The Gold Report: John, at the recent Casey Research Recovery Reality Check conference you described the economic recovery heralded by the Obama administration as an illusion based largely on skewed inflation data. Can you walk us through why, based on your calculations, a recovery is impossible?

John Williams: We can start with the gross domestic product (GDP), which like most economic reports is adjusted for inflation. If you take inflation out of it, what is left should be changes in economic activity, as opposed to changes from prices going up or down.

Reported GDP activity for Q3/11, Q4/11 and Q1/12 was above where it had been going into the recession. Formally, that is a recovery. The problem is that no other major economic series shows that same pattern, which is a physical impossibility if the GDP numbers are accurate.

I contend that the recovery is an illusion created by the government using inflation numbers that are too low when deflating economic series. The lower the inflation rate you use for adjustment, the stronger the resulting inflation-adjusted growth.

In addition, a number of reports such as payroll employment have no ties whatsoever to pricing or inflation. Payrolls have risen a little bit since the trough, but they just recently recovered the levels they hit before the 2001 recession, some 12 years ago. They have not come close to their pre-2007 highs.

TGR: Would you include the unemployment rate among those unreliable reports, given that it does not count people who have stopped looking for jobs or are underemployed?

JW: It is a matter of definition, but that is right as to the headline number at 8.1%. Looking at the number of people who consider themselves unemployed, there has been no real decline in the unemployment rate. It remains at a level not seen outside of the worst recessions.

If you include people who are out of work and have given up looking for work, but consider themselves unemployed because they would take a job if one were available, the unemployment rate is something over 22%. Again, this is not a number tied to inflation.

TGR: You compared that to the Great Depression in your presentation.

JW: During the Great Depression, the estimated unemployment rate peaked in 1933 at 25%. But that included 27% of the population living and working on farms. Today, less than 2% of the population works on farms. A more meaningful comparison perhaps would be the non-farm unemployment rate, which in the 1930s peaked at about 35%. We are still shy of that.

TGR: Which is a more accurate indicator, the payroll employment rate or the GDP?

JW: The indicator here, in terms of payroll employment or the number of jobs, is well off its peak. There has been no employment growth in 10 years, despite 10% growth in the population. There is no recovery based on the employment data, which is a coincident indicator. That is a more accurate picture of what is happening in the economy than the rosy scenario coming out of the GDP estimates.

Another series that has no ties to inflation is housing starts. This is perhaps the hardest hit area of the economy. It peaked in 2006, has dropped about 75% and is bottom-bouncing. It is stagnant at a historically low level.

Consumer confidence is the same. It plunged and is bottom-bouncing.

TGR: Consumer liquidity is related to consumer confidence. There is a lack of positive, inflation-adjusted income growth. Your statistics show the real average weekly earnings for production for non-supervisory employees was down 0.6% from the first quarter of 2011. It peaked in 1973 and has been going downhill ever since. How important are real earnings and associated retail spending to a recovery?

JW: They are quite important. We are not in recovery because consumers are in severe financial straits. There is a structural problem with income. We have lost a lot of jobs offshore—generally higher paying production jobs—due to our ever-expanding trade deficit.

Not only are average earnings down at an individual level, so is household income. In the 1970s, when earnings peaked, it was more common to have one person in the household working, usually the husband, with the wife at home raising the kids. As individuals saw their income drop off faster than inflation, many households needed to have two people working to make ends meet.

Adjusted for the government’s inflation measure, household income continues to shrink month after month. Without real growth in income—growth that’s faster than the pace of inflation—you can never have sustained, positive growth in consumption. You can buy short-term growth through debt expansion, but the key is sustainable growth.

TGR: Student loans, which are up 29.9% from 2011, have been in the news lately. Are student loan burdens and their interest rates having a real impact on the economy or are they just an isolated piece?

JW: I think of student loans as one part of outstanding consumer credit. A lot of people looking at the system’s liquidity believe that consumer credit outstanding has almost reached its pre-recession high. That is due solely to the expansion of student loans.

Normal consumption lending—credit cards or fixed loans—has been dropping off and is bottom-bouncing. The extraordinary growth in student loans looks like a big problem going forward, a bubble like the mortgage market.

If you look at the overall bank lending, banks’ balance sheets are so impaired that they cannot lend normally. Everything considered, bank lending is flat.

