What We’re Reading (Week Ending 11 September 2022) - 11 Sep 2022
Reading helps us learn about the world and it is a really important aspect of investing. The legendary Charlie Munger even goes so far as to say that “I don’t think you can get to be a really good investor over a broad range without doing a massive amount of reading.” We (the co-founders of Compounder Fund) read widely across a range of topics, including investing, business, technology, and the world in general. We want to regularly share the best articles we’ve come across recently. Here they are (for the week ending 11 September 2022):
1. The Stock Market’s Real Inflation Fighters Might Surprise You – Jason Zweig
We need to realize, though, that when we look back at the past, we don’t recapture it; we reconstitute it. We turn it into something it never was: clear from the start.
The stagflation of the past, so obvious to us now, was ambiguous then.
The rate of inflation fell sharply in 1971-72 and again in 1975-76 before going bonkers in 1979. Economic growth was flat in 1970; it went negative in 1974 and 1975 and again in 1980 and 1982, but exceeded 4% in five years of the 1970s.
The term “stagflation” didn’t even appear in The Wall Street Journal until April 1973 (although it was evidently coined by a British politician in 1965).
Like a funhouse mirror, hindsight distorts other facts.
Knowing today that the price of oil exploded over that period—crude went from under $3 a barrel to more than $39 between 1966 and 1980—you might expect that the energy industry dominated the list of the best-performing stocks of the time.
Nope.
Sure, a few, such as Texas Oil & Gas Corp., Southland Royalty Co. and Gearhart Industries Inc., were among the top performers.
The single-best performing stock between early 1966 and late 1982, however, was Tandy Corp. (later known as RadioShack Corp.). According to the Center for Research in Security Prices, Tandy returned 14,175% over that period.
The second-biggest winner? O’Sullivan Corp., a plastics manufacturer that also made rubber shoe heels, returned 4,820%.
Not far behind were media and entertainment giant Harcourt General Inc., up 3,196%; theater, tobacco and insurance conglomerate Loews Corp., up 3,190%; and retailer House of Fabrics Inc., up 2,916%.
Among those biggest winners, only Loews is still publicly traded, although a few stocks lower on the list of top performers, including CVS Health Corp. (up 2,005%) and Altria Group Inc. (up 1,738%), still exist.
CVS, however, wasn’t a huge drugstore chain then. It was part of Melville Corp.—the second discount footwear and apparel retailer, along with Scoa Industries, near the top of the list.
Say what?
Most of the companies that turned out to be the “superstocks” of this stagflationary period don’t seem to have had the ability to foist rising costs onto their customers without losing business.
That’s what professional investors call pricing power—and conventional wisdom says it’s what companies must have to prosper amid stagflation.
Certainly Altria Group, then Philip Morris Inc., had pricing power: Smokers generally don’t resist paying more over time for something they’re addicted to.
Also, products like tobacco and movies offer consolation in tough times. Alcohol and sugar companies did well, too.
Many other stars of that stagflationary time tell a different story, though.
Tandy’s TRS-80 desktop microcomputer was one of the first personal computers to hit the market. In a Wall Street Journal advertisement for the TRS-80 in 1978, Tandy emphasized its “affordability” at $599; by 1980, a far more powerful version cost just $699.
Between 1976 and 1982, Tandy’s earnings roughly quadrupled—not because it had pricing power, but because its business boomed in a stagnant economy.
Meanwhile, House of Fabrics, which sold sewing machines, textiles, “notions” and other cheap tchotchkes, also had little pricing power—but raked in cash anyway as consumers, reluctant to buy new clothes at ever-climbing prices, took to mending old ones at home.
2. YWR: 7 things I learned in Zimbabwe – Erik Renander
When I left HSBC in 2013 to join some friends investing in Africa, I didn’t know where in the continent I should expect to be focused, but probably something like Kenya. Instead, our firm had an office in Zimbabwe and was deeply engaged in the local market both in public and private equities. So my life took a turn and I went from living in San Francisco to spending a considerable amount of time at B&B’s in Harare. It turns out Harare is actually a really nice place. The people are pleasant and friendly, and it has the world’s best weather. 65-85 degrees all the time.
The Guinea Fowl’s Rest was my favorite B&B and run by a couple who had lost their dairy farm during the 1980’s farm invasions. This had forced them to move to the city and ‘make a plan’ as they say, which was to get into the hotel business. The routine on these trips was that after my day’s meetings I would return to the Guinea Fowl and enjoy a can of Castle Lager with the husband and talk about the history of Zimbabwe. We covered the big events from the 1980’s to the first hyperinflation in 2000 and then eventually the beginning of the second hyperinflation in 2016. The other fun thing was that at dinner we would all eat together at a big table with the other guests, so it was like the Zimbabwe version of the Joe Rogan show with lots of unexpected people and experiences.
