German politics is tilting towards federalism

Conservatives see measures proposed in the coalition talks as a slippery slope

Wolfgang Munchau

Supporters of Martin Schulz (left) are becoming weary of his broken promises, such as his pledge never to serve under Angela Merkel (right) © EPA

There is something in me that would prefer the members of Germany’s Social Democratic party to vote against a grand coalition with Angela Merkel’s centre-right Christian Democrats. A permanent coalition would end up strengthening the hard left and the hard right. We know that in a democracy, governments tend to produce opposing forces of equal or greater strength, given enough time. This would be Germany’s third grand coalition in 12 years. Better to end this sooner than later.

But there is also something in me that says that this particular coalition might actually do something useful. The chapter in the preliminary agreement on Europe is astonishing. The CDU and SPD accept the principle of a fiscal union for macroeconomic stabilisation, and transforming the European Stability Mechanism (ESM), the rescue fund, into an institution of the EU.

What genuinely surprised me was the initially muted response from the usual suspects on the right. The Eurosceptic backbenchers of the CDU and their Bavarian allies, the Christian Social Union, were unusually quiet. So were the economic commentators in the media. My only explanation is that they either did not read the section, or did not understand it.

The silence ended abruptly last week with an article by Otmar Issing in Frankfurter Allgemeine Zeitung. Mr Issing, a former member of the European Central Bank’s executive committee, rightly recognised the importance of the EU section in the agreement. As an economic conservative he was appalled by the ease with which Germany raised the white flag in the eurozone debate. Banking union, fiscal union, transfer systems — it could all happen very soon. It is what the conservative, ordo-liberal German establishment always fought against. I personally do not agree with their world view, but they are right that the preliminary coalition agreement matters.

This course of events will not go unchallenged. For starters, the SPD membership might vote against the coalition agreement. The Europe section matters more to Martin Schulz than to the average party member. The SPD leader omitted to campaign on this issue in last year’s election campaign. He has lost much of his authority since he left the job of president of the European Parliament to enter German politics a year ago. His supporters are becoming weary of his broken promises, such as his pledge never to serve under Ms Merkel and his promise not to enter a grand coalition as a junior member.

The SPD’s leadership and the outside world are too complacent about the upcoming vote on the coalition. Referendums in parliamentary democracies are inherently unpredictable. With this vote, the party gives its members an opportunity they have not had before. At a single stroke, they can get rid of both their own leader and Ms Merkel. For some, this is a temptation hard to resist.

Another source of obstruction for eurozone reform is the rise of opposition inside the CDU. Mr Issing’s article has stirred up a debate in the party’s Bundestag group as MPs reported that the grassroots are particularly unhappy about the section on the ESM. Ms Merkel pointed out that the Bundestag will retain its veto right on any ESM programmes even if the rescue fund were to become a European institution. She said the ECB is also rooted in EU law, yet independent.

Her response is both true and misleading. Anchoring the ESM in EU law will not change the national veto right over programmes that are funded out of the ESM’s existing facilities. But it opens up new funding channels and decision-making procedures in the future. One has to look at the proposed shift in the legal basis in combination with the plans for a fiscal union. If a newly created fiscal capacity were to backstop the ESM in the future, then surely national governments would no longer have a veto right? It would not be their money any longer.

Mr Issing and other conservatives see the measures proposed by the CDU/CSU and the SPD as a slippery slope towards a regime no longer based on fiscal and financial sovereignty, rooted at the national level, but towards mutual governance. That’s what the debate on the eurozone was always about. It is a variant of the old conflict between federalism and inter-governmentalism. On the specific issue of eurozone governance, German politics is tilting the balance of opinion in favour of the federalist view. For that, and that alone, I would probably buy into the grand coalition, but perhaps not for a full term.

A People’s Democracy in America

Laura Tyson , Lenny Mendonca

BERKELEY – You’ve probably heard this before: Markets are soaring, and wealth is growing, but most of the gains are going to those at the top. Rapid technological advances are transforming daily life and creating new industries, but are also fueling anxiety about lost jobs and occupations. People are increasingly angry at giant corporations’ perceived monopolistic power.

