):

  • Global GDP growth picks up moderately

  • Inflation remains low and stable (a positive reflationary impulse from rising GDP growth is offset by a disinflationary impulse from falling costs and lack of wage pressure)

  • Labor market distortions and inequality worsen; chronic underemployment develops (too many workers, not enough jobs)

  • Global interest rates rise modestly from rock-bottom levels amid stronger economic growth (but disinflationary conditions limit the extent of the increase)

  • Yield curves modestly steepen, but only if growth impulse more than offsets disinflation impulse; otherwise, curves could flatten

  • Equity markets perform well given improving economic growth, muted inflation, and rising corporate profitability (falling costs and minimal wage pressure)

“Technological Unemployment,” in the extreme, is the scenario in which we humans are relegated to the beach while machines do all the work for us. The distribution of wealth across society could well become even more uneven given rising polarization between the “capital owners” and everyone else. This is a grim scenario for Main Street, and it would pose significant challenges – not only economic but also political and social.

Productivity rebound scenario 2: ‘Productivity Virtuous Circle’

Our “Productivity Virtuous Circle” scenario involves a different (and better!) type of productivity growth – one where innovation drives productivity gains without rendering human workers redundant. Here’s how. First, new technologies and processes employed in one industry generate cost savings and efficiencies in that industry. But they also create new jobs – jobs that require new skills we didn’t yet know we needed. A virtuous circle then develops: Technological growth in one industry forces related industries to innovate (or fall behind), creating even more demand for new skills. And on we go. The upshot: In this scenario there is no mass of discouraged (former) workers plodding off to the beach. Mechanically, productivity gains are driven mostly by a rising numerator (output) rather than by a falling denominator (hours worked).

Here is the potential long-term economic and market impact of “Productivity Virtuous Circle” (… still speculating):

  • Global GDP growth approaches “old normal” levels (4%+) in an enduring escape from secular stagnation

  • Inflation normalizes but remains well-contained (“demand-pull” inflation is offset by disinflationary impulse from positive productivity shock)

  • Labor markets strengthen (full employment and solid wage growth)

  • Global interest rates rise given strong economic growth

  • Yield curves bear-steepen (term premium normalizes at the long end)

  • Equity markets perform well given solid economic growth – but remain sensitive to the sustainability of profit margins (potential for labor to garner a larger share of the economic pie)

Clearly, in this scenario, bonds underperform in the short run (higher rates and steeper curves). But ultimately, we believe the “Productivity Virtuous Circle” would be the very best long-term outcome for fixed income investors.

We summarize the forces at play across all our scenarios in Figure 3.

What could go wrong? Barriers to diffusion

For the global economy to realize its full productivity potential under any rebound scenario, we need a lot to go right. While global industry leaders have enjoyed strong productivity gains in recent years, the median firm has not (recall Figure 2). The key to boosting aggregate productivity, therefore, is to speed up the diffusion of best practices from industry leaders to laggards. To maximize diffusion, governments need to continue to support free trade, a key enabler of global competition; liberalize product markets to enable the forces of creative destruction to do their work; make labor markets more flexible so that human capital will flow to its most productive uses; and help workers learn the skills required to best leverage tomorrow’s technologies. (Worthy topics for a future note …)
Bottom line: productivity’s upside risks are growing

So, what should we expect going forward? Secular stagnation or a productivity rebound?

Our crystal ball isn’t that good. But whereas many market participants are coalescing around a secular stagnation baseline view, we are decidedly less convinced. In fact, we see a growing risk that we collectively underestimate the global economy’s pent-up productivity potential. It wouldn’t take a leap of faith to envision some variant of our “Technological Unemployment” productivity rebound (putting aside, in this note, its potentially serious social consequences). If future innovation displaces low-skill labor first, as we suspect it will, the impact on employment could indeed be negative – absent herculean worker-retraining efforts.

But don't count out a “Productivity Virtuous Circle,” which – lest we forget – is not lacking in historical precedent. The Luddites of 19th century England and their ilk have been wrong for two centuries; historically, over long periods of time, technological change has been a net creator of higher-skill jobs – and has not jeopardized full employment. (Over the past 50 years in particular, global labor productivity and employment have grown together in most multi-year periods.) Yet many observers seem certain this time will be different.