The main story is that economically speaking Zimbabwe used to be well run with some of Africa’s best farms. They used to call it the bread basket of Africa. Harare used to be called Salisbury and was planned with wide roads, large parks and golf courses throughout the city. It’s quite unique in that way and why I always think Harare has amazing real estate potential.
Nowadays many of the farms are abandoned. It’s weird to mountain bike around and see rusty irrigation pivots which haven’t moved in 40 years. Zimbabwe has gone from the bread basket to importing most of its food from South Africa and Zambia. The power supply is barely functioning and generators run for hours a day. The buildings look like you have gone back in a time machine to the 1980’s.
Depending on the state of the hyperinflations sometimes you can get a wide variety of food items in the supermarkets, sometimes you can’t. There are also persistent problems in getting your money out of the country because the central bank tries to manage the currency at unrealistic levels. If you need dollars you go to the guys on the street. There are also the sanctions. The UK government is only sanctioning three insignificant entities, but try telling that to a western bank. All they know is Zimbabwe = Sanctions and they don’t care about the fine print. Which is a shame for 15 million people in the country. In summary, it’s been a disaster…
…The market can go up a surprising amount even though things are ‘bad’. In fact the worse things are the more the market rises. ‘Bad’ = ‘Bull Market’. Yes, there can be abrupt shake outs, but that is part of the bull market. I also draw your attention to the 50% sell off from 2014 to 2015. That was when I was there. Things were definitely deteriorating and sliding from a period of calm into the hyperinflation. As you can see there was a 50% market decline before the 87x gain. Maybe with the current situation in the world we get a 2014-2015 type situation in global markets, followed by a Zimbabwe style bull market. Then again it’s hard to call. If your time frame is long enough maybe you just sit tight…
…Even though the pie is shrinking the big can get bigger. When the economy is going into a recession it’s easy to think it will be bad for everyone, but what I noticed is for the well run companies this can actually be the best of times. I’ve watched smart CEO’s acquire all their struggling competitors during the downturns and actually post great earnings growth even as the economy is crashing. The economic pie is shrinking but they keep eating a bigger and bigger slice. It’s almost as if the bad times are good for them. Again, ‘bad economy’ can paradoxically equal good returns.
As inflation kicks in earnings grow tremendously. This is kind of obvious but worth remembering. Inflation increases the prices of everything in nominal terms, so stated company earnings explode. Economists always talk about ‘real’ earnings but stock market prices are based on nominal earnings. It’s something to remember with 8% inflation in the U.S. Corporate earnings might surprise quite positively this year. Below is the Commercial Bank of Zimbabwe’s 4 year earnings trend from when they earned 5 ZWL/share in 2017 when the FX rate was 1 ZWL/$ to 1,184/per share when it is 220 ZWL/$.
Successful entrepreneurs carefully leverage their assets. There is a key realisation which happens when you are in a hyper-inflationary environment. You realise the real way to preserve value is to leverage your business or real estate and that you aren’t really making money from the house price going up, but rather from the value of the loan going down. It seems like you are buying an asset, but really you are shorting the currency. The balancing act is to make sure you aren’t over leveraged, and have stable cash flows so you can stay in the game. The smart entrepreneurs would obsess about the cash flows of the businesses they were buying because as soon as they were done buying the business they would go to the bank to borrow more money.
3. The quantum computing bubble – Nikita Gourianov
Quantum computing is often portrayed as an up-and-coming technology whose eventual impact will only be rivalled by artificial intelligence. According to the quantum evangelists, it is only a matter of time before a fully-functional quantum computer will appear and do everything from revolutionising drug development to cracking internet encryption schemes.
Billions of dollars have poured into the field in recent years, culminating with the public market debuts of prominent quantum computing companies like IonQ, Rigetti and D-Wave through 2021’s favourite frothy market phenomenon, special purpose acquisition vehicles (Spacs)…
…The reality is that none of these companies — or any other quantum computing firm, for that matter — are actually earning any real money. The little revenue they generate mostly comes from consulting missions aimed at teaching other companies about “how quantum computers will help their business”, as opposed to genuinely harnessing any advantages that quantum computers have over classical computers.
The simple reason for this is that despite years of effort nobody has yet come close to building a quantum machine that is actually capable of solving practical problems. The current devices are so error-prone that any information one tries to process with them will almost instantly degenerate into noise. The problem only grows worse if the computer is scaled up (ie, the number of “qubits” increased).
A convincing strategy for overcoming these errors has not yet been demonstrated, making it unclear as to when — if ever — it will become possible to build a large-scale, fault-tolerant quantum computer. Yet according to the evangelists, we are apparently in the middle of a Quantum Moore’s Law (aka “Rose’s Law”, after D-Wave founder Geordie Rose) analogous to the microchip revolution of the 1970s — 2010s.
Another fundamental issue is that it is unclear what commercially-useful problems can even be solved with quantum computers — if any.
