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.