SALT Cap Directly Responsible for GOP House Loss in 2018

Originally sent to VIXCONTANGO subscribers on November 14th, 2018

The Tax Cuts and Jobs Act (TCJA) is directly responsible for the GOP loss of the House. I did an analysis last night of all the House districts that switched parties in 2018 mid-term election and discovered that nearly 60% of the districts (18 of 31) that turned from Red to Blue are High SALT districts. In yellow below, I have highlighted districts in New Jersey, New York, Washington, Virginia, California and Florida which turned. While Florida is not a high SALT state, the 2 districts on this list are Miami which has very high property values and thus property taxes. I have looked into housing in Florida – property taxes there are higher than Connecticut. Yes, there is no sales tax, but property taxes are very high. Believe it or not, Miami has had a Republican Congresswoman since forever but this year she lost to a Democrat. Why? Well, when the party in power raises your taxes by removing a critical deduction, what do you think will happen? Particularly if the other party is campaigning on restoring the deduction.


The GOP in their infinite “wisdom” is claiming that Trump lost them the election. So the same people who voted for Trump in 2016 now voted against him in 2018? Well, first of all, Trump was NOT on the ballot. GOP congressmen were on the ballot. The only major policy difference between 2016 and 2018 elections was the Tax Cuts and Jobs Act and a few military spending and omnibus bills. There were no major changes made to Obamacare or to immigration policy or to anything else. In 2016, GOP campaigned on repealing and replacing Obamacare, on closing the Budget Deficits and on cutting Government Spending.


Instead, from 2016 to 2018, the GOP did NOT repeal Obamacare, the Budget Deficit increased by $100 billion, Government Revenues (receipts) stayed flat and Government Spending (outlays) increased by $100 billion. I don’t think there is a single GOP voter out there who voted for this combination of increased government spending and higher deficits. They might as well have voted for Democrats. While it is easy to point the finger at Trump, it was Paul Ryan and the GOP congressmen who wrote all these bills and presented them at Trump’s desk for signing. Those GOP congressmen and their bills were on the ballot in 2018. And their $100 billion tax hike on individuals (primarily by means of repealing the SALT deduction) cost them House. There is no other reason. One thing voters don’t expect is for Republicans to be raising their taxes. For many voters, if Republicans are raising taxes, might as well be politically correct and vote Democrat.

Democratic Health Care Proposals

Originally sent to VIXCONTANGO subscribers on December 6th, 2019

Now that Democratic primary season is upon us and the top 4 candidates are crystal clear (Biden, Sanders, Warren, Buttigieg), I want to provide you with a guide to the most important issue of the 2020 election which is Health Care. I have already sent a mailer about Bernie Sanders’ Medicare-for-All plan earlier in the year and if you haven’t read it, you can read it again here. Bernie’s plan is the most unlikely to pass through Congress since I doubt Americans are ready to jump from fully private health care to 100% government health care overnight. Even if Bernie Sanders base in the 2020 Democratic Party is solid, it is barely 10% of the US population and there is no way 10% of the US population will dictate what the other 90% will do, particularly when a good portion of the population is Republican. So I am not going to revisit Bernie’s Medicare-for-All here, instead I will focus on the Medicare-for-All vision of the other 3 candidates.


To put the discussion below in context, I would like to share with you my wife’s company health insurance plans and also how much they cost for a variety of people and situations. There are 2 types of plans in the US health care system – Silver and Gold. The Silver plans have a higher deductible (out of pocket expense) in exchange for slightly lower health insurance premium. The Gold plans have a lower deductible in exchange for higher premiums. People that are young and healthy tend to pick Silver plans, people with families tend to pick Gold plans. The combined premium that a company and an employee pay to the health insurance company tends to be around $500 per month for Silver plans and about $800 for Gold plans for single people. For families, the premium depends on the number of dependents (kids) but generally speaking a Family of 4 pays $2,050 per month for a Silver Plan and $2,150 per month for a Gold Plan. However, as you see in the chart above somebody with a big family may be paying up to $4,000 per month (the person with 6 teenagers/young adults). Also notice the massive increases in 2020 in both premiums and deductibles. Premiums are up about 6.5% while deductibles are up 14% for Silver plans (from $3500 to $4000). That means Americans will have to spend potentially 20% more on health care in 2020. For a Family of 4 on Silver Plan the total annual deductible increase is $2,000 (4 * 500), while premiums are up another $2,000 (150 *12), for a total of $4,000 potential new out-of-pocket expense on top of current rate. Pretty hefty. People have to plan for that and that is hurting the US economy right now. This hit is at least double the paycheck relief people may have experienced last year due to the Trump payroll tax cut. I have summarized the rough financial below. As the table below shows, Single singles will most likely choose the Silver plan while families will go for the Gold plan because those options result in lower total potential liability (health care spending).


The Biden Plan

The Biden Plan is a big expansion of Obamacare and provides a much desired public option. But the public option is not Medicare. It is a plan with benefits that are less than Medicare currently provides. The main points of the plan are as follows:

  • Increase the value of health insurance tax credits. Under Obamacare families that make up to 400% of federal poverty level may receive a tax credit to cover the health insurance premiums. The amount is calculated as % of income for a Silver Plan. Biden will remove the 400% eligibility cap and lower the limit from 9.85% to 8.5% of income. Also the size of tax credits will be based on Gold Plans instead of Silver Plan (there is a substantial difference in benefits).

What does that mean practically? A Family of 4 making $100,000 will pay $8,500 per year for a Gold Plan. Currently, a Family of 4 pays $25,800 for Gold plan coverage as shown above. This is massive savings of about $17,300 or $1,400 per month. Biden estimates the average family will save $750 per month (that is because the average family makes $50,000 per year). This is going to radically cut the cost of health care for average Americans.

  • Force Obamacare Medicaid Expansion to states that opted out. Many Red states didn’t take up the Medicaid expansion leaving about 5 million potentially eligible people without coverage. Biden will allow the federal government to cover those people. This move also has big political implications as it will guarantee that those voters will vote Democrat in the 2020 election.
  • Stop surprise billing. Out of network providers tend to hit patients with big bills and Americans often don’t even know the provider is out of network. They only learn later through a big bill. Biden will bar health care providers from charging out of network rates when patient doesn’t have control over the provider he sees.
  • Drug Cost Control and allow Medicare to negotiate drug prices. I don’t need to cover this, it is well known Democratic stance. Allow generic imports, limit drug price increase to inflation rate, etc.

The Biden plan is expected to cost $750 billion over the next decade or $75 billion per year. Biden plans to pay for it by reversing some of the Trump tax cuts – primarily lifting the corporate tax rate to 28%. The Biden plan will create a new government health care bureaucracy in Washington DC in addition to the bureaucracy that currently administers Medicare.

Cost: $750 billion

Deficit Impact: Neutral

The Buttigieg Plan (Medicare for All Who Want It)

The Buttigieg Plan has been ripped off from the Biden plan – it is identical – but it adds a few goodies. Here are the additional goodies:

  • Cap out of pocket costs for Medicare beneficiaries (seniors)
  • Limit out of network charges by health care providers to twice the Medicare rate
  • Create a centralized government Claims Database (central clearinghouse for claims)
  • Break up health care mergers

The out-of-pocket cap and the out-of-network charge limit adds up to a lot of money and thus the Buttigieg plan costs about double the Biden plan at $1.5 trillion. But Buttigieg plans to pay for it through a full repeal of the Trump tax cuts (yes, bring back the 35% corporate tax rate) which cost $1.5 trillion. Buttigieg wants his plan to be deficit neutral. My view is that full repeal of the Trump tax cuts is unrealistic. The highest corporate rate I see is 28%. Most likely corporate rate will be rolled back to 25% and the rest has to be financed with higher income tax rates on millionaires. Not impossible.

Cost: $1.5 trillion

Deficit Impact: Neutral

The Warren “Transition” Plan

As you can imagine the Warren transition plan is the most ambitious of all and different from the Biden and Buttigieg plans. It is also simpler to understand in my opinion.

  • Lower Medicare eligibility age to 50 (from 65). In addition, children under 18 and people making less than 200% of the federal poverty level will be eligible. This is massive expansion of Medicare eligibility.
  • Allow people between 18 and 50 to buy into Medicare with premiums capped at 5% of income. Thus a Family of 4 will spend $5,000 on premiums vs $8,500 under Biden/Buttigieg and $25,800 today.
  • Add Dental benefits to Medicare. This is a substantial expansion of benefits.
  • Reduce Medicare Advantage fraud
  • Expand Medicaid Expansion to states that opted out
  • Central clearinghouse for claims, drug cost control, etc

Warren says this plan can pass through reconciliation which means the total deficit hit will be about $1 trillion. Assuming she reverses the Trump’s tax cuts completely without any other revenue raising provisions, her plan would thus cost about $2.5 trillion or a trillion more than the Buttigieg plan. The Warren plan will reuse the current Medicare administration in DC saving the costs of yet another government bureaucracy.

Cost: $2.5 trillion

Deficit Impact: $1 trillion


These 3 plans are far more mainstream than Bernie’s Medicare-for-All proposal which is a total takeover of the health care industry by the government. Americans hunger for a public option and each of these plans provides that. In terms of benefits, eligibility coverage and minimizing costs to families, the Warren plan is the best followed by the Buttigieg plan and then the Biden plan. When it comes to actual policymaking in 2021, the only constraint will be what will pass through Reconciliation in Congress assuming full Democratic control but only a 50 seat advantage in the Senate. Even though Biden and Buttigieg promise to be deficit neutral, I highly doubt they won’t take full advantage of Reconciliation like the Republicans did in 2017. So Biden and Buttigieg will end up passing more than they promise today. But I don’t see them winning anyway. Ultimately, I think the final plan that will pass is a slightly smaller version of the Warren transition plan that costs about $2 trillion with about $1 trillion of the Trump tax cuts reversed to fit it under Reconciliation. This will be a massive improvement in the lives of Americans even if corporate profits will suffer greatly. The passage of any of these plans is very bullish for America and the American economy but unfortunately bearish for stocks (because corporate tax rates go up and after tax earnings decline). I cannot overstate how big a help it will be for American families to start paying $500-$800 per month for family coverage vs $2,000 they are paying now. A $1000-1200 per month in relief for each family is a huge amount of money and huge economic stimulus that will dwarf anything that Trump has done.

One final note I need to make here is the political calculus. All Democratic candidates now have a public option for health care. Cheap health care option is something Republicans don’t have at all. Health care in 2020 is a political weapon that Republicans have no answer for. The forced Medicaid expansion in Red States will bring in about 5 million voters to Democrats which are crucial in beating Trump. But it is not only that group of voters. These proposals will bring a massive amount of people who haven’t voted before who want to get cheaper health care coverage or get any coverage at all – we are talking small businessmen, middle age people, various young communists, anarchists and other knuckleheads. It will be a weird coalition but a very populous coalition that will obliterate the Republican Party at the polls. There are 30 million uninsured today. All of these 30 million people that have been kicked out of the health care system will show up to vote for Warren or whoever wins the Democratic nomination (which I am pretty sure it will be Warren given the Biden slide in Iowa, New Hampshire and California after the Ukraine scandal). I understand if you watch Fox News, you might have massive illusions about what will happen in 2020, but from my perspective this is very simple. People care about their health and they will vote for the people that promise them health care. Democrats promise that. Republicans don’t. Democrats won the House with Medicare-for-All as a headline in 2018, they won a number of local elections in 2019 and they will win with that very simple but effective message in 2020 as well.

Endgame: The Next FED Bailout

Originally sent to VIXCONTANGO subscribers on February 16th, 2019

Over the past 6 months I have had discussions with various subscribers about how to approach the next market crisis. They asked me how I think various trades will play out. My first immediate impression is that folks are very ready to fight the last war. All of the concerns I heard formulated read like a rerun of 2008:

  • The commercial paper/money market will seize up
  • The housing MBS market will seize up
  • Corporate bond market will seize up and credit spreads will widen a lot (junk bonds will tank)
  • Gold is going to moon because of QE4

Everybody assumes that in the next market crisis the FED is going to do exactly what it did in 2008:

  • Lower rates to zero, potentially even do negative interest rates leading to money market and commercial paper market problems
  • Do QE, buy Treasuries and MBS and expand the balance sheet a lot and thus send gold to the moon

Basically everybody assumes that the problems the US economy has today are the exact same problems it had in 2008. Also people assume that the policy tools the FED and the US government have today are the exact same that they had in 2008. The problem is the setup we have today is different and what will happen will also be very different.