Cities are thriving as magnets for the wealthy and ambitious, but rural residents often feel left behind. Anti-immigrant sentiment has become intense, and sometimes violent. Women are challenging male power in viral protests. Political corruption is fueling widespread fury, with many convinced that moneyed interests have captured their democratic institutions. Trust in political parties is at new lows. And amid all the dismay and dysfunction, some of the new plutocrats have stepped up as philanthropists to underwrite social reform.

Yes, it all sounds like Trump-era America. But these conditions also prevailed more than a century ago, during the Progressive Era of the early 1900s.

Disgusted by the massive inequalities of the Gilded Age, the first Progressives sought comprehensive reform. Changes to the US Constitution adopted during this period include the introduction of the federal income tax with the Sixteenth Amendment, direct election of senators with the Seventeenth Amendment, the prohibition of alcohol with the Eighteenth Amendment (some ideas were really bad), and women’s suffrage with the Nineteenth Amendment.

Progressives wanted citizens to rule more directly, overturning a powerful and often corrupt political-industrial complex that had gradually usurped their rights. They championed recall votes as a way to remove leaders and officials serving vested interests rather than citizens. They created direct primary elections, empowering citizens to choose which candidates to nominate, thereby undermining the power of party “machines.” And in 1902, Progressives in Oregon won overwhelmingly approval of a ballot measure creating the initiative and referendum processes. Since then, most states have adopted these fundamental democratic processes, enabling citizens to introduce or approve proposed laws or amendments to their state constitutions.

As James Fishkin of Stanford has written, “deliberative democracy” has a long history, extending back to the original democracy in Greece in the fifth century, BC. In this model, informed and engaged citizens directly set the agenda for their representatives (though not with the Greeks’ narrowly circumscribed definition of who is a citizen).

Today, a new generation of progressive federalists are leveraging the initiative process to give citizens power over policy. The specifics of how citizens can put measures to a popular vote or require the legislature to address them vary substantially from place to place, but 26 states and hundreds of cities, accounting for more than 70% of the US population, have initiatives in their governance tool box.

Sometimes initiatives have created ongoing challenges for elected leaders, as has been the case with California’s Proposition 13, which capped state property taxes when it passed in 1978. And sometimes they have addressed frivolous issues, as was the case with a failed attempt in 2016 to require condoms in pornography. But they have also been fundamental to major reforms that have reshaped governance, especially in California. Citizen-based redistricting, open primaries, changes to term limits, majority-vote budgets, a rainy-day fund, and legislative transparency have all been the direct result of civic-minded leaders deploying the initiative process for the public good.

California is not alone. In the last several years, the initiative process has led to redistricting in Arizona, and ranked-choice voting in Maine. In many other states, voters have approved public financing of elections, the adoption and preservation of Medicaid expansion, and marijuana legalization. Voter initiatives in several cities have also resulted in significant increases in the minimum wage and other worker benefits. On average, 150-200 initiative measures are on the ballot in states across the US every election year.

Now, leading reformers are seeking to launch a movement to use initiatives in a more coordinated national campaign. The lessons learned from the minimum-wage campaigns show the promise of such an effort. Beginning in mid-2016 in California and Washington, DC, ballot measures to raise minimum wages passed with overwhelming support. In November 2016, even as Donald Trump was winning the presidency, minimum-wage increases passed in Arizona, Colorado, Maine, and Washington by margins of 10-18 percentage points. Total spending of $25 million (less than was spent on a special election for the House of Representatives in Georgia) brought 8.1 million workers in six states a pay raise of over $2.5 billion (growing to more than $20 billion when fully implemented).

In November of this year, Maine shocked observers again, when voters there approved Medicaid expansion by 59-41%, overturning five vetoes by Governor Paul LePage of legislative efforts in favor of the expansion. For a total campaign cost of $1.7 million, 89,000 Maine citizens now stand to gain health insurance.

Watch this space. In 2018, initiatives for democratic reforms – including redistricting, stricter ethics standards, and broader voting rights – are in the process of being qualified across the country. These measures build on a legacy of reforms that have spread across the country over the last few election cycles.

The original Progressives would be proud. It may have taken more than a century, but their effort to ensure that democracy actually works, by putting power in the hands of citizens through the initiative process, created what may be the most powerful reform tool in US history. Let’s hope so.

Laura Tyson, a former chair of the US President's Council of Economic Advisers, is a professor at the Haas School of Business at the University of California, Berkeley, and a senior adviser at the Rock Creek Group.

