Gold – The Cost Of Production Argument

On CNBC this morning Peter Toogood, of Old Broad Street Research, argued that he could see no basis in terms of the store of value argument, for the price of Gold to be where it is, or to be rising. The reason for this, he argued, was based on the cost of production of Gold. The cost of production of Gold currently is around $1350 an ounce, whereas the current price of Gold is now approaching $1600.

If then we are to argue that people are demanding Gold because it forms a store of Value, its current price is already above its Value. Generally, Marxists would have some sympathy with this argument, although we would argue that it is the Price of Production (Cost of production plus the average rate of profit), which is the basis of an equilibrium market price. However, there are a number of reasons why his argument here is wrong.

The Marxist argument concerning market prices goes something like this. The fundamental basis of market prices is Exchange Value. The Exchange Value of any commodity is determined by the amount of average, socially necessary labour required for its production. Labour here is not the specific labour used in the production of the specific product, but abstract labour used as merely a unit of measure.

To understand this concept, think of the measurement of length. The unit of measurement we call “the foot”, is an abstraction. Originally, people's actual feet served as a basis of measurement. But, clearly all feet are different, just as all Labour is different – the labour of a Tailor is not the same as the Labour of a Bricklayer. Other measurements were similar, a Cubit the length from the elbow to the tip of the finger and so on. But, as it became more important to have more accurate, and commensurate measurements of length these names remained, but the actual lengths they represented became fixed, even though this fixed length might not represent the length of any person's actual foot. It was merely an abstraction. So with Abstract Labour as a unit of measurement. In just the same way that a foot might represent only 80% of the length of one person's foot, or 120% of the length of another's, so one hour of Abstract Labour might represent just 50% of an hour of skilled Labour, and so on.

On this basis every commodity can be objectively measured in terms of how much of this Abstract Labour is required for its production. That does not mean just in the actual Labour used to manufacture it, but also the Labour contained in the machines used up in its production (depreciation), and in the materials used in its production. But, Marxists argue that one of these components used in production is different from the others, and that is the actual Labour used to set the machines in motion, and to transform the materials into the finished product. It is different for this reason. The machines, and materials used in the production process have an Exchange Value determined as above. If they were sold on the market that is the Value they would have. They are incapable of increasing in value on their own account.

For this reason Marxists call them Constant Capital, because they can only transfer the Exchange Value they already have into the finished commodity. However, in order to set these machines in motion, and transform the materials, real living labour is required. The worker who represents this Labour, sells his/her capacity to perform it to the Capitalist. In other words what the worker sells to the Capitalist is not Labour – which would mean selling him/herself i.e. becoming a slave – but their capacity to perform Labour i.e. their Labour Power.

Labour Power then is also a commodity – which is why the claims of the Tories about the right to strike i.e. not to sell the commodity Labour Power unless a given price is paid for it, undermine the very principles of a market economy they claim to defend – in fact, it is the only commodity that workers have to sell, which always puts them in a disadvantaged position versus Capital. If, Capital is to be free not to buy Labour Power from workers when it chooses, and to make them unemployed, then workers too must have the right not to sell their Labour Power to Capital as and when they choose, if its price and other conditions are not met.

As a commodity this Labour Power also has an Exchange Value determined by the Labour-time required for its production. In other words, how much Labour-time is required to produce the food, shelter, clothing, healthcare, education that has to be consumed by a worker to perform the required Labour for a given length of time.

However, unlike the machines and materials which can only ever transfer their Exchange Value into the final product, the Labour-Power bought has the unique quality of being able to continue to perform Labour beyond the point at which its price has been repaid. This can be easily seen if we look at previous Modes of Production. In slave owning societies, the slave owner directly provides the slave with accommodation, food, clothes etc. But, he then expects the slave to continue to work, and to produce value beyond what has been laid out to enable the slave to perform that work.

There would be no point having slaves otherwise, and in fact, the holding of slaves only began after the development of tools and other productive forces had reached a stage where an individual could produce more than was required for their own subsistence. Similarly, under feudalism, the peasant worked half the week on their own land, producing the food and other products needed for the subsistence of their family, and in the other half of the week, worked for free on the land of the Lord of the manor, as payment of rent.