The Last War

Let’s look at what caused the Financial Crisis in 2008:

  • Massive housing oversupply – massive build out of McMansions for the smallest generation (GenX) in recent history.
  • Massive housing bubble spurred on by low interest rates which were first driven by the FED and then by Chinese purchases of Treasury bonds
  • Undercapitalized and highly leveraged banks (40/1 leverage ratio was widespread because of deregulation)

What the FED did then was to address the problem it had on its hands:

  • How do you fix undercapitalized banks? Well, the traditional method since Abraham Lincoln and Samuel Chase invented modern banking was to stuff bank balance sheets with US treasury bonds. The FED went out and bought a ton of short-term treasuries from banks and fixed their capitalization and leverage ratios. Done in QE1
  • There was no market for mortgage backed securities (MBS). The FED took those bad loans off the hands of the banks as well in QE1.
  • Since the economy was tanking and the deleveraging process brought on deflation, the FED thought that interest rates need to be lowered to hike inflation expectations. FED overnight rates went down to zero very quickly. But 3-4 years later long term rates still didn’t go down as much as the FED wanted, so in QE2 and QE3 the FED had to target the long term rates by buying those treasuries.

As a result of all of this the FED quintupled the balance sheet from 800 million to 4.5 trillion sending gold up 5 times as well from $400 in 2005 (pre-crisis) to $2000. Note that the gold market moved higher 2 years ahead of the eventual FED balance sheet expansion announcements.

Are We Fighting the Last War?

Is the situation today the same as in 2008? Do we have the same problems?

Is there a massive housing oversupply and housing bubble? No

No, there isn’t. If anything we have a housing shortage. Millennial generation is much bigger than GenX and because of 10 years of no houses being built, there is simply no inventory. The FED successfully reflated home prices so we have a situation with high housing prices but also no supply. How are prices going to go down if nobody is selling? So where are millennials going to live? In apartments. Multi-unit housing development is exploding. You can sell an apartment for $200-300K and millennials can afford that. Millennials can’t afford a $500K starter home (unless they work at Google like my old neighbors). The new starter home is an apartment and the new 2nd home is the former starter home. But here is the bigger issue – the housing market is not going to tank anytime soon. If anything, rent and housing prices continue to outpace inflation and they will continue to do so because THERE IS NOT ENOUGH HOUSING SUPPLY. If there is no supply, there is no bubble.


Are banks undercapitalized? No

Nope, not a problem either. The FED has been keeping a tight leash on bank liquidity and we have Maxine Waters as House Financial Services Chairman. Bank balance sheets are not a problem.


Long story short, the FED is NOT fighting the last war.

Tools Available in 2008

When you consider what will happen in the future, you also have to consider the tools that are available. That is very important. Let’s look at the tools the FED and the US government had in 2008.

Small FED Balance Sheet

The FED had an 800 billion balance sheet on $15 trillion economy (about 5%). There was plenty of room for balance sheet expansion. If anything the balance sheet was ridiculously small in 2008. Now the FED has a 4 trillion balance sheet on a 20 trillion economy (about 20%). The FED considers this an “ample” balance sheet. In other words, in the next crisis the FED will not be able to ratchet up the FED balance sheet 5 times like it did the last time. There is much less room to move here without triggering inflation.


High Interest Rates

The FED went into the 1990 recession with 8% interest rates. Into 2000 with 6% interest rates. Into 2008 with 5%. Both on the FED rate and the 10 year. Going into the next recession the FED is going in with 2.5% interest rates. As you can see from that chart, the FED had to lower rates about -5% to get the economy running up and running quickly. Next time around, they don’t have -5% to go down. They can only go down -2.5%. Which means that the economy isn’t going to be able bounce as hard. It is one thing to refinance 8% mortgage down to 4%. People’s mortgages go from $3500 to $2500 with no underlying inflation. That is a big boost. When you go from 4% to 2% mortgage, you go from $2500 to $2000. Still a boost but much smaller boost particularly if you have inflation.


Low Debt to GDP Ratio

The US went into the 1990 recession with a debt to GDP ratio of 53%. Into the 2001 recession with 54%. Into the 2008 recession at 62%. Guess where the debt-to-GDP ratio is today? 104%. Clearly there is less room for massive fiscal spending today. The interest expense is going up dramatically. It was at $324 billion in 2018. That 50% more than 2008 (220 billion). This is $100 billion per year that can’t be spent on the economy. Interest expense is almost as much as Medicaid spending! The burgeoning interest expense is going to put a real constraint on the amount of fiscal spending available in the future. What that means is that you can’t do tax cuts anymore without paying for them. What that also means that you can’t do military or infrastructure spending without paying for it. The never ending magical money pot provided by the US government that markets have been tapping since 2008 is rapidly coming to an end.



When you look at these numbers above it is very easy to panic. You see a lot of pundits and articles screaming and pointing at these charts and advocating for imminent doom and gloom and hyperinflation and so forth. Well, it has been 10 years without doom and gloom and hyperinflation. I am showing you the same numbers everybody else is showing you. Where we differ greatly is the interpretation.

There is only one question that you need to answer when you look at these numbers:

What can the government do without triggering inflation?

Would massive expansion in the balance sheet trigger inflation? Not if the balance sheet was scarce to begin with.

Would massive government spending trigger inflation? Not if the money is spent in Afganistan. 6 trillion of the debt under Obama/Bush went into the Middle East. How is that going to trigger inflation in the US? Now if you throw the same 6 trillion on the US, yes you will have inflation.

So what matters really is NOT HOW MUCH money is being spent, but WHERE it is being spent. The real question is what can the FED/US government do in the next crisis that does NOT trigger inflation? Inflation is really what limits their policy responses. In 2008, they had a lot of artillery at their disposal because they were fighting DEFLATION. If you are fighting deflation, you basically have a blank check. That is not the case today. However, the FED and US government are not completely out of tools. Somebody like Peter Schiff who says the FED/US is out of tools is exaggerating. The FED does have tools. The tools are simply smaller than what they were in 2008 and thus need to be deployed more efficiently.

The Next Crisis Response

The FED has been providing an enormous amount of information on what is going to happen next. If anybody is paying attention. We covered how money markets are NOT going to cease up, how people are NOT going to be defaulting on their mortgages and how banks are NOT going to collapse. We covered how the FED is NOT going to be able to ratchet up their balance sheet 5 times and how the US government will NOT be able to borrow 10 trillion again. But they will not need to.

What is the next battle the FED is fighting? INFLATION. That was the headline of my market outlook for 2019. This is very different than 2008, when the FED was fighting DEFLATION.

In 2008, the FED fought deflation caused by a decade long demographic lull (peak years of GenX). In 2019, FED is fighting inflation caused by a demographic crush of millennials coming into their peak years. And the FED has to fight inflation without triggering a spike in the federal outlays for interest expense. Going forward, the FED has to be super-efficient.

Average Inflation Targeting

The first thing the FED is going to do is make its own job easier. It will move the goalposts. FED will start tolerating inflation overshoots. Vice Chairman Clarida alluded to this a couple of times in his speeches but yesterday we had former New York FED Chairman Dudley say it outright: The FED is looking to change its approach on inflation. Dudley said:

Right now, they have what’s called a bygones policy, and what that means is that if they miss on one side, they don’t try to miss on the other side to make up for it. I think the Fed is going to change that policy subtly over time. They are going to talk about, ‘We want to hit 2 percent inflation on average.’ And that’s going to imply to people that if they miss on the low side for a while, that they’ll be willing to miss on the high side for a while.

So the FED will tolerate CPI of 3% for a while if we had a CPI below 2% for a while. They will target a long term average of 2%. This theoretically is not that big of a deal and should not lead to hyperinflation. Many inflation observers think inflation has a momentum and that the FED won’t be able to stop inflation at 2% but so far it seems the FED thinks it can do just that. Let’s assume that they can do that.

In the immediate term, Dudley’s statement means that the FED is done with rate hikes for now. If that wasn’t crystal clear after Powell’s U-Turn. But Dudley provides the rationale for Powell’s U-Turn. Dudley’s statement also means that the FED will not be cutting rates for a while. FED rates are likely to stay at 2.5% for a while. Why? Well, if the FED rates are less than neutral and you have an economy operating at peak capacity, by definition inflation will remain strong. The FED can’t cut with core inflation readings above target. FED is not going to raise, but it can’t cut either.

QE with Positive Interest Rates (Yield Curve Control)

The fact that inflation will remain strong does not mean that there aren’t financial stability risks on the horizon. In fact, the FED is well aware that inflation is likely to start obliterating corporate earnings. Inflation also might keep long term bond yields/mortgage rates high thus putting pressure on the housing industry. The FED previously used QE only AFTER interest rates were at zero. But the FED may not have the luxury of cutting rates to zero before a QE intervention is needed because of inflation.

The San Francisco FED issued a paper to address this issue just last week. The paper is called “The Effects of Quantitative Easing on Interest Rates” and in the paper the authors outline how the FED QE policy in 2008-2012 period really was very haphazard and not targeted well. And as such not very efficient in achieving its policy goals. For example, in the paper they said that buying short term treasuries did not necessarily mean long-term rates went down as much as the FED wanted. That is a total “Duh, of course”, but it is one thing for me to say it, it is another thing for FED research staff to say it. They also said that the FED buying MBS directly had exactly the intended effect to lowering mortgage rates dramatically and improving financial stability in that sector. In other words, the next round of QE is going to be highly targeted towards the specific rates that the FED wants to suppress or specific loans/industries the FED wants to bail out.


So if the FED deems long-term rates a problem in the future, guess what? The FED will be buying 10-year or 30-year treasuries directly. That is called “yield curve control”. That is exactly what the Bank of Japan is doing right now. They just stand ready to buy at a certain interest rate and take everything from the market. So if mortgage rates are high and the housing industry screeches to a halt, the FED will start buying 30-year bonds. Look at the FED balance sheet. Majority of their Treasury security holdings are shorter term maturities, basically 2-year bonds. They don’t own much above 10-year in duration. Look for the FED to start monetizing long-term debt next time around if long term rates aren’t where the FED wants them. The FED might want to take the 30-year down to 2.5%, for example, now that 2 and 10-year are already there.

Add Corporate Bonds To FED Balance Sheet

But that is not all. What is the number 1 risk the FED identified in its inaugural Financial Stability report? Corporate bond yields are too low. Powell repeatedly is saying how corporate leverage is out of control and credit spreads are too low. Powell is after all a former Carlyle partner and he knows corporate leverage from inside out. I initially thought that Powell wanted to raise rates to burst the corporate bond bubble. He may have intended that but he may have been forced to get religion by Trump and Cramer. He might have been forced to accept a bail out the corporate bond sector instead. You never know what is going on behind the scenes. Clearly there was massive change of course by the FED over the holidays. Instead we will get a Carlyle partner bailing out Carlyle’s bad loans!


There is another aspect to this. Once earnings decline, credit spreads tend to widen out. Markets tend to ignore the FED cutting rates and instead focus on the widening credit spreads. Everybody is looking at those and screaming “panic”. How does the FED get control of that situation? Mute that market signal. It is like whac-a-mole. If some rates shoot up and panic the market, the FED whacks them.

The FED’s job is to suppress rates in economic distress after all. They have just slowly expanded their footprint over the years. In 1913, it started by controlling overnight rates. In 2008, they added Treasury bills and notes up to 2-5 years. In 2019, it will be 10-year bonds and corporate bonds. The FED is slowly taking over interest rate control over the entire economy as it seeks to manipulate all risk signals.

Summary of the Next Policy Response

Because the FED is fighting inflation, the FED will NOT be able to cut rates to zero. It will instead do QE while rates are still positive. This QE will be very targeted and it will target long-term Treasuries and corporate bonds. Corporate bonds will be a new balance sheet item the FED has never had before. The FED will expand its existing portfolio of long-term Treasury holdings.

Scope of next FED QE

What and how much the FED will be buying? The total bond market is about 40 trillion. Treasuries are 15 trillion. Mortgage is 9 trillion. Corporate debt is about 8 trillion, etc.



Let’s look at Treasury debt first. As of Sep 2018, total treasuries outstanding are 15.7 trillion. Of those 2.2 trillion are Treasury Bills (up to 1 year), 9.1 trillion are Treasury Notes (1 to 10 years) and 2.1 trillion are Treasury Bonds (20 and 30 year). The part that the FED will likely want to target are the 30-year mortgages to restart the housing industry. If somebody in the private market has 30-year debt at 3.5% and inflation is 2.5% they will be holding onto that. It is still yielding more than inflation. The FED won’t be needed to buy that. Where the FED will have to step in is all the long bonds that have yields below inflation. Normally investors will have to sell those and move their money somewhere else. But if inflation is 2.5% and you are holding a 2.2% 30 year bond, you can’t get rid of that. That is where the FED will monetize. Most of the long-term debt is above current levels of inflation. So I think the treasury debt the FED will monetize is all the sub 2.5% issuance from 2013 and 2016. I think there is at most 1 trillion of that. At most. If I were to guesstimate there is probably about $500 billion that might need a bailout. I think the most likely scenario is the FED simply monetizes the new debt that is coming out of the Treasury that international buyers will not want to buy. I think that is why the FED is stopping QT. They want to start repurchasing the debt Trump is issuing. But that will most likely happen without the FED significantly expanding the balance sheet. At least not this year and next year. The FED was going to do $600 billion of QT in 2019. If they stop the QT, that means the FED can monetize $600 billion of new capacity that the Treasury needs in 2020. Long story short, by stopping QT the FED will monetize the Trump tax cut.