Lenny Mendonca, Chairman of New America, is Senior Partner Emeritus at McKinsey & Company.

Reports Of My Demise Were Greatly Exaggerated

by: The Heisenberg

- And so we close the book on yet another extraordinary week for markets.

- This was the best week for U.S. stocks since 2013 and it comes one week after a veritable train wreck.

- What to make of it all? Well, I've got some thoughts.

- Here's a sweeping trip across markets complete with everything you'd expect from a Heisenberg Friday evening missive.

I don't think I have ever enjoyed commenting on markets as much as I have over the last two weeks.

This has been one of those most amusing and entertaining stretches I can remember, and I've been commenting on markets for a long - long - time (Heisenberg newcomers should note that the "Heisenberg" moniker is a fairly recent phenomenon; I've been doing this under my real name in one capacity or another for the entirety of my adult life).

The implosion of the short vol. trade prompted a swift reappraisal of things by investors and traders of all stripes which was highly amusing to observe for two reasons: 1) everyone who had studied those short vol. ETPs knew they were going to blow up one day and in the process cause a supercharged spike in the VIX, but more importantly 2) the proximate cause of the entire unfortunate episode that swiftly triggered a correction in global equities was the bond selloff catalyzed by signs of inflation pressure and the worsening fiscal outlook in the U.S. The point: exactly none of what happened was really "news".

In fact, "inflation surprise" and "bond crash" had been at the top of everyone's "biggest worries" list for months headed into 2018 and the tax cuts and fiscal stimulus were quite literally a campaign trail promise of Donald Trump's, so the deteriorating fiscal outlook was telegraphed a full 14 months in advance.

If you were bullish headed into 2018, you shouldn't have been surprised by the rapid rise in yields; I mean maybe the pace of it was a bit alarming, but not if you'd been paying attention to how things were developing over the preceding six months. Neither should you have been all that alarmed by the short vol. ETP blow-up because if you understood the mechanics of it, you would have known that while it would surely be painful in the short-term (you can't really "contain" a sudden 100% spike in the VIX), it was technical in nature (the reason the implosion of XIV was preordained was precisely because the risk and hence the fallout were to a large extent quantifiable ahead of time). So too was the domino effect from the VIX spike preordained and technical in nature. I've written so much about that over the last year I couldn't catalogue all of the articles if I tried, which is why last summer I simply dedicated an entire archive to it on my site just to make sure I had a convenient link to point people to when what I dubbed "the doom loop" was finally triggered.

You'll also note that one of the reasons why what happened earlier this month was so easy to call was because once it became apparent in late January that the rapid rise in yields was on the verge of flipping the stock-bond return correlation positive, you could see the systematic unwind coming. That was going to happen either way and indeed, risk parity had a terrible 5-day stretch the week prior to the short vol. implosion. So with the bond/equity correlation rising and momentum already reversing, it was going to be a rough stretch for some of the systematic crowd anyway.

Well, if you knew that and you also understood how pervasive the short vol. trade in all its various forms really was, it didn't take a leap of logic to understand that if something pushed up vol. enough to trigger the rebalance risk in the levered and short VIX ETPs, what was already a precarious situation for risk parity, CTAs, and the vol. targeting crowd would suddenly get worse in a hurry, likely leading to a cascade where that means deleveraging into a falling market. And that's exactly what happened.

CTAs and risk parity were forced to offload some $200 billion in equity exposure (on BofAML's estimates). More generally, think about what the implications were for global portfolio managers with positions already close to pre-defined risk limits measured with a VaR metric. Consider this from a Barclays note out last week:

For example, assume a risk manager is comfortable with an equity portfolio manager losing USD1mn in one month 5% of the time. Prior to the recent pickup in volatility, Figure 1 shows the 5th percentile equity portfolio return was -21.1%, suggesting a maximum position size of approximately USD4.7mn to stay within the defined VaR limit of USD1mn. With the recent pickup in implied volatility, however, the 5th percentile move has become more negative as the distribution of returns has become wider and is now -29.5%, implying a new VaR of almost USD1.4mn for the same portfolio – well above the USD1mn risk limit. To return to the VaR limit, the portfolio manager needs to reduce the position by about 28% to approximately USD3.4mn.