The position of the wage worker is essentially no different. They work for part of the week producing Value that repays the cost of producing their Labour-Power, and the rest of the week they work for free, the value of what they produce during this period being appropriated by the Capitalist as Surplus Value, which he shares with the Money Capitalist as Interest, the Landlord as Rent, and the Capitalist State in Taxes. For this reason, we call this part of Capital, Variable, because the amount of Value it creates is variable depending on the length of working day, intensity of the labour etc.

Unlike, the slave or the peasant, the wage worker believes that they are making a fair deal exchanging like for like, but that is only because the payment of their wages takes the form of money, and because they have the appearance of free sellers of their commodity, Labour-Power, within the market. As Nicholas Taleb puts it,

“Karl Marx, a visionary, figured out that you can control a slave much better by convincing him he is an employee.”

So, Marxists present the Exchange Value of any commodity as being formed as follows:

C 1000 + V 1000 + S 1000 = K 3000.

These quantities can be viewed as hours of Abstract Labour. But, if we assume that a Money Commodity exists, whose Exchange Value is also determined by the labour time required for its production, then these quantities can also be viewed as amounts of this commodity e.g. Pounds. In this example, the workers work for half the time to produce Exchange Value equivalent to the Exchange Value of their Labour Power (paid in wages), and the other half of their time is then producing Exchange Value, which is appropriated by the Capitalist as Surplus Value.

The total exchange Value is 3000 comprising the Exchange Value of the machines and materials used up in its production, and the Labour used to set those machines in motion, and to transform the materials. This latter value then being divided between the workers as wages, and the Capitalist as Surplus Value.

Its clear from this why the capitalists want to reduce the Value of Labour Power by making the things required to produce it cheaper i.e. food, education, healthcare, shelter, clothing etc., because by doing so, they can simultaneously raise workers real living standards, and increase profits.

But, imagine another company which uses the same amount of Capital, but which is composed differently.

C 1500 + V 500 + S 500 = K2500.

In the first instance, the Capitalist makes a Rate of Profit of 50% (1000/2000), but in the second the capitalist makes a Rate of Profit, of only 25% (500/2000), where Rate of Profit is S/C+V. But, in that case, because Capitalists will always invest their Capital where they can make the highest return, Capitalists would take Capital out of the second type of industry, and move it to the first. The consequence would be that Supply would contract in the second industry pushing prices up, as demand and supply adjust, and as a consequence increasing the Rate of Profit, whereas in the former the influx of Capital would increase Supply, thereby reducing prices, and profits. By this means the Rate of Profit across industries is constantly being adjusted towards an average level, which is itself always changing.

So, on this basis, we would tend to agree with Peter Toogood's argument that if the cost of production of Gold is $1350 an ounce, but its current price is $1600 an ounce, then we would expect that the higher rate of profit that this generates, would encourage more capital to be invested in Gold production, its Supply would then rise, driving down prices, and profits.

To some extent, that can indeed, be seen. In the last 10 years, there has been considerable investment in prospecting for new goldmines, and in establishing them in Kazakhstan and other Central Asian countries. But, there are a number of reasons why this will not determine the price of Gold now, or in the near future.

Firstly, the process by which Capital flows from one area to another is not instantaneous. It takes seven years to establish a Gold mine, and longer than that before it reaches peak production. In the intervening period Supply can fail to match demand, and so prices will remain above the Price of Production during that period. The production of commodities such as Gold, are not the same as for say Mars Bars, because it is not possible to quickly adjust production upwards to respond to an increase in demand.

Secondly, a commodity such as a Mars Bar, is bought and consumed. Gold, cannot be destroyed or consumed. Every ounce of Gold ever mined, is still in existence, and is stored in private and State hoards, or in the form of jewellery. Newly produced Gold, forms only a small proportion of the Gold that is traded on the markets, and, therefore, in periods when demand for Gold is strong, the price of production plays a smaller role in determining the market price.

Far more important, becomes the willingness of those with existing Gold hoards to sell them, which in itself becomes a function of whether they believe the price will continue to rise, or will fall. So long as the demand for Gold exceeds the Supply made up of that made available from existing hoards, and new production, its price will continue to rise.