Corporate Debt

In the corporate debt market, you have about $8 trillion of debt. $2.5 trillion is investment grade. 2.5 trillion is BBB rated which currently people consider to be overpriced. Then you have high yield and leveraged loans. The talk is around BBB bonds and leverages loans. If we have issues blow ups there, the FED will rescue them. After 2015 Oil Crisis, I think the FED is ready to start buying junk bonds to bail out energy companies if oil prices go down. This is effectively monetizing the shale build up. I don’t think oil is going to $25 again, but if it was, the FED would be ready to step in and take over the bad loans.

The average default rate in the corporate bond market is 1.5%. A-rated issues have default rate of 0.20%. In the junk bond market, the default rate is around 3% (some say 4%). In the C rate issues, the default rate is 25%. Recovery rate for junk bonds is 40%.

Long story short, let’s assume 10% of the non-high grade corporate bond market needs a bailout because inflation is higher than the yield offered or there is simply default prospects because corporate earnings are getting slaughtered by inflation or low oil prices or whatever. 10% is a very high default percentage but let’s say we have a stagflation economic scenario where that is necessary. 10% of 5 trillion is $500 billion. That is how much the FED needs to monetize in the corporate bonds space.


To summarize, the next FED QE will bail out:

  • $500 billion in long term treasuries
  • $500 billion in corporate bond issues

The scope of the next FED QE as I see it right now is about 1 trillion. That means the FED will have to expand its balance sheet from $3.5 trillion (projected currently) back to about $4.5 trillion. Back to Financial Crisis era levels.

Dr. Goodfriend or How I Learned To Stop Worrying and Love Bitcoin

Originally sent to VIXCONTANGO subscribers on December 12th, 2017


Trust me, I don’t like him because he kind of looks like Jeb Bush. But that will most assuredly secure him a passage through the Senate. Democrats would have Jeb Bush over Trump any day of the week. Especially on the FED board.

I honestly have no idea why he hasn’t received a Nobel Prize yet. Perhaps, it was not his time yet. But with what is about to unfold over the next few years, he will most certainly be on the short list for a Nobel Prize. I have never seen a monetary policy architecture as simple, as effective and as elegant as the one he has outlined. It is almost Russian in its combination of fundamental simplicity and devastating effectiveness.

Marvin Goodfriend started out on Reagan’s Council of Economic Advisers. Then he became an economist and Director of Research at the Richmond Fed from 1993 till 2005, where he attended FOMC meetings regularly. He is considered to be an internationalist and has frequently been a visiting scholar at the European Central Bank, the Swiss National Bank, the central banks of Sweden, Norway, Germany, China and South Korea. He has been around the block and is well known and respected. He has delivered speeches at the Jackson Hole conference. He is also a member of the Shadow Open Market Committee (SOMC) or the Shadow FED – an organization of former FED members and other monetarists whose job is to criticize the FED. Currently he is a Professor of Economics at the Carnegie Mellon’s Tepper School of Business. He is an established thought leader on the subject of monetary policy on par with Stanley Fischer, Janet Yellen and Ben Bernanke. He will be the architect of FED monetary policy in the Powell FED. Jerome Powell (the FED chairman) is an executive manager. He is like Trump – he hires good people to do the work. But unlike Yellen or Bernanke, he is not a monetary policy architect or activist with a plan. You give Powell a plan, he checks it out if it makes sense, and if it does, signs off on it. Dr. Goodfriend will be THE architect of monetary policy while Powell is in charge. Powell’s job will be to sell Goodfriend’s plan to Congress, Trump and the American public.

The rough scoop on him is the following:

  1. He supports Congressional Oversight of the FED. That means measuring the FED’s actions against a mathematical formula such as the Taylor Rule. That is not something anybody at the FED has ever liked.
  2. He thinks 2% inflation target should be written into law by Congress to make it more credible. Again not something that anybody at the FED has ever liked. They like to change their mind all the time.
  3. He does not like Quantitative Easing. He was a mild proponent of QE in a 2000 paper, but even then it was a secondary approach to combat recession for him. Now he thinks that QE is too much of a “Fiscal Policy” tool to be used by a Central Bank. He particularly does not like the FED buying Mortgage Backed Securities. He thinks this is something that Congress or the Treasury should do but not the FED. Again, this is at odds with the present orthodoxy at the FED.

Overcoming the Zero Bound on Interest Rate Policy

Let’s get down to what Dr. Goodfriend is really about. The heading above is literally the name of one of his papers written in August of 2000. For 20 years, he has been a staunch advocate of a particular approach to monetary policy at the zero lower bound which for some very good reasons has not been used. But now it seems that his time has finally come.

At the 2016 Jackson Hole Conference “Designing Resilient Monetary Policy Frameworks for the Future”, he presented a new paper on overcoming the zero bound on interest rate policy which was the latest and greatest version of his research on the topic. It was the most talked about presentation at that conference. I didn’t cover this conference in great detail because I didn’t think that the US economy was about to enter a recession or that inflation would stay particularly low. As such I didn’t think that the discussions about Negative Interest Rate Policy (NIRP) in that conference were particularly relevant for the stock market at the time. As we saw clearly later, they weren’t. But that does not mean that the NIRP discussion is irrelevant overall. It is very relevant for crypto-currency markets today and eventually it will become relevant for stock and bond markets as well.

The Jackson Hole paper starts with how monetary policy has evolved over the decades. First, the Gold Standard was abolished because it limited the money supply at exactly the wrong time and inflicted random economic recessions because the gold price of goods fluctuated wildly. Gold is, after all, a commodity with relatively wild volatility compared to what a stable medium of exchange (currency) should have. In the place of a Gold Standard, Fixed Foreign Exchange Rate regime was put in place, but that construct also failed because it infused domestic price levels with the volatility of international trade. Fixed exchange rates were abandoned so that central banks could pursue domestic monetary policy to stabilize employment and inflation without worrying about the side-effect of subsidizing international trade. So today, all “traditional” constraints on monetary policy have been removed except for one – the Zero Bound on Interest Rates (i.e. nominal interest rates cannot go below zero). And Dr. Goodfriend goal in life is to remove that Zero Lower Bound (ZLB).

Let’s start with the “why” and then move onto the “how”.

Why Remove the Zero Lower Bound

Dr. Goodfriend thinks that when the economy goes into a recession and the FED lowers the rates to zero, businesses and consumers also lower their inflation expectations (I very much agree with this observation, it is astounding he is the only major monetarist to acknowledge that the FED directly affects broader inflation expectations). When businesses and consumers expect inflation in the future and are confident of their higher earnings prospects, they borrow from future earnings today to bring some consumption forward. Thus they are willing to take on credit to invest in purchases and capital investments and the economy is humming. However, if businesses and consumer expect deflation in the future and are sure they will earn less in the future and that goods will cost less in the future, they hoard their savings and their investment capital today because they will get more bang for the buck later. So they delay consumption and the economy comes to a halt.

A Central Bank can effectively control inflation expectations by hiking interest rates as much as needed (see Paul Volcker and his 20% interest rates in the 1980s). However, a Central Bank can NOT effectively control DEFLATION expectations because it can’t go lower than zero on interest rates (Bernanke in the 2010s). So when the FED rate is pegged at zero and remains substantially higher than negative inflationary expectations, then monetary policy is actually restrictive. It is tighter than it should be. Many people wondered why we didn’t have hyperinflation after 2008 and that is precisely the reason: monetary policy was actually very hawkish. Relatively speaking.

Dr. Goodfriend thinks that the FED has earned a very good reputation for combating inflation after Volcker and Greenspan slaughtered the inflation beast in the 80s and 90s. However, he doesn’t think the FED has earned a good reputation for fighting DEFLATION. According to him the last 10 years of monetary policy have been an abject debacle in that respect. And if you use his standards, they have been.

Dr. Goodfriend believes in a 2% inflationary target. But he doesn’t believe it the way the current FED does. The current FED is perfectly satisfied with less than average of 2% inflation over a long period of time. The FED is concerned with deflation and with higher than 2% inflation, but is somewhat content with disinflation. There are some on the FED that are ok with inflation overshooting the 2% target to bring the average inflation over time to 2%, but most actually are perfectly ok with hitting the brakes at 2% and thus letting inflation average less than 2% over time. For the current FED, 2% is a target to aspire to but not necessarily a target to actually attain. Dr. Goodfriend is not in these camps. He thinks if inflation is low, it must be immediately raised back to 2%. And if inflation is above 2%, it must be immediately put back down to 2%. 2% is a hard target. And ideally, it is enshrined as such by a Congressional mandate!

Dr. Goodfriend does not like Quantitative Easing. He does not think “Balance Sheet Stimulus” was effective in pushing inflation higher. He views it as government subsidy for the bond carry trade. In his view, if the interest rate is pegged at zero and Central Banks use only balance sheet policy in lieu of interest rate policy they create distortionary credit allocations, the assumption of credit risk and maturity transformation, which are all risk taken on behalf of tax payers. He calls this “destructive inflationary finance” (I couldn’t agree more). In his view, interest rate policy is far superior to balance sheet stimulus and he views it as necessary and SUFFICIENT for countercyclical stabilization purposes.

Dr. Goodfriend also thinks that we have a big unacknowledged problem. He thinks that large government debt burdens are hindering business capital investment. He cites Reinhard & Rogoff study that the average level of gross public debt to GDP in advanced economies exceeds 90% (it is more than 100% in the US) and that since 1800 in 26 different situations debt overhang slowed the expected potential output of an economy. High public debt burdens signal to businesses that they will encounter higher taxes in the future (as governments try to pay back their debts) and they curtail their capital investment activities today. Households become pessimistic about the future because they will work less hours and face higher taxes. Thus the “intertemporal terms of trade” become depressed as wealth and consumption is moved to the future where it is expected to be more valuable on the margin. So large public debt, in his view, is a significant and unacknowledged factor that drives inflationary expectations permanently lower.

Still wonder why the 10-year Treasury Yield is hanging out at 2.30% for years on end?

In Dr. Goodfriend’s own words:

It is only a matter of time before another cyclical downturn calls for aggressive negative nominal interest rate policy actions

Given the current 1.5% on the 10-year Treasury yield in the United States today, the federal funds rate would have to be taken down at least -1% and more likely to -2% to stimulate recovery from the next cyclical downturn.

How to Remove the Zero Lower Bound

This is all fine and dandy in theory. The real question is how do you implement negative interest rates? This is where Dr. Goodfriend is considered to be very controversial in some circles. Libertarian think tanks like the Mises Institute are going bananas over him. New York Times, Wall Street Journal, Financial Times editorial boards (as you can guess) are fine with him, because they like the concept of negative interest rates. But the small and very vocal libertarian group is opposed to him. So what are the libertarians freaking about?

The practical implementation of a negative interest rate policy has 2 major obstacles. First, Banks are committed to honor paper currency at par. Second, while Central Banks can charge Banks negative interest rates, Banks can’t charge retail customers negative interest rates without a sparking a run on the bank (to cash). In a fractional banking system, that is a really bad idea, because no bank actually holds the money that people have deposited, only a fraction of it. So these 2 obstacles have made attempts at breaking the Zero Lower Bound very ineffective in the few places (Switzerland, Japan and Sweden) where it has been tried. How do you implement NIRP without sparking bank runs?

  1. Abolish Paper Currency

That is really straight forward and requires no technical innovation. But it will be highly unpopular (just ask Rand Paul). Paper currency enables low value transactions and is readily accessible for low income consumers. Until buying with a phone is ubiquitous enough, it’s not practical.

  1. Variable Market Based Price of Paper Currency

This is similar to replacing a foreign currency exchange peg with a floating currency. Or removing the gold standard. Currently Central Banks and banks are committed at meeting paper currency at par. Par is the peg. Remove the peg and set the value of the currency based on a formula which includes the GDP growth rate and currency demand. The idea is that in a recession, once the currency starts to go below par (because GDP is contracting), people will be incentivized to spend it or invest it, rather than hoard it. And vice versa in good economic times, paper currency will be higher than par and that allows consumers to combat inflation more effectively.

  1. Provide Electronic Currency

Quoting Dr. Goodfriend, one can imagine the central bank offering electronic currency as a substitute for paper currency. As a direct liability of the central bank, electronic currency would be as safe as paper currency”. Basically you get a debit card with FED crypto money. That card then is used for purchases alongside your existing credit and debit cards. Since these cards are a direct liability of the FED, the banking system is BYPASSED and the FED can directly change rates on consumer accounts. This eliminates the system friction that banks have caused monetary policy implementations in the past. You will still have paper currency, but over time the convenience and popularity of the electronic currency will start to surpass the paper in circulation.

Option Number 3 is particularly attractive, especially in the age of bitcoin. The concept of FED electronic currency keeps showing up in Dr. Goodfriend’s writings. There is some speculation that bitcoin is actually a US government invention. Online “sources” point to this 1996 paper by the NSA Cryptology Division that outlines the architectural design of Anonymous Electronic Cash. You look at this architecture and it is identical to the Bitcoin network and how it functions. The only thing missing is the miner reward system and the replacement of a centralized clearing system with a distributed computer network that acts as a centralized clearing system (or what we call “blockchain” today).

