One of least understood areas of economics seems to be the stock market (how stock prices are formed, and how different types of financial entrepreneurs [e.g. speculators] interact to affect these prices).  The first good attempt to explain the role of the stock market in the market economy that I came across was L. Albert Hahn’s Common Sense Economics, but even this explanation was rather elementary.  To date, I have not really run across any one person who can explain to me price formation in the stock market (and, it is probably because there are so many relevant forces at work that it is not worth spending the time figuring it out.  What this has caused, though, is a deficient explanation for what is behind the recent upward trend in the price of gold and other similar commodities (silver, copper, et cetera).

Paul Krugman gave a possible theoretical explanation (after his initial guesses, which were incredibly poor: Asian “hoarding” and/or speculators influenced by Glenn Beck).  His argument is basically that the price of gold on the market has risen as a consequence of gold owners preferring to hold (or “hoard”) there stocks; in a sense, taking gold off the market.  Why?  Because, the expected returns made off the rising price of gold is higher than the expected returns of a possible investment that makes use of gold (dentistry, jewelry, et cetera).

This reasoning comes off as inadequate, though.  That Krugman’s argument hold true requires that there be a second reason behind a rise in the price of gold, otherwise there would be no reason for gold investors to hold their stocks of gold in the first place.  There has to be a reason to expect higher gold prices in the future, otherwise Krugman’s theory collapses.

An alternative rationale is the “Austrian” one (or the one that many Austrians subscribe to), which is that the Federal Reserve’s monetary injections have impacted commodity prices first.  My main problem with this explanation is that it is incomplete — why is this the case?  By what mechanism does new money reach the hands of investors who then bid it towards gold?  Not many of the proponents of this argument were able to explain this phenomena, probably because there is a general lack of knowledge with regards to how the modern financial sector works (and, I do not blame anybody — as mentioned above, it is a very complicated topic that has really become a subject of its own).

Lee Adler, writing at Seeking Alpha, gave his own reasoning for the relationship between monetary injection (by part of the Federal Reserve) and commodity prices,

But the opposite is true of commodity prices because of the method in which POMO works. POMO goes first through the conduit of Primary Dealer trading accounts. And guess what else it is that they trade. Did you guess commodity futures? Congratulations. It only takes a few billion dollars spread around among the various complexes over time to keep the fires burning under these trends. This is pocket change to the dealer crowd, whose banking arms are also extending the credit to the leveraged speculating community to play this game.

The category of economists who lack adequate knowledge on the workings of the financial sector includes me (and, actually, I am probably someone who knows the least), so I really have no idea whether Adler’s argument is accurate or not.  Maybe someone can lend their opinion.

What other alternative explanations are there?

H/T James Miller.