California screaming …

In August 1971, President Richard Nixon went on national television and shocked the world by defaulting on the gold-backed dollar system created at Bretton Woods in 1945.

Up to that point, dollars were essentially coupons for real money … gold. Foreign dollar holders could turn in their dollars and walk away with gold at $35 per ounce.

Nixon repudiated that deal without warning, promising it was only a “temporary” measure. That was over 48 years ago … and the world is still waiting.

It reminds us of Ben Bernanke’s promise that quantitative easing was only temporary. Yet, here we are 10 years later and it’s still here.

Yes, we know Jerome Powell doesn’t want to call it QE. Most people forget Ben Bernanke didn’t want to call the original QE “QE” either.

So Nixon tried to take the edge off the gold default by saying it’s only temporary, but he knew the world would react by dumping dollars … crashing the dollar and causing prices to rise.

If that’s confusing, just think of dollars like stocks. When something happens to trigger people to sell, the price falls.

When the dollar falls, it takes more dollars to buy the same products. That’s called inflation. And it hurts people who do business in the falling currency.

So while foreigners were upset about Uncle Sam’s broken promise, those paying attention could sell their dollars quickly and buy gold in the open market.

American citizens were not so fortunate.

That’s because back then it was still illegal for U.S. citizens to own gold. And the government had already taken all the silver out of the coins in 1965.

So even if Americans were smart enough to know what was happening, the best escape routes were blocked. Real money wasn’t readily available to them.

Being aware the American voter would be facing rising prices and falling purchasing power headed into the 1972 election cycle, Nixon attempted to stop inflation by executive order.

In fact, at the same time he defaulted on the gold standard, Nixon also ordered a national freeze on prices and wages.

You read that right.

In the United States of America, the land of the free, bastion of free market capitalism …

… by executive decree, and without warning, it became immediately illegal for a private business owner to raise prices on a customer or increase wages to an employee.

Of course, it didn’t work.

In fact, as discovered through his now infamous penchant for tape recording everything, it’s well-documented Nixon knew it wouldn’t work when he did it.

On February 22, 1971 in a recorded conversation with his Secretary of the Treasury, Nixon said,

“ The difficulty with wage-price controls and a wage board as you well know is that the God damned things will not work.”

“I know the reasons, you do it for cosmetic reasons good God! But this is too early for cosmetic reasons.”

But by August 12, 1971, the Secretary of the Treasury apparently convinced Nixon the time had arrived to put lipstick on the pig …

To the average person in this country this wage and price freeze–to him means you mean business. You’re gonna stop this inflation. You’re gonna try to get control of this economy. …If you take all of these actions … you’re not going to have anybody…left out to be critical of you.

In other words, it was all political theater to pander to pundits and voters. It doesn’t matter if it works … or if you even think it can. It only matters that you’re seen trying.

So just 3 days later, Nixon went on TV and pulled the trigger.

What does all this have to do with YOUR real estate investing?

Maybe more than you think. History often has valuable lessons for those who take the time to reflect on it.

You may have heard … California just enacted state-wide rent control.

California’s not the first to do this … Oregon holds that “honor”, having enacted their own version of state-wide rent control last February.

Of course, this is a governmental policy, so any discussion of it runs the risk of turning political and divisive.

But it doesn’t matter whether you or we agree or disagree with the spirit or letter of the law. That’s irrelevant.

The rent control laws are here like them or not, so the more germane discussion is about what rent control on this scale might mean for real estate investors … regardless of political stripe.

Now if you think none of this matters to you because you have no intention of investing in California or Oregon … think again.

Because even though each state’s law is different, the motives are similar … to “do something” (or at least appear to be trying) to address growing homelessness presumably created because “rent is too damn high.”

If this way of thinking catches on (and it seems to be), state-wide rent control could be coming to a market near you.

And like California, rent control laws could be RETROACTIVE.

Think about that.

Let’s say you’re a value-add real estate investor and you find an older, run-down, poorly managed property in a decent area.

You put together a plan and invest generously to improve the property to the benefit of the tenants and the neighborhood, expecting to earn higher rents for a better product.

