At every recorded price, there is an exchange. For every buyer, there is a seller. Gold has a price. Someone is buying gold.
There are several possibilities. (1) He thinks the price of gold has not yet peaked. (2) He thinks he has no better use for his capital. (3) It isn’t his gold; he’s buying it on behalf of someone else. If “someone else” is the electorate, then the buyer can do what he wants. Voters have no meaningful understanding of gold. In this respect, they are a lot like University of Chicago economists.
Who are the major buyers of gold? Gold mining companies, central banks, gold speculators, and Indians. Then there are short-term speculators who sell promises to buy gold in the future at a fixed price, but who own no gold. We call them long speculators.
What I have written here is the mirror image of what I wrote in my previous report, “Sellers of Gold.” The main point I am trying to make here is this: the primary buyers of gold are members of the same classes of people as the primary sellers of gold.
GOLD IN THE GROUND
This observation may not seem to be apply to gold mining companies. It initially appears that a gold mining company is exclusively a seller of gold. This is not the case, however. A gold mining company is an owner of gold in the ground. At some additional price, this gold could be mined at a more rapid rate. This would take additional capital investment and additional laborers, but the gold is there. It is, in this sense, stored in a vault. The vault is the ground.
This is Milton Friedman’s argument against the gold standard. He says that an economy wastes resources by extracting gold from a below-ground vault in order to store it in another vault. In his book, Capitalism and Freedom (1962), which was the book that launched his long career among non-economists, Friedman wrote this:
The fundamental defect of a commodity standard, from the point of view of the society as a whole, is that it requires the use of real resources to add to the stock of money. People must work hard to dig gold out of the ground in South Africa — in order to rebury it in Fort Knox or some similar place (p. 40).
The argument is clever but specious (i.e., anti-specie). The central economic issue here is liquidity. Gold in the ground is “dry” — illiquid. Men do not know exactly how much there is in some mine’s ground. They do not know how much it will cost to extract it and refine it. Owners cannot extract gold ore fast enough, or get it into a recognized, certified form fast enough, to enable them to respond rapidly to consumer demand.
Consumers cannot use gold in the ground to make precise exchanges — exchanges precise enough for gold in the ground to serve as money, which is properly defined as the most marketable commodity. Gold in the ground is “maybe.” Gold stored in the form of ingots or coins in a vault above ground (or at least below street level) is “almost for sure.”
Let me put this a different way. (1) The information costs of refined, certified, and labeled gold in a vault are much lower than the information costs of gold ore in the ground. (2) It is not possible to reduce information costs — a major advantage for economic participants — at zero price. (3) The cost of lowering the information costs regarding gold is what gold mining is all about.
Friedman, in his career-long, ideologically driven quest for arguments favoring the government-created monopoly of central banking, has always ignored one of the truly important insights of the Chicago School of economics, of which he is the leading member: information is not a zero-cost resource. (By far, the best book on this subject is Thomas Sowell’s Knowledge and Decisions.)
My conclusion is that an automatic commodity standard is neither a feasible nor a desirable solution to the problem of establishing monetary arrangements of a free society. It is not desirable because it would involve a large cost in the form of resources used to produce the monetary commodity (p. 42).
This chapter of his book should have been titled, “Anti-capitalism and Freedom.” On matters monetary, Friedman has always been a statist. It is also worth noting that his reputation as a great economist among his professional peers has always been based primarily on his monetary writings.
(Note: I like Milton Friedman personally. I have known him for almost 30 years. But on the issues of gold as money and educational vouchers as freedom-producing, he and I have disagreed — sometimes publicly — for years. On the voucher question, see The Freeman, July, 1993.)
Gold mining firms are owners of less liquid gold. Managers may decide that at the present price, it is uneconomic to supply gold to buyers. Because they are holders of gold, gold mining companies are in effect buyers of gold. We call this form of demand “reservation demand.” It is that form of demand that says, “at this price, I am not a seller of gold.”
Most demand is reservation demand. We forget this because prices are set by buyers and sellers at the margin. Here is how this process works. Fred and Bill make an exchange. Fred (a buyer of gold and a seller of dollars) and Bill (a seller of gold and a buyer of dollars) act as self-interested individuals in making an exchange: dollars for gold/gold for dollars. If this exchange is recorded on an open free market, and it is also the most recent exchange, then the free market’s participants impute this price of gold in dollars to the value of the same quantity of gold in everyone’s holdings. If Fred buys an ounce of gold for $320, and if this exchange takes place in an open market in which other participants are allowed to make bids to buy or sell, then the market’s decision-makers impute to every ounce of gold a price of $320.
The reservation demand for both money and gold is gigantic. Everyone except Fred and Bill are implicit participants in the gold market, either as demanders of dollars or demanders of gold. Fred and Bill are explicit participants. The two of them act as surrogates for the rest of us.
A holder of gold who refuses to sell to Fred for $320 when Bill is willing to sell gold to Fred at $320 is an implicit buyer of gold. He is an owner of gold who hangs onto it. His demand is implicit, but it is nonetheless real. The gold owner thinks, “I want a higher price than $320. I will hold onto my gold.” The same analysis applies to the holders of dollars.