See this just underscores the notion that if you care at all about seeing these kind of unwinds coming, you really need to try and understand the underlying issues. People will tell you that wrapping your head around all of this isn't necessary for most investors and those people are absolutely right. But if that's the position you want to take, well then don't act surprised when you can't figure out how it's possible that we can have a week like February 5 through February 9, where the Dow has two 1,000+ point drops just two days apart and the VIX spikes 100% in a single afternoon.

And look, I don't want you to get the impression that it was just retail investors who were blindsided here. For instance, Shahraab Ahmad apparently took a 25% hit during the turmoil.

But there are indeed signs that retail still doesn't get it. Take a look at this chart:


As JPMorgan's Marko Kolanovic writes in a new note out Friday, it's not clear that people really understand how this works. To wit:
We note the drawdown in these products represents a permanent impairment to the strategy, and investors shouldn’t look for a return to previous trading levels even as volatility continues to fall. For example, SVXY peaked ~$138 in mid January and is currently trading ~$13—if the one-month weighted VIX future were to fall ~35% from the current level (~17.5) back to the same level as it was trading in mid January (~11.5), SVXY would only rally to ~$17.503 (i.e., 13 x 1.35) and would still trade ~87% below its recent peak.
See what I mean? Also, some of the smart money did indeed see this coming. Take Peter Thiel who, assuming he was still holding onto positions he had in December, very well might have made an obscene amount of money betting on a vol. spike. You can bet he understood what was going on here.

All of that said, you might very fairly point out that reports of the rally's demise were greatly exaggerated (hence the title of this post). After all, we just witnessed the best week for the S&P since 2013:


A couple of things to note here. First of all, history was on the bulls' side and there was no shortage of commentary to that effect last weekend. Goldman, for instance, wrote the following in a note dated February 9:
Most equity market corrections recover without developing into bear markets or presaging recessions. There have been 16 drawdowns of 10%+ since 1976. Of the 16 corrections, only five occurred around a recession. Of the remaining 11 non-recession episodes, 1987 was the only one that turned into a bear market.
Of course on the same day, the bank's co-head of global equities trading Brian Levine sent a letter to clients that, if you're inclined to being extremely cynical, seemed to contradict the more sanguine take that's evident in the excerpted passage above. Here's what Levine said about the outlook (full letter here):
Bottom line, we haven’t reached the short-term bottom, but you’ll know it when you see it (or at least 5 minutes later!). But longer-term, I do believe this is a genuine regime change, one where you sell-the-rallies rather than buy-the-dips.
Again, that sounds foreboding, but he didn't say "there will be no rallies." He just said the mindset might be shifting in terms of how people respond to rallies.

The point is, I'm not entirely sure the rally's demise was "greatly exaggerated." I mean sure, I talked a lot about what the pitfalls were and you can always find the doomsayers if you're looking for them, but the ostensibly "serious" folks were pretty measured if not outright bullish in their assessments following the pullback.

For instance, you might remember that one of the reasons cited for last Friday's late afternoon rally (so, the now infamous late-day surge that unfolded on February 9) was a note from JPMorgan's Nikolaos Panigirtzoglou. I wrote about that earlier this week. This is the headline that was blasted out on the Terminal at 3:30 ET that afternoon:


At least one commenter thought my article on that was silly (of course if you actually read my article as opposed to just skimming it, what you'll find is that I myself was very skeptical about whether the note in question was actually behind the surge, but you know, who reads the whole article, right?).

But as it turns out, that JPMorgan note proved to be pretty prescient. Because it basically suggested that if the overhang from systematic deleveraging was what was spooking people, that overhang was largely cleared. Sure enough, that was borne out this week and Marko Kolanovic himself was out on Friday reiterating the point. Here's what he said in the same note from which the bit about SVXY excerpted above is taken:
With nearly all of the required de-leveraging by systematic investors behind us, we believe markets should continue to recover. Further, systematic investors could begin to re-lever equity positions as momentum is positive at all but short-term horizons (allowing CTAs who were stopped out on the sharp sell-off last week to reenter longs) and realized volatility begins to decline (causing Volatility Targeting funds to gradually re-lever).
As I put it on Friday afternoon, last week’s forced systematic unwind is next week’s tailwind as the deleveraging offer turns into a re-leveraging bid.

Again, it's not clear that the rally's demise was "greatly exaggerated" and if it was, it was likely to the Johnny-come-lately retail crowd that was doing the exaggerating because as I showed you earlier this week, SPDR S&P 500 Trust ETF (SPY) saw a $23.6 billion outflow during the selloff.