As you can imagine the libertarian Mises Institute is up in arms about Options 1 and 2 mentioned above. These guys like their cash in their mattresses and the gold in their vaults and they don’t want these touched. So it is highly unlikely that this will happen. The public backlash will be large. But Option 3 is definitely coming. Both current FED board members, Jay Powell and Lael Brainard are crypto currency experts and now Trump is adding Dr. Goodfriend – the intellectual godfather of electronic currency.

I think the astronomic appreciation of bitcoin this year after 4 years of slumber is not a coincidence. I think financial institutions are preparing themselves for an upcoming NIRP regime and it appears the only way to escape NIRP in volume would be to buy limited supply digital currencies like bitcoin. The cash in the system is orders of magnitude bigger than the bond market not to mention the stock market. So there is extra cash left over that needs to find a home outside of the current financial and banking system. By investing in bitcoin infrastructure, financial institutions are building the plumbing that will allow them to effectively counteract Dr. Goodfriend’s upcoming policies. Everything happens for a reason. This is the reason why you can no longer buy a bitcoin with lunch money. Bitcoin is now nearly $20,000 which is a single VIX futures contract. Soon a bitcoin will be as much as an SPX futures contract ($200,000). CBOE and CME exchanges launched futures trading in bitcoin because bitcoin will be an institutional vehicle in the future. I have said since 2013 that bitcoin will eventually be a Tier 1 Central Bank asset (as the FED tries to control that limited commodity, just like it does with Gold). But before bitcoin shows up on the FED balance sheet, the first step will be financial institutions running to crypto-currencies to escape negative interest rates.

You should do the same thing by the way! Get yourself some crypto.

Taylor Rule

So while the Mises Institute is panicking about Dr. Goodfriend’s thinking on NIRP, at present NIRP is not a relevant issue. Right now, the economy is growing 3% driven by excessive Fiscal Policy stimulus (corporate tax cuts) and inflation is hitting 3% on some measures (Producer Price Index). In a good economy, Dr. Goodfriend is a conventional Taylor rule thinker. Dr. Goodfriend points out in his speech at the Shadow Open Market Committee (SOMC) how Alan Greenspan slayed the Inflation Dragon in 1994 by pre-emptively hiking the interest rates while the full employment objective hadn’t been yet attained. In good economic times, Dr. Goodfriend advocates for substantially higher rates. The Taylor rule specified below is something he would like to see the FED implement.


I have to say that using the Taylor rule would most likely have prevented the Housing Bubble of the mid 2000s by hiking rates a lot earlier than Alan Greenspan did. And also it would have helped the economy recover faster after the Great Recession by emboldening bank lending through rate hikes (higher rates lead to more risk taking by banks). Also negative rates as prescribed by the Taylor rule would have sparked much needed inflation in 2008 and halted the stock market decline midstream. It looks like the Taylor Rule would have worked very well in the recent past… and it looks like it may finally be put to use!

Dr. Goodfriend’s High Voltage Markets

What does Dr. Goodfriend’s monetary policy architecture mean for the financial markets? In a word, volatility.

Volcker and Greenspan’s primary goal in life was to defeat inflation because of the hyper-inflation after the removal of the Gold Standard in 1973. Bernanke and Yellen FED were obsessed with eradicating volatility because of the precipitous market declines during the Great Recession. Goodfriend’s primary goal in life will be to unwind the excesses of the Bernanke/Yellen FED. He will unwind the short volatility trade in all of its forms that succeeded so greatly during the previous monetary regime. He will normalize interest rates, normalize volatility, normalize the economy and normalize the financial markets. Bring back cyclicality.

Markets that never go down are not good for society. Never ending bubbles are not good for society just as much as never ending bear markets are not good for society. Young people do not choose when they will enter saving age which unfortunately might coincide with the peak of a stock market bubble and result low forward returns. Middle age people do not choose when to buy a house – they buy when they have kids. They can’t sit and time the housing market. Retirees can’t choose when they need to sell their stock investments and move into bonds. They do it when it is time to retire. Hundreds of millions of people cannot be expected to be astute market timers. They cannot be expected to suffer through decades of one way markets. As such the market needs to provide opportunities for some to accumulate productive assets at a cheap price and for others to dispense of productive assets at a high price. Markets accomplish that through volatility. Dr. Goodfriend will bring back volatility.

At the onset of the next easing cycle when we expect negative interest rates via a FED electronic currency, what you will want to invest in is limited supply commodities that are effective inflation hedges – gold, silver, bitcoin, litecoin. Markets will front run the negative interest rates which will culminate in businesses and consumers panically buying commodities instead of keeping cash at a negative rate in their bank accounts. Financial institutions will move into crypto-currencies and regular folks will go to the metals. You will also want to invest in high dividend sectors such as staples and utilities and secular growth sectors such as tech and health care. Any dividend is better than negative dividend. And secular growth likes low rates. You want to be short cyclical growth like industrials, materials and financials. You will want to be long volatility.

But then as the economy starts to recover, interest rates will swing fast back into the positive. There will be no more 0% interest rates for 10 years. Then you want to be playing cyclical growth sectors – industrials, materials, financials and you want to short defensive sectors like staples and utilities. You will also want to short volatility.

Basically you will have the normal investment playbook that we utilized before the Obama years. Active management will pay off much better. Hedge funds will look a lot better as well. The financial world will not be dominated by the nanny state and the heavy hand of the government will not extinguish every market gyration. Bonds will be able to deliver much higher returns either through higher yields or capital appreciation. The economy will be more dynamic and grow faster. But also there will be down cycles which will provide upcoming generations with good opportunities to buy the dip.

It’s not going to be all good, it’s not going to be all bad, but for sure it won’t be purgatory like the last 8 years.

Once Goodfriend is on the FED board, he will be in favor of faster Quantitative Tightening schedule as he wants the QE rolled back quickly and completely. He will also want to jack up the rates as quickly as possible to the 2.5%-3% area (where the Taylor rule is) in order to slay the oncoming inflation because of tax cuts and infrastructure spending. So strap on your seat-belts.

The Greenspan, Bernanke and Yellen put under the market is no more.

Low Real Yields Mean Very Bad Recession Prospects

Originally sent to VIXCONTANGO subscribers on June 13th, 2019

The St. Louis Fed came out with some devastating research on the relationship between yields and recessions earlier this year. This is a topic that hasn’t been explored as much but right now has become relevant since the yield curve has inverted and the clock to the recession has started ticking. While policy makers will publicly try to drum up optimism and try to stop the self-reinforcing pessimism that can exacerbate recessions, the overarching question for them right now is not WHETHER there will be a recession but HOW LONG and HOW BAD the recession will be. We are after all in the longest expansion in history and therefore historical precedent postulates another recession should be just around the corner. While the exact timing of a recession is important for traders, policy makers have a different problem in mind. They need to fight the recession and for them the question of timing is less important. What is more important is do they have enough tools to fight what is coming. And before they can figure out if they are armed appropriately, they need to size up the problem. How big and how long will be the next recession?


The researchers at the St. Louis Fed have discovered that the REAL 10-year Treasury Yield at the time of inversion (inversion defined as the 10-Year Treasury Yield is less than the 3-Month Treasury Yield) correlates with the longevity and size of the recession that follow. The lower the real interest rate (which is TNX – CPI) at time of inversion, the longer and bigger the recession that follows. By “bigger” recession understand bigger loss of employment, higher unemployment rate. The Fed research doesn’t try to explain why this relationship holds and why it is happening but they are there to tell us that it exists and that the Fed is aware of it.



Here is the bad news. The real interest rate at the current inversion is the LOWEST in history. We are 0.35% real interest rate. TNX is 2.15%, CPI is 1.8%. 2.1%-1.8% = 0.35%. This means that the next recession will be both longer and more severe than anything we have seen over the past 40-50 years. It sounds like the next recession will make the Financial Crisis look like a walk in the park! It will be even worse the recession of the late 70s which is the worst recession experienced by any American alive today. On the charts above, I have plotted what type of recession we can expect based on the Fed data presented.


The upcoming recession will be about 45-50 months (4 years) long and unemployment rate will go up about 5.5%-6% from current levels (to roughly 10%). So this is what the FED is grappling with right now. How to confront a 4 year long recession and 10% unemployment rate!


Are 5 rate cuts (one 50 bps cut each) going to be enough to forestall this? I doubt it. Rates need to go down 500 bps to forestall a recession. There will definitely going to be some balance sheet expansion (which is bullish for gold and pushes potential targets past 2000), but I don’t think the FED will shoot its QE bullets early on in the recession. I think the FED will do yield-control first (because it is likely to cost them less than outright QE) and then QE will be the final bazooka. Let’s hope that sequence works. I think QE will fail to resurrect markets and then after that FED has to come up with something else. But that is a topic for another day. For now though, know that the FED is getting ready to combat a 4 year long recession and 10% unemployment rate and that is why Clarida has been sounding so despondent lately.

Statewide Model Predicts Trump Loses by 30 Electoral Votes in 2020

One way to predict which way a state will vote in the Electoral College is to examine races for statewide positions such as Governor and Senator that were held together with or a couple of years before the Presidential Election. Statewide races are similar to a Presidential election in that the entire state votes thus they reflect the political preference of a given state and could hold a clue as to how voters will vote in the upcoming Presidential election. In this analysis, I will identify the key swing states of 2020 and then look into the history of each state and see how the Senate and Governor elections predicted how the state voted in Presidential races of the past. Based on that information I will assemble a 2020 Electoral Map prediction. On Nov 1st, 2019, the 2020 electoral map starts out like this:2019-11-03_091515I will assume that all pink and red states are won by Trump. Actually any state that has a hint of red, I will assume that Trump wins. I will also assume that key swing states of Florida and Ohio go for Trump. I will assume that Maine goes Democrat because a Republican hasn’t won Maine since 1992. Maine is a state that rejected Trump in 2016 and I am not sure why he would do any better there now given that his net approval rating there is at -13. I will assume that any state that is “Likely” to vote Democrat will vote Democrat (that would be the Blue states like Colorado and New Mexico). I will consider “Leans Democratic” (Light Blue States like Minnesota) to be “Toss Up” states. After making these adjustments, we are looking at Trump getting 239 votes and Democrat Candidate getting 243 votes with about 86 votes hanging in the balance. The tossup states are: Arizona, Minnesota, Wisconsin, Michigan, Pennsylvania, North Carolina and New Hampshire.2019-11-03_091525For each of these tossup states I look at the Senatorial and Gubernatorial elections and look at how well they aligned or predicted with the Presidential election in the past. I look at data starting 1980 which is when the current political map was formed. For example, prior to 1980 Texas and the South in general were Democratic states which hasn’t been the case for the past 30 years. So I will focus on more recent data starting 1980. Below is an example of how I calculate the “Success Rate” for one state. In Arizona, the Senate election predicted the state’s vote in the Presidential election 75% of the time. Gubernatorial election was less accurate at 56%.2019-11-03_0915352019-11-03_091807After I calculate Historical Prediction Rate (or Success Rate) for each of the states, I calculate “Trump Odds”. I take the type of race (Governor or Senator) with the highest prediction rate for the state and give it 65% weight. For the other race, I give 35% weight. For example, in Arizona the latest Senator to be elected is Kyrsten Sinema who is a Democrat. Since in Arizona Senator prediction rate is 75%, I assume that Trump’s odds if you listen to the Senate race are only 25%. I give that a weight of 65% because Senatorial prediction rate is better than Gubernatorial prediction rate. The Governor who is a Republican gives Trump odds of 56%. That I multiply by 35%. So Trump odds in Arizona are = 65% * 25% + 35% * 56% = 36%.2019-11-03_091905

As you can see in the chart above, Senatorial races tend to align more closely with how a state votes in a Presidential election. Senate and Presidential races are often general “values” races and in those voters tend to vote their values whereas in Governor races voters tend to vote on local issues. In any case, there are states like New Hampshire and Minnesota where Gubernatorial races have better than 60% success rate.