This is why the primary classes of sellers of gold are the same as the primary classes of buyers of gold. They are the people who “make the market.” They are the people who are best informed about the relationship between gold and money. As specialists with their own money at risk, or the money of the organization that employs them, the members of these groups act on behalf of all holders of gold or money. The best information available (at today’s price of information) is brought to bear on the price of gold.
The same analysis applies to all other specialized markets.
Conclusion: reservation demand dwarfs recorded demand on every market at any point in time.
HOLDING ON TIGHT
On both sides of Bill and Fred’s final, marginal transaction of gold vs. dollars are hundreds of millions of people. Most people hold onto dollars, caring little about gold. A comparatively few people hold onto gold in preference to dollars. Or, I should say, more people hold onto monetary gold in preference to dollars. With respect to gold jewelry, holders of gold are quite numerous.
The extension of the credit-based-money economy has escalated steadily since the day that commercial banks confiscated their depositors’ gold at the outbreak of World War I, and then all national governments immediately legalized this confiscation. The public has been taught by government-funded and government-regulated schools and also by the media that the pre-war gold standard was inefficient. Hardly anyone knows that the wholesale price level for commodities remained stable, 1815 to 1914, in those economies that were part of the international gold standard. The largest confiscations of monetary wealth in man’s history took place in Europe in 1914, and in the United States in 1933, yet the vast majority of the victims never complained. They were told that this violation of contract was necessary for the good of the nation, which in fact meant the good of the politicians, the commercial bankers, and the central bankers. Three generations of government-funded propaganda and central bank-funded propaganda have produced today’s world, which Friedman identifies as one in which “the mythology and beliefs required to make it [the gold standard] effective do not exist” (Capitalism and Freedom, p. 42).
The result has been the depreciation of the purchasing power of the dollar since 1914 by a factor of about 18, according to the inflation calculator on the Web site of the Bureau of Labor Statistics. Gold in 1914 sold for $20.67. Today, it is over $300: an increase of about 15 to one, i.e., a little less than the general depreciation of the dollar.
Will gold remain in the present price range? Will prices in general stabilize? If consumer prices do stabilize, and gold’s relation to prices also stabilizes, then there will be no spectacular rise in the price of gold. If gold’s price were to rise to 18 to one over 1914’s price of $20.67, it would rise to $372. Yet a few forecasters today are talking about gold at $1,000.
The speculator who believes that gold’s price will rise to such levels has to believe one or more of the following: (1) the price of gold is being kept down by gold sales by central banks that have been disguised as gold leasing. (2) Future reservation demand by central bankers is significantly lower than future reservation demand by Indian housewives and gold speculators. (3) The thinness of the gold market at the margin will result in a major price increase when a relatively small number of holders of dollars start buying gold. (4) The general economy is about to become more visibly inflationary.
I believe in all four. I believe them in descending order.
Central bankers hold most of the world’s monetary gold. Indian housewives hold gold in the form of jewelry. Either form of gold can be converted into the other. The question is: which way is the conversion process likely to take place? I think from monetary gold to jewelry gold. Central bankers don’t like gold, since it inhibits their monetary independence. They hold it mainly because they don’t trust the dollar, the world’s reserve currency. Putting it bluntly, they don’t trust each other. On this matter, I fully agree with them. When we read of gold sales today, these are generally inter-central bank gold sales. They are not sales to the general public. The sales to the public are disguised as gold leasing.
Gold leasing is one-way: from monetary bullion bars into jewelry or private hoards of coins (minimal). I believe that this one-way flow of gold will deplete the major reserves of gold that central bankers are willing to transfer to the general public. I think the United States and Great Britain will run out of disposable gold in this decade.
I think that the would-be holders of gold have been hampered in their willingness to hold gold by their fear of a falling price of gold. They are convinced that two factors are responsible: (1) falling prices of commodities in general; (2) central bank sales. They are unaware of the permanent nature of gold leasing. They are unaware of the magnitude of the one-way flow of gold into the hands of gold accumulators, such as Indian housewives, at the expense of central banks.
The gold confiscations of 1914 and especially 1933 are being reversed. But instead of Europeans and middle-class Americans taking advantage of the return of gold into the private sector, Indian housewives, Asians, gold bugs, and other “ill-informed” consumers are buying at central bank-subsidized prices what had once been the property of European and American commercial bank depositors.
Three decades ago, an economist friend of mine who served on the Senate Banking Committee’s staff suggested a way to hurt sellers of illegal drugs. The government should occasionally take its supplies of confiscated heroin and cocaine and dump them onto the market. This would force down the price of drugs and bankrupt drug dealers. This, he thought, would reduce the supply of illegal drugs by reducing the supply of pushers. The government has never followed his advice, but central bankers have.
