Gold4Cash

Yesterday, Gold hit a new high of more than $1190 an ounce. It is only $10 away from all-time high prices in sterling and euro terms too. In the last year it has risen by 50% in dollar terms. Some people are referring to a “Gold Bubble” similar to the bubbles we have seen in the dotcom bubble, or in house prices. But, the rise in the price of Gold is not a bubble. Far from it, the rise in Gold prices has much, much further to go. One definition of a Bubble is where everyone jumps on a bandwagon to buy some particular asset, without really understanding why they are buying it. Some of the “smart money” investors, for example, said that when they were getting technology share tips from taxi drivers, in 2000, they knew it was time to sell! But, so far it is not Taxi drivers or other members of the General Public who are buying Gold. The buyers of Gold are the “smart money” investors, and increasingly Central Banks like China, India, and Russia. In fact, a look at the TV shows that the adverts, of the last few years, encouraging people to take on increasing amounts of debt, at high rates of interest, over prolonged periods, in order to buy things they don’t really need, have been replaced with adverts exhorting people to exchange their Gold Jewellery for cash. So long as Joe Public is exchanging Gold for a rapidly depreciating paper currency, Gold still has a long way to run. When all those people, who have sold their Gold jewellery off cheap, for that depreciating currency, begin instead to buy Gold its price will go parabolic.

The Value And Price of Gold

In the 1970’s the price of Gold rose 30 fold to reach its peak of $800 an ounce in 1980. If, it did the same thing this time it would rise from its 1999 low of $250 an ounce to $7,500 an ounce, or about a six-fold increase from where it is now. Its necessary to understand the difference between the value of gold, or more accurately what Marxists call its Price of Production (Cost of production plus average profit) and its price. The prices of commodities vary around this price of production, which can be viewed in orthodox economics terms as the equilibrium price. However, in the short run shifts in supply and demand will move prices up or down from this equilibrium. A change in tastes, which increases demand, which cannot immediately be met by increased supply will cause prices to move up and vice versa. Where supply is relatively fixed, prices will move up, and this may cause a vicious circle to develop. Buyers, fearful of not being able to buy, will not only scramble to buy at higher prices, but may also attempt to buy more than they need, in order to hoard. Speculators seeing the opportunity to buy now, and sell later, at even higher prices, may become buyers, even though they have no need of the commodity themselves. At the same time, suppliers, seeing rapidly rising prices, may decide to hold back supply in order to be able to sell later at even higher prices. All of these factors contribute to pushing prices in an upward spiral far removed from the actual value or price of production of the commodity – i.e. a bubble.

The latter can already be seen in relation to oil. There are dozens of tankers sitting off the coast of Britain and other countries, full of oil, whose owners are keeping them there, simply watching the oil price rise, so that they can sell at a higher price later. The Price of Production for oil is probably between $80-100 a barrel. Below $80, although many established, low cost oil fields are profitable, it is not profitable to open up new expensive oil fields, for example in deep sea locations. Because the world has reached Peak Oil production, the amount of oil, produced in the low cost fields, is insufficient to meet normal world demand, certainly not capable of meeting the rapid increase in demand of the next few years, as China, India and other developing economies swallow up huge amounts for their own consumption. Above $100 a barrel demand begins to get choked off, both as a result of the effect on world economic growth, and because of substitution by consumers of other alternatives to oil. Last year, as the price of oil rose above $100 as booming economic growth around the world sent demand up, consumers began to hoard. China, in particular, was using its vast dollar reserves to buy oil in order to diversify away from a depreciating dollar into appreciating hard assets. But, as oil appeared a one way bet, because Peak Oil meant that oil producers could not ramp up production to meet this new demand – in fact Russian oil production was falling – speculators saw the chance to make a quick buck. They bought oil futures, thereby withdrawing even more supply from the market. The price bubbled up to $147 a barrel. Like all bubbles it burst, because eventually there was no bigger fool to buy at a higher price, and in particular, as I said at the time, Severe Financial Warning , the first warning tremors of the Credit Crunch were seen by the fact that Banks, Hedge Funds and other financial institutions, who had made large profits by such speculation, became forced sellers, in order to raise cash they increasingly could not raise from within the interbank markets.

