What Is Key for the Price Formation of Gold?

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Previously by Robert Blumen: Misunderstanding Gold Demand

     

In this exclusive interview for Matterhorn Asset Management, Robert Blumen discusses some important but widely misunderstood elements acting on the gold price. He explains that frequently cited gold demand statistics have no relationship to the gold price. In addition, he explains that the annual gold mine production is of very little influence, as gold is hoarded, not consumed like other commodities.

Robert Blumen was born in 1964 and grew up in Boulder, Colorado, United States. He is a graduate of Stanford University in physics and the University of California Berkeley in engineering. He lives in San Francisco, United States where he works in the technology sector as a software engineer, specializing in server applications and the architecture of scalable systems. He has maintained a lifelong interest in the Austrian School of Economic Thought and is an avid reader in economics and finance. His writings on gold and a variety of economic topics have been published by Financial Sense, the Ludwig von Mises Institute, LewRockwell.com, The Dollar Vigilante, and Marc Faber's Gloom Boom and Doom letter as well as other gold and financial sites.

Lars Schall: Mr. Blumen, how did you become interested in the subject of gold in general?

Robert Blumen: There were two main influences when I was growing up in the 1970s and 80s. We went through a period of very high inflation in the United States. President Nixon imposed wage and price controls in a misguided, or perhaps very cynical, attempt to fight inflation. And Nixon's successor, President Ford, handed out these silly little lapel buttons that said u201CWhip Inflation Nowu201D. I remember seeing a young man on the TV news who had reported a chain store for the economic crime of raising the price of one of their products. He was being given some kind of award for this.

The second historical event was the gold bull market of the late 70s. Then Reagan came in along with Paul Volker who he inherited from the former president, Carter. I wasn't paying much attention at the time but it stuck with me that gold had made this huge move.

Those two things came together and had a life-long influence on me. From that time I took away a curiosity about inflation. And that led me eventually to be curious about the whole field of economics. I was lucky that I came upon the Austrian School of Economics. I started reading Austrian economics in high school. The Austrian School emphasized gold as the basis of the monetary system and how well that has worked out over the course of human history.

L.S.: The growing interest in gold was underlined recently in a report that was published by the Official Monetary and Financial Institutions Forum (OMFIF), which has the title u201CGold, the renminbi and the multi-currency reserve systemu201C. (1) I think that this report is quite remarkable for various reasons. Do you agree?

R.B.: The report suggests that the international monetary system will accept gold in a more recognized way as a reserve asset. I think that this is already true, informally. There are many signs of this. Central banks have gone from selling to buying in recent years.

On the intellectual plane, I think there the consensus of many decades, namely that gold had been permanently removed from its monetary role, is changing. There is increasing discussion gold as a monetary metal among the elites. Several years ago, Benn Steil, a CFR economist wrote an opinion piece for the Financial Times (excerpted here) suggesting that the global gold standard worked better than the current system of floating rates. Robert Zoellick, who was president of the World Bank at the time, wrote a gold-friendly op-ed also in the FT a couple of years ago.

L.S.: What is your overall view on China?

R.B.: The popular perception of China an economic juggernaut on a path to eclipse the economies of the developed world. And how did that happen? Because their wise central planners chose an export-driven growth strategy. Many people now think that this strategy has gotten them to a point where they are deficient in domestic consumption, so they need to switch to a consumption-driven mode of economic growth; and that this also will be accomplished by the same wise central planners through a series of carefully designed five-year plans.

I think almost everything about this view is wrong; it is still largely a centrally planned economy and we know from the economics of the Austrian economist Ludwig von Mises, central planners cannot allocate resources.

L.S.: Why not?

R.B.: Mises wrote a paper in 1920, which became quite a famous and very controversial thesis in economics that was debated for decades. His paper was called Economic Calculation in the Socialist Commonwealth and you can find it for free at the Mises site.

If you have a very simple economy where people make consumption goods with their bare hands, this can be done with central planning. But Mises was trying to explain the economic growth that has occurred in the world from small villages to vast modern economies with millions of goods and a complex division of labor. How could this type of growth occur? The process requires the development of a complex inter-relationship of capital goods, natural resources, and division of labor.

In a modern economy, the number of things that could be produced is nearly unimaginably large. And the number of different production methods for even a single good is incalculable. Take gold for example — finding a deposit is quite complex. There are many ways to look for it. Magnetic fields, chemistry, electrical, drilling. How much drilling and where? And then, when you have the deposit, should it be open pit or underground? Should a resource estimate be established first or start mining and follow the vein? And what about the metallurgy, the chemistry? What type of electrical power? What types of labor? Refine the ore on site, or partially refine? Build roads, rail, or ship the ore? There are millions of decisions and each one needs to be fully answered down to the hire or purchase of specific pieces of capital and individual workers.

Mises' point was that all of these production decisions, not only what gets produced and what does not, but how it's done, can only be decided on the basis of prices. In particular Mises noted that the prices of capital goods are crucial to production decisions. Contrary to what you read endlessly in the financial news about consumption driving the economy, spending on capital goods is the major part of total spending.

Only with prices can you have accounting, which is the ability to calculate profit and loss. In a market economic system, the important decisions are made on the basis of an anticipated profit and loss, which is the difference between the expected prices received on sales and the costs.

Mises had the insight that prices of capital goods are only a meaningful tool for resource allocation if they are established by a competitive bidding process among entrepreneurs. Entrepreneurs must choose how much they are willing to pay to acquire a specific capital asset and hire the skilled workers they need. Entrepreneurs are people who put at risk their own capital, and will either earn a profit or suffer a loss.

The diversity of entrepreneurs is a key part of this. Each business firm or company founder has a unique view of their own market, which may be highly detailed and based on years of experience. Mises also noted that each entrepreneur has his idea about what the customer will want. The market is a decentralized process in which the entrepreneur who has the best plan for each particular asset, along with some cash, will end up in a position to choose how that asset gets used.

In my own former job, I worked for a company that was in a small sub-sector of a sub-sector. There are perhaps half a dozen people in the world who truly understood our industry, maybe fewer. The entire world is full of experts like this, people who understand a particular industry or product really well.

Can you imagine, for example, that we would have iPhones or Kindles if the technology industry was planned by a central committee? Before the iPhone, competition in the mobile industry was primarily over how many minutes per month you got on weekdays or weekends. When Steve Jobs decided to develop the iPhone, he risked $150 million of his shareholder's money and took on the US mobile industry, who did not want a disruptive phone taking away the spotlight from their monthly plans.

Central planning means the abolition of this type of competition. And that is the problem that Mises identified. There is no way to replace this competitive bidding process with a single planner or a planning committee. The central committee cannot bid against itself for the opportunity to acquire specific capital goods and labor. That would be nothing more than the left hand bidding against the right hand. They could assign fake prices to resources and pretend to calculate the best projects, but the numbers that would come out of this process would not be prices, they would be arbitrary numbers that did not reflect the best possible use of scarce productive resources. Mises showed that a central planner has no basis for making economic decisions, even if the process did not become entirely politicized, as it always does.

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Robert Blumen [send him mail] is an independent software developer based in San Francisco. Robert wishes to thank James Hickling of GoldMoney for assistance in copy editing the final version.

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