TGR: Is our GDP structured such that domestic consumer spending is needed for a recovery?

JW: Consumer spending accounts for 71% of the GDP and everything else is pretty much related to it in some form or another.

For example, look at retail sales. If you remove the artificially depressed inflation numbers imposed by the government, you see a pattern of plunging activity and bottom-bouncing. The same is true for industrial production.

The liquidity problems are at a point now that consumers, both in terms of income and credit, have not been in a position to fuel a recovery. There is no recovery coming. That has all sorts of implications for the markets.

We had a financial panic and a near collapse in 2008. The people in Washington, D.C. had to prevent a collapse. The primary function of the Federal Reserve is to keep the banking system healthy, to keep it afloat. Taking care of the economy and containing inflation are secondary goals.

The federal government and the Fed created, spent, guaranteed or loaned whatever money was needed to keep the banking system alive, and the government will do that again. The problem is, that creates inflation and is not very effective. Yes, we avoided a systemic collapse, but the banking system is still in trouble four years later. The solvency crisis continues. The economy has not recovered. All they have done is kick the proverbial can down the road.

TGR: What do your money-velocity statistics show relative to the existence or absence of a recovery?

JW: I still track what used to be the broadest measure of the money supply, M3. There are three M measures. The M1, the smallest measure, includes cash, checking deposits, traveler’s checks and such. The M2 includes M1 plus savings accounts, small time deposits and retail money market funds. That is as far as the Fed goes today.

It used to have an M3 category, which included M2 plus substantial categories such as institutional money funds and large time deposits. The M3 is almost twice as big as the M2. The Fed stopped reporting M3, but I still track it.

A lot of people have noted the strong growth in M2 recently, but I believe that growth is out of context. That growth is due to funds flowing out of M3 accounts into M2 accounts. The broadest measure, M3, had some recent growth, but it is beginning to stagnate and turn down. That is a sign of stress in the system.

I put together a stress measure based on the ratio of M3 to M2. When the ratio is high, you generally have good confidence in the banking system. Big, uninsured funds are flowing into the banks.

At the crisis point in 2008, the ratio plunged. Immediately, the Fed introduced quantitative easing (QE). When that failed to bring the banks around, it introduced QE2. The ratio of M3 to M2 continues to worsen. I would expect we will see QE3 from the Fed in the not-too-distant future.

The Fed may call it something else, because QE3 will not play well politically to announce the infusion of a couple of trillion dollars into the banking system. The Fed will say it is necessary to stimulate a slowing economy.

This is a very dangerous situation, one that eventually will lead to a massive decline in the U.S. dollar. Global confidence has been lost in the dollar. I think the Fed’s next action will trigger renewed dollar selling, leading to dollar inflation, which is already starting to accelerate. Weakness in the dollar tends to spike oil prices, a big factor behind domestic inflation.

We have been having inflation in a weak economy. Instead of being driven by strong demand—which is a relatively happy circumstance for having inflation—inflation today has been created by a weak dollar and unstable monetary policy by the Fed. That is not a happy circumstance. It is a circumstance that promises much higher inflation as people look at preserving their assets.

TGR: The federal government has been reporting inflation between 2% to 3%. You just updated your 2012 hyperinflation report. What is real inflation right now?

JW: The government’s numbers are accurate by its definition, but they are not what people think they are. Over the years, the methodologies have changed.

The average person thinks that the Consumer Price Index (CPI) measures inflation, that it reflects the cost of maintaining a constant standard of living. They also believe that it reflects out-of-pocket inflation. It does not, nor does it reflect the cost of maintaining a constant standard of living.

After World War II, the CPI was used to measure the cost of inflation for a fixed basket of goods and services. For example the basket of goods might contain a gallon of gas, a pound of steak and a loaf of bread. The government would measure the same, year after year. However much the price had gone up, that was how much inflation had gone up.

In the 1990s, Fed Chairman Alan Greenspan and Michael Boskin, then chairman of the Council of Economic Advisors, started pushing the story that the CPI was overstating inflation. They figured that adjusting the CPI reporting would reduce the Social Security cost-of-living adjustments. That is why they did it. If they had not changed the CPI, Social Security checks would be about double what they are today.