Peak Gold

We appear to have reached a similar situation of “Peak Gold”. As an indication, the deepest mine in the world is a Gold Mine in South Africa. The mine is so deep that the temperatures inside it rise so high that it requires the electricity consumption of a small town just to cool it enough for it to be worked! That gives some idea of the costs of production of the Gold from it. Up until the turn of the century many Gold producers sold Gold short on the Futures markets, because its price had been continually falling. This provided them with a hedge against their rising costs and falling prices. For the last few years, pretty much all of the Gold producers are themselves buying Gold Futures in the expectation of continual rising prices. Some new Gold production is being established in Central Asia, particularly in Kazakhstan, but, not only will it take some years before this production is fully on stream, but also, compared to the existing level of production – let alone the existing reserves of Gold – the effects of this new production, on Supply, will be marginal.

In fact, Gold appears to be facing a perfect storm. To understand it, it is necessary to properly understand the role that Gold plays. In previous blogs Gold – Why Its price is Soaring I’ve tried to explain that role. Every commodity has an Exchange Value, which is expressed as a certain quantity of some other Use Value. 1 Yard of linen equals 10 lbs of cotton, 1 Yard of Linen equals 2lbs of potatoes, and so on. These equivalences, which are okay in relation to barter trade, are a restriction on market exchange, and so it becomes necessary to have some commodity which acts as a universal equivalent, a commodity everyone is prepared to accept as standing in the place of varying quantities of all these other commodities i.e. a Money Commodity. Although, many commodities, including salt, have fulfilled that role, the money commodity par excellence is Gold, because of its high value, its ability to be divided into precise aliquot amounts, its consistency of quality and so on.

Gold As Real Money

A certain weight of Gold, having a given Exchange Value, expressed as varying quantities of other Use Values, implies the reverse, the Exchange Value of every commodity can be expressed as a certain quantity of the Use Value Gold. These quantities then become the names of different amounts of money e.g. a Sovereign. However, it became apparent that, insofar as these coins like Sovereigns circulated, they became debased. Not only was their weight diminished by simple wear and tear, but it was also deliberately diminished by “clipping”, that is people would nibble pieces of gold from the coin. Yet, although the coins now did not contain the required amount of Gold (or silver in the case of silver coins), they still tended to be circulated at their full value! In effect, what was being circulated, was a token, which represented, in its name, a certain quantity of precious metal.

What gave these tokens their value was the fact that they were redeemable at any time against an equivalent amount of Gold or silver. Provided the tokens were only issued in line with the amount of gold or silver required for circulation then they could fulfil that function. However, in line with the laws of supply and demand, if the number of tokens was increased above that level then the value of each token had to be diminished in terms of how much Gold it actually represented. In terms of paper currencies, indeed, they had no intrinsic value of their own. They only had value because they were accepted in circulation. As Marx, put it,

“How many reams of paper cut into fragments can circulate as money? In this form the question is absurd. Worthless tokens become tokens of value only when they represent gold within the process of circulation, and they can represent it only to the amount of gold which would circulate as coin, an amount which depends on the value of gold if the exchange-value of the commodities and the velocity of their metamorphoses are given…

“The number of pieces of paper is thus determined by the quantity of gold currency which they represent in circulation, and as they are tokens of value only in so far as they take the place of gold currency, their value is simply determined by their quantity. Whereas, therefore, the quantity of gold in circulation depends on the prices of commodities, the value of the paper in circulation, on the other hand, depends solely on its own quantity….