The most prominent application by far is the Shor algorithm for factorising large numbers into their constituent primes, which is exponentially faster than any known corresponding scheme running on a classical computer. Since most cryptography currently used to protect our internet traffic are based on the assumed hardness of the prime factorisation problem, the sudden appearance of an actually functional quantum computer capable of running Shor’s algorithm would indeed pose a major security risk.
Shor’s algorithm has been a godsend to the quantum industry, leading to untold amounts of funding from government security agencies all over the world. However, the commonly forgotten caveat here is that there are many alternative cryptographic schemes that are not vulnerable to quantum computers. It would be far from impossible to simply replace these vulnerable schemes with so-called “quantum-secure” ones.
And the uncertain practical viability of Shor’s algorithm is only the tip of the iceberg. There has been much controversy regarding where and when quantum computing can actually offer any practical advantage. The latest research points out that there is no evidence that even quantum chemistry calculations can be significantly sped up with quantum computers. That is bad news for the much-touted idea of quantum computers being useful for drug design.
4. The Long Tail: The Internet and the Business of Niche – Rex Woodbury
The concept of the long tail was popularized by Chris Anderson in an October 2004 article in WIRED. Anderson’s opening lines read like a prophecy of YouTube, which would be founded the following year:
“Forget squeezing millions from a few megahits at the top of the charts. The future of entertainment is in the millions of niche markets at the shallow end of the bitstream.”
I’ve written in the past about another quote in WIRED, one that didn’t age quite so well. In 2005, the media mogul Barry Diller declared:
“There is not that much talent in the world. There are very few people in very few closets in very few rooms that are really talented and can’t get out. People with talent and expertise at making entertainment products are not going to be displaced by 1,800 people coming up with their videos that they think are going to have an appeal.”
Yikes. It turned out that there was a lot of talent in the world—many people in many closets in many rooms. The same year that Barry Diller uttered those words, YouTube was born in a small room above a pizzeria in San Mateo. On April 23, 2005, the first YouTube video was posted. The video is titled “Me at the zoo” and features YouTube cofounder Jawed Karim…at the zoo. In the 18-second clip, he talks about elephants and their trunks 🐘
The concept of the long tail remains one of the best investing frameworks for internet companies. Many of the most successful technology companies in history have been built on the long tail. Google and Facebook turn to small businesses for the lion’s share of their advertising revenue. Ebay grew by tapping into a variety of niche interests and markets. Some of our most successful investments at Index have harnessed the power of niche: Etsy showed that a lot of people are interested in buying (and making) artisanal products; GOAT showed that sneakers are a deceptively large market; Discord has 19 million (!) weekly active servers.
One of the powers of the long tail is its ability to expand selection. Amazon might be the best example. As Anderson put it in 2004:
What’s really amazing about the Long Tail is the sheer size of it. Combine enough non-hits on the Long Tail and you’ve got a market bigger than the hits. Take books: The average Barnes & Noble carries 130,000 titles. Yet more than half of Amazon’s book sales come from outside its top 130,000 titles…
…The two major categories for the long tail framework are content and commerce.
Let’s start with content. TikTok is the best modern extension of this framework. Building on the concept of recommendations, TikTok’s For You Page is entirely algorithmically-generated, tailor-made to the user’s tastes and preferences. And TikTok’s built-in creation tools make producing content easier, enabling the long tail to be even longer than it is on YouTube.
TikTok relies heavily on remix culture, allowing people to build on each other’s sounds and trends; this removes the friction to create that exists even with robust creation tools (“What video should I make?”) and leads to a stunning amount of creativity..
…As creation gets even easier, the long tail will continue to lengthen. Innovations like Midjourney, DALL-E, and StableDiffusion—which provide text to image AI generation—may unlock new levels of creativity and expression. This will shift content even more away from the handful of big-budget hits, and more to the long tail of creators.
5. The Transcript Q2 2022 Letter – The Transcript
Despite concerns of a recession, we’ve cataloged more positive macroeconomic commentary than negative commentary in recent weeks. Still, we’ve recently been noticing that there is a negative divergence between macroeconomic and microeconomic commentary. Many companies are seeing signs that could indicate that we are in the early stages of deceleration. These signs include bloated retail inventories, lower-income consumers trading down, falling used car prices, the pace of hiring slowing down, and weak consumer electronics sales, to name but a few.