(Bloomberg, Heisenberg)

That came hot on the heels of a record monthly inflow into U.S. equity ETFs in January, and January was also a month that saw E*Trade add 64,581 gross new brokerage accounts, the most for a single month since September of 2016:

(E*Trade data, Heisenberg)

So I guess when I hear people saying that the rally's demise was "greatly exaggerated", I wonder who that refers to. You can plausibly say it refers to me, but it certainly doesn't refer to some of the bigger names on the Street and when it comes to anecdotal evidence, it seems to me like the people who were panicking the most were the people who might not have had a firm grasp on things in the first place.

Anyway, the most interesting thing about this week (well, besides the fact that it was the second-best week for U.S. equities since December of 2011) was the extent to which equity traders' perception of rising inflation changed. There was myriad new evidence to support the notion that price pressures are rising in the U.S. and that foretells an end-of-cycle dynamic and presages a more aggressive Fed.

In other words, if you were worried about that average hourly earnings number that led directly to the selloff, well then you had even more reason to worry this week, courtesy of the CPI beat on Wednesday and then from Fed surveys and PPI data on Thursday, all of which supported the inflation narrative.

But stocks ignored it. And I have yet to hear a good explanation for why. I would just chalk it up to dip buying and the fact that the systematic deleveraging boogeyman is back in the closet for a while, if it weren't for the violent reaction in futures on Wednesday morning. Of course some of that was algos reading the headlines but still, there was exactly no evidence on Thursday and Friday that anyone was still worried about inflation pressures.

Ultimately, I think that's a mistake. Treasurys rallied on Friday helping yields retrace some of the post-CPI move higher, but we're still uncomfortably close to 3% on 10s. Beyond 3% is "where the wild things are" - so to speak.

This week, as fun as it was, raised more questions than it answered. At some point, equities are going to have to come to grips with rising inflation pressures and what that might mean for central bank forward guidance. Meanwhile, it is close to a foregone conclusion that the fiscal stimulus being piled atop the overheating U.S. economy is going to pull forward the end of cycle.

My guess would be that the disparity between how the market reacted to evidence of inflation this week and how the market reacted to evidence of inflation earlier this month will be reconciled sooner rather than later. Make sure you have a view on that. I'm not going to tell you what your view should be, but you need to have one. Either stocks were right in their interpretation this week or they were right earlier this month, but it can't possibly be both.

So there's my Friday night missive. It's close to 9:00 p.m. here on the island as I wrap it up.

Now it's time for a steak. Or a cigar. Or more likely both.

Iran’s Protests Are Over, but Uncertainty Lingers

By George Friedman, Phillip Orchard, and Xander Snyder

On Dec. 28, 2017, Iran’s second most populous city, Mashhad, situated in the northeast near the border with Turkmenistan, was the site of protests that would soon expand to dozens of towns, villages, and urban centers throughout the country. On the first day, three cities held demonstrations. (Some reports say it was five.) On the second day, an additional nine cities saw protests. By the sixth day, they had spread to all corners of the country.

Initially, the protests seemed to be focused on economic concerns, namely, the sharp increase in prices of two food staples: poultry and eggs. But within days they turned political, with protesters chanting anti-regime slogans such as “death to Khamenei,” “Khamenei’s regime is illegitimate,” and “free political prisoners.” President Hassan Rouhani delivered a speech acknowledging people’s grievances but stated that “violence and damage to public property” would not be tolerated. Ayatollah Ali Khamenei, the supreme leader of Iran, also gave a rare speech, accusing outsiders of instigating the uprising.

Source: Geopolitical Futures (Click to enlarge)

Now, the protests have dissipated and it seems that things have largely returned to normal. But while the regime was able to put down the unrest, it has been unable to address its underlying causes: a lack of economic opportunities combined with frustration over the regime’s continued spending on its own defense and foreign interventions in places such as Syria, Lebanon, and Yemen. The regime must choose between increasing spending on domestic economic initiatives that address the concerns of the population, or maintaining the strength—and loyalty—of the security apparatus that ensures the regime’s very survival. Both options come with drawbacks, none of which the regime can take lightly.