All told, we’d put better-than-coin-flip odds on a productivity rebound in some form in the coming years – and an escape from secular stagnation toward “old normal” global GDP growth. (The composition of GDP growth, however, will be skewed much more toward productivity gains than labor force growth.) The microeconomic catalysts have arrived. These catalysts – to recap, rising synergies in the use of leading technologies, declining costs, greater small-firm adoption and green shoots in services – may put 4% annual global productivity growth within reach. And that 4% includes zero credit for potential unknowable future innovations. (Yes, “unknowable unknowns” can be positive!)

There may also be a nascent macro catalyst at play. Global central banks are beginning to rein in extraordinary post-financial-crisis monetary stimulus, which – as our colleague Scott Mather suggests – probably has for years distorted the allocation of capital worldwide. The withdrawal of ultra-accommodative monetary policy may encourage a more efficient capital allocation throughout the global economy, potentially helping jumpstart creative destruction – the key to shrinking today’s massive productivity gaps.

Why, as investors, do we care? A productivity rebound could mean higher interest rates and steeper yield curves – greener pastures, indeed, for savers, pension funds and financial institutions. It could mean equity investors wouldn’t be doomed to a stagnant future of low returns. And it could boost the resilience of the global economy in the face of several looming secular risks. Productivity’s right tail is getting fatter; if history is any guide, the night often appears darkest just before dawn.
Closing Remarks from John

All of us might wish for a virtuous productivity cycle like the one they describe a scenario number two, and that is what has happened in the past. People left the farms and went to the cities to work in the factories and then moved on to other jobs. Technology created new jobs in the process of destroying past jobs. It was in the height of this process that Schumpeter wrote his famous “creative destructio” paper.

The problem with that scenario playing out in the future is that we literally had generations of time to adapt. If we had tried to go from 80% of the people working on farms in 1880 to 2% in 10 or 15 years – less than a generation – it would have been far more disruptive than the actual 20 generations it took. People had time to change.

I am far more concerned about today’s “technological unemployment.” Automated cars are just the tip of the iceberg. The Council of Economic Advisers thinks that 60% of lower-paying jobs will be automated in the next few decades. Where will these people go to work? Yes, we can retrain them for other work, but are they willing and able to be retrained? Will they be willing and able to move?

Given the nature of the change that I see coming, I think that income inequality will actually grow. In my upcoming book I will put a mathematical formula to it and demonstrate that in the future income inequality will be worse, no matter how you cut it. And increased taxes are going to slow down growth and reduce employment opportunities. There are no free lunches.

Add that in the coming debt crisis, the inevitable demographic changes and geopolitical tensions are going to contribute to the slowing of GDP growth. All of which makes it difficult to be a pure technological optimist. I mean, yes, we’re moving toward a world of abundance and marvelous new technologies, but like the past, the future will be unevenly distributed for quite some time.

And that does not even get into the issue that the way we measure GDP is so fundamentally flawed as to produce statistics that are essentially misleading. Seriously, to an economist, a $100 barrel of oil or two $50 barrels of oil have the exact same GDP impact. Ask a kindergarten child which is better, one cookie or two cookies? Just saying…

I will close here, but you get the thrust of what I’m trying to cover in the new book. I think that Matt and Joachim did a fabulous job in taking us on a thought trip and making us question our assumptions.

Celebrate loyalty in politics giving way to honesty

Electoral volatility is chiefly the legacy of the global financial crisis

by: Bill Emmott

So Donald Trump is not the only leader to demand loyalty but receive honesty instead. Theresa May thought a country that had voted for Brexit would loyally support a “strong and stable” leader who pledged to deliver it, but instead the electorate gave her an all-too-honest rude gesture. Too many voters were not at all sure she was going to deliver what they really wanted: rising incomes, public services, security.

Yet, while Mrs May contemplates the glittering career that lies behind her, she can comfort herself that political earthquakes are now the norm all over the west. Until recently, the main explanation was the fading of class divides and the collapse of ideological loyalties with the end of the cold war. Now we must add another explanation: the failure of too many traditional parties to deliver what voters have come to expect.

This has two dimensions: rising expectations and falling governmental performance. Whatever the information revolution may have done to our attention span or our news-consuming habits, it has made citizens both more demanding and less tolerant — even less loyal. Meanwhile the perceived failure of established parties to provide the political goods is the biggest cause of electoral volatility.