“So as used car prices are moderating there, we’re sort of — we’re buying and as the prices are falling. So we’re having to sell at a — the spread that we’ve established isn’t as wide as we would have expected.” – IAA CEO John Kett (22nd Aug: Under Pressure)
“We are observing some trade-down behavior within various classes at home..It’s not that specific types of goods are getting traded down, other types of goods aren’t. It’s more a little bit across the board” – Wayfair CEO Niraj Shah (8th Aug: Optimism Prevails)
“At the end of Q2, Walmart U.S. inventory growth was 26% versus last year, reflecting over 750 basis points of improvement from Q1 levels — We have cleared most summer seasonal inventory, but we are still focused on reducing exposure to other areas such as electronics, home, and sporting goods.” – Walmart CFO John Rainey (22nd Aug: Under Pressure)…
…Internationally, global economies seem to be fighting the same forces as the US economy. In many countries, the trouble appears even more severe than in the US. In Europe, energy prices are weighing heavily on economic activity. There appears to be particular concern about the way that high energy prices will impact the European economy as we approach winter.
“Turning to gas prices — The outlook for global gas prices is heavily dependent on Russian pipeline flows. We expect prices to remain elevated and volatile during the third quarter, due to a lack of supply to Europe.” – BP CFO Murray Auchincloss (8th Aug: Optimism Prevails)
“One of the areas that I’m keeping a close eye on is Europe. We’re seeing a lot of challenges in Europe, seeing energy prices, for example, are really, really high over in Europe. We’re coming into the winter session. So you could see potentially less graphic related to people cutting subscriptions or doing things like that, less shopping online” – Akamai CFO Edward McGowan (16th Aug: Cost Pressures Falling)…
…Credit quality still remains strong overall at US banks. There aren’t any signs of deterioration despite economic pressure. There are some pockets where credit card delinquency rates are up slightly but still at historical lows:
“While delinquency rates have increased slightly, they remain near historical lows. We expect credit cards to be less negatively impacted by a mild recession than personal loans. In the mild recession of ‘01-02, credit card originations declined only a few points. And for context, credit cards represent nearly half of credit card revenue in fiscal year 2022.” – Intuit CEO Sasan Goodarzi (29th Aug: Until the Job is Done)…
…In general consumer spending has remained strong but is facing a myriad of challenges. The consumers are now under pressure and there are some signs that low-income consumers are feeling especially squeezed by the environment.
“The consumer, which is the backbone of the U.S. economy, well, he may still be spending but this confidence is the lowest point it’s been in decades and it’s even worse in Europe. So there’s no question that the consumer will stop spending the way he has spent in my mind…he’s facing dwindling savings rates because he’s spending his money on gas, food, rents and housing prices, and interest expense. I don’t see the offset” – Starwood Property Trust CEO Barry Sternlicht (8th Aug: Optimism Prevails)
The big question going forward is whether this pressure will extend to higher-income consumers. We have recently seen comments from Walmart and Dollar General indicating that they are seeing households making $100,000 per year trading down. If higher-income consumer spending is starting to weaken then it would likely be a factor pointing towards recession.
“We believe we’ll be able to capitalize on that trade-down that we’re already seeing. And that trade-down is coming from income levels that are upwards of $100,000 which we really are encouraged in seeing a younger consumer, a little bit more affluent, and again, very digitally and tech-savvy.” – Dollar General CEO Todd J. Vasos (29th Aug: Until the Job is Done)…
…We’ve also seen signs that tech spending is under pressure. We’ve heard that consumers are spending less on PCs and smartphones, which is impacting semiconductor companies.
“…we anticipated there would be inventory adjustments in PC and smartphones and then some isolated adjustments in some other areas like enterprise. And that happened, of course — But actually, in the quarter here that we’re in, the August quarter, it’s broadened and actually weakened more. We’re seeing inventory adjustments across most end markets. That includes the cloud” – Micron CFO Mark Murphy (16th Aug: Cost Pressures Falling)
Salesforce also indicated that IT spending has been more cautious recently, which would be another significant change in trend and a negative macro data point.
“…we started to see more measured buying behavior from our customers, which began in the last month of the quarter. This resulted in stretched sales cycles, additional deal approval layers, and deal compression.” – Salesforce CFO Amy Weaver (29th Aug: Until the Job is Done)..
…Oil companies are generating strong profits in the current environment and are very bullish on their long-term prospects. Executives say that oil supply and demand are out of balance: demand has rebounded but new supply is not coming online. Given the source, we take these forecasts with a grain of salt, but the facts do not sound inaccurate. If it is true that there is an upside to oil prices, it would be an unwelcome inflationary surprise.
“Global oil demand is now similar to pre-pandemic levels. And while there are growing concerns about potential demand impacts from a recessionary environment, supply factors may overwhelm those demand impacts. In previous cycles, high oil prices have led to significantly oversupplied markets. In the current situation, however, major sources of supply are below pre-pandemic levels and trending lower” – Pason Systems CEO Jon Faber President (22nd Aug: Under Pressure)
6. Good Enough – Morgan Housel
Small, brightly colored, and terrible at defense, the guppy faces an unusually high rate of predator attacks. Birds eat guppies. Small fish eat guppies. Big fish eat guppies. Crabs eat guppies. It’s everyone’s favorite lunch.
How does a species under so much threat avoid extinction?