MR. GREENSPAN, MEET THE PATELS
The reservation demand by central bankers is low compared to the reservation demand by Indian families. This is my personal estimation, which I cannot prove from statistics I am aware of. I base it on what I know about official central bank statements regarding the monetary role of gold (decreasing role) and the size of the gold leasing market (increasing). Central bankers have an ideological commitment to reduce the use of gold in monetary affairs. So do Indian families. There is mutual agreement here, and therefore the basis of a long-term exchange of gold ownership. These exchanges produce a one-way flow of gold from central bank reserves into jewelry.
The steady purchase of gold by Indians will continue for as long as central bankers sell gold to the general public, either officially (Bank of England, 1999-2002) or unofficially (gold leasing market). The primary limit is not demand by Indian families. The primary limit is central bank reserves.
Reservation demand by Western central bankers is lower than reservation demand by Indian families. If demand increases from other Asians, plus Indians whose income has risen or whose fear of war has risen, plus the central bank of China, then either the one-way flow of gold will accelerate or the price of gold will rise.
GOLD MINES AND RESERVATION DEMAND
Reservation demand by gold mining companies will increase. Here is why. Ask yourself this question: “If I were sitting on top of a gold mine, and I believed that the price of gold is likely to rise, would I sell all of the gold I produce, day by day?” Not if you were profit-motivated. You would hoard some of it.
Meanwhile, your competitors, who made a lot of money by selling future supplies of gold at a fixed price, and then profited when the price fell, are now experiencing the opposite effect. They are now required by contract to deliver gold at a fixed price. Their profits are falling. Yours are rising.
Gold mines that did not lock themselves into such contracts are now making more money per ounce sold. They can sell less gold, make a profit, and hold gold reserves for a future rise in price.
Mining operations reverse the conventional textbook picture of supply and demand. As prices fall, mining output increases for a long time before bankruptcy closes a lot of them. Mines have fixed costs, such as debt obligations. Management also doesn’t want to lose workers. So, when metals prices fall, mines increase output to meet payments on their fixed costs. They keep increasing output until their income from sales will no longer pay for their variable costs (e.g., labor expenses). Managers deplete existing reserves in order to keep the mines operating.
On the other hand, when metals prices rise, managers cut back on output for the opposite reasons. They seek a speculative profit either by withholding part of their output or by actually reducing output, thereby reducing their variable costs.
So, when gold rises in price and is expected to keep rising, buyers find that the supply of gold from mines does not rise fast enough to push prices back down. Would-be buyers find that they are facing new competition from gold mining companies whose managers have increased corporate reservation demand.
If central banks decide to buy gold, they must pay the going price. Usually, they buy either from gold mines or each other. If gold mines refuse to sell all of their output, and if other central banks refuse to sell, and if Indian families are unwilling to sell enough gold to meet demand at older prices, then the price of gold will rise.
Western central bankers are unlikely to increase their demand for central bank gold reserves. After all, it is not their gold. It belongs to the central bank, whose profits are regulated by the national government.
In contrast, the central bank of China is likely to increase its demand for gold as a way to demonstrate China’s growing influence in world markets. While Chinese central bankers have read the same textbooks as Western central bankers, Chinese government officials are interested in showing the West that China is no longer a backwater country. Gold has long been a way that most Chinese have measured their wealth and influence. They have not all accepted the West’s economic dogma that monetary gold is either a barbarous relic (Keynes) or a waste of resources (Friedman).
Buyers of gold (sellers of dollars) at the margin are likely to increase their demand. Gold’s price is going to increase because:
More investors will perceive that gold leasing is a one-way street, and so will not greatly fear gold dumping by central banks.More Indians will be able to afford to buy gold if the Indian economy grows.More Indians will buy gold if the threat of war increases.China’s central bank will increase gold purchases.Central banks always inflate.
Today’s reservation demand by gold mining companies is likely to increase when the price increases. This will reduce supplies offered to the public from new sources of gold.
Gold is a political metal. Central bankers will use gold reserves owned by the banks (not by themselves personally) to increase central banking’s autonomy from gold. They will sell gold to the general public from time to time. But, never forget, central banking’s autonomy from gold requires central banking’s dependence on the world’s reserve currency, which is the dollar. The more gold central banks sell, the more green they accumulate. Central bankers face a dilemma: “More green => more Greenspan.”
Over the long haul, more people than today will learn to trust gold rather than central bankers. Friedman dismissed “the mythology and beliefs required to make it [the gold standard] effective. . . .” But he was correct in his general thesis: capitalism does increase freedom, and freedom increases people’s wealth. Although Friedman and Keynes and central bankers dismiss the suggestion that the monetary system should be based on “an automatic commodity standard,” the essence of capitalism is reliance on automatic, market-created, market-supplied, market-policed institutional means of exchange, including money. To reject a free market in money is to reject the ideal of capitalism. It is also to reject the idea of freedom.
The 1990’s proved that freedom works. Communism collapsed. Capitalism is efficient. Statism doesn’t work.
Today’s monetary system is statist. As surely as the public in 1980 should have expected the collapse of the Soviet economy, people should expect the failure of central banking.
Gold or green? Gold or Greenspan?
June 6, 2002