This is chiefly a legacy of the 2008 financial crisis, but not only. Well before that, democracies such as France, Italy, the US and elsewhere had neglected to deal with ailments such as the stagnation of real incomes, out-of-control healthcare and pension costs, and the impact of automation on blue-collar jobs. With disillusion caused by the Iraq war added, the result was the first big populist earthquake of the 21st century: the election of Barack Obama to the US presidency in 2008.

Had the autumn of his election not coincided with the worst financial meltdown in 80 years, Mr Obama and President Nicolas Sarkozy, elected in France the previous year, would have been far better placed to revitalise their economies and societies, and restore some sense of fairness to their angry citizens. Instead, these reformists and others were overwhelmed by the need simply to avoid a new Great Depression in America and in Europe.

Something similar happened in Japan. In 2009 its political drama metaphor of choice was the landslide, as the novice centre-left Democratic party of Japan swept the Liberal Democratic party out of power for the first time in the best part of half a century on the back of rising inequality and dissent at the country’s long stagnation. The DPJ struggled to deliver reforms before being overwhelmed in 2011 by real natural disaster: earthquake, tsunami and nuclear accident. The LDP was returned to power in its own landslide a year later.

Nearly a decade since the 2008 crisis, with unemployment in France and Italy still close to a tenth of the workforce, and with nearly 10m prime-age people still idle outside the US labour force, political volatility and disloyalty ought not to be surprising. When shock is expressed at such volatility, it is a sign that governments and parties have underestimated the true level of discontent and disillusionment that the long recession and slow recovery have left behind.

Admittedly, our reactions to these earthquakes depend critically on our standpoint: when they bring us President Trump, we are liable to despair of democracy’s flaws; when they bring us President Emmanuel Macron, they bring us hope; when referendums reject four decades of British foreign policy or well-meant Italian political reforms, we may resent the apparent ingratitude.

Clearly, there are dangers in this volatility, with electorates and political systems swerving dramatically one way or the other, damaging national institutions or making irrevocable decisions in haste to be regretted at leisure. Mrs May and her close advisers, when they are past the self-flagellation, could well conclude British voters are being ungrateful and reckless, especially in so far as they are flirting with a populist prime minister in Jeremy Corbyn.

They would do better to draw a more positive, optimistic conclusion. This is that while political loyalty was comforting in the past, political honesty is much more refreshing. Volatile swings one way bring hope of a swing back. But most of all they are a welcome sign of political engagement and a demand for accountability. If Britain, America, France or Italy are ever to recover from their post-crisis torpor and solve their deeper-seated ailments, this is how it will happen. Democracy works, Mrs May. Grin and bear it, if you can.

The writer is author of ‘The Fate of the West’

Billionaire Philanthropists Are Shaping a New Gilded Age

The number of billionaires has increased sharply in recent years — and they are using their charitable giving to influence the direction of a host of issues, such as education, the environment, science, among others, according to a new book, The Givers: Wealth, Power, and Philanthropy in a New Gilded Age. Author David Callahan, founder and editor of the website Inside Philanthropy, leads a team whose goal is to shed light on the intentions of foundations and donors.

He recently joined the Knowledge@Wharton show, which airs on SiriusXM channel 111, to talk about his book. 

An edited transcript of the conversation follows.

Knowledge@Wharton: What do you see as the state of philanthropy right now?  

David Callahan: There’s a lot of it going on. It’s the next chapter, what I call this new gilded age, that got going in the 1980s when Forbes first published that list of the wealthiest Americans. It had only 13 billionaires, but you could get on the list if you had $80 million. Now you need $1.7 billion to get on that list. A lot of billionaires don’t even make it onto the Forbes 400. Many of those people who are on the list are turning to philanthropy. They have a lot of extra money. They want to solve problems, and they’re charging forward with their giving.

Knowledge@Wharton: You noted an estimated $27 trillion is expected to be given to charities in the next five years. That’s a lot. We should be able to cure every cancer and everything else in the world with that kind of money.

Callahan: Just to keep it in perspective, the federal government spends about $4 trillion a year. But the portion of government money that can go for discretionary spending — to cure diseases, to engage in environmental protection, to send a man to Mars, whatever — is shrinking. So, philanthropists are stepping forward to do things that often government can’t.