The regime in Iran has a history of suppressing protests and making small concessions to try to relieve the pressure caused by the demonstrations. Its response to the most recent protests is no different. A leaked version of the 2018 budget sparked anger in December over funding for the Islamic Revolutionary Guard Corps (IRGC) and cuts to public subsidies. (Ninety-five percent of Iranians receive such subsidies.) The regime subsequently made changes to the budget, and they appear to address some of the concerns: the planned cuts to cash subsidies will now target higher-income earners; a hike in fuel prices that was in the initial budget has been eliminated; and the government will set aside $3.3 billion to cover two million to three million depositors affected by unregulated credit institutions.

But Khamenei also allocated $2.5 billion of the country’s National Development Fund—which was estimated to have $68 billion in assets in 2016—for additional defense spending. Why would Iran continue to increase defense spending if it was the perception of a privileged IRGC—an institution that got more funding while subsidies for average Iranians were slashed—that set off the protests in the first place? The short answer is that Iran has no other option. It’s facing increasing security risks both at home and abroad, and it can’t afford to let its security institutions go underfunded.

Further complicating the situation are the divisions within the regime itself that are being exacerbated by the increasingly apparent socio-economic problems. To increase his own support base, President Hassan Rouhani is using the recent protests as evidence that the policies of the clerical elites, the main backers and beneficiaries of the IRGC, have failed. Khamenei, who is part of the clerical establishment, has cautiously acknowledged the concerns of the protesters but remains focused on strengthening and funding the IRGC to ensure its loyalty lies with the clerics.

At the same time, Khamenei instructed the IRGC last week to divest large portions of its business interests, which represent a substantial portion of the Iranian economy—30% by some estimates. The IRGC became increasingly involved in the management of the Iranian economy following the Iran-Iraq war when critical infrastructure needed to be rebuilt. Khamenei’s reasoning for wanting the IRGC to withdraw from the economy is two-fold. First, it attempts to address some of the protesters’ concerns by decreasing the IRGC’s economic power, but without actually defunding it. Second, and more important, privatization is seen as a step toward increasing transparency and, therefore, attracting more foreign investment, which remains at risk due to uncertainty over US commitment to the nuclear deal. Either way, divestment could create even more internal divisions, both between the clerics and the IRGC and also within the IRGC itself, because the organization’s leadership is split on whether to support the move.

The external pressures on Iran come from various sources but meet in one location: Syria. President Bashar al-Assad, an Iranian ally, is facing new challenges in western Syria. Turkey has invaded the northwestern Afrin region. Given the size of the Turkish force, its technological superiority, and the relatively small number of Kurdish defenders, it seems likely that Turkey will take control of it. And with that, Turkey will have essentially surrounded Aleppo, Syria’s largest city, on three sides.

Surrounding most of Aleppo with Turkish forces would present a major threat to both Assad and Iran. Iran has to consider the risks that a resurgent Turkey would pose to it and will therefore be highly motivated to keep its proxies in Syria and Iraq. Containing Turkey in northwestern Syria is cheaper and safer than trying to fight off Turkish troops in eastern Syria, assuming that they’re able to advance that far. But if Turkish-backed Sunni Arab forces can take control of eastern Syria—the areas that the Islamic State used to dominate—then the Iranian position in Iraq becomes vulnerable. A coalition of Sunni groups in eastern Syria can support the Sunni minority in western Iraq, which would be a threat to the Shiite-dominated regime in Baghdad.

Closer to home, the IRGC clashed with 21 IS militants in western Iran on Jan. 27. Iran believes that the fighters emerged from hiding in Kurdish-held areas of Syria, although it doesn’t seem to believe that the Kurds were assisting the militants. The Islamic State has lost most of its territory in Syria, but that doesn’t mean IS fighters have all left the country—they have simply blended into the local population. This was a small skirmish—although three Iranian soldiers were killed—and the IRGC was able to defeat the militants. IS suicide bombers and gunmen attacked Tehran in June, but this was the first time an organized IS militia has attacked Iran, driving home the fact that Iran is still at risk within its borders. The growing IS presence in Afghanistan, a country that shares a border with Iran, is also a concern.

While Iran has emerged from the Syrian civil war in a strong position relative to its regional adversaries, its social and political stability has been shaken. Eventually, Iran will be forced to make a choice, and this will limit its foreign adventures just as Turkey, its longtime nemesis, increases its power and its involvement in Syria, presenting an ever-greater challenge to Tehran.