“The intervention of the State which issues paper money with a legal rate of exchange – and we speak only of this type of paper money – seems to invalidate the economic law. The State, whose mint price merely provided a definite weight of gold with a name and whose mint merely imprinted its stamp on gold, seems now to transform paper into gold by the magic of its imprint. Because the pieces of paper have a legal rate of exchange, it is impossible to prevent the State from thrusting any arbitrarily chosen number of them into circulation and to imprint them at will with any monetary denomination such as £1, £5, or £20. Once the notes are in circulation it is impossible to drive them out, for the frontiers of the country limit their movement, on the one hand, and on the other hand they lose all value, both use-value and exchange-value, outside the sphere of circulation. Apart from their function they are useless scraps of paper. But this power of the State is mere illusion. It may throw any number of paper notes of any denomination into circulation but its control ceases with this mechanical act. As soon as the token of value or paper money enters the sphere of circulation it is subject to the inherent laws of this sphere….

“The rise or fall of commodity-prices corresponding to an increase or decrease in the volume of paper notes – the latter where paper notes are the sole medium of circulation – is accordingly merely a forcible assertion by the process of circulation of a law which was mechanically infringed by extraneous action; i.e., the law that the quantity of gold in circulation is determined by the prices of commodities and the volume of tokens of value in circulation is determined by the amount of gold currency which they replace in circulation. The circulation process will, on the other hand, absorb or as it were digest any number of paper notes, since, irrespective of the gold title borne by the token of value when entering circulation, it is compressed to a token of the quantity of gold which could circulate instead. …

“In the circulation of tokens of value all the laws governing the circulation of real money seem to be reversed and turned upside down. Gold circulates because it has value, whereas paper has value because it circulates. If the exchange-value of commodities is given, the quantity of gold in circulation depends on its value, whereas the value of paper tokens depends on the number of tokens in circulation. The amount of gold in circulation increases or decreases with the rise or fall of commodity-prices, whereas commodity-prices seem to rise or fall with the changing amount of paper in circulation. The circulation of commodities can absorb only a certain quantity of gold currency, the alternating contraction and expansion of the volume of money in circulation manifesting itself accordingly as an inevitable law, whereas any amount of paper money seems to be absorbed by circulation.”

A Contribution To A Critique of Political Economy.

Gold And World Money

Marx’s message is clear. If States – and fiat currencies had to eventually be the preserve of States to issue – printed more money tokens (notes and coins) than was necessary to meet the needs of circulation, then, because, unlike precious metal, these notes and coins would not be removed from circulation – hoarded, melted down for their intrinsic value – they would continue to circulate, but at a reduced actual value. More of them would be required than previously, as an equivalent of all commodities against which they were exchanged. In other words, there would be inflation. In a world, in which international payments were settled in Gold, this would be a problem inside the particular country, but not between countries, because this inflation would raise the price of Gold itself in relation to that currency. However, once international payments begin to be made not just in Gold, but in so called reserve currencies, first the pound, and later the dollar, obvious difficulties can arise.

A country like the US, whose currency acts as a reserve currency – that is a currency accepted as a means of payment in international trade – obtains a significant advantage. The very fact that its currency is used to make such payments means that it automatically is confronted with demand by other countries, who need it to make such payments. Such demand raises its value against other currencies. In turn, such a country can pay for its own foreign transactions by simply printing more of its own currency. The consequence of that was demonstrated in 1971, and is being demonstrated again today. In 1971, faced with massive printing of dollars, by the US, to pay for the Vietnam War, and repeated does of Keynesian stimulus, to counter act economic decline, President DeGaulle demanded payment for French exports to the US in Gold rather than dollars. He was entitled to do so, because each dollar was supposed to represent a given quantity of Gold. The US, under President Nixon, responded by ending the dollars convertibility into Gold. But, as Marx says, Governments can undertake the mechanical act of printing more currency with a given face value, but their control ends there. Once that currency enters circulation the laws of economics govern its actual value. It was this massive printing of dollars – and other currencies, during the 1970’s, to try to offset the effects of the onset of the new Long Wave decline – which resulted in their mutual devaluation, and the thirty fold increase in the price of real money – Gold – referred to earlier.