Knowledge@Wharton: Is it more a of private-public partnership than ever before?

Callahan: Yes. We see this a lot with public parks, for example. In New York City, billionaire Barry Diller stepped forward to put a little island park off the west side of Manhattan. It caused a lot of controversy. The Highline in New York City [a park converted from an old railroad line] was built with private money.

Knowledge@Wharton: Another statistic you bring up is that the number of foundations is soaring as well.

Callahan: In the last 15 years, wealthy people created about 30,000 new private foundations.

The numbers of people who have extra money to give away is staggering. Here’s a statistic that blew my mind: 70,000 of U.S. households have assets of $30 million or more, not including their real estate. That’s some serious liquid money. If you want to try to do some good in the world, you have that spare change to do it.

Knowledge@Wharton: People expect certain things to be done with their money when they are giving it to charity. How much of it is always done for good, and how much of it is causing angst in other areas, like public policy?

Callahan: It depends upon your point of view. Michael Bloomberg, for example, has given $130 million, working with the Sierra Club, to shut down coal-fired power plants. If you’re worried about climate change, if you’re worried about coal pollution, that’s great. If you’re a coal miner or you work in the coal industry, that’s not so great.  

If you like charter schools, these billionaires have put a lot of money behind that. That’s fantastic if your kid goes to a charter school. If you feel like public education shouldn’t be run by billionaires, you may have more of a problem.

Knowledge@Wharton: Cities such as Philadelphia, Chicago and others certainly could use more funding for their public school systems. Yet charter schools are seen as the next step beyond public education to provide kids with what they need for academic success. It’s a tough push and pull.

Callahan: Absolutely, yes. And there are no simple answers or analysis. My book is pretty rich in nuance about the pros and cons of this. Philadelphia is a great example. This is a city that’s been hurt by fiscal cuts, budgets for education have gotten whacked, many private donors have stepped forward to help out. But they have done so with strings attached.

They want the schools to change in certain ways. They want more charters, more teacher accountability. You have to ask, is that any way to run a city education system that you give power to billionaires in exchange for money that the taxpayers won’t put forward themselves?

Knowledge@Wharton: There was a lot made in the last couple of years about The Giving Pledge.

Bill Gates and Warren Buffett put together the group of the uber-wealthy to give away a majority of their wealth towards charity. When that came out, many jumped on board. What’s its impact?

Callahan: It’s still too early to say. But about 150 billionaires in the United States and around the world have now signed that giving pledge, committing themselves to give away at least half their wealth. Among them is Facebook founder Mark Zuckerberg and his wife, Priscilla Chan, who committed to giving away 99% of his Facebook stock to try to solve problems. What’s not to like, right? This is a solution to economic inequality to have the rich give it back. Except who is Mark Zuckerberg to have that kind of power as a private citizen?

It does raise troubling questions about who’s in the driver’s seat of American life because government as an agent for change to solve problems is going to continue to be on the downward trajectory as those budget cuts kick in. That’s not just at the federal level with what we’re seeing with the Trump administration, but at the state and local level. All those Giving Pledge billionaires are coming in, and government is on the decline.

Knowledge@Wharton: What does that mean for a democratic government going forward?

Callahan: It’s starting to look a little like a benign plutocracy with a lot of these really well-meaning, wealthy people having growing influence. It’s hard to say how that will play out, but it’s important to have the conversation now to bring attention to this. I think most Americans don’t pay much attention to philanthropy. When they think about philanthropy or charity, they think about donations to universities, to hospitals, to museums. They don’t think about people using their money to push a public policy agenda, to have a lot of say in what government does.

Another good example of how private philanthropy has had a big impact is in LGBT rights. In my book, I talk about Tim Gill, who made his money in tech and created a foundation. He put all of the money in the foundation dedicated to one cause, which is advancing LGBT rights. He, along with other funders, really accelerated that move to marriage equality and getting that Supreme Court victory. If you believe in marriage equality, that’s a great example of philanthropy speeding along progress to more rights for more people. If you’re uncomfortable with marriage equality, you feel wealthy donors maneuvered this issue faster than maybe citizens would have been comfortable.

Knowledge@Wharton: The good side to it is the fact that you have all of these wealthy people who want to be more involved in philanthropy, right?

