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Gold the Antidote for Moral Hazard, Uncertainty and Cowardice

By Mike Niehuser      Printer Friendly Version Bookmark and Share
Aug 17 2010 12:55PM

www.beaconrockresearch.com

Gold, taken in correct dosages to cure the ills which plague the economy and future financial security may be just what the doctor ordered. But this remedy administered without following proper protocols may increase the incidence of unwanted side effects such as nausea, vomiting and loose stool. Taken to excess, addiction may follow, and the antidote may prove to be a gateway to harder substances. Many a parent has lost hope when a son or daughter has moved on from gold to silver and fallen prey to more exotic rare earths or the influences of Ron Paul, or the musings of Friedman, Hayek or von Mises. Children are our future, you know.

It has been over six months from my completion of the Herculean assignment to grade 219 research papers critiquing the Financial Crisis by mid-career bankers at the Pacific Coast Banking School in Seattle, Washington. The most pedestrian explanation for the crisis, falling to the level of Oliver Stone’s awakening in Wall Street, was greed. While greed undeniably was ubiquitous during the crisis, so too were earth, wind and fire; all unacceptably simplistic scapegoats for what should have been very serious analyses. Another frightening undercurrent was a disturbing lack of faith in the Law of Supply and Demand, with the desperate hope that the next time government might get it right and make life fair. As sure as the law of gravity, the Law of Supply and Demand cannot be amended, appealed, or overturned.  Karma would have been preferred to greed.

The Role of Moral Hazard in the Financial Crisis

The papers which intrigued me the most are those which recognized the debilitating effects of a culture that has nurtured Moral Hazard and rooted the Great Depression.  Moral Hazard is like the middle child, who redirects blame to the eldest child (greed in this case) and avoiding judgment and responsibility. Moral Hazard sprouted in the U.S., undeniably the world’s most free society and stable economy, during the sixties with the societal awakening of social relativity. This is a particularly strong franchise among the baby boomer generation.  Not to justify or make rationalizations for their behavior, but one could say that they never had a chance with academics pushing loose monetary policy and a leadership vacuum at the highest levels including a string of four of the most financially flawed U.S. Presidents: Johnson, Nixon, Ford and Carter. These brought us the Great Society and Vietnam, the end of Bretton Woods, Wage and Price Controls, the EPA, Whip-Inflation-Now, and the Misery Index. Who wouldn’t choose sex, drugs and rock’n roll? 

The harm done by Moral Hazard and embracing absolute relativity is that individuals make the excuse that their actions, in the big picture, have no consequences.  Politicians can and do make careers out of these little white lies, but as a society it is the end of social order and placing civilization at risk. Let’s examine the presence of Moral Hazard in the current crisis. Borrowers made promises to pay without the ability or willingness (or collateral) to repay. Lenders, independent mortgage bankers to major banks, willingly made loans on the condition that for a fee they could sell the loan and pass all the risk down the line. Financial intermediaries packaged, securitized, rated and willingly recommended these “assets? to their most “valued? institutional clients. These institutions gladly accepted higher returns without due diligence, while assuring their clients that the risk was diversified away. 

Moral Hazard Metastasized in Systematic Risk

How correct their assumptions were, since the ultimate owners of these assets were the compilation of all the world’s investors. The “assets? became ubiquitous, and diversification as a concept was replaced by systematic risk as a reality. The Karma of “what goes around comes around? was realized as we took our gains and passed on risk, and risk made it all the way around to the source.  In October of 2008, the circle was closed and we truly became one world with the near-meltdown of world credit markets. 

Most of the world’s advanced economies responded in similar fashion. Liquidity was uniformly made available by central banks and each instituted reforms in their best interests. Countries with large resource based economies (hard assets) such as Australia or Canada, as global participants, were affected but had the financial flexibility. Since the height of the crisis, countries returning to classic liberal ideals of low taxes, smaller government and free trade have enjoyed greater progress to normalcy. In fact, countries in Asia, including Brazil and the Middle East are making good progress in advancing developing economies and bypassing the west with free trade agreements as they accelerate the creation of wealth and modern consumer economies. 

The U.S. and the west have pursued national policies to preserve systematic risk, concentrating it at the national level. In the U.S. this would extend to the largest corporations and financial institutions. This would include GM, AIG, any financial institution identified as “Too Big To Fail?, as well as Fannie Mae and Freddie Mac.  In the world’s greatest financial experiment, the success of these institutions is now underwritten by the full faith and credit of the U.S. government. 