Since the 2016 Trump election, in these 7 tossup states of Arizona, Minnesota, Wisconsin, Michigan, Pennsylvania, North Carolina and New Hampshire, Democrats have won a series of wave elections. The only Republicans to win a Senate seat or Governorship are Ducey of Arizona and Sununu in New Hampshire. Burr was elected with Trump in 2016. All other 11 statewide races were won by Democrats, unbelievably even in Arizona which traditionally is a heavy Republican stronghold. This presents a big problem for Trump right off the bat since Senate races tend to skew the odds greatly in Democrat favor. In the states of Arizona, Minnesota and Wisconsin, Trump has below 40% odds of reelection. You can basically write those off for Trump. The only tossup state where you can predict a Trump win based on statewide races is North Carolina where Trump’s odds are north of 60%.2019-11-03_091545That leaves us with three “true” tossup states of Pennsylvania, Michigan and New Hampshire where Trump’s odds are about 50%. Both Pennsylvania and Michigan have Governors and Senators that are Democrat and Trump is the only Republican to win those since HW Bush. To break the tie in these states I look into Trump’s Net Approval Rating (Approval – Disapproval) in these states. In Michigan his net approval rating is -11 and in Pennsylvania it is -8. Those are states where his approval rating was heavily positive just 2 years ago: +7 in Michigan and +10 in Pennsylvania at the start of 2017. So whatever Trump has done in the last 2 years (ill-conceived tax legislation) is not working out for voters in these 2 states. Both of these states had thumping Democratic wins in the latest 4 statewide races in 2018. These states were razor thin wins for Trump in 2016 and if you adjust the statewide race odds with the net approval rating, the picture does not look good for Trump. 50% Odds -10% Net Approval Rating = 40% Reelection Odds. Reelection Odds < 50% means Trump loses the state. Basically, the only state with better than 50% reelection odds is North Carolina.


2019-11-03_091612When I make the changes and put Arizona, Minnesota, Wisconsin, Michigan, Pennsylvania and New Hampshire for the Democrats and North Carolina for Trump we get a 284-254 win for the Democrats in this Statewide Prediction Model. So the most likely 2020 election outcome is a 30 vote win for Democrats.


What Happens If Nobody Gets 270 Votes?

But let’s say, you think Trump losing Arizona is a stretch and New Hampshire is winnable because it has a Republican Governor that still doesn’t give Trump a victory (assuming Maine goes for Democrats). It is a split 269-269 decision at which point the race goes to Congress.2019-11-03_091650

This is an important strategic question that almost nobody is asking today. The US Electoral College has the following rules for selecting a President and Vice President in case no ticket gets 270 electoral votes:

  1. The House of Representative elects the President from the 3 Presidential candidates who received the most Electoral votes. Each state delegation has one vote.
  2. The Senate elects the Vice President from the 2 Vice Presidential candidates with the most Electoral votes. Each Senator would cast one vote for Vice President.
  3. If the House of Representatives fails to elect a President by Inauguration Day, the Vice-President Elect serves as acting President until the deadlock is resolved in the House.

In the Presidential vote, each state gets one vote which is determined by the state delegation. Currently most of the Democratic House reps are from New York and California and thus even though the House is held by Democrats in an electoral scenario Trump might win because most state delegations would be Republican. Here is a breakout of party representatives by State. Republicans would carry 32 state votes and Democrats only 17.2019-11-03_091629However, I still think if Congress had to choose between Trump and a Democrat candidate, I think it elects the Democrat. Trump is already considered too extreme or toxic. Trump has a very wide opposition within the Republican Party. Many GOP congressional candidates distanced themselves from Trump in 2018 to get the suburban and woman vote. If it came down to it, I don’t think Wisconsin Republicans would vote for Trump if Paul Ryan’s stance was any indication. I don’t think Arizona Republicans vote for Trump given how loyal they are to the McCain family.

You can also get into a situation where there is a standoff between Democrats and Republicans. I have seen situations like these in other countries and usually a middle of the road candidate emerges after a long standoff between the 2 extremes. These are professional politicians, not regular voters. They will pick a candidate that checks all the boxes and if there is a candidate that checks no boxes, that would be Trump.  Honestly, I just can’t picture Congress electing Trump. I just can’t picture professional politicians electing Trump. In the list above Arizona, Colorado, Iowa, Kansas, Michigan, Montana, Nebraska, North Carolina, North Dakota, South Dakota, Utah, Virginia, West Virginia, Wisconsin and Wyoming are all listed in the Republican column. I don’t think these states are automatic Trump votes given how anti-Trump their senators are. The 10 GOP Senators from these states voted against Trump on a resolution of disapproval on Trump’s national emergency declaration around the border wall. I understand all the math, I just don’t think the GOP brass would cast their vote for Trump if it came down to them in 2020. They would rather put Pence atop the ticket than subject the country to another 4 years of Trump mayhem.

Trump to Lose in 2020 by 7 million votes in Biggest Ever Landslide

Originally sent to VIXCONTANGO subscribers on July 22nd, 2019

This move by Trump – make no mistake about it – weakens even further Trump’s electoral chances in 2020. This debt ceiling explosion will infuriate the Tea Party (or should infuriate them) and even if Congressional Tea Party Lawmakers vote with Trump, the voters likely won’t in 2020. The whole premise of the Tea Party is small government and balanced budgets and all they see is Trump funding Pelosi’s agenda and ever bigger government. This will have a substantial impact on tea party voters and will suppress their turnout. To summarize, Trump has so far suppressed the Bannon voter (mid-west manufacturing renaissance/economic nationalists) with his weakness on China, the Ann Coulter voter (border wall) with his weakness on immigration and now the Tea Party voter (monumental deficits) with his weakness on budgetary matters. It is not possible for Trump to win with a coalition of one – evangelicals. This is almost as if Trump doesn’t want to get reelected in 2020 – which is likely what is going on here because the Presidency has been an enormous drain to his businesses and financial net worth. At this point, it looks like Trump’s landslide loss in 2020 is going to be bigger than McCain’s loss in 2008. And it doesn’t matter who the Democratic presidential candidate is.



If you don’t like my voter group analysis, I would like to point some more conventional polling stats for you. First of all, Trump has the lowest average approval rating of any President at 39%. He is 10 points below the lowest one on the list (Obama/Ford/Truman) which is pretty remarkable. He only has support of less than 40% of the population. But my political analysis focuses on hate more than love and the problem for Trump that just like Hillary he is more widely hated than loved. There is no bigger killer for a politicians than hate. It simply suppresses turnout and sends voters to the opposition. In 2016, it wasn’t that Trump won, but more that Hillary lost. My wife never supported Trump but she absolutely hated Hillary. At home, we have a Hillary in jail suit bobble head doll, not a Trump doll. Hillary simply had a lot of baggage from the Clinton presidency and particularly with Republican women who hated how she went after Clinton’s female accusers and stood by him throughout his cheating. Hillary brought with her a very specific “anti-Hillary” vote that numbered in the millions that doomed her REGARDLESS of who was going to be the Presidential choice of the Republican Party. You could have had a horse on the ballot and people would rather vote for the horse than Hillary. Trump is facing a very similar situation now even if the reasons why he is hated are drastically different. The point is he is hated. How can that hate be seen in the polls? Through disapproval rating. No President that ever reached a 50% disapproval rating in his first term got reelected. The last 2 such Presidents are named George HW Bush and Jimmy Carter. On the charts below, it is the size of the red that matters more than the size of the green. While many Presidents like Truman, Lyndon Johnson or George W Bush had horrible disapproval ratings in their second terms all of them were never at 50%+ disapproval ratings in their first terms.

I know it is fashionable/establishment thinking that 2020 will play out like 2016 and Trump will spring the big surprise and pull out another Hail Mary, but that is the intellectually lazy way out. Just like in 2016, it was the intellectually lazy way out to think that Hillary will win in a landslide and ignoring the closeness in the polls in key states. It is just that a deeper dive into the stats doesn’t validate either of these theses. And if you watch football, you know a Hail Mary pass wins one game a year. You can’t win a championship with a Hail Mary every single game. You just don’t get the chance. The problem for Trump is that 2020 is not going to be close at all. Neither Biden, nor Harris, nor Warren carries Hillary’s baggage.







Originally sent to VIXCONTANGO subscribers on October 19th, 2019

Trump Going Out in a Blaze of Glory

On the political front, increasingly it seems to me that Trump is trying to get impeached. His decision to abandon the Kurds to be slaughtered by Turkey makes absolutely no sense in any form or fashion. Even if you believe in US withdrawing from the Middle East, you don’t leave battle allies to be slaughtered like that. US troops may not fight but just their presence can prevent aggression and slaughter. His decision to grant Trump Doral the business of hosting the G7 also makes no sense. Politicians back in the day would hide conflicts of interest like that. Trump is announcing it publicly. Getting the government to spend money on your own business like this is very brazen. It is interesting to note that Trump Doral has been hammered in revenues and income since Trump became President. Trump is losing $50-$100 million per year there. Trump is a businessman and businessmen measure their self-worth with their income. These are big losses for Trump. At some point he will just want to go back to making money. So his bizarre actions lately scream “IMPEACH ME”. These aren’t some Twitter antics anymore. Foreign policy or corruption transgressions are acts for which he can legitimately get impeached.


I think Trump actually wants to get removed from office. Then he can complain about the “Deep State” on his own TV network to big ratings for the remainder of his life. I was doing some basic preliminary election analysis and the initial estimate is that Trump will lose by somewhere between 5 to 8 million votes in 2020, with Michigan, Wisconsin and Pennsylvania, North Carolina, New Hampshire and Arizona voting against him. He will lose by minimum of 20 electoral votes. Believe it or not, despite being President for 3 years, he is polling 3% below where he polled in 2016 in the important states. Basically the suburbanites in Pennsylvania and Michigan that voted for him in 2016 and got hit with the SALT are not going to vote for him again in 2020. He has less support today.  Trump is going to get blown out in 2020 regardless of the nominee. But the nominee is going to be Warren and if the nominee is Warren, it will be the biggest electoral win in history for Democrats. Follow this math here. Romney and McCain pulled about 60 million votes. That is the GOP hard core base – 60 million – which is not expanding. It is the same old white Baby Boomers. Trump got 63 million votes – or 3 extra million votes – because he wasn’t going to be a standard GOP president. But he disappointed. He turned out to be a standard issue Republican president in terms of policy. Tax cuts and military spending. These are the only accomplishments of his administration. He was dropping bombs on Afganistan, rocket attacks against Assad. Leaving the Kurds for slaughter is not going to wipe out the previous 3 years from people’s memory. In particular, his massive military budgets are there plain for everybody to see. Nobody is being fooled here. Trump is going to claim he is anti-military with a phantasmagorical military budget?!? Some of the 3 million extra that voted for him did that because he is a half-Democrat. They won’t be fooled again. There is no drug cost control, no infrastructure spending, nothing that would appeal to a conservative leaning Democrat. Some of the 3 million extra that voted for him, had a Supreme Court to rescue from liberal takeover. That is no longer an issue as courts are locked up for my lifetime with McConnell’s focused work in that area.

So that 3 million extra is not going to vote for him. I project half of those people – about 1.5 million will go back to vote Democrat. The number of Obama-Trump voters is estimated to be anywhere from 6.7-9.2 million. So I am vastly underestimating the number of voters that could switch from Trump to Warren. I am assuming only 20% conversion rate. If Trump goes back to 60 million and Warren picks up 1.5 million of disgruntled Trump voters and adds those to Clinton and Obama’s base of 66 million voters, we get about 67.5 million for Warren. So very preliminary estimate I have Warren 67.5 million and Trump 60 million. A difference of 7.5 million. You can’t overcome 5-8 million vote difference in the Electoral College. So Trump is looking at these numbers and impeachment route is the only way for him to get out in a blaze of glory. So an impeachment/resignation bomb is probably due any week now. Odds for Trump impeachment in his first term are at 75%. Odds for him resigning are at 25%.




Why You Should Invest In Bitcoin and How

Originally sent to VIXCONTANGO subscribers on February 16th, 2014

It is often amusing to watch the current public debate about bitcoin (BITCN). On one side stands the financial community with its legion of bankers, highly credentialed academics and mainstream financial media. On the other side, a group of highly skilled computer programmers (cryptographers), venture capitalists and e-commerce retailers. These two groups are not comfortable around each other in real life and now they are forced to come to a consensus about a technology that sits at the cross-section of their respective industries. The learning curve in both of these industries is long and difficult. It takes dozens of years of study and practice for someone to become a seasoned financier and just as much to become a top notch computer architect and cryptographer. Very few are the people who can speak fluently both industry languages and so for the time being, we have two groups that are shouting past each other.


The general public knows little about high-finance and even less about grid computing. All they see is a lot of noise coming out from both camps and are rightfully confused and probably even a little amused. There is nothing like watching a good catfight.  But as a software developer in the financial industry for the past 10 years, nothing excites me more than the technology of money and I am a little frustrated by all the fracas. I am writing this article in order to bring some clarity to what bitcoin is, dispel some common myths about it, provide a valuation framework for it and educate investors about the current  methods for investing in it.

So.. What Exactly is Bitcoin?

Everybody who wants to learn about bitcoin should start by reading the Bitcoin Whitepaper. It is a succinct academic paper worthy of a tenured professor at Stanford. I will take the liberty and highlight a couple of important paragraphs and then I will  provide some clarifications about the concepts expressed for those not versed in computer programming.

Bitcoin: A Peer-to-Peer Electronic Cash System

Abstract: A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution..

We have proposed a system for electronic transactions without relying on trust. We started with the usual framework of coins made from digital signatures, which provides strong control of ownership, but is incomplete without a way to prevent double-spending. To solve this, we proposed a peer-to-peer network using proof-of-work to record a public history of transactions that quickly becomes computationally impractical for an attacker to change if honest nodes control a majority of CPU power. The network is robust in its unstructured simplicity. Nodes work all at once with little coordination. .. Nodes can leave and rejoin the network at will, accepting the proof-of-work chain as proof of what happened while they were gone. They vote with their CPU power, expressing their acceptance of valid blocks by working on extending them and rejecting invalid blocks by refusing to work on them. Any needed rules and incentives can be enforced with this consensus mechanism.