Callahan: Absolutely, particularly with many of these billionaires worrying about the plight of poor people and low-income kids who are struggling in our schools. Who would have thought back in the 1980s during the Bonfire of the Vanities — the age of greed — era, that the big cause of hedge fund billionaires would be poor kids in the inner cities? In New York City, the Robin Hood Foundation now raises about $160 million every year from these wealthy finance people to fight poverty. That is a sea change, and it’s a positive thing.

We don’t want to say all this philanthropy is a bad thing. Many of these people also are coming from business. They’re good at solving problems. They know how to scale up organizations, manage people. They’re innovative. A lot of the philanthropists are from the tech sector. They have new ideas. There’s a lot to be excited about here as well.

Knowledge@Wharton: Still, would you like to see more transparency in the process?

Callahan: At the very least, we need to know where this money is coming from and where it’s going. We’ve heard a lot about dark money in politics. There’s also a lot of dark money in philanthropy, and much of that money is going to the same things. It’s also aimed at trying to influence what government does. It’s a form of political spending, but it’s all tax deductible.

You can get a charitable deduction for giving money to kind of sway public policy. I’m not sure that that’s what Americans think of when they think of charity.

Knowledge@Wharton: We have an economic divide in this country. It probably would be better to close that gap a little bit and open up opportunities for people.

Callahan: It’s a good point that underscores a troubling fact I note in my book, which is that giving by ordinary Americans has been flat or going down, while giving by the people at the very top has been going up. That reflects the economic trends that we’re seeing with all this inequality, which is that all the income gains in the last 15 years have gone to that top 1%.

They’re the people who have the extra money lying around to do something charitable. Most households are running in place or losing ground and don’t have some extra money. The charitable sector is increasingly being dominated by these wealthy people.

… Some of them give a lot to politics and also to philanthropy. Some of them don’t give much to politics at all. But the most sophisticated ones are good at pulling all the levers of influence. They know that if they want to advance an agenda, whether it’s for LGBT rights or the environment or low taxes and fiscal conservatism, they will be most effective if they invest in all the different avenues of change. They give money to think tanks, policy groups, litigation organizations and activist groups to push that agenda with their charitable dollars.

They give money to politicians and super PACs. They give money to lobbyists. That is an enormous amount of leverage that most citizens couldn’t even imagine having. When the average person wants to try to change something, maybe they can sign a petition or write their representative. They can’t bankroll a think tank to come up with new ideas to hand off to policymakers.

Knowledge@Wharton: Beyond transparency, are there solutions to try and keep charitable giving on focus without a lot of the strings attached?

Callahan: One idea that I discuss in the book is to limit politicized giving. Is it OK that billionaires get a tax deduction for giving money to groups that work closely with political parties to advance an agenda? In the past 30 years, philanthropists have built up this whole network of think tanks in Washington: The Heritage Foundation, The Cato Institute, the American Enterprise Institute. Those are all organizations on the right that have been bankrolled by conservative donors.

On the left, liberal donors got with it and built up their own network of think tanks like the Center for American Progress. Many of these work hand-in-glove with people in government and partisan political officials. The Heritage Foundation right now is one of the big forces in the Trump administration. Trump did not just come into office with all those executive orders in his briefcase. He didn’t bring those down from Trump Tower. No, he turned to the experts. He turned to places like the Heritage Foundation, very far conservative organizations bankrolled by tens of millions of dollars every year in donations.

You have to ask, does giving money to a group like that really count as charity? Should they get the same tax deduction? I suggest probably not, that we need to redraw the line. With trillions of dollars coming into philanthropy, we want to see that money go ideally to more hands-on efforts to help communities, to help children, build up cultural institutions, help universities.

We don’t want to see it just go into this bigger and louder ideological combat between billionaires. It’s like watching these gods throw lightening bolts at each other and battling it out in this war of ideas, all at taxpayer expense.

Knowledge@Wharton: Is it a concern that we’re going to get to a point in 20, 30, 40 years where the money that these people are giving becomes more important than what the government can provide?