In fact, Gold in terms of its Value – its real terms exchange ratio against other commodities – hit its peak not in 1980, but in 1960, around 11 years after the beginning of the Post War Long Wave boom. This tends to be the pattern during the Long Wave cycle. In the Spring Phase of the cycle, primary products, like Gold, rise in price rapidly, because the spurt of economic growth raises demand for these products, whose supply cannot be quickly increased. In contrast, the majority of other commodities increase in supply rapidly and with falling marginal costs. That is because labour, for their production, tends to be in plentiful supply, and new inventions and techniques bring about big rises in productivity. But, by the time that the Summer Phase of the cycle begins around 12 years in, high primary product prices have driven frantic exploration and development of new supply, which begins to meet demand, and stabilise prices. At the same time, the first flush of productivity gains tends to slow down, and the reserves of labour used up, leading to the price of labour power being bid up, and workers, finding a new confidence, begin to take action to raise wages and conditions further. In new labour markets, workers quickly begin to create new labour movements etc. Consequently, the prices of primary products begin to fall relative to other commodities.

Perfect Storm

Its for this reason that I say Gold faces a perfect storm. On the one hand it is perfectly natural for its Value to have risen during this phase of the Long Wave. If it followed the pattern of the last wave then taking the beginning of that wave as 1999, I would expect to see it reach its real terms peak against other commodities in 2010, just as it reached its peak in 1960 11 years after the commencement of the boom in 1949. Of course, there is no mechanical relationship between the two, and there is scope for leeway by a year or so. But, as said earlier, the price of Gold reached its nominal peak in 1980, reflecting the destruction of paper currencies during the 1970’s, and the consequent hoarding of Gold, and speculation. Yet, during the 1950’s and 1960’s there had been no huge increases in money supply over and above what was required for circulation – which is why inflation was muted during that period, in fact there was some deflation – despite repeated bouts of Keynesian stimulus, during that period, to cut short the recessions that recurred every few years.

Compare that with now. Although, the early 80’s were marked by the utilisation of Austrian economic theories, which led to severe constrictions of money supply – under Paul Volcker in the US, and under the tutelage of Hayek in Great Britain – when those policies had had their effect in both driving inflation out of the system, and defeating the Labour Movements by direct confrontation, mass unemployment, and forcing employers to take on the workers because they could not raise prices, both Governments changed course. They dropped the Austrians, and adopted Chicago School Monetarism, which argued that in order to get the economy out of its doldrums it was necessary to increase money supply. They did, and on the back of it created large numbers of low paid, low status jobs, whilst at the same time scrapping financial regulation and creating the kind of climate of “shop till you drop”, and “retail therapy” mentality that was necessary to get people to take on increasing amounts of debt, and to spend it in the various new shopping malls, and retail parks where many of these low-paid, low status jobs had been created – often on the sites of former collieries or steel works – and which increasingly sold very low priced goods, now being bought from China.

It also created a sizeable number of very well-paid jobs symbolised by Harry Enfield’s “Loadsamoney” character, as deregulation turned the City of London into the world’s leading financial hub, through which trillions of pounds in transactions were funnelled as a new world economy was forged in which China, and other emerging Asian economies recirculated their increasing pools of dollars and sterling into Treasury Bills. Even in the 1980’s this infusion of liquidity led to Stock market and housing bubbles with the attendant bursting of those bubbles, the Stock Market crash of 1987, and the UK housing crash of 1989. And that policy of increasing liquidity, particularly in the US, and to a similar extent in the UK, continued throughout the 1990’s, each time some Stock Market or other asset correction appeared, let alone any serious economic decline.