In short, guppies get busy as soon as they’re born. They can reproduce at seven weeks old, and deliver new offspring every 30 days. By the time a six-month-old guppy is eaten by a bird it might be a great-great-grandmother. The family lives on.
But this evolutionary trick has a nasty flip side.
Knowing how much danger they’re in, guppies expend nearly all their energy on reproducing from the moment they’re born. They grow as fast as possible, then devote a huge portion of their resources to nourishing their young.
That leaves little energy left to care for themselves. Their bodies are thrown together slipshod, like cheap plastic toys, and few resources are available for cell repair and maintenance. By the age of a year or two old it’s a crusty senior citizen, crippled by disease and decline, soon to go belly up. That’s how it should be: No use investing in the future when you’re likely to be eaten anyway.
Now compare the guppy with the Greenland shark, whose life is nearly a mirror image.
The Greenland shark has no natural predator. It rules its habitat like a dictator.
With few threats, it takes its sweet time becoming an adult. It’s one of the slowest-growing creatures we’ve discovered, reaching sexual maturity at – and this isn’t a typo – 150 years old.
In the meantime it spends more than a century devoting its energy to building itself a perfect body. Slow and methodical, with all of its resources going to cell repair and maintenance, it becomes virtually immune to cancer and infectious disease. As best we can tell a Greenland shark can live for 500 years, maybe more.
The point is that nature is very good at assessing future risk and uncertainty and allocating resources accordingly…
…Everyone knows the economy is hard to predict, and the history of economic predictions is abysmal.
But leaving it at that is too simplistic.
I think we’re actually very good at predicting the future – except for the surprises, which tend to be all that matter.
In most years the biggest economic risk turns out to be something nobody could have seen coming at the beginning of that year. 9/11, or Covid, or Lehman Brothers’ failure to find a buyer, or Russia invading Ukraine – the biggest risk is always what you don’t and can’t see coming…
…Investing in your long-term future is of course great, because the odds that you’ll be around and everyone else will become more productive are pretty good.
But trying to predict the exact path we’ll take to get there can be such a waste of resources.
I describe my forecasting model as “good enough.”
I’m confident people will solve problems and become more productive over time.
I’m confident markets will allocate the rewards of that productivity to investors over time.
I’m confident in other people’s overconfidence, so I know there will be mistakes and accidents and booms and busts along the way.
It’s not detailed, but it’s good enough.
When you keep forecasting that simple, you free up time and bandwidth to invest elsewhere. I like studying the investing behaviors that never change, and I’d never have the time to do that if I spent my day predicting what the economy will do next quarter. For others it’s operating a business, or understanding an industry. Or something else entirely.
7. The Weakness of Xi Jinping – Cai Xia
I have long had a front-row seat to the CCP’s court intrigue. For 15 years, I was a professor in the Central Party School, where I helped train thousands of high-ranking CCP cadres who staff China’s bureaucracy. During my tenure at the school, I advised the CCP’s top leadership on building the party, and I continued to do so after retiring in 2012. In 2020, after I criticized Xi, I was expelled from the party, stripped of my retirement benefits, and warned that my safety was in danger. I now live in exile in the United States, but I stay in touch with many of my contacts in China…
…Another feature of the party system has remained constant: the importance of personal connections. When it comes to one’s rise within the party hierarchy, individual relationships, including one’s family reputation and Communist pedigree, matter as much as competence and ideology.
That was certainly the case with Xi’s career. Contrary to Chinese propaganda and the assessment of many Western analysts that he rose through his talent, the opposite is true. Xi benefited immensely from the connections of his father, Xi Zhongxun, a CCP leader with impeccable revolutionary credentials who served briefly as propaganda minister under Mao. When Xi Jinping was a county party chief in the northern province of Hebei in the early 1980s, his mother wrote a note to the province’s party chief asking him to take an interest in Xi’s advancement. But that official, Gao Yang, ended up disclosing the note’s content at a meeting of the province’s Politburo Standing Committee. The revelation was a great embarrassment to the family since it violated the CCP’s new campaign against seeking favors. (Xi would never forget the incident: in 2009, when Gao died, he pointedly declined to attend his funeral, a breach of custom given that both had served as president of the Central Party School.) Such a scandal would have ruined the average rising cadre’s career, but Xi’s connections came to the rescue: the father of Fujian’s party chief had been a close confidant of Xi’s father, and the families arranged a rare reassignment to that province.
Xi would continue to fail upward. In 1988, after losing his bid for deputy mayor in a local election, he was promoted to district party chief. Once there, however, Xi languished on account of his middling performance. In the CCP, moving from the district level to the provincial level is a major hurdle, and for years, he could not overcome it. But once again, family connections intervened. In 1992, after Xi’s mother wrote a plea to the new party leader in Fujian, Jia Qinglin, Xi was transferred to the provincial capital. At that point, his career took off…
…When Xi took the reins, many in the West hailed him as a Chinese Mikhail Gorbachev. Some imagined that, like the Soviet Union’s final leader, Xi would embrace radical reforms, releasing the state’s grip on the economy and democratizing the political system. That, of course, turned out to be a fantasy. Instead, Xi, a devoted student of Mao and just as eager to leave his mark on history, has worked to establish his absolute power. And because previous reforms failed to place real checks and balances on the party leader, he has succeeded. Now, as under Mao, China is a one-man show.