But AFTER you make your investment, the government decides to make it illegal for you to raise the rents to your projections. And it’s retroactive.

You made a plan and took a calculated risk based on the rules in place … and wham-o! The government changes the rules after the fact.

Ouch.

Call us crazy, but that doesn’t seem fair. At least Oregon “only” made their rent control effective immediately. California’s law is retroactive seven MONTHS.

We understand politicians are trying to pre-empt landlords from jacking up rents before rent control kicks in.

Of course, this reveals a paradigm of how politicians view landlords … as greedy takers looking for every opportunity to screw over their customers.

Funny, some people see politicians the same way … but we digress.

It’s painfully obvious these lawmakers don’t understand real estate investing.

While it’s true, the laws allow rents to rise a “generous” spread of 5-7% over the (artificially low) CPI.

Maybe this is okay for new or fully renovated properties. No cap ex needed.

But the law specifically targets properties over 15 years old … the very ones most likely to need substantial renovation.

Worse, the law does NOT make an exception for capital expenditures, so the limit on rental increases potentially caps the incentive to fix up old, ugly properties.

Will rent control create a greater divide between the nice and not-so-nice areas as existing properties are starved of cap ex?

History says it will. Time will tell if it’s different this time.

Meanwhile, it’s wise for real estate investors to pay attention to laws in places like Oregon and California … even though they may not apply to you … yet.

Because when you look at California, it seems like they got some of their ideas from Oregon. Like Hollywood, politicians tend to copy each other.

And because affordable housing is a national problem heading into a heated election year 

… it’s likely other states are looking at the “leadership” of California and Oregon … and could be considering a rent control law variation of their own.

The opportunity could be in the overt and implied exemptions …

… like mobile home parksresidential assisted livingself-storage and other niches outside the cross-hairs of perhaps well-meaning, but sometimes misguided politicians.

Remember, markets are dynamic, complex systems affected by fiscal, tax, monetary, and regulatory policy as much or more than local demographics and economics.

It’s smart to pay attention to ALL of it … and objectively evaluate how each factor might impact you and your portfolio.

The future of growth …

Put on your thinking cap.  This one’s going to use some brainpower.  But if your investment plans involve money and the future, it’s probably worth the effort.

During our 2017 Investor Summit at Sea™, Chris Martenson warned that a financial system dependent on perpetual growth is unsustainable in a world of finite resources.

We’ll forego discussing “finite resources”, though there’s probably a lot of opportunity there.  The New Orleans Investment Conference is a great place to learn more.

For now, let’s consider “a financial system dependent on perpetual growth” … one of the most important, yet least understood, concepts about the eco-system we all operate in.

It’s simple, yet confusing.  Here it is in two sentences …

When dollars are borrowed into existence, the only way to service the debt is to issue more debt.  If the debt is paid off, the economy ends.

Imagine playing Monopoly and each player starts with $1,500.  With four players, the “economy” of the game is $6,000.  This “start” money comes from the banker.

New money is introduced two ways:

When a player passes Go and collects $200 from the banker … or when a player mortgages a property by borrowing from the banker.

Notice all the money to play comes from the banker.

So let’s MODIFY the game ever-so-slightly …

Let’s have the banker LOAN the start and payday money to each player at 10% interest per turn.

We still have four players starting with $1,500 each for an “economy” of $6,000.  But at the end of the first round, each player now owes the bank $150 of interest.

(We’ll forget about the additional payday loans … it just complicates the math and isn’t necessary to make the point)

But borrowing money into circulation creates three (hopefully) obvious problems …

First, there’s only $6,000 in circulation.  With total debt of $6,000 borrowed plus $600 of interest owed, it’s now IMPOSSIBLE to pay off the debt using only the money in the game so far.

And if the only way players get NEW money is borrowing, this creates a cycle of perpetually expanding debt.

Second, if each player paid ONLY the interest out of their $1,500 start money, after ten turns, they’ll have no money left at all.  But they still owe the original $1,500!