The idea that neo-Liberalism meant that during the period from 1980 onwards, the State gave up economic intervention is not just a myth, it’s a downright fabrication. The State during that period became bigger than it has ever been, and intervened in economic activity more than it has ever done before in history. Only its mode of intervention changed, and even that was to do with what it saw as the best means by which to guarantee and increase the rate of profit, rather than any ideological shift, as the massive interventions to nationalise the banks and other institutions over the last year or so have demonstrated.

Gold Out Of Favour

After 1980, the price of Gold fell. Partly, that was due to the introduction of the Austrian economic policies referred to above. As paper currency was removed from circulation, so the value of that currency rose against Gold. But, part of the price of Gold, in 1980, was the kind of speculation referred to earlier, hoarding as people shun devaluing currencies, and actual speculation by the “smart money” who saw the possibility of capital gain. The curbing of money supply pricked the bubble. Even when money supply did begin to be increased rapidly again, Gold prices continued to fall. Part of that is explained by the factors relating to the relative prices of primary products and other commodities at that stage of the Long Wave, as described above. But, also by the late 80’s increased money supply was not leading to inflation, precisely because the money was flowing into the purchase of vast amounts of new commodities being imported from China and other Asian economies. And, that which did not, was being diverted into other forms of speculation such as on the Stock Market and in the housing market. There was no demand for Gold as Money, because there was no inflation of commodity prices, and China and other suppliers were happy to accept dollars rather than Gold, because they could recirculate those dollars into US Treasury Bills, thereby providing the US Government, and US consumers, with the necessary funds to be able to continue to consume all of the goods that China wanted to sell to them! Under such conditions it is the nature of Gold as a commodity in its own right with an intrinsic value, which determines its price, not its role as the money commodity. If anything, during such a period its price may be lower than its Value, precisely because the Gold in existence, especially that sitting in Central Bank vaults, acts as a huge overhang of supply on the market.

During this period Central Banks sitting on an asset that earned no interest, and which was depreciating in value, looked to dispose of it in return for foreign exchange, particularly dollars, which could be placed on deposit, and at least earn interest. Each sale brought a huge new quantity of supply on to the market thereby depressing its price. Its no wonder that the Gold producers themselves began to short gold, thereby introducing an element of speculation into its price in the opposite direction to that of a bubble. In short, Gold is only demanded as Money when faith has been lost in the prevailing money tokens. During such periods its price is determined by its Use Value as a commodity, its use for jewellery, and in industrial production, and so by its price of production. Its typical that Central Banks like the Bank of England began to dispose of large amounts of Gold just at the moment when its price actually began to rise, thereby losing billions of pounds in the process!

But, not only has the relative value of Gold been rising compared to other commodities during the last decade, but we have also an increasing loss of faith in money tokens, in particular in the dollar, whose role as world reserve currency is itself now being brought into question. Within economies, people do not demand Gold as Money for the purpose of conducting transactions. But, as Marx demonstrates the function of Money is not just to act as currency, as means of payment. Money also acts as a unit of account, and as a store of value. It is this last function of Money that leads to Gold being demanded, because as paper money becomes increasingly devalued people seek to store their wealth in something that will retain its value. They can as I suggested some time ago Buy Gold & Baked Beans buy other commodities like baked beans, which are storable and needed for consumption. That was one aspect of the hyper-inflation of Weimar Germany. But, the reason that Gold, and not Baked Beans assumed the role of Money Commodity was precisely that you would need a very big storehouse indeed, to hold the same value in baked beans that can be stored in a small quantity of Gold! In fact, I’d recommend reading that blog from just over two years ago, which accurately predicted what, in fact transpired.

Ripped Off

All of the people who are hurriedly sending in their gold jewellery in return for cash are getting doubly ripped off. Only a fraction of the value of jewellery actually consists of the gold or other precious metal content. The majority of the value consists of the labour-time of the jewellery workers who turn it into articles of consumption. Yet, the companies buying up the jewellery are only interested in the gold, which they are melting down, to turn into bullion, to meet the growing demand from smart money investors, and its only the gold content, therefore, they are paying for, less their costs and profit margin. But, those selling are getting ripped off from another angle. Even in the last couple of months gold has risen in price by 20%, by the time Joe Public jumps on the bandwagon the price will be much higher.

