Banking System’s Conflict of Interest Should Underpin Gold’s Rise

``O gold! I still prefer thee unto paper which makes bank credit like a bank of vapour.”- Calvin Coolidge (1872-1933), Thirteenth President of the US (1923-29)

As we have earlier said, present market actions denote of ongoing deflation of several asset classes brought about by the massive deleveraging in the US banking system. For instance, the rapid decline of gold prices has been lauded by global depression proponents as working in favor of their cause, see figure 4.

Figure 4:stockcharts.com: Gold and Oil Still Intact, Yen and US dollar bottoms

Depression advocates argue that the prevailing deflation momentum in the US will overwhelm the world and set forth a chain of global financial market meltdown and economic reversals. We do not buy such apocalyptic theory (as discussed last week).

True enough, deflation is having its field day as the rising Japanese Yen (lowest pane) signifies the deleveraging of the global carry trades amidst last week’s carnage, while the bottoming signs of the US dollar index (upper pane below center window) possibly represents the stampede towards the hoarding US dollar and US dollar denominated-US treasuries.

Incidentally debt deflation is a manifestation of the painful adjustments by market forces on the massive imbalances imposed into the system by the accrued colossal distortions of inflationary activities shaped by government activities over an extended period of time. On the other hand, the inflationary forces are simply the redistributive policies enacted by policymakers to appease the voting public or special interest groups to perpetuate themselves in political power.

For us, while deflation seems to be at the edge today, the present turmoil signifies only an episode of an epic ongoing battle between market forces and government activities.

For instance Martin Wolf columnist for the Financial Times in an outstanding piece “Regulators should intervene in bankers’ pay”, wrote why bankers appear to be distinguished from the rest of the field we quote (highlight ours),

``No industry has a comparable talent for privatising gains and socialising losses. Participants in no other industry get as self-righteously angry when public officials – particularly, central bankers – fail to come at once to their rescue when they get into (well-deserved) trouble…

``It is the nature of limited liability businesses to create conflicts of interest – between management and shareholders, between management and other employees, between the business and customers and between the business and regulators. Yet the conflicts of interest created by large financial institutions are far harder to manage than in any other industry.

``That is so for three fundamental reasons: first, these are virtually the only businesses able to devastate entire economies; second, in no other industry is uncertainty so pervasive; and, finally, in no other industry is it as hard for outsiders to judge the quality of decision-making, at least in the short run. This industry is, in consequence, exceptional in the extent of both regulation and subsidisation.”

While Mr. Wolf believes that the solution to this is to regulate bankers pay in order to align it with their accompanying incentives, our thoughts is that the major culprit, aside from those indicated (which are more reflective of symptoms than causes for us), is the present monetary system-the US dollar standard operating under the Fractional Banking system-whereby the conflict of interest paradigm emanating from a “limited liability businesses” is best exemplified.

Central bankers are designated for social tasks; to ensure price stability and generate maximum employment (a.k.a. inflation). On the other hand private bankers undertake risks to generate profits. But since the underlying privilege of private bankers-as primary agents or conduits for Central Banks-hence the issue of limited liability businesses emerge out of divergent incentives.

To quote Ludwig von Mises in Human Action, ``Bureaucratic conduct of affairs is conduct bound to comply with detailed rules and regulations fixed by the authority of a superior body. It is the only alternative to profit management. . . . Whenever the operation of a system is not directed by the profit motive, it must be directed by bureaucratic rules.” (emphasis mine)

In essence, when you combine the role of private and public interests you have natural case of conflicting incentives, easily known as the agency problem or principal-agent problem.

Since our extant monetary system operates under the unique arrangement between Central banks and private bankers (Central banks cannot afford the banking system to go under hence the subsidy), the latter conducts risk-taking activities under the assumption of “limited liabilities” or implied “subsidies” or the knowledge “socialization of losses” from their political patron, given their indispensable role.