  1. Bitcoin Computer Network

This is a peer-to-peer computer network that facilitates the transfer of digital property from one computer to another. A peer-to-peer network is a computer network that allows any computer to participate in it; there is no central computer that acts as a hub for decision making or transmission. As a result, you can’t simply target one or two computers and shut down the entire network. The computers can reside in any country in the world. Unless you shut down the entire internet, the bitcoin network computers will always be there to power the network.

  1. Bitcoin Wallet

There is widespread confusion about what a digital coin is. We are all familiar with the dollar bill or a gold bar. Something tangible that represents a unit of value. The fact is digital coins do not exist. What does exist however is a digital wallet. The bitcoin wallet is simply an account with a balance. We are all familiar with the concept of a bank account – a unique identifying number that has another number (the balance) attached to it. In fact, this is how the Fed executes quantative easing – they simply credit bank reserve accounts with digital dollars. A bitcoin wallet carries a balance in a fictitious unit of value (currency) called a Bitcoin (BTC). When a bitcoin transaction occurs, one wallet sends an amount measured in BTC  to another wallet.

Bitcoin wallets come in two flavors – a personal computer wallet and an online wallet. The PC wallet is an application like Bitcoin Armory, which is installed on your personal computer and creates a file on it that becomes your bitcoin wallet. You need to secure the wallet (the file) with a password (also called 1-Factor Authentication). You can only send a bitcoin to another wallet if you provide the password. An online wallet, on the other hand, is an internet company like which creates a bitcoin wallet for you which is stored on their computers. You can send bitcoin to another wallet by logging into the site and providing your password. The better online wallet companies like Coinbase employ 2-Factor Authentication. In addition to your online password, they employ a second verification procedure by sending a one-time code to your smart phone or via a phone call.


By convention, the first transaction in a block is a special transaction that starts a new coin owned by the creator of the block. This adds an incentive for nodes to support the network, and provides a way to initially distribute coins into circulation, since there is no central authority to issue them.  The steady addition of a constant of amount of new coins is analogous to gold miners expending resources to add gold to circulation. In our case, it is CPU time and electricity that is expended.. … Once a predetermined number of coins have entered circulation, the incentive can transition entirely to transaction fees and be completely inflation free.

  1. Miners

The miners are simply the computers that power the bitcoin network. They provide computing power in exchange for bitcoins. Mining is the only way to fund a wallet with a bitcoin balance without a transfer. Since computing power costs real money, the network awards them bitcoins in return hoping that the bitcoins carry enough value to justify the expense. This has the added effect of drawing participants to the network as miners instead of hackers trying to bring it down. Why would anybody incur a significant expense to bring the network down when they can just mint digital money from it? When the bitcoin money supply is reached in the future, the network will continue to pay miners by awarding them transaction fees in bitcoin.

  1. Blockchain Ledger

This is a publicly available ledger available from each Bitcoin miner in which all transactions are recorded for everyone to see.  When one wallet sends an amount to another wallet, a transaction is recorded. The verification of each transaction is based on the previous transaction. Because the entire history of transactions is always available, potential hackers cannot duplicate transactions or reverse transactions. In other words, people can’t make digital balances appear from thin air. As a side benefit, every transaction is perfectly traceable allowing law enforcement perfect visibility into the flow of money. It should not be a surprise that all bad actors have been fairly quickly brought down by the FBI. The block chain and all currently happening transactions can be observed at


  1. Proof-of-Work Algorithm

This is a SHA256-based computer cryptography algorithm that is used to execute a transaction. The algorithm takes a log of all existing transactions in order to verify the current transaction. This requires substantial computing power. Computing power can only be generated by electricity. So an inherent cost of running the bitcoin network is electricity and computer equipment. Electricity and computer equipment cost money. In order for a bad actor to try and take the network down, they have to have access to computer equipment and electricity larger than the combined resources of all independent miners participating in the bitcoin network.

Common Myths About Bitcoin

The following myths are widespread in the media, the blogosphere and general public opinion. I’ll take the time to rebut them one by one:

Myth #1 – Bitcoin is insecure, hacker heaven

The Bitcoin network uses SHA256 cryptography which is currently unbroken. All instances of hacking have occurred when hackers have hacked into people’s PC wallets and transferred money from their wallets. Hackers can hack into anybody’s computer and steal their bank account user name and password and transfer money. In fact, banks incur north of $1 billion in losses due to hacking. People who are not computer experts will always be hacked. The bitcoin network itself has never been compromised. It has been attacked, but it has never been breached or broken. Hackers have also attacked successfully online wallet companies such as the Australian company TradeFortress. It is very important that you do your due dilligence properly and only open accounts with leading bitcoin wallet companies who employ top notch computer security experts such as or

Myth #2 – Bitcoin is untraceable, money launderer heaven

The presence of the block chain ensures that every transaction is publicly visible and publicly tracked. The openness and transparency of bitcoin transactions is at a far higher level than that of any current payment network – be it Paypal or interbank transactions. You currently cannot go and inspect Paypal or interbank transactions anywhere online. A bitcoin transaction occurs between two wallets and wallets are either the property of online wallet companies or individual computer. Law enforcement can always track down a wallet owner by requesting information from the wallet companies or inspect the IP address of a PC’s wallet. As a matter of fact, gold or cash is far more anonymous than bitcoin. There is no link between a gold bar or a dollar bill and its owner. In the bitcoin world, a computer IP address and a wallet can be linked (please note that the IP address is not recorded on the block chain, only the wallet).

Myth #3 – Bitcoins have no intrinsic value

The bitcoin network allows two people to make a transfer of value that is unquestionable, irreversible and recorded for posterity. It is unquestionably a medium of exchange.  The value of the bitcoin network, as anything else out there, comes out of the value that it provides. So long as people use the network to transfer value, the network itself will have value. According to Metcalfe’s law the value a communication network is proportional to the square number of its users. At present, there are roughly 140,000 bitcoin addresses used per day and 70,000 transactions. Clearly if 140,000 people use something every day, it has value. And the higher the number of users in the bitcoin network, the higher its value will go.  Since the access mechanism to the network is a digital wallet with a ballance, any user of the network will have to pay to get access to the network’s unit of account – the Bitcoin (BTC). That makes Bitcoin also a store of value. The best way to think of bitcoin is digital gold. While the price will fluctuate based on market conditions, it has inherent utility and people will pay to use it. Marc Andressen, the famous venture capitalist, recently wrote an excellent article “Why Bitcoin Matters” here on Seeking Alpha. He makes very compelling arguments in favor of bitcoin’s real-world usability and found a number of practical applications that will contribute to a further increase in its value.

Myth #4 – Bitcoin is illegal

The legality of bitcoin depends on what jurisdiction you live in. Certain countries have passed taxation laws regarding bitcoin. If it is taxed, it is legal. Other countries have banned it. The following is summary of important countries and their treatment of bitcoin. Note that bitcoin is problematic mostly for countries with a history of strong capital controls such as Russia, China, etc. The preponderance of countries seem to be leaning towards making bitcoin legal:


Bitcoin Valuation

I will attempt to provide a valuation framework for Bitcoin by looking at it from a variety of angles. I will employ a top-down valuation method (comparing it as a currency versus the global money supply and as a commodity versus gold), a comparable valuation method (comparing it against the market cap of other payment networks such as MasterCard) and a cost-based valuation method (what does it cost to run the bitcoin network).


Bitcoin as Currency

The definition of currency in Merriam Webster is as follows:

something (as coins, treasury notes, and banknotes) that is in circulation as a medium of exchange

Bitcoin is clearly a currency as it is a medium of exchange. While it doesn’t take physical form, many officially accepted currency transactions today are done in a similar fashion – electronically. Only about 10% of US Dollars in circulation – $1 trillion- exist in physical form as banknotes and coins. The remaining $9 trillion is all digital. Let’s take a look at global money supply:


I have decided to look into the top 10 economic areas of the world since that is where the overwhelming majority of global economic activity happens. In the table above, I have taken the 2013 year end money supply figure from Trading Economics  and the corresponding year end exchange rate to arrive at a valuation of all currencies in US dollars.

As can be seen clearly, the US dollar is only the third biggest fiat currency in the world superseded by the Yuan and the Euro. To all critics who think the Fed is too loose, they only need to look here to discover the worse offenders. China is by far the biggest printer of fiat currency in the world, followed by the ECB which for some reason has a hawkish reputation.

There are currently about 12.4 million bitcoins. About 1.8 million BTC will be mined in 2014. The lifetime money supply of bitcoins is limited to 21 million. If all the bitcoin ever minted backed the entire G10 money supply, that would give it a valuation of $2,714,000. If bitcoin ever backed the reserve currency of the world, the US dollar, it would give it a valuation of approximately $524,000. However, this is unlikely to happen, so instead we will value it based on possible adoption. There are 3.8 billion people living in the G10. According to the latest figures from and Coinbase – the two largest online bitcoin wallet operators – they have a combined 1.4 million registered bitcoin users. There are 3.8 billion people living in the G10. So that gives bitcoin a current penetration of 0.04%.

At present approximately 1.5 million people give bitcoin an $8 billion market cap with 12.4 million BTC in circulation. The following is a table which models future increases in the bitcoin supply, user adoption in millions and a linear extrapolation of bitcoin value based on user adoption. According to Metcalfe’s law, the value of the bitcoin network should go up proportionally to the square of the nodes (users with wallets). I will be conservative here, however, and assume a linear increase.


According to this fairly conservative model, if less than 8% of the G10 population adopts bitcoin by 2023 and the bitcoin currency backs less than 3% of the G10 money supply, we are looking at a price of $77,000+ per bitcoin. Now granted, 8% of the G10 is 300 million people, population the size of the United States. However, this model assumes no population growth over the next 10 years which should also be considered extremely conservative.


Bitcoin as Commodity (Store of Value)

The definition of commodity in Merriam Webster is as follows:

an article of commerce especially when delivered for shipment

Bitcoin is often referred to as digital gold due to its limited supply. Bitcoin rose to prominence during the Cyprus crisis of 2013 as a safe haven store of value. Some countries such as Taiwan and Canada have decided to tax it as a precious metal and a commodity. As a result, it is not farfetched to see bitcoin emerge as a safe haven commodity during the next financial or market crisis.

All The World’s Gold (AWG) is currently valued at 6,300 billion dollars (168,000 metric tons times the 2013 year end closing price of $1200). In this model, I assume conservative increases in the price of gold as well as a conservative penetration of bitcoin as safe haven commodity. By 2022, I assume that bitcion will have only 10% of the value of AWG and gold spot will be trading at levels just below its all time high in 2011.


According to this fairly conservative model, if bitcoin emerges as a safe haven commodity that stores 10% of All The World’s Gold value, we are looking at a price of $54,000+ per bitcoin by 2022. If bitcoin truly emerges as a new money paradigm, it will not be farfetched to believe that such a penetration is possible if not downright conservative.


Bitcoin as Payment Network

There are already research reports out of Bank of America Merrill Lynch and Wedbush Securities that compare the bitcoin network to other existing payment networks. They assign different values to the potential bitcoin price ranging from $1,500 to $100,000. You can find more in information in depth here. The total basket of payment network companies has combined market cap of $315 billion. There are 5 billion credit cards in the world (1.5 billion of which are in the United States). This means that each credit card contributes nearly $63 to the market cap of the industry. At present levels, the corresponding number for a bitcoin user(wallet) is $5400. Clearly a very high value. Over time, the average market cap contribution will fall as adoption increases. However it is not out of the question, that bitcoin can one day carry a market cap of $315 billion. At that level a single bitcoin will cost $15,000. Assuming the more conservative bitcoin adoption that I have used in the prior two valuation models, I get the following table:


Bitcoin is currently only 0.03% of the global payment industry in terms of user penetration. At 300 million bitcoin users, the penetration will be roughly 6%. At 6% penetration, assuming a static market cap of $315 billion for that industry over the entire 10 year period, we are looking at a price of $900 per bitcoin.


Cost Based Valuation

One of the most geeky-fun aspects of bitcoin is the computing power required to run the network. According to a recent Forbes article, the computing power of the computers mining the bitcoin network recently passed 64 exa FLOPS (exa FLOP = 1,000 peta FLOPs = 1,000,000 tera FLOPs = 1,000,000,000 giga FLOPs). The combined computing power of the top 500 supercomputer in the world is 250 petaFLOPS. This means that the bitcoin network of computers employs 256 times the computing power of all the super computers in the world combined! To clarify a FLOP is a basic unit of measuring computing power. It stands for a Floating Point Operations Per Second. For comparison basis, the standard top-line Intel based desktop computer generates about 7 giga FLOPs. So the bitcoin network effectively employs 1 billion standard top-line personal computers.

