Gold Meditations

In a Twitter exchange a few weeks ago I mentioned an insight offered by Jacques Rueff into the gold pricing mechanism under a classical gold standard in his book “The Monetary Sin Of The West”.

A few people asked me to expand on that comment. (As usual I’m late in getting this post out.) Long story short, Jacques Rueff tells us that there were two reference points for setting a currency peg with gold. In gold producing countries it was the average production cost of mining gold. In countries without significant gold production the reference point was average exports.

He also talked about gold having a place in the “price hierarchy” of commodities which, by inference, is discovered as a result of mining for gold. (I’ll provide some page references and extracts from Rueff’s book below.) So gold mining had two inter-related pricing functions.

The traditional price discovery mechanism for the commodity price of gold wasn't trades on a COMEX style exchange or a “fix” by a group such as the LBMA. (In the case of the LBMA perhaps it might be more realistic to view the fix as a market maker’s operation. Meaning the LBMA clearing members simply provide liquidity like the primary dealers in the US Treasury securities market by standing in the market with a bid and offer price.)

Rueff’s insights have some interesting implications for the COMEX gold market. If this paper by Douglas Pollitt is on the money then a realistic assessment of the current overheads in the gold mining business means that miners require a gold price many hundreds or even thousands of dollars higher than the price COMEX is signalling. In my opinion the disconnect between the COMEX price and the production cost of gold requires an explanation.

As Rueff points out the price of gold also regulated the supply from mines by disciplining the “marginal producers”. It exerted pressure on them to reduce supply when prices were low and encouraged production to expand when prices were high. Could this apparent mispricing be due to the gold miners sucking in capital without being able to provide a return?  (Mining their stockholders as Pollitt's paper suggests to Uncle costata.) Are other commodities produced for years despite being priced below their production cost?

As I mentioned earlier I’ll provide some page references to the digital copy of Jacques Rueff’s book that I linked above. He described gold as having a place in the “price hierarchy” of commodities (P. 33). He talked about gold residing in the “general price hierarchy” (P. 208) and that gold’s place in this hierarchy was determined by the cost of mine production.

That makes sense to me. The costs that impact on other commodities also affect the cost of gold production – labour, capital, technology, interest rates, machinery, energy, various consumables, land, government fees/charges and so on. Gold mining was the conduit through which the components that make up the “general price level” (P. 142) impacted on the overall cost of gold production. This is Jacques Rueff’s description (P. 58) of the benefits of pegging to one of these reference points:

“No doubt, the fact that legal parity is pegged is the main feature of the gold standard. I would even say that its major virtue is that it maintains the whole scale of prices in the countries that apply it at a level where the average cost of gold production [10] coincides with the legal parity of the currency.

But when its operation has been suspended—as was the case in nearly all belligerent countries during the last two world wars—or disrupted—as was the case as a result of the application in the greater part of the world of a system which, like the gold-exchange standard, stretches nearly to breaking point the link between gold and aggregate purchasing power—then there is no alternative but to jettison appearances to save realities and, while acknowledging the situation that you have allowed to develop, to re-create the basis for continuing expansion without impairing order or stability.

[10] And in the non-gold-producing countries, the average price of gold in terms of exports.”

Gold provided an anchor for the currency to the rest of the commodities that constitute the general price level. When this level increased significantly (e.g. as a result of a major war) Rueff’s policy recommendation was to increase the price of gold in order to restore equivalence. Expressed in currency terms this meant cutting the exchange rate of the currency peg to reflect the change in the general price level. In a situation where prices had doubled a peg set at 50:1 before the rise would require a reset to 100:1 in order to recognize the true position of gold in the general price hierarchy of that currency zone.

Rueff seems to be offering a way of approaching a fundamental analysis of gold pricing. Now I realize a lot of people believe that fundamentals play second fiddle to technical analysis (TA). And the savants of Team TA have certainly been racking up the points against Team Goldbug lately. I posted a comment here recently with a quote from a post that I thought summed up the current situation perfectly. It's from a blogger who styles himself Tiho (at The Short Side Of Long blog) who said: “Fundamentals are useless until the market decides to price them in.” After further reflection I began to have doubts about how the average person could profit from adopting this perspective. 

If you don’t know what the fundamentals are how can you position for the market’s ultimate recognition of their existence? (Perhaps Tiho's statement could be restyled as Technical analysis is useless unless you know when the fundamentals will be priced in.)

If you do know gold's fundamentals (and they aren't being priced in) how can you determine in advance that the market is about to price them in? Can TA answer this question? 

If you think you have the answers to these questions or you would just like to comment about this post please join the discussion.