A multi-level scourge

Pyramid schemes cause huge social harm in China

Crackdowns may not be working

THE authorities call them “business cults”. Tens of millions of people are ensnared in these pyramid schemes that use cult-like techniques to brainwash their targets and bilk them out of their money. In July 2017 victims of one such fraud held a rally in central Beijing (pictured), an extremely unusual occurrence. The police quickly dispersed it and the government, in panic, declared a three-month campaign against the scams. Hundreds of them were closed down and thousands of people arrested. But the cults are adopting new guises. The problem may still be growing.

Li Xu shows how they work and why they are so hard to fight. Mr Li was 34 when his family got him a job at Tianshi, which claimed to be a company selling cosmetics and health products in the coastal province of Jiangsu. He paid 2,800 yuan ($340) as a “joining fee” and rose quickly through the ranks. He recruited others, including his younger sister. “They gave you a vision of wealth and success,” he says. “It does wonders for your confidence.”

As he became more senior, however, Mr Li started to worry about the business. Its head office was miles from anywhere. Surrounded by colleagues day and night, he rarely saw outsiders, or customers—let alone the riches he had been promised. There is a genuine cosmetics company called Tianshi, but the firm Mr Li worked for was not it, nor did it seem to make money selling cosmetics. Rather, he thought, its revenue came from the “donations” which he, his sister and other members of the swelling workforce willingly paid out in the expectation of big returns. Eventually Mr Li realised the operation was a scam. The firm’s real business, he realised, was to trick people into handing over money and then persuade them to hoodwink others to do the same.

Mr Li left the firm and convinced his sister to do so as well. But most of his colleagues believed the company, not him. They stayed with it right up until it was closed down for breaking laws on fraud. Determined that others should not suffer as he had, Mr Li told his family that he was going to become an itinerant labourer. Instead, his travels took him in search of other victims of pyramid schemes. Most of those he found believed, like his former colleagues, that the companies which had taken their savings had their best interests at heart. Beginning with a couple of phones and volunteers, he founded and built up an NGO, the China Anti-Pyramid Promotional Association, into the main private institution taking on this warped product of China’s growth.

Many countries suffer from Ponzi schemes, which typically sell financial products offering extravagant rewards. They pay old investors out of new deposits, which means their liabilities exceed their assets; when recruitment falters, the schemes collapse. China is no exception. In 2016 it closed down Ezubao, a multi-billion-dollar scam that had drawn in more than 900,000 investors. By number of victims, it was the world’s largest such fraud.

Chinese pyramid schemes commonly practice “multi-level marketing” (MLM), a system whereby a salesperson earns money not just by selling a company’s goods but also from commissions on sales made by others, whom the first salesperson has recruited. People often earn more by recruiting others than from their own sales. Since 1998 China has banned the use of such methods, although it does allow some, mostly foreign, MLM companies to do business in China as “direct sellers”. This involves recruiting people to sell products at work or at home.

Family connections

The distinguishing feature of the Chinese scams is the way they combine pyramid-type operations with cult-like brainwashing. Typically, says Mr Li, a friend or family member will persuade a new recruit to go to an unfamiliar, often isolated place for a week of “introductions and training”. Cao Yuejie, for example, was enticed into joining such a scheme by her husband while on honeymoon. In many cases the recruiter (who is often duped) will spend the first three days trying to persuade the victim that the firm is a benevolent institution (not like those awful Ponzis!) and that working for it would be for the good of the family. For the next four days, the company’s representatives will appeal to the recruit’s ambition and greed, as well as his loyalty to his family.

In southern China these interactions usually take place in small groups, or one to one. In the north the persuasion is often done in groups of 30, crammed into a small room. In both systems victims sometimes have their mobile phones taken from them. They say they never have a moment to themselves. By the end, eight out of ten will leave but the last two will become converts. Once in the firm, everyone lives and eats together and sings communal songs. Some sample lyrics: “The poor shall escape their fate and the rich will gain more than they dream of.” “Invest once and your family will be rich for three generations.”

Many perfectly legal companies try to boost morale by getting staff to sing company songs or organising awaydays. China’s business cults, however, combine such techniques with violence. Zhang Chao was a 25-year-old who was trying to break away from an illegal MLM company outside the northern port city of Tianjin. He was found dead from heatstroke, dumped at the side of a road by colleagues. In another case, Cheng Cuiying and his wife walked for two days to Tianjin to rescue their son from an MLM business. They found him drowned in a lake. People were arrested in connection with both deaths. But the firms, and the money, disappeared.