Apart from the cost to purchase such equipment, it takes electricity to run this network. The network solves 7.5 trillion “hashes” per hour. Each of these 7.5 million giga hashes requires 650 watts of electricity to solve. This is equivalent to 5 million kilowatts per hour or roughly 120 million kilowatts per day. At the US average of $12 cents per kilowatt hour, this means that that the miners spend $15 million in electricity per day. According to stats, there is the equivalent of $2.5 million in new bitcoins mined per day (at price of $650 BTC/USD). Apparently, the miners are operating at a steep loss here losing north of $12 million dollars per day. Now the numbers for electricity cost are based on US prices. Some of the mining pools are based abroad, if not most of them, and can utilize lower electricity rates. But taken as it is, this model projects that it takes $15 million to mine 4,600 bitcoins per day which gives bitcoin a fundamental price of $3260.


We cannot really have a complete discussion about bitcoin without discussing some of the risks it faces. Here in order of importance, I will discuss some of the challenges bitcoin will face over the next few years.


Rise of Alternative Digital Currencies

Bitcoin is the first digital currency but hardly the last. Since it is an open-source code (meaning everybody can access it, read it and modify it), the rise of alternative digital currencies is inevitable. All it takes is for somebody to copy the code, change a functions in it and call it a DoggyCoin (ok, I know it is DogeCoin). You can find a list of all digital currencies at .Most of the current alternative currencies such as Litecoin, Namecoin, Primecoin, etc . are based on the Bitcoin software framework. They simply try to improve on some of its basic features such as the Proof-of-Work algorithm. Keep in mind that because the code is inherited, any improvements put into the bitcoin code will automatically flow into the alternative currencies based on top of it. The plethora of new currencies significantly changes the narrative of limited supply of digital coins. If money starts to flow into the alternative currencies, the overall amount allocated to digital currencies will get diluted across them and that could lead to sharply lower valuations of bitcoin. If 50% of investment and transaction flows go through alternative digital currencies, it is inevitable that the BTC price will have to reflect that and this is a risk that needs to be accounted for in the valuation models presented above. Adoption of alternative currencies is still a question mark as it takes more than a guy with a computer to get a currency adopted on a world-wide basis.

I need to mention here that two alternative digital currency frameworks have emerged over the past year that can prove to be serious competitors to the bitcoin framework:

Ripple – a Google Ventures project and currently the 2nd highest digital currency by market cap

Ethereum – an audacious project that will enable corporations, governments and the like to create their own cryptocurrencies fairly easily.

50%+1 Attack

The bitcoin framework requires that at least 50% + 1 of the computers (miners) in its network to be “honest”. If dishonest nodes are a larger majority than honest nodes, they can try to reverse the block chain and create duplicated coins or erase prior transactions. Given the large scale computing power employed by the network, a 50%+1 attack cannot really be perpetrated by a random group of unfunded hackers like Anonymous. An attack can be perpetrated by two sources:

  1. Rogue Government Attacker

If China decides to build a 100 exa FLOP computer deep in its mountains, it is entirely possible for them to launch a zero-day attack and disrupt the network. It is also entirely possible that the US government may already have a computing network with that power as recent NSA disclosures have revealed. The benefits to government related attack are unclear however. Most governments are rational operators and such an attack will probably not be started unless there is a war and the payment mechanisms need to be brought down.


  1. Miner Collusion

Miners operate in pools. The distribution of mining pool mining share can be found here. The top 3 mining pools are GHash.IO, BTC Guild and Eligius and they command a 72% share of the mining capacity. If these 3 pools decided to collude to bring down the network, who is to stop them? As discussed above, miners are probably operating at a loss at present. It is entirely possible that computing power may be withdrawn from the network in order to make it a profitable enterprise. This consolidation can lead to unintended consequences, one of which could be a collusion and an attack on the remaining participants.

Instability in the network will slow its adoption and as such it can be a significant risk to its valuation. At present, the bitcoin network gets attacked daily but so far the cryptographic community that supports it has been able to successfully defend against all attacks.

Government Regulation

I need to mention government regulation as a potential source of risk although I highly doubt that it will in fact come to fruition. As mentioned in a segment above, most governments are on track to tax bitcoin and therefore legalize it. After all which government doesn’t want more money in its coffers, even if it is bitcoins!

Future Catalysts

There were two big catalysts for the bitcoin rise to prominence in 2013. The Cyprus Crisis in March established bitcoin as a safe haven and brought the world’s attention to it. The price spiked from $10 to $200 in a matter of days. The second catalyst was the US Senate hearing on digital currencies on November 18, 2013.

“We all recognize that virtual currencies, in and of themselves, are not illegal,” Mythili Raman, acting assistant attorney general at the Justice Department’s criminal division, said at the hearing.

The conclusion from that hearing was that bitcoin is not illegal (which means pretty soon it will be taxed and made legal). That made bitcoin spike from $100 to $1000 within days.

Looking towards 2014, what are the big catalysts:

  1. Introduction of a Bitcoin Exchange Traded Fund (BITCN)

The Winklevoss twins of Facebook fame are major investors in the digital currency and have appeared on CNBC and various other venues to promote it. They have also filed paperwork with the SEC to establish the Winklevoss Bitcoin Trust which is an Exchange Traded Fund.  It is currently not approved yet as the government and the Winklevii are trying to determine whether bitcoin is a currency or a commodity. In due time, though, the fund will be approved and that will open up bitcoin to the liquidity of the world capital markets. I expect that event alone to lead to 10x spike in the price of bitcoin as various asset allocation funds start to allocate capital to it.

  1. Major Retailer Adoption

Already and accept bitcoins. has already booked over $1 million dollars in sales from bitcoin sales. Major retailers are aware that bitcoin can shave their payment fees and in addition can open their website to the world. Every internet retailer out there can be accessed from abroad, the problem is that foreigners lack the ability to make a payment via a credit card or check. Bitcoin will very neatly side-step that problem and retailers can now increase their footprint on a global scale without investing a cent in additional infrastructure. They all will be very happy to ship to China or Europe. I look to bitcoin being accepted by major internet companies like Google and Microsoft or retailers like Amazon and Walmart as a major catalyst in its adoption and I think that will attribute to a 2x spike in the price of bitcoin. From the rumors I have seen posted online both Google and Microsoft are looking into adopting bitcoin. Google has a stake in Ripple and Bill Gates, through his philanthropy work in Africa, is well aware of the benefits of bitcoin as a micropayment system.

  1. Introduction of taxation framework in the United States

When the bitcoin tax guidelines get released by the IRS, this will put uncertainty as to the legal status of bitcoin to rest. Bitcoin has already been declared not illegal, but most people are not aware of that fact. When the government issues bitcoin tax guidelines, that will be the final undisputable proof and the majority of skeptics will have to accept it. That will also remove uncertainty in the venture capital community as well and funds will be released to companies in the bitcoin economy.


How to invest in bitcoin now?

There are 2 ways to invest in bitcoin right now:

  1. Open an Online Bitcoin Wallet at Coinbase

Coinbase is the largest US based online wallet. It has a US banking partner (Sillicon Valley Bank) and allows you to purchase bitcoins directly. It has opened wallets for over 600,000 customers. Coinbase employs Charlie Lee, a top notch cryptography expert, a former Google security employee and creator of Litecoin – the second most popular digital currency. One of its founders is a former Goldman Sachs employee. Coinbase keeps your bitcoins offline in case their systems get compromised. That hasn’t happened yet and the fact that prominent VC Marc Andreessen just invested $25 million in them should give you the peace of mind that no expense will be spared to protect you. Coinbase also has a very easy to use website and makes converting USD into BTC and BTC into USD a snap.


  1. Buy Physical Bitcoins

You can buy physical bitcoins on eBay issued by official Bitcoin minters such as Casascius, Titan BTC and Lealana. These vendors are authorized by the Bitcoin Foundation to mint bitcoins and their purpose in life is to represent the bitcoin world with integrity and spread trust in the system. You can also buy the physical bitcoins directly from these vendors by contacting them via email or going to their websites.  Please note that due to their limited supply physical bitcoins often trade on eBay far above the spot BTC price. For example, a funded 1 oz Silver Cascascius 1 BTC coin with Gold Rim goes for north of $3,000.


Physical bitcoins are also collectibles and the earlier the minting date of the coin, the higher the price. I have seen early edition Casascius coins go for as much as $10,000. Physical bitcoin is probably the best way to invest in bitcoin for an investor who is uncomfortable storing money on the internet with companies that might get compromised. The only thing an investor needs to know is that the coin is funded and that it hasn’t been compromised. All of these coins utilize 1-Factor security. In order for the digital bitcoin to be spent, the hologram on the back of the coin has to be scratched to reveal the password needed in order to transfer the coin. The issuers of these coins destroy the private key behind the hollogram. Make sure you buy a funded coin with an untampered hologram, put it in a bank safe and you are good to go.


Every decade a new disruptive technology comes along that radically changes our lives. The new technology is always met with significant consternation by the public and it triggers a worldwide cultural debate. The proponents think it moves civilization forward, the critics denounce it as the end of civilization. The personal computer in the 1980s, the internet in the 1990s, the smart phone in the 2000s. Over time the technology gets adopted and becomes a part of our everyday life. The next generation can’t picture their life without it. The 2010s are here and the technology of the decade is digital currency. Bitcoin’s purpose is clear and audacious. Revolutionize the second oldest industry in the world – the financial industry! Such a significant invention threatens the status quo and its initial adoption will be difficult and meet a lot of resistance. Institutions need time to adjust to the change but adjust they will. There is no doubt that – in the end – progress always wins and civilization emerges the better for it.


Senate 2020 – Early Handicap

Originally sent to VIXCONTANGO subscribers on December 12th, 2018

With Democrats just having captured a large majority in the House (235 seats), one of the positives for Republicans was that they were able to increase their Senate majority by 2 votes to get to 53. I was expecting Republicans to do a little better, however, and get to 55 by picking up the John McCain seat in Arizona and take the John Tester seat in Montana. Republicans were only able to add seats in Florida, Indiana and North Dakota on the heels of the Kavanaugh hearings and I was expecting them to do better. So I got a negative disappointment here versus my expectations. While my political prognostications are vastly better than most of what you see out there, I still review my failures even as small as they are to see what I got wrong. In the shadows of those marginal surprises is where big new political trends lurk. In particular, what pissed me off to no extent was the loss of the Arizona Senate seat. The GOP most definitely screwed up with Martha McSally who was a weak candidate but I still thought the McCain mafia was going to push her through. But they couldn’t and that is super important because the demographic trends in Arizona don’t get any easier for the GOP over the next 2 years. If Kyrsten Sinema could squeak by in 2018, her clone will trample in 2020.


 While the map for Democrats was historically difficult in 2018, the script is going to flip in 2020 when the GOP will face a historically difficult map. In 2020, the GOP will defend 22 Senate seats while the Democrats will only defend 12 seats. It is a sea of red up there. Most of Democratic seats up for grabs are in Democratic strongholds such as Oregon, Illinois, Virginia, New Jersey or Massachusetts. The only real question mark for Democrats is the Doug Jones seat in Alabama. On the other hand, Republicans have a very problems in a lot of places. Here is a list of the Republican Senators who won with less than 53% of the vote:

Arizona – Jon Kyl (appointed on McCain’s death and will not run for reelection)

Alaska – Dan Sullivan – 48%

Colorado – Cory Gardner – 48%

Georgia – David Perdue – 53%

Iowa – Joni Ernst – 52%

Kansas – Pat Roberts – 53%

North Carolina – Thom Tillis – 48%

South Dakota – Mike Rounds – 50%

Maine – Susan Collins (state overall votes heavily Democratic)

This is definitely a list of Senate seats that can flip Democratic in 2020. Democrats just won in Arizona and demographically they will only build a bigger lead in this state over the next 2 years. Add Colorado, Georgia and North Carolina to this list of states that are going through a demographic makeover. Iowa and Kansas voted with a decidedly Democratic bent in 2018 at the House level. Some of the shocking victories for Democrats in 2018 were in the Bible Belt. In Maine, we have a unique situation where Susan Collins has made some big votes (most notably for Kavanaugh) which can cost her in what tends to be a very Democratic State otherwise. Maine doesn’t have a single Republican House representative.

If I was to handicap this, this I would say Democrats lose the Doug Jones seat but gain seats in Arizona, Alaska, Colorado, Georgia, Iowa, North Carolina and Maine. This is a net pickup of 6 seats. So Senate goes from 53 seats for GOP to 53 seats for Democrats in 2020. Chuck Schumer had a very mysterious smile the entire time during the “Rumble in the Oval”. The reason why he had the smile is that he knows that Trump’s Senate majority will only last 2 years. And after that the Senate goes back into Democratic hands with 95% probability.