So you MUST GROW your asset base by more than the interest expense or you’re consumed by the debt.

Third, if all players try to free themselves from debt, they would take ALL the money in the game and give it to the banker, the game would end, and each player would still be in debt.

In this system, it’s physically impossible to extinguish the debt without extinguishing the economy and ending the game. 

Naturally, to keep the game going, the banker continually extends credit to the players.

It’s basically the way the global money system works and why people way smarter than us say it’s unsustainable.

It’s also like a Venus fly trap because any attempt to reduce overall systemic debt is deflationary, making existing debt even more burdensome.

Deflation means borrowers pay debt down with dollars worth more than those they originally borrowed.

Worse, any assets borrowed against have dropped in value.

Think of 2008 when the credit bubble deflated.  Property values fell, while the outstanding debt remained fixed.  Property owners were “underwater” (negative equity).

Meanwhile, the dollar was STRONG.  It took a whole lot LESS dollars to buy anything.

Everything was on sale and cash was king.  Lots of people got rich buying things with cash when others couldn’t borrow to buy.

Deflation is awesome when you’re sitting on cash.

You’d think lenders are happy to be paid back with better dollars.  And they are … IF they actually get paid.

But underwater borrowers often decide to default on the loan so they can keep their dollars.

So bankers HATE deflation.  No wonder the system they set up in 1913 demands perpetual expansion of debt and prices.

In fact, the Federal Reserve overtly targets 2% per year INFLATION:

“… inflation at the rate of 2 percent … is most consistent over the longer run with the Federal Reserve’s statutory mandate.”

Here’s the problem with perpetually expanding debt … it weakens an economy.

Sure, it drives inflation, but inflation weakens consumption.  When things cost more, people buy less.

Debt also requires interest.  Even at minimal rates, HUGE balances require big payments.

Interest on public and private debt take money away from production and consumption … causing both to shrink.  Just not at the beginning.

When first injected into an economy, debt gooses activity and provides a temporary high.

And as in our modified Monopoly game, once deployed, more NEW money is required just to keep the interest from consuming the economy. There’s a point where new injections produce diminishing returns.

Whew!  Thanks for staying with us.  Tape an aspirin to your forehead.

With that backdrop, consider this headline from Investor’s Business Daily

Here’s Why China’s Latest Growth Scare Should Worry You – May 30, 2017

Credit has been growing twice as fast as nominal GDP for years. The diminishing returns suggest that many loans are going to unprofitable ventures. They also signal that sustainable economic growth is far less than current growth rates. Such a rapid deceleration from the world’s No. 2 economy would sap demand and prices for raw materials such as copper, exacerbate overcapacity issues and act as a drag on an already-sluggish worldwide economy.”

Uh oh.  “Diminishing returns” and “deceleration” in the face of rapid credit growth.

When a junkie can’t get high, they either increase the dosage to the point of toxicity … or they wean themselves from the drug.

China is getting serious about weaning its economy off torrid credit growth, and data and financial markets already are showing early withdrawal symptoms.

Hmmm… sounds like they’re leaning towards weaning.  We like the addiction metaphor.

China and the United States are the two biggest economies.  What either does affects the world.

Right now, headlines say China is slowing its use of debt, which in turns slows its economic growth, with a ripple effect on other economies.

Meanwhile, the Trump Administration is talking bigly about reducing the deficit and debt. Will he do it? Can he do it?

Who knows? But if the global economic system sustains itself on ever-increasing debt. and the two biggest borrowers are going on debt diets … who’s willing and able to take on a bigger share of global debt?

And if no one does, then what happens to asset values?  Is deflation on the horizon?

Last question … then you can take a nap …

Would the Fed and other central banks allow deflation … or do they roll out QE4ever (quantitative easing) in an attempt to stop it?

Meanwhile, now seems like a good time to consider repositioning equity from properties and stocks with high asset values into properties with sober valuations and strong cash-flows.

After all, stocks and even real estate values might be a roller-coaster ride, but rents are more of a merry-go-round. Boring, but a nice place to hide when feeling queasy.

Until next time … good investing!


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