Callahan: The water crisis in Flint, Mich., is a great example. After it turned out that that water was contaminated, a number of foundations stepped forward and gave $120 million to help provide clean water in Flint and solve some other problems in the city. When Detroit was going bankrupt, a number of foundations stepped forward and helped bail it out with $800 million. When Kalamazoo, Mich., was facing a big budget deficit, philanthropists stepped forward and put up $80 million to bail out the city. We just saw in Hartford, Conn. — a number of insurance companies coming forward with philanthropic contributions to help bail out the city. Again, with those donations comes power. You don’t write a check to bail out the city and not have some say over what happens next.

The Middle East Changes Shape

By Kamran Bokhari and Jacob L. Shapiro


Geopolitics often unfolds slowly, based as it is on broad, impersonal forces that develop over long spans of time. There are periods, however, when these forces reach a critical stage, and a flurry of important events, seemingly unconnected, combine to quickly reshape the world or a region or a nation before settling back down. The Middle East is going through one of these periods right now.

The past week attests to its transformation. It started with Saudi Arabia, which a seven-nation group that cut diplomatic relations with Qatar over Qatar’s alleged support for terrorist groups and its willingness to work with Iran. The next day, the Kurdish-dominated Syrian Democratic Forces began their offensive to gain control of Raqqa from the Islamic State. Then, just 48 hours after the Qatar row erupted, the Islamic State attacked Iran — the first time it has ever done so — hitting the parliament building and the mausoleum of Iran’s founder, Ayatollah Ruhollah Khomeini. Hours later, the Kurdistan Regional Government in northern Iraq announced that it would hold an independence referendum on Sept. 25.

These events may have happened independently of each other, but together they represent a powerful shift. Qatar’s willingness to rebuke Saudi Arabia shows that Iran is growing stronger or that Saudi Arabia growing weaker — or both. Turkey, meanwhile, sees this as an opportunity to support Qatar and position itself as the region’s leader. The Islamic State is going back to its roots as a highly effective insurgent organization as it loses territory in Iraq and Syria. And the Iraqi Kurds seem closer than ever to officially breaking apart Iraq. Simply put, the powers of the Middle East are realigning.

Qatari Foreign Minister Mohammed bin Abdulrahman al-Thani gives a press conference in Doha, on June 8, 2017. Qatar’s foreign minister rejected attempts to interfere in the country’s foreign policy and said a “military solution” to the country’s crisis with its Gulf neighbors was not an option. KARIM JAAFAR/AFP/Getty Images
Volatility Spreads to the Gulf
Arab states in the Persian Gulf have remained relatively stable, thanks to their oil wealth and small populations. But that is no longer the case. The drama with Qatar rightly made headlines this week, but it is indicative of a deeper problem. The Gulf Arab states are at odds over how to manage radical Sunni groups and Iran and its Shia proxies. Oman, a non-Sunni state, has always been the outlier in the bloc and has had the closest ties to Iran. Kuwait, while close to the Saudis, has managed to stay neutral on various issues and is currently acting as a mediator in the Qatar dispute. Bahrain, a majority Shiite nation with a Sunni-controlled regime, is completely dependent on the Saudis. That leaves the United Arab Emirates as the Saudis’ only other real partner.

The Arabian Peninsula’s relative calm is at risk, and Saudi Arabia was trying to prevent any further divisions by launching a diplomatic campaign against Qatar. It’s a risky maneuver, but it could pay off if it brings Qatar back into the fold and demonstrates how powerful a Sunni bloc of countries can be with Saudi Arabia at the helm. It could also backfire if Qatar remains defiant in front of the rest of Arab Gulf states.
The Islamic State Loses Ground
The Islamic State has been the center of the gravity in the Middle East for years.

But over the past year, it has been losing strategic territory in Iraq and Syria and now appears to be losing hold of its capital, Raqqa.

The loss of this territory will be a major blow. It knew that it would be unable to sustain its caliphate in the short term, but with the bigger picture in mind, the Islamic State will go back to its roots as an insurgent group carrying out terrorist and guerrilla attacks from ungoverned spaces in the Syrian and Iraqi deserts. The underlying social, political and economic conditions that allowed IS to emerge in the first place, meanwhile will remain in place even if Raqqa falls, and if IS doesn’t exploit them, another group will.