Notwithstanding, the worsening conditions in the US banking system today, such dynamics underpins the crucial relationship [as per Martin Wolf…only businesses able to devastate entire economies…no other industry is uncertainty so pervasive…no other industry is it as hard for outsiders to judge the quality of decision-making] from which should lead to more subsidies or “socialization of losses” disguised in variant forms, even when some of them declaim such as “Moral Hazard”-for us a PR stint. Under such premises, gold prices will likely continue to flourish as global policymakers continue their currency debasing activities.

Thus, we believe that gold’s recent decline is likely a countertrend reaction to its recent surge more than a sign of “depression”. By depression we mean a prolonged agonizing period of recession.

Figure 5: US Global/Moore Research: Seasonal Activities in Gold Prices

In addition, Figure 5 illustrate to us that the present actions of gold could also signify seasonality. Gold tends to peak during the first quarter, then tapers of until the third quarter before resuming its upside.

Third, following gold’s latest feat of achieving record nominal milestone highs, gold’s decline could also represent the issue of popular-crowded trades.

Since mainstream media has finally caught up with the gold fever with such commentary from Financial Times, “Gold is the new global currency”, momentum, speculative and retail investors tend to crowd in on fashionable themes.

Moreover, crowded trades appear to have piled in as shown in Figure 6.

Figure 6: Rude Awakening: Sell Gold!..or Buy it

This from Eric Fry from the Rude Awakening (underscore mine)

``Gold's price has been soaring recently, and so has its popularity, especially among the "Speculators" in gold commodity futures. According to the latest Commitment of Traders Report from the CFTC, the Speculators – also known as the "dumb money" – are holding a record-high, net-long position of 220,000 gold futures contracts. For perspective, that's double the position this group held six months ago and four times the position they held two years ago. For additional perspective, the Speculators held their record-high, net-short position on April 9, 1999, shortly before gold launched its dazzling run from $280 an ounce…

``It is worth noting, therefore, that while the Speculators are flowing into the gold market, the "smart money" Commercial traders are ebbing. The "Commercials" are holding their largest-ever net-short position in the gold market. In other words, they are betting heavily against rising gold prices. By contrast, back in 1999, the Commercials were taking the other side of the Speculator's big bet against gold. In April of 1999, the Commercials held their largest-ever long position in the gold market, just before the gold price took flight.

In short, technicalities, sentiment, overcrowded trades and seasonality factors could weigh against gold over the short term. But again we won’t count much on these as governments are likely to intercede and continue measures aimed at mitigating the circumstances of the public via “safety nets” (for political reasons) or to “socialize losses” for special interest groups even at the extent of some possible sacrifice among their constituents.

Bottom line: Today’s monetary standard depends on the operating principle of the privileged “Fractional Banking system: Central Bank-Private Bank” arrangement where authorities will likely fight to preserve the status quo, even if they require socializing more losses for its upkeep at the expense of the general public. This should be good for gold.

As an aside, depression advocates could end up being right for the wrong reasons: Collective Central bankers (mostly Keynesians) could proselytize into Austrian economists and allow for the maladjustments in the system to run its course without government interference despite the public’s outcry. Or perhaps war or protectionism overcomes globalization trends. The latter of which seems to be a more credible risk.

Figure 7: Prieur Du Plessis/GaveKal: Gold’s Rise has been correlated with the China’s surging Purchasing Power

Finally the chart from Gavekal shows how the explosive growth of Chinese purchasing power (measured through wages) has been correlated to surging gold prices.

No, this is not to suggest that China’s buying patterns has been responsible for the recent surge in gold prices to record highs, but it does show how Chinese consumption as the fourth largest consuming country, which accounted for 9.2% of worldwide global consumption (Forbes) has played a modest role in its turbocharged performance.

It also implies that as the Chinese grows wealthier the likelihood is that gold consumption will likewise reflect the rise of its purchasing power.