One part of Xi’s plot to consolidate power was to solve what he characterized as an ideological crisis. The Internet, he said, was an existential threat to the CCP, having caused the party to lose control of people’s minds. So Xi cracked down on bloggers and online activists, censored dissent, and strengthened China’s “great firewall” to restrict access to foreign websites. The effect was to strangle a nascent civil society and eliminate public opinion as a check on Xi.
Another step he took was to launch an anticorruption campaign, framing it as a mission to save the party from self-destruction. Since corruption was endemic in China, with nearly every official a potential target, Xi was able to use the campaign as a political purge. Official data show that from December 2012 to June 2021, the CCP investigated 393 leading cadres above the provincial ministerial level, officials who are often being groomed for top positions, as well as 631,000 section-level cadres, foot soldiers who implement the CCP’s policies at the grassroots level. The purge has ensnared some of the most powerful officials whom Xi deemed threatening, including Zhou Yongkang, a former Standing Committee member and the head of China’s security apparatus, and Sun Zhengcai, a Politburo member whom many saw as a rival and potential successor to Xi.
Tellingly, those who helped Xi rise have been left untouched. Jia Qinglin, Fujian’s party chief in the 1990s and eventually a member of the Standing Committee, was instrumental in helping Xi climb the ranks of power. Although there is reason to believe that he and his family are exceedingly corrupt—the Panama Papers, the trove of leaked documents from a law firm, revealed that his granddaughter and son-in-law own several secret offshore companies—they have not been caught up in Xi’s anticorruption campaign.
Xi’s tactics are not subtle. As I learned from one party insider whom I cannot name for fear of getting him in trouble, around 2014, Xi’s men went to a high-ranking official who had openly criticized Xi and threatened him with a corruption investigation if he didn’t stop. (He shut up.) In pursuing their targets, Xi’s subordinates often pressure officials’ family members and assistants. Wang Min, the party chief of Liaoning Province, whom I knew well from our days as students at the Central Party School, was arrested in 2016 on the basis of statements from his chauffeur, who said that while in the car, Wang had complained to a fellow passenger about being passed over for promotion. Wang was sentenced to life in prison, with one of the charges being resistance to Xi’s leadership.
After ejecting his rivals from key positions, Xi installed his own people. Xi’s lineage within the party is known as the “New Zhijiang Army.” The group consists of his former subordinates during his time as governor of Fujian and Zhejiang Provinces and even university classmates and old friends going back to middle school. Since assuming power, Xi has quickly promoted his acolytes, often beyond their level of competence. His roommate from his days at Tsinghua University, Chen Xi, was named head of the CCP’s Organization Department, a position that comes with a seat on the Politburo and the power to decide who can move up the hierarchy. Yet Chen has no relevant qualifications: his five immediate predecessors had experience with local party affairs, whereas he spent nearly all his career at Tsinghua University.
Xi undid another major reform: “the separation of party and state,” an effort to reduce the degree to which ideologically driven party cadres interfered with technical and managerial decisions in government agencies. In an attempt to professionalize the bureaucracy, Deng and his successors tried, with varying degrees of success, to insulate the administration from CCP interference. Xi has backtracked, introducing some 40 ad hoc party commissions that end up directing governmental agencies. Unlike his predecessors, for example, he has his own team to handle issues regarding the South China Sea, bypassing the Foreign Ministry and the State Oceanic Administration.
The effect of these commissions has been to take significant power away from the head of China’s government, Premier Li Keqiang, and turn what was once a position of co-captain into a sidekick. The change can be seen in the way Li comports himself in public appearances. Whereas Li’s two immediate predecessors, Zhu Rongji and Wen Jiabao, stood side by side with Jiang and Hu, respectively, Li knows to keep his distance from Xi, as if to emphasize the power differential. Moreover, in the past, official communications and state media referred to the “Jiang-Zhu system” and the “Hu-Wen system,” but almost no one today speaks of a “Xi-Li system.” There has long been a push and pull between the party and the government in China—what insiders call the struggle between the “South Courtyard” and the “North Courtyard” of Zhongnanhai, the imperial compound that hosts the headquarters of both institutions. But by insisting that everyone look up to him as the highest authority, Xi has exacerbated tensions…
…In any political system, unchecked power is dangerous. Detached from reality and freed from the constraint of consensus, a leader can act rashly, implementing policies that are unwise, unpopular, or both. Not surprisingly, then, Xi’s know-it-all style of rule has led to a number of disastrous decisions. The common theme is an inability to grasp the practical effect of his directives.