The Advanced State of Moral Uncertainty of Success

A strong dollar seems to offer support to the notion that the experiment in the U.S. is working.  In the big picture, the U.S. Dollar continues to hold in with the Euro, giving back as much as it has taken since the depths of the crisis. Interestingly, the U.S. Dollar on a gold exchange basis has not fared as well. Simply put, gold prices on a dollar basis have increased and stabilized. Gold may simply be a barometer of the uncertainty for the eventual success for the U.S. growing an economy with a decade of $600 billion plus deficits, and the increasing likelihood of monetizing a mountain of national debt.

Current U.S. national policy may not be able to extinguish the Hydra of Uncertainty threatening the greatest experiment in national fiscal policy since the Great Depression. The three heads are higher taxes, increasing regulations, and declining levels of confidence in the U.S. Dollar as a long-term store of value. The Bush tax cuts are set to expire at the end of 2010, and it is not clear that this will lead to sustained tax revenues to the federal government without retarding economic growth. Likewise, the U.S. Administration has installed dozens of czars, expanding the reach of the government to an extent unknown even to themselves. 

Investors and consumers are not sure what the future holds. This is made apparent by the confusion over inflation-deflation. With record bank reserves, bank credit and credit demand is suspect, and the velocity of money declines amid growing chronic unemployment. The U.S. Congressional mid-term elections may provide some redirection toward certain ground, but this is optimistic at best, with good prospects for the continuation of six more years of the current administration. The prospects for cutting off all three heads of the Hydra of Uncertainty, in order to compete against developing countries while dealing with looming demographic issues, appears uncertain and problematic at best.

Moral Courage is Now at a Premium

It is interesting that the challenges of the present day do not appear to exceed levels experienced in the past. Unemployment reached upwards of 25% during the Great Depression, even without the confidence of an underlying social safety net beyond family, church and community. Many in government or government sympathizers advertise that the crisis has been averted and are sounding “all is clear? to get back to business. These seem to be concentrated among recipients of stimulus funds, or with too much influence in government to fail. The other small businesses, community banks or the millions of unemployed (or underemployed) individuals who lack a lobby, special caucus and voice in major media to be interesting, may not be so confident. 

It is interesting that gold is considered to be a relative measure of confidence, and a low gold price implies a relatively high level of confidence. This would suggest that the pre-9/11 Bush/Clinton years were a veritable age of stability. The question U.S. residents are asking is if they are better today than they were six years ago.  More importantly, if they are going to be better off six years in the future.  While moral courage is a pre-requisite for economic survival, the supply and nature of gold on the earth is a constant. 

Gold in Proper Doses May be an Appropriate Antidote.

Many have recognized and made physical gold, gold ETFs and gold equities part of their investment portfolio. Should this be acted upon, the limited supply of gold and gold equities may present an option for mitigating growing uncertainty in the near-term for the systematic risk posed by government solutions. As more nations around the globe liberalize their economies, the U.S. and western nations may come under increasing competitive pressure, and for residents in these economies gold may be an even more important antidote for what ails their wealth. 

Many gold analysts and experts are becoming more emboldened to predict gold reaching several thousand dollars per ounce in the near to mid-term. My earlier estimated range of $900 to $1,200 per ounce in 2010, with the potential of reaching $1,500 at year end still appears reasonable. The likelihood of staying within the range seems reasonable given the deflationary pressures of unemployment and credit supply/demand. Despite the record monetary base, banks appear interested in leveraging the arbitrage of investing in Treasuries, not supporting risk-taking commercial endeavors. Should a shock to the market’s confidence in the U.S. Dollar erode the moral courage of the market, gold could move beyond our year-end estimate.  In any event, the U.S. government’s absorption, concentration and underwriting of systematic risk presents significant uncertainty for U.S. investors, and is a call for appropriate respect for gold.

Mike Niehuser,

 

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Beacon Rock Research is an independent research firm focused on mining, metals, and natural resource companies for the benefit of institutional investors. Beacon Rock Research has a bias toward small cap stocks with heavy emphasis on evaluating management abilities and locating opportunities not fully recognized or understood by the broader market. The firm seeks to publish information and opinion that is educational and appropriate for increasing the understanding of investors in both risk and return.