Re: [A-List] Gold strikes back

["Anne Williamson" <annewilliamson@xxxxxxx>]

Last week I posted North's "Sellers of Gold"
to the A-List.  "Buyers of Gold," posted below,
is the second half of Dr. North's discussion of
gold initiated last week.

Anne

                Gary North's REALITY CHECK

Issue 146                                      June 3, 2002


                      BUYERS OF GOLD

     At every recorded price, there is an exchange.  For
every buyer, there is a seller.  Gold has a price.  Someone
is buying gold.

     Why?

     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.)
Friedman continues:

     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."


RESERVATION DEMAND

     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 the 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: http://www.bls.gov.  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) 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 governments.

     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).


CONCLUSION

     Buyers of gold (sellers of dollars) at the margin are
likely to increase their demand.  Gold's price is going to
increase because:

          1.   More investors will perceive that gold
               leasing is a one-way street, and so will not
               greatly fear gold dumping by central banks.

          2.   More Indians will be able to afford to buy
               gold if the Indian economy grows.

          3.   More Indians will buy gold if the threat of
               war increases.

          4.   China's central bank will increase gold
               purchases.

          5.   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?

     Choose gold.


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