Guess what that means? The Democrats will be digging in their heels big time against Trump. Every trick in the book will be used against him. And if Trump is impeached or loses the 2020 election, with an even bigger Democratic majority in 2020 and 53 Senators, the entire Trump agenda will get erased from the history books. The tax cut, everything. If there are any “deals” or wins for Trump over the next 2 years, they will be all on Democratic terms. Don’t expect Chuck Schumer and Nancy Pelosi to back down on anything. And given the progressive bent of the new incoming Congress, even if anything gets done, I am not sure there will be much gravy in it for Wall Street. Sorry.

Early 2020 Senate Projection: 53 seats for Democrats

The Border Adjustment

Originally sent to VIXCONTANGO subscribers on January 14th, 2017, almost a year before Trump’s Tax Cuts And Jobs Act was signed

New Economic Geography

Ever since the fall of the Berlin Wall on November 9th, 1989, we have lived in the era of Globalism. Many long-standing economic and societal borders fell around the world between the Communist block that encompassed 70% of the civilized world and the Capitalist block that covered the more economically successful remaining 30%. Governments across the world started to build a new world order of international economic cooperation that was going to bring peace and prosperity. A major undertaking like that has a theory behind it and the creator of the theory of Globalism is none other than conservative pariah and liberal idol, Paul Krugman. Paul Krugman is one of the premier economists of our time and an extremely smart individual. And he would have been universally revered if he didn’t compromise his integrity by advocating for unreasonable radical economic solutions and misused his economic integrity in the pursuit of partisanship, thereby becoming a political hack with a limited shelf life.


Krugman major contributions to the world are 2 academic papers. The first paper is called “International Trade and Income Distribution: A Reconsideration” published in 1979. In it he lays out an economic theory called “New Trade Theory” (NTT). Prior to New Trade Theory, international trade theory emphasized that trade between countries is based on comparative advantage of countries with different characteristics. Saudi Arabia has oil, France has wine and they trade red gold for black gold. While that is still true to an extent, as borders and tariffs fell, international trade started to move differently and the original model couldn’t explain these movements. This is what Krugman’s paper did, explain the new patterns of trade. In it, Krugman observed that a larger share of trade happens between countries with similar characteristics. Why are Japan and the US, trading so much when both economies make the same things – cars, power tools, electronics, computer chips? Krugman says that consumers prefer a diverse choice of brands (expanded selection) and that production factors economies of scale. Consumer preference for diversity explains why you have 20 different car brands, but economies of scale make it so that production is localized. In addition to economies of scale, lower local transportation costs lead to a “home market effect”. A country with large demand for a certain good will produce more than the proportionate world share of the good and will over time become a net exporter of it and that process will kill off production of that good in smaller markets. So production doesn’t occur in all countries in the world but just one or two or three over time. That is why now you only have France and Napa Valley as the only wine producers of major sales consequence. Why only Japan, the US and Germany produce cars. Why only US and Europe produce airplanes. And why China and the US are the only ones making smartphones. This is New Trade Theory. It is very obvious, but it was not so obvious 35 years ago. In that paper Krugman also correctly predicts that while there are economies of scale in production, countries will eventually become “locked into” disadvantageous patterns of trade. Krugman points out that while globalization is a net positive, ultimately globalization turns into hyper-globalization which plays a major role in rising income inequality.

He expands on the concept of hyper-globalization in a paper called “Increasing Returns and Economic Geography” published in the Journal of Political Economy in 1991. In that paper he lays a new economic theory called “New Economic Geography” (NEG). In NEG, the “home market effect” is exacerbated and that results in disadvantageous patters of production inside a country and across economic geographies. Not only is production concentrated in countries, it increasingly becomes concentrated in metropolitan city regions. The regions with most production become more profitable and they then have the ability to attract even more production and kill off production in competing regions. So instead of production being spread evenly around the world, it becomes concentrated in a few countries, regions and cities which become very densely populated and feature higher levels of income. So the world becomes either a high rise city of highly paid professionals or a barren countryside with barns that are falling apart.


The body mass of all 7 billion people of the world inside the Grand Canyon

That is why if you live in Manhattan you are concerned with the “overpopulation” of the world and if you blow a tire in Fishkill only 50 miles away from Manhattan, you have wait 5 hours for the AAA truck to show up (trust me, it has happened). In other words, if you want to have a good high paying job, move from Detroit to New York. If you want to make money in real estate, sell Detroit, buy Brooklyn. I have personally observed this in my lifetime where landing me in New York was the best thing that ever happened to me professionally. I could always line up at least 2 job offers in the span of a week. That gave me both choice of work and an advantage in salary negotiations. I wanted to live in San Diego originally, but for my skills there were zero jobs there at the time. I looked for months. In New York, I didn’t have enough time to reply to all the job postings posted in a single day. And none of this is a function of how smart I am but simply the relative strength of the economic region.

Needless to say Krugman’s theories have been very prescient, what they have described has become a focal point of international affairs and very deservedly he was awarded a Nobel Prize in 2008. In fact, in his case, even a Nobel Prize is an inadequate reward for his intellectual achievements. What is even weirder is that his theories foresaw the rise of desolate economic regions, the resulting increase in inequality and the rise of political movements to counteract this effect of hyper-globalization. And of course having foreseen it, he has fought the emergence of economic nationalism tooth and nail from the very beginning. What is unfolding right now is his worst nightmare come to life.

In the mind of our leading economists, globalization is really the preferred approach to worldwide economic organization because it leads to larger cross-national economic regions. Larger economic regions result in increased economic activity via trade, result in higher specialization which means higher paying and more interesting jobs and results in efficiencies of scale which results in higher standards of living (people pay less for the same good over time). It is undeniable that they mean well for the world as a whole. There is hardly much to be argued with from a theoretical perspective.

But explain that to an air conditioning mechanic with 20 years of experience who just lost his job and there is no other such job anywhere in the entire country. He has to move to Mexico and learn a new language at 45-years of age in order to receive a lower salary. In the meantime, how is he going to pay for the $100,000 outstanding on his house loan given that his house value just tumbled by $40,000 dollars and if he sells his house, he is $40K in the hole which exceeds his meager savings? Economic theory is great, but the reality of life tends to get in the way of economic perfection.

The main factor that is NOT considered in globalist economic models is the concept of nations. Nations are not organized as such because they have a comparative economic advantage but because they have are a conglomeration of people of similar ethno-centric group, similar religion or simply a militaristic agglomeration. In fact nations exist for all kinds of reasons but economic advantage is not one of them. The reason why economics is not a reason for nation-state organization is because the economics of war, of military conflict, are highly asymmetrical. And have been since the beginning of time. A simple cheap cannon can destroy many houses that took years of effort, materials and investment to build. A nuclear bomb can destroy the combined accomplishments of thousands of years of civilization in a given city in an hour. As such the cheapness of military conflict and its ability to asymmetrically inflict economic damage, is the reason why nations are defined based on military characteristics more than anything else. Economic globalism is therefore a very fragile function of global peace.

Not only is the concept of nations not covered in Krugman’s theories, but also many more mainstream economic considerations such as:

Economic debt and credit levels

If a nation has high debt levels and loses its productive capacity, the leverage speeds the decline of the nation into bankruptcy. A bankrupt nation is therefore not capable to contribute as a consumer to the economic system. So a system with 10 participants, because of NEG becomes a system with only 3 rich participants and 7 bankrupt participants that ceize to be economic units. Production is concentrated but in the long run sales become economically concentrated as well as bankrupt consumers fall off the map.

Lower living standards

When productive capacity in an economy or country is removed, also its ability to pay taxes is removed. As such the citizens of this country experience a lower standard of living as they get less benefits. This not only does not stimulate economic growth it actually eliminates it.

Lack of flexibility in adverse circumstances

If all production is concentrated, during a war it becomes a very simple task to be destroyed quickly by simply eliminating a few important economic units. Decentralization is key component of war and of survival in general. A human can breathe through the nose and through the mouth. In case one thing malfunctions, the other one can take its place. That is why there are 2 eyes, 2 ears, 2 hands and 2 legs. Not because they are useful, but because they are redundant. They provide backup and added resiliency for survival in case the primary mechanisms are attacked or malfunction. Similar concepts apply to complex systems such as economies or computer systems. Centralized globalist economies are thus much more in danger of quick destruction than decentralized ones.

It is perhaps very befuddling for Krugman to witness the age of slow economic growth in the US over the past 20 years. He couldn’t have foreseen that the largest economic power will fall victim to Globalization. After all power should’ve concentrated more and more in the US as it is the dominant producer and the home market effect should’ve enabled that across a number of industries. The problem for an economic theory as always is reality and the lack of inclusion in it of enough important factors. For example, in Krugman’s theories nowhere is there made a reference to taxation regimes. In practically all of the world except the US, consumption is deemed a bad societal characteristic and is thus taxed. Countries with communist lineage love to tax consumption via VAT. Also in non-secular countries, religions often postulate that consumption is unholy or that interest is unholy. Consumption = bad. So the USA is pretty much the only country where consumption is not taxed because it is socially acceptable. So in the WTO, the US is the only country that taxes production and not consumption and everybody else taxes consumption but not production. The net effect is that corporations will choose to produce where they are taxed less and then sell where they are taxed less. Pretty logical choice, right? So corporations will chose to produce outside of the US and sell in the US. Normally, these discrepancies would get fixed by currency adjustment. But what if currencies are not allowed to adjust? What if China pegs its currency to the US dollar? Then the imbalance remains forever and heavily impacts economic activity.

Taxation is one factor that is seriously crimping Krugman’s vision. Others are loss of tax revenue, loss of government benefits, state subsidies and other mercantilist policies and the overall reality that global trade is a shark tank where each actor tries to get as much advantage as they can get and screw the others. The Globalist kumbaya is largely a figment of Krugman’s imagination. Every incomplete or bad theory eventually meets its inglorious demise and so does Krugman’s theory of New Trade and Globalization in 2016. So while Krugman’s theories crumble, the US has to adjust and somehow start collecting the tax revenue it ceded to China and other mercantilist players. How?

Border Adjustment Taxation

Before I delve further I want to make 100% clear one thing. The Border Adjustment IS NOT A TAX. Repeat again. The Border Adjustment IS NOT A TAX OR A TARIFF.

As I go further into the specifics of the House GOP (“The Better Way”) tax plan, it is very important to note that there isn’t a single tax hike anywhere in the plan. There isn’t a single tariff. The price of any good imported in the United States will not go up by a single cent. In other words, $100 of Mexican avocados in the US will still be $100 of avocados after the GOP plan passes, because there will be no additional tax or tariff applied to them. What changes is underneath the surface and is brilliant in its design and simplicity. And yet, it will result in massive amounts of money being put in the government coffers:


So what is the Border Adjustment?

Eliminate the deduction of imported goods and exempt sales of exported goods.

 That’s it. A simple accounting trick. Anything purchased abroad can no longer be deducted and anything sold abroad is no longer taxable (which is essentially what a territorial regime is). In other words, it makes complete sense even at the most fundamental of levels. If you bought it abroad, this is not economic activity in the USA so therefore why should it show on your US taxes in any form or fashion? Likewise, if something is sold abroad, that is where it gets taxed. What the heck does the US have to do with its sale? In all honesty, it is not even an accounting trick. It is how things should be.

This is the taxation regime of many countries in the WTO already. There is nothing earth shattering here. It is what corporations have always wanted – territorial taxation. Tax the sales where they occur, not where the corporation is headquartered or where the production plant is. In a cloud world, it gets very hard to pinpoint concepts such as headquarters or production plants. A web company with a global software engineering team produces in all 20 countries where it has engineers. Does that mean it has to pay production tax in 20 countries where each dude is? How much value add each dude contributes to the final product? It is a logistical nightmare to figure this out. It is much simpler to simply tax where the sales occur. And that is that. That immediately kills the need for inversions, because being headquartered in the US doesn’t mean you have to share 35% of profits in Saudi Arabia with Uncle Sam anymore. What you sell in Saudi Arabia gets taxed there and that is that.

What does that mean in practice? That means that importers will pay more in taxes as their import costs will not get deducted and what they pay extra in tax will get transferred to exporters who then get a tax credit. Very simple. The imports subsidize the exports. And make exporters more desirable on an after tax basis. No changes for domestic companies. And importers – they have to pay more in tax.


Source: Kyle Pomerleau, Tax Foundation

The most important thing of this is that prices for consumers will not change one iota because there is no tariff on an additional consumption VAT tax anywhere to be seen. Effectively from a retail sales perspective, the GDP growth projections do not have to change one cent. It is just that being an importer becomes a less profitable business. You know I feel really bad for the Chinese princelings that own the major Chinese import companies in the US. It’s going to put a crimp on their lifestyle. But not much else.

Would the WTO object to this? Here is what the Tax foundations says:

The World Trade Organization generally allows and expects consumption-based taxes (called “indirect taxes”) to be border adjusted. However, it objects to income-style taxes (called “direct taxes”) being border adjusted. So the corporate income tax is considered not eligible for border-adjusted treatment. This is the conventional treatment going back to the 1950s. However, there is a case for treating this tax as an indirect, consumption-based tax. Once a business tax allows full and immediate expensing of capital investment spending, it takes on the nature and tax base of a consumption-based tax.

Brilliant move, right?