Thirdly, Gold as store of value is an indication not of existing levels of inflation, but of what those demanding it, think is going to happen to inflation in the future. In 1971, the price of Gold was $30 an ounce, which was the price it had been set at in 1947 at Bretton Woods. During the 1970's, as inflation increased rapidly due to massive money printing in the US and elsewhere, and as it looked as though the international monetary system was on the verge of collapse, the loss of faith in paper currencies was reflected in a rise in the price of Gold, as real money.

By 1980, it had risen more than 25 fold to just over $800 an ounce. Current levels of inflation though rising, are in reality flattered. Over the last 20 years, massive money printing around the globe has not resulted in general inflation. That is because, that excess liquidity was soaked up in two ways. Firstly, it was soaked up by China, which became the workshop of the world. Large amounts of western currency went to buy Chinese manufactured goods, and some of that currency was recirculated in loans back to the West, whilst another large part of it went to building new production capacity in China, as well as in demand for massive quantities of raw materials from Latin America, Central Asia, and Africa.

The low production costs of those manufactured goods from China, reduced the Value of Labour Power in the West, and thereby facilitated a modest rise, or only slight decline in western real wages, despite growing uncompetitiveness of its economy. It meant inflation remained low.

But, the era of cheap Chinese imports is coming to an end. China is facing rapidly rising inflation itself, which is the manifestation now of the depreciation of all that paper money that has been printed. Wages are rising rapidly in China, driving up prices fast, and those prices will be transmitted into the global economy, as rapidly rising import prices.

The second, way in which the paper money was absorbed was in the bubbles in asset prices. Over that period, their were repeated bubbles blown up in Stock Markets, and in Property Markets.

As inflation rises, and more money is required from disposable income to pay for everyday things, such as food and clothing, so the ready supply of money to finance those bubbles will cease, and as they pop those markets will correct sharply downwards. As I've said previously, based on the OECD data, house prices in Britain are due for an 80% drop. But, as money moves away from these bubbly asset classes, so it will tend to move into where a real store of value is seen to reside. Rising commodity price inflation, will, in fact, rapidly push up the money price of production of Gold and all other commodities.

The cost of wages for gold miners, of equipment to mine etc. will rise sharply, and so that $1350 an ounce could in two years time easily have risen to more than $2000 an ounce, and that is where Gold can even be mined at something approaching current levels of productivity. Already in South Africa, the world's largest Gold producer, mines are having to go down to record depths to get out gold, and the lower you go, the higher the cost becomes.

Fourthly, and related to the above, in a world of global uncertainty, demand for assets that provide security goes beyond what might seem in the abstract as rational levels. For example, the Yield on the UK Ten year Gilt, has fallen from 3.8% to now hovering just above the 3% level in a matter of weeks. That is not because of confidence in the Government's austerity measures. On the contrary, Japan, which has a debt to GDP ratio of more than 130%, and is spending more due to the earthquake and tsunami, is paying just over 1% on the 10 Year JGB, whilst the US, which has far more debt than the UK, is paying less than 3% on the US 10 year Treasury. The reason for these low, and falling rates, is that Bond investors are concerned over the European debt crisis. They are trying to get out as quick as they can, from Greek debt, Irish debt, Portuguese debt, and now Spanish and Italian debt, with Belgium lined up too. They are doing so for fear that they might not get all or most of their money back, if these economies default, which in the case of Greece, everyone recognises as being inevitable.

Yet, on the face of it, this seems to be irrational. Bond investors are accepting 3% on the UK 10 year Gilt, whilst inflation is already at 5%, meaning that they are losing 2% in real terms on their investment every year! But, they are prepared to do that because, they think its better to lose 2%, than to lose 30, 40, 50% of their money by investing in Greece, Ireland, Portugal, Spain or Italy. Its on that basis that under current conditions, demand for Gold can continue to rise way beyond what might seem rational in terms of its current price of production.

At the moment, there are still plenty of people prepared to sell their bits of Gold, to the rip-off merchants, springing up on every high street, offering worthless bits of paper in return for real money. If anything, that is keeping the price of Gold down. But, at a certain point that will turn around, and all those people now giving away their Gold to the rip-off merchants will be trying to buy it back at much higher prices. Then the price of Gold will begin to soar.