As the Islamic State weakens on the battlefield, so too will the shared cause of those fighting the group. They will now fight among themselves as IS focuses on exploiting regional divisions, especially the conflict between Sunni and Shiite forces, to further weaken the Sunni Arab leadership.
Threats Emerge in Iran
On June 7, 12 people were killed and many more were injured in two attacks by six assailants with high power assault rifles and suicide vests. The Islamic State claimed responsibility, and the fact that it could carry out such attacks indicates that IS likely had been operating in Iran for a while.

IS pulled off these attacks at an opportune time, just three weeks after U.S. President Donald Trump visited Saudi Arabia and identified Iran as the main threat to the region. Around the same time, the Saudi king ruled out any dialogue with Iran and said that the struggle against Iran has to take place on Iranian soil. There have also been major crackdowns on Shiites in Saudi Arabia and Bahrain.

From Iran’s point of view, the Saudis actually benefit from the Islamic State, which helps counter Iran and its Shiite allies in the region. Whether this is actually the case is immaterial. The Islamic State would like Iran to believe that this were so because it could lead to a confrontation between Tehran and Riyadh. Recent statements from Iran’s Islamic Revolutionary Guard Corps accusing Saudi Arabia of being behind the June 7 attacks would likely be welcomed by the Islamic State.

Iranian intelligence will try to neutralize IS elements in the country, though the Quds Force, a special unit of the Islamic Revolutionary Guard Corps responsible for overseas operations, may go further and try to retaliate against the Saudis for the attacks. Either way, these attacks to have aggravated tensions between Iran and Saudi Arabia, and the Islamic State will do all it can to aggravate them more.
Independent Kurdistans?
Kurdish groups, meanwhile, are taking advantage of the region’s blurred borders to create new ones of their own. The Syrian Kurds’ primary motivation in fighting the Islamic State is to secure land and U.S. support for an autonomous, if not independent, Syrian Kurdish state. Their distant cousins in Iraq are also pursuing sovereignty, threatening to break apart the Iraqi experiment once and for all.

Following the 2003 Iraq war, the government in Baghdad recognized an autonomous Kurdistan Regional Government in Iraq’s three northernmost provinces. Over time, the Iraqi Kurds expanded their influence south to include large parts of three additional Iraqi provinces where they have territorial disputes with Iraqi Sunnis. The Shiite-dominated government, however, has long opposed greater autonomy for the KRG. The rise of the Islamic State in 2014, and particularly its capture of Mosul, actually helped the Iraqi Kurds because it weakened Baghdad and forced it to cooperate with the KRG to fight back IS in Sunni areas.

Emboldened by its progress, the KRG announced June 7 that it will hold an independence referendum on Sept. 25. Beyond this vote, the KRG’s path to independence remains unclear. Much depends on how the Turks and Iranians respond.
Turkey: Still on the Sidelines
Turkey, meanwhile, is watching all of this carefully. It opposes Kurdish independence, and its goals in Syria conflict with almost every other power in the region. Even so, beyond funding some proxy groups in Syria and creating a small corridor in the northern part of the country, it has stayed out of the fray. It prefers to let the Arabs fight among themselves until they are so weak that Turkish power becomes impossible to resist. Turkey is also dealing with domestic issues that prevent it from projecting power too far abroad.

The Qatar dispute, however, presented Turkey with an opportunity that it couldn’t pass up. Turkey is an ally of Qatar; they have a relationship the Saudis and other Arab states deeply resent. But they also need Turkey to counter Iran. The Arabs will have to accept Turkish influence as a balance to Iranian influence. Turkey is trying to act as a mediator in the crisis between the Gulf states, which could become a stepping stone for a wider Turkish role in Arab affairs. And to really demonstrate how much Turkish power has expanded, the Turkish parliament fast-tracked passage of a bill on June 7 to station 3,000 troops in Qatar.

To deal with the multiple challenges emanating from Syria, Turkey needs to position itself as the region’s leader. One tactic it is using is to support Sunni Islamists of the Muslim Brotherhood that are loyal to Turkey and therefore will support Turkish interests. The problem is that Saudi Arabia and Egypt do not want to Turkey to be a leader. Iran may be the immediate threat, but Turkey as a hegemon is an equal if not greater threat in the long-term.

It’s has been a heady week in the Middle East, full of important developments that are reshaping the geopolitics of the region. This will eventually calm down into a new normal as some of these issues lay dormant – but they are not going away, and there are more significant episodes than these to come.