Consider foreign policy. Breaking with Deng’s dictum that China “hide its strength and bide its time,” Xi has decided to directly challenge the United States and pursue a China-centric world order. That is why he has engaged in risky and aggressive behavior abroad, militarizing the South China Sea, threatening Taiwan, and encouraging his diplomats to engage in an abrasive style of foreign policy known as “Wolf Warrior” diplomacy. Xi has formed a de facto alliance with Russian President Vladimir Putin, further alienating China from the international community. His Belt and Road Initiative has generated growing resistance as countries tire of the associated debt and corruption.
Xi’s economic policies are similarly counterproductive. The introduction of market reforms was one of the CCP’s signature achievements, allowing hundreds of millions of Chinese to escape poverty. But when Xi came to power, he came to see the private sector as a threat to his rule and revived the planned economy of the Maoist era. He strengthened state-owned enterprises and established party organizations in the private sector that direct the way businesses are run. Under the guise of fighting corruption and enforcing antitrust law, he has plundered assets from private companies and entrepreneurs. Over the past few years, some of China’s most dynamic companies, including the Anbang Insurance Group and the conglomerate HNA Group, have effectively been forced to hand over control of their businesses to the state. Others, such as the conglomerate Tencent and the e-commerce giant Alibaba, have been brought to heel through a combination of new regulations, investigations, and fines. In 2020, Sun Dawu, the billionaire owner of an agricultural conglomerate who had publicly criticized Xi for his crackdown on human rights lawyers, was arrested on false charges and soon sentenced to 18 years in prison. His business was sold to a hastily formed state company in a sham auction for a fraction of its true value.
Predictably, China has seen its economic growth slow, and most analysts believe it will slow even more in the coming years. Although several factors are at play—including U.S. sanctions against Chinese tech companies, the war in Ukraine, and the COVID-19 pandemic—the fundamental problem is the CCP’s interference in the economy. The government constantly meddles in the private sector to achieve political goals, a proven poison for productivity. Many Chinese entrepreneurs live in fear that their businesses will be seized or that they themselves will be detained, hardly the kind of mindset inclined to innovation. In April, as China’s growth prospects worsened, Xi hosted a meeting of the Politburo to unveil his remedy for the country’s economic woes: a combination of tax rebates, fee reductions, infrastructure investment, and monetary easing. But since none of these proposals solve the underlying problem of excessive state intervention in the economy, they are doomed to fail.
Nowhere has Xi’s desire for control been more disastrous than in his reaction to COVID-19. When the disease first spread in the city of Wuhan in December 2019, Xi withheld information about it from the public in an attempt to preserve the image of a flourishing China. Local officials, meanwhile, were paralyzed. As Wuhan’s mayor, Zhou Xianwang, admitted the next month on state television, without approval from above, he had been unable to publicly disclose the outbreak. When eight brave health professionals blew the whistle about it, the government detained and silenced them. One of the eight later revealed that he had been forced to sign a false confession.
Xi’s tendency to micromanage also inhibited his response to the pandemic. Instead of leaving the details of policy to the government’s health team, Xi insisted that he himself coordinate China’s efforts. Later, Xi would boast that he “personally commanded, planned the response, oversaw the general situation, acted decisively, and pointed the way forward.” To the extent that this was true, it was not for the better. In fact, his interference led to confusion and inaction, with local health officials receiving mixed messages from Beijing and refusing to act. As I learned from a source on the State Council (China’s chief administrative authority), Premier Li Keqiang proposed activating an emergency-response protocol in early January 2020, but Xi refused to approve it for fear of spoiling the ongoing Chinese New Year celebrations.
When the Omicron variant of the virus surged in Shanghai in February 2022, Xi yet again chose a baffling way to respond. The details of the decision-making process were relayed to me by a contact who works at the State Council. In an online gathering of about 60 pandemic experts held shortly after the outbreak began, everyone agreed that if Shanghai simply followed the latest official guidelines, which relaxed the quarantine requirements, then life in the city could go on more or less as usual. Many of the city’s party and health officials were on board with this approach. But when Xi heard about it, he became furious. Refusing to listen to the experts, he insisted on enforcing his “zero COVID” policy. Shanghai’s tens of millions of residents were forbidden from going outside, even to get groceries or receive life-saving health care. Some died at the gates of hospitals; others leaped to their deaths from their apartment buildings.