But at the same time, they introduced a substitution that made the CPI worthless for anyone trying to use it as a target for calculating, for example, what their minimum return on investment should be in order to maintain their standard of living.

If you use an inflation rate that is too low, you get a too-strong inflation growth. You see recovery that is not there, which is what we’ve been seeing.

Other changes have been made beyond the CPI substitution. Usually, when the government changed its methodology, it published an estimate of the change’s effect on inflation. If you add all of those changes together, you find that, since 1980, about five percentage points have been taken away from the annual inflation rate. Another two percentage points can be attributed to changes the government did not consider methodological and therefore did not estimate the effect, but they are very much a factor.

So, seven percentage points have been taken out of the CPI. If inflation is being reported at 2.5%, adding that 7% back in puts inflation up around 9.5 to 10% using the 1980 CPI methodology. Using the 1990 methodology, it would be 6% to 7%. That is what people need to be making to stay ahead of inflation.

TGR: What can individuals do to protect themselves if the hyperinflation you are predicting comes to pass?

JW: We keep moving down the road to hyperinflation. This is not the time to worry about short-term gains or losses in the marketplace. It is the time to make sure your basic wealth and assets are protected against inflation, and that you are in a position to ride out a bad financial storm ahead.

TGR: How do you do that?

JW: Your primary hedge is physical gold; precious metals, including silver; and some assets outside the dollar. I still like the Swiss franc—its ties to the euro will not last. I like the Australian dollar and the Canadian dollar. Having funds actually outside the U.S. is a plus. To get through the crisis, you need a hard asset that is liquid for the near term.

Over the longer haul, gold stocks are wonderful hedges, but if the system gets into real trouble, which I think it will, you may have liquidity issues in the market. I am talking about limitations on the physical ability to transact in the market. You may also have liquidity problems with real estate, although over time, real estate is a tremendous hedge against inflation.

TGR: What is the best investment advice you ever received?

JW: Well, I do not generally take investment advice, but the best investment advice I ever gave myself was to buy gold.

TGR: Advice our readers will appreciate. John, thank you for your time.

Walter J. “John” Williams has been a private consulting economist and a specialist in government economic reporting for 30 years. His economic consultancy is called Shadow Government Statistics. His early work in economic reporting led to front-page stories in The New York Times and Investor’s Business Daily. He received a bachelor’s degree in economics, cum laude, from Dartmouth College in 1971, and was awarded a Master of Business Administration from Dartmouth’s Amos Tuck School of Business Administration in 1972, where he was named an Edward Tuck Scholar.

Williams went into much more detail about the economic troubles he foresees for America during his presentation at the recent Casey Research Recovery Reality Check Summit. You can hear it in its entirety, as well as every recorded summit presentation with the Summit Audio Collection. It contains over 20 hours of recordings and features contrarian investing legend Doug Casey, Porter Stansberry of “End of America” fame, former director of the US Office of Management and Budget David Stockman, and Thoughts from the Frontline Editor John Mauldin. All together, 31 of the greatest financial minds of our time were on hand to share their views of the economy and offer actionable investment advice, including specific stock picks, to protect you in these troubling times. For more information about how to add this invaluable collection to your resource library, click here.

The Energy Report: EVs don’t burn gas, but power must come from some source of fuel, such as nuclear, coal, hydro, gas, solar, geo or wind. So, what is the value of an electric vehicle (EV)? How does it help?

Mansur Khan: From a societal and governmental point of view, there are a number of benefits. EVs can really help reduce carbon emissions. Their energy efficiency is very high, sometimes over three times that of conventional combustion engines. I think it can be argued that, even assuming an EV uses a power-generating mix that includes carbon-emitting sources such as coal- or gas-fired power plants, its life-cycle net carbon-emission production is significantly less—anywhere from half to one-third of that from comparable combustion vehicles. Reducing our dependence on oil is another concern, although it’s more geopolitical. I think there is a top-down push to essentially steer the automotive industry into adopting electric vehicles.

Finally, from the end-consumer point of view, the operating cost of an EV is expected to be significantly less than an internal combustion vehicle. On average, they are about one-third the cost on a per-mile basis.

TER: In January, General Motors Inc. (GM:NYSE) announced that it would be producing 60,000 (60K) Chevrolet Volts per year, beginning this year. Does this signal a new wave of EV or hybrid development? How positive is this for lithium consumption?