Business cults seem to be growing. In the first nine months of 2017 the police brought cases against almost 6,000 of them, twice as many as in the whole of 2016 and three times the average annual number in 2005-15. This was just scratching the surface. In July 2017 the police arrested 230 leaders of Shan Xin Hui, a scheme that was launched in May 2016 and had an estimated 5m investors just 15 months later (see chart). In August 2017, after the government launched its campaign against “diehard scams”, police in the southern port of Beihai, Guangxi province, arrested 1,200 people for defrauding victims of 1.5bn yuan ($223m). One scheme in Guangxi, known as 1040 Project, was reckoned to have fleeced its targets of 600m yuan. If Mr Li’s estimate of tens of millions of victims is accurate, they must have handed over tens of billions of yuan in total.

The scale of the scams worries the government. Their cultish features make it even more anxious. The Communist Party worries about any social organisation that it does not control. Cults are especially worrisome because religious and quasi-religious activities give their followers a focus of loyalty that competes with the party. Hence the relentless repression since 1999 of Falun Gong, a spiritual movement which the government describes as a cult. Hence, too, new rules on religious activity that took effect on February 1st. They are aimed at reinforcing state control over worship, decreeing that no religion may imperil the stability of the state. The party decides what constitutes a threat. Its threshold is very low.

The case of Shan Xin Hui suggests that, although business cults are a problem, people do not blame the authorities for causing it. If anything they want the government to help the schemes. The protest in Beijing last July was held by thousands of Shan Xin Hui’s depositors. The authorities closed off roads in the city centre and sent the police to break up the demonstration. Yet the unrest was triggered not by the scam but by the arrest of the company’s bosses. “They have accused the company of pyramid selling, but they did nothing wrong. They only wanted to help poor people,” one demonstrator-investor told the Reuters news agency. “Shan Xin Hui supports the party’s leadership”, says the banner pictured on the previous page.

The authorities will find it hard to curb the scams for three main reasons. First, in order to encourage cheap loans for industry, the central bank keeps interest rates low. For years they were negative, ie, below inflation. That built up demand among China’s savers for better returns. With gross savings equal to just under half of GDP, it is not surprising that some of that pool of money should be attracted to schemes promising remarkable dividends.

Second, it is often hard for consumers to spot frauds. In 2005 China legalised direct selling, arguing that there was a distinction between that practice and the way that Ponzi schemes operate. But Qiao Xinsheng of Zhongnan University of Economics and Law argues that the difference is often “blurred” in the eyes of the public. Scammers can easily pass them themselves off as legitimate. Dodgy companies exploit government propaganda in order to pretend they have official status. For example, they may claim to be “new era” companies, borrowing a catchphrase of China’s president, Xi Jinping.

Third, argues Mr Li, business cults manipulate traditional attachments to kin. Companies in America often appeal to individual ambition, promising to show investors how to make money for themselves. Those in China offer to help the family, or a wider group. Shan Xin Hui literally means Kind Heart Exchange. It purported to be a charity, offering higher returns to poor investors than to rich ones. (In reality everyone got scammed.) Business cults rely on one family member to recruit another, and upon the obligation that relatives feel to trust each other. This helps explain why investors who have lost life savings continue to support the companies that defrauded them.

Off with their many heads

It also explains why they are hydra-like. As the authorities shut down large business-cults, smaller ones find new ways to survive. Experts say that, increasingly, pyramid schemes are moving onto the internet. They are often relatively small, usually with hundreds or thousands of followers, not millions. They cannot rely on brainwashing in an isolated location, as face-to-face schemes do. But they are skilled at using the closed environment of social-media chat groups to replicate that kind of real-world experience. And they appear to be flourishing.

These new forms could be even more pernicious than the old because they are extending their social reach. Previously, schemes concentrated on pensioners and migrant workers, the two groups that save the most in China. The new scammers target all sorts: from the ultra-rich with money to burn; to poor students who face a tightening job market; to the children of migrant workers, struggling with poor education and falling demand for cheap labour. It was bad enough when the scammers operated mainly on the margins of society, targeting its most isolated members. Now, says Mr Li ominously, “there is a business cult for everyone.”