When I first decided it would be a good idea to start buying gold, in 2002, I had no idea how to go about it. I went to a couple of banks to enquire about buying gold coins or bullion, and was met by blank looks. I went to a local jeweller who confidently told me that it was a bad idea, because there was so much Gold about that the price would never rise, which is why he’d stopped buying Gold Bullion and coins several years before. The same jeweller, I noticed last week, is now running large adverts in the local paper asking people to sell him their gold jewellery and coins!!! In fact, buying physical Gold is fraught with problems. You can, I discovered, buy Gold Bullion from a number of dealers, but you need several thousand pounds to buy each ingot. You can buy Gold Sovereigns, for around £150 each, and Krugerrands for around £600 each. But, not only do you need to take into consideration the costs of storage, and insurance, but you also get screwed on buying and selling by between 5% and 7%, in the difference with the spot price of gold. There are alternatives; you can buy Gold Certificates from the Perth Mint in Australia amongst others. They hold the gold, and you just get a certificate for the amount you have bought. Alternatively, you can buy Gold through an Exchange Traded Fund (ETF), such as the Lyxor Gold Bullion Securities ETF. It is like owning a share, in this case each share is equivalent to a tenth of an ounce of Gold. The price of the shares goes up as the price of gold rises, and because its an ETF the price spread is very small. As more shares are demanded, so more Gold is bought to cover the increased number of shares.

Gold, Inflation and A New World Currency

The fact that such instruments have been developed, which enable ordinary savers to buy Gold, in itself will play an important role in the future rise in the price of Gold. Already 20%, of physical Gold purchases are by such ETF’s, and up to yet, there has been no real demand from retail investors. As I have written previously, the way that Governments will overcome their debt problems will be through a large dose of inflation. The oceans of paper money tokens, already printed, provide the means for accomplishing that, and once economic activity picks up more strongly in the coming months, the velocity of circulation of those money tokens will increase rapidly, fuelling rapid inflation – which will fuel increased demand in itself. Already, Mervyn King has warned that inflation will rise sharply in the coming months. Anyone with cash in the Bank will lose out, as paper money gets devalued rapidly. In the last week the dollar has again begun to fall rapidly, which has partly been the cause of Gold hitting new all-time highs.

The Chinese RMB cannot yet act as a new reserve currency, and the main prospect, the Euro, is itself suspect due to the liquidity pumped out by the ECB, and the fact that European Capital will squeal loudly, if it believes that its competitiveness is being threatened by a rapidly rising Euro relative to the dollar and the RMB, and Yen. The Euro is likely to become the new reserve currency, but only painfully, and over a number of years. The other alternative, the use of IMF Special Drawing Rights, is almost certainly a non-starter, because they could have fulfilled that function any time since the inception of the Bretton Woods Agreement. They could not, because any fiat currency, including a world reserve currency, requires a State standing behind it, and no world state exists. Its in that light that the developments in relation to the EU, and the need for a European State standing behind a European currency have to be viewed. The only money that can fill the vacuum is real money, Gold.

The price of Gold will rise because its value relative to other commodities is rising, but as demand for it as Money, as store of Value, and even increasingly as a means of international payments resumes its price will rise over and above that. As demand rises, whilst supply remains relatively fixed, especially as paper currencies are rapidly devalued, it will not just be smart money investors who pile into Gold, but ordinary savers looking to protect their savings, and increasingly speculators, driving its price parabolic. The real peak price of Gold achieved in 1960, will then be combined with the nominal peak price of Gold in 1980, into a single event in this cycle. The $7,500 per ounce figure, then might be a considerable underestimate of the price Gold might rise to this time round.