Control what you can control
Psychological autonomy, planning, and investing.
One of the most helpful things I learned from my elders as a child was that I and everyone else have a secondary superficial self that most people mistake for their real self. This secondary self rejects new information out of hand because it feels threatened by anything it doesn't understand. This knowledge has helped me immensely in that I can most often laugh at my own defensive reactions to new information, see the hostility that many people respond with to new information for what it is, and attempt to buy time for the information to sink into the real Self. It doesn't always work, of course, but it does help to avoid needless arguments and conflicts. More importantly, it has helped me avoid bad relationships and focus on building genuine relationships built on trust and sincere desires to care for each other and be worthy of each other.
What does this have to do with wealth management and planning? Over the last 20+ years of helping families maximize risk-adjusted investment income, I have found that effective investing is technically quite easy but psychologically difficult for most people.
The average person simply does not have the required degree of psychological autonomy to execute a functional risk-adjusted investment strategy through all the ups and downs of capital markets, politics, and personal life; sustainable financial independence is inseparable from psychological autonomy.
What Housing Prices Can Tell Us About Psychology and Markets.
Santa Barbara County can never build enough private market housing to meet either shelter or investment demand. Yet, our politicians continue to enrich private developers and landlords by failing to impose local population caps based on relevant ecological constraints and by purchasing and building residential and commercial properties owned and managed by the local Municipality or County.
My family and I are long-term residents of Santa Barbara County. My wife's family has lived here for over a century. I am also an investor and investment manager who has tried for many years to educate our politicians and civil servants about financial theory and how it relates to land use, housing costs, and social outcomes. Real estate is not a commodity. It is a financial asset and a necessary good supplied by the largely private banking sector. Unlike commodities, financial assets are defined by the fact that they yield long-term cash flow. In the case of Real Estate, we call this rental yield.
The unregulated private market as a whole will not supply financial assets at a rate that reduces asset yields (cash flows). Rental yield = annual cash flow from the stock of the asset). The public must understand that assets are priced based on global investors' willingness to hold the asset's stock. Understanding that "investors" does not mean professional investors and corporations alone is critical. It means anyone who owns or seeks to own financial assets such as housing, stocks, and bonds. As a global group, investors attempt to maximize yield. Therefore, they compare yields on real estate, stocks, and bonds. Then, they adjust for local and relative risks. The adjustments create price differences between different housing stocks (locations), companies, municipalities, nations, etc.
This all means there is no rational reason to believe that the private real estate sector will ever supply so much housing to raise vacancy rates to the point where rental yield falls in any sustainable manner in any location. No, the private market will always and everywhere stop supplying financial assets as soon as surplus supply sits idle for too long.
We could permit developers to build 10,000 private market housing units in 2024, which would do nothing to reduce the cost of housing in Santa Barbara County. Why? Because far more than 10,000 people worldwide have the means to pay more than the market rate for housing units in Santa Barbara County. Investment demand (not composed of corporate demand alone, but all private demand for financial assets such as housing units) at Epsilon above the prevailing rental yield is effectively infinite. "Epsilon" in the context of housing is the always limited quantity available above the prevailing market rental yield.
Therefore, I have been preaching for many years, mostly to deaf ears, that the only solution to affordable residential and commercial buildings in Santa Barbara County (and everywhere else in the developed world) is public funding and ownership of downtown properties and a significant share (roughly 20%) of the residential housing stock. Everything else is political preferences.
Suppose we are truly interested in solving land use problems in our country. In that case, I recommend talking to financial experts like me who understand how markets work and to biologists, ecologists, and sociologists who understand the biological constraints we are all subject to. By contrast, Economists love things that only make sense if we ignore the problems of incomplete information and supply and demand dynamics driven by limited human rationality; human group psychology defines the path of prices.
The dynamics of inflation
Economics is of little help to investors, city planners, or policymakers. What we need is financial theory, math, and biology. Which brings us back to the opening paragraphs of this letter. What is inflation, and why is it so poorly understood by Economists?
Definitions
Inflation is a sustained increase in the price level of goods and services.
Disinflation is a decrease in the rate of inflation.
Deflation is a sustained decrease in the price level of goods and services.
Economics has so much difficulty with, not just inflation and deflation, but also interest rates, asset pricing, and supply and demand dynamics because, to make standard economic models work out mathematically, two simplifying but false assumptions are made by economics. The first false assumption is that humans are fully rational, and the second one is that humans can efficiently filter noise from signal; that they have high quality information.
Like housing costs, inflation and deflation are not mysterious forces that cannot be understood or managed. Biology/Sociology tells us precisely what persistent inflation or deflation is; a generalized breakdown of institutional trust generally associated with poor nations where the urgency of consumption is very high. When interpersonal and institutional trust breaks down bad things happen, and everything becomes more inefficient and expensive. Such nations experience a high degree of price volatility because supply and demand cannot enter into a stable relationship; distrust and uncertainty is simply too high.
The dynamics of ideology
A breakdown of the national administrative state has preceded every historical instance of persistent inflation or deflation. In modern times, the United States has never experienced persistent inflation or deflation. We have experienced transient episodes of inflation. Transient spikes in inflation are a completely different phenomenon. They are set off by supply disruptions such as those experienced in the United States in the 1940s, 1970s, and 2020s.
Persistent inflation is a product of poverty and a broken administrative state.
When global Capital markets lose trust in the ability of a nation to hold fair elections, collect taxes, invest, enforce the Constitutional order, and organize justice and defense, markets lose faith in that nation's future output capacity.
Capital markets will then demand higher and higher rates of interest on that nation's bonds. Therefore, real (inflation-adjusted) rates tell us if institutional trust is rising or falling.
The chart below show the year over year real interest rates of Argentina and the United States through 2022. The Red line is real rates in Argentina and the Green line is real rates in the US. One nation is trusted by global Capital markets to maximize national output and the other is not. (The absolute levels are less important as an indicator of institutional trust than the volatility).
The United State's national debt is not growing too fast and US government debt levels are not "unsustainable."
The spike in interest rates and inflation has, in fact, nothing to do with Government debt. These price movements were set in motion by the COVID-19 pandemic and global concerns about the American Administrative State.
With two significant exceptions, from 1945, global Capital markets have rated American institutional integrity and efficiency highly. The first crisis of confidence occured when the Nixon administration abandoned the Gold standard and shortly thereafter was found to have interfered directly with the election process. This loss of confidence crashed the US economy and first took real rates into negative territory during the deflationary episode of 1975 followed by a decade of rising real rates that finally peaked in 1984.
Market confidence in the US Treasury, Federal Reserve, IRS and the capacity of the American Administrative State, kept growing until about 2012 when it became increasingly clear to investors that 40+ years of deregulation had not just set Corporate America free to compete in global markets, but had also done serious damage to the nation's administrative capacity.
National output depends on a functional administrative state; make no mistake about it.
The Covid pandemic and the chaotic transition of political power in 2021 that culminated with a mob successfully assaulting the United States Capitol, proved to global Capital markets that the American Administrative State is badly damaged. (See black arrow).
We have seen what happens when global Capital markets lose trust in the integrity and resilience of a nation's institutional structure; will we learn from history?
The American people now have a simple choice as a nation; either rebuild the American Adminsitrative State and reform our instituitional structure on more resilient foundations, or face increasingly volatile socioeconomic conditions as global Capital markets demand higher and higer compensation for holding our debt. For now, real interest rates have peaked as of November 2023, but global Capital markets are not going to tolerate any further erosion of the american administrative state.
Talk Soon!