Just like that, a modern, prosperous city was turned into the site of a humanitarian disaster, with people starving and babies separated from their parents. A leader more open to influence or subject to greater checks would not likely have implemented such a draconian policy, or at least would have corrected course once its costs and unpopularity became evident. But for Xi, backtracking would have been an unthinkable admission of error…
…Indignation at the elite level is replicating itself further down the bureaucracy. Early in Xi’s tenure, as he began to shuffle power, many in the bureaucracy grew disgruntled and disillusioned. But their resistance was passive, expressed through inaction. Local cadres took sick leave en masse or came up with excuses to stall Xi’s anticorruption initiatives. At the end of 2021, the CCP’s disciplinary commission announced that in the first ten months of that year, it had found 247,000 cases of “ineffective implementation of Xi Jinping’s and the Central Committee’s important instructions.” During the Shanghai lockdown, however, resistance became more overt. On social media, local officials openly criticized the zero-COVID policy. In April, members of the residents’ committee of Sanlin Town, a neighborhood in Shanghai, collectively resigned, complaining in an open letter that they had been sealed in their offices for 24 days with no access to their families.
Even more troubling for Xi, elite dissatisfaction is now spreading to the general public. In an authoritarian state, it is impossible to accurately measure public opinion, but Xi’s harsh COVID measures may well have lost him the affection of most Chinese. An early note of dissent came in February 2020, when the real estate tycoon Ren Zhiqiang called him a “clown” for bungling the response to the pandemic. (After a one-day trial, Ren was sentenced to 18 years in prison.) Chinese social media platforms are awash in videos in which ordinary people beg Xi to end his zero-COVID policy. In May, a group calling itself the “Shanghai Self-Saving Autonomous Committee” released a manifesto online titled, “Don’t be a slave—save yourself.” The document called on the city’s residents to fight the lockdown and form self-governing bodies to help one another. On social media, some Chinese have sarcastically proposed that the most effective plan for fighting the pandemic would be to convene the 20th National Congress as soon as possible to prevent Xi from staying in power.
Meanwhile, despite Xi’s claims of having vanquished poverty, most Chinese continue to struggle to make ends meet. As Li revealed in 2020, 600 million people in China—some 40 percent of its population—barely earned $140 a month. According to data obtained by the South China Morning Post, a Hong Kong newspaper, some 4.4 million small businesses closed between January and November 2021, more than three times the number of newly registered companies in the same period. Facing a financial crisis, local governments have been forced to slash government salaries—sometimes by as much as 50 percent, including pay for teachers. They will likely resort to finding new ways of plundering wealth from the private sector and ordinary citizens, in turn generating even more economic misery. After four decades of opening up, most Chinese don’t want to go back to the days of Mao. Within the CCP elite, many resent Xi’s disruption of the traditional power distribution and think his reckless policies are jeopardizing the future of the party. The result is that for the first time since the 1989 Tiananmen Square protests, China’s leader is facing not only internal dissent but also an intense popular backlash and a real risk of social unrest…
…Despite all this, the most likely outcome this fall is that Xi, having so rigged the process and intimidated his rivals, will get his third presidential term and, with it, the right to continue as head of the party and the military for another term. And just like that, the only meaningful political reform made since Deng’s rule will go up in smoke.
What then? Xi will no doubt see his victory as a mandate to do whatever he wants to achieve the party’s stated goal of rejuvenating China. His ambitions will rise to new heights. In a futile attempt to invigorate the economy without empowering the private sector, Xi will double down on his statist economic policies. To maintain his grip on power, he will continue to preemptively eliminate any potential rivals and tighten social control, making China look increasingly like North Korea. Xi might even try to stay in power well beyond a third term. An emboldened Xi may well accelerate his militarization of disputed areas of the South China Sea and try to forcibly take over Taiwan. As he continues China’s quest for dominance, he will further its isolation from the rest of the world.
But none of these moves would make discontent within the party magically disappear. The feat of gaining a third term would not mollify those within the CCP who resent his accumulation of power and reject his cult of personality, nor would it solve his growing legitimacy problem among the people. In fact, the moves he would likely make in a third term would raise the odds of war, social unrest, and economic crisis, exacerbating existing grievances. Even in China, it takes more than sheer force and intimidation to stay in power; performance still matters. Mao and Deng earned their authority through accomplishments—Mao by liberating China from the Nationalists, and Deng by opening it up and unleashing an economic boom. But Xi can point to no such concrete triumphs. He has less margin for error.
The only viable way of changing course, so far as I can see, is also the scariest and deadliest: a humiliating defeat in a war. If Xi were to attack Taiwan, his likeliest target, there is a good chance that the war would not go as planned, and Taiwan, with American help, would be able to resist invasion and inflict grave damage on mainland China. In that event, the elites and the masses would abandon Xi, paving the way for not only his personal downfall but perhaps even the collapse of the CCP as we know it. For precedent, one would have to go back to the nineteenth century, when Emperor Qianlong failed in his quest to expand China’s realm to Central Asia, Burma, and Vietnam. Predictably, China suffered a mortifying loss in the First Sino-Japanese War, setting the stage for the downfall of the Qing dynasty and kicking off a long period of political upheaval. Emperors are not always forever.
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