MK: GM’s commitment to the EV model is reflective of what you’re seeing across the board with major auto manufacturers rolling out some form of an EV model in their lineup.

Aside from GM and Toyota Motor Corp. (TM:NYSE), Hyundai Motor Co. Ltd. (HYMLF:OTCPK), Nissan Motor Co. Ltd. (NSANY:OTCPK;7201:TYO), Volkswagen AG (VLKPY:OTCPK)—all the majors have announced their own models. And when you look on the battery side, you’re seeing considerable research and development (R&D) investment going into battery manufacturing and technology development. Majors like Chinese battery and car manufacturer BYD Co. Ltd. (BYDDF:OTCBB), of which Warren Buffett owns approximately 10%, and BASF Corp. (EUR53.17:XETRA) are making inroads into the technology’s development.

To answer your question, this is of course positive for lithium demand and consumption. Industry consultancy SignumBOX put out an estimate that electric and hybrid electric vehicles made up about 5% of total lithium carbonate equivalent (LCE) consumption in 2011, and that’s expected to grow to about 25% by 2020. So there’s quite a bit of room for growth there. The industry still has a long way to go, but in general, it’s absolutely positive.

TER: Mansur, what is the lithium-ion battery industry’s biggest challenge right now?

MK: The industry’s main challenge is really to scale up in size, from the small consumer electronics to the larger batteries required for EVs, and to be able to do this without compromising on cost, safety and longevity. Technological development may not be happening as quickly as people had expected a few years ago, but it is certainly happening, and I think you will see these growing pains addressed over the coming years as other derivative applications are opened up.

As manufacturing capacity continues to expand, the cost of these lithium-ion batteries will come down, and that is already happening. A few weeks ago a Bloomberg report said the cost of lithium-ion batteries fell 14% year over year, and has fallen about 30% since 2009.

TER: Your February 2012 report cited a third-party consultancy firm, Roskill, which found that lithium consumption has outperformed both industrial production and GDP trends since 2002. But I don’t see that reflected in equities. An index of small-cap lithium stocks shows a 40% decline over the last 10 years. A mix of larger- and small-cap companies is down 30% during the same period. Can you talk about the disconnect here?

MK: Without knowing the specifics of this particular index, I think I can make some general comments. Our view on this is that there are two aspects at play here, and both stem from the global recessionary environment that we are in.

Against this backdrop and coupled with slower technology development, we have seen a slower-than-expected uptake of lithium-ion batteries and EVs. The consensus view still holds that you’re likely to see a mass adoption of EVs by about 2015 and thereafter. We argue that the equities are taking a bit of a wait-and-see approach to this, and so that would probably be one aspect of why they have not done so well. EVs currently make up only a small part of the overall lithium market, as just mentioned, but they are expected to really drive the majority of the growth over the coming decade.

The second aspect is more directly linked to equity markets in general. As you know, stock markets dislike uncertainty and volatility, and unfortunately we have plenty of both right now. In this kind of risk-averse environment, small-cap stocks can face the additional challenge of financing their exploration and development projects without causing a lot of dilution. So there’s a bit of an added risk that is reflected in small-cap performance. We think these factors explain why the equity markets have not really kept pace with the underlying growth and demand for lithium that we are seeing.

TER: You’ve written that the lithium market is currently in a tight supply-demand balance, and that this has prompted capacity expansions by three of the four major lithium producers. You also wrote that prices have stabilized in the $5,500–6,500 per ton (/t) LCE. I realize there are different lithium compounds, but do you foresee a futures market for lithium?

MK: I think it’s too early for that. You would need a market sizeable enough to maintain a spot supply inventory. Right now, what we are seeing is that most of the supply and demand is on a contract-by-contract basis, and these are typically one-year contracts. There isn’t much of a spot market to speak of, and until you have a secondary market open up, you are unlikely to see a futures derivatives market develop.

TER: Looking at the lithium equities market today, do you see it as a deep-value market? Or do you see it as a growth market? Are we at the foot of a growth curve?

MK: Going to the question of growth, I think that’s definitely there in our view. The majors have been reflecting that, not just in what they’ve reported, but also in their outlooks. If you peruse through some of the recent commentary by the majors, they are all reporting strong growth in volume and prices, and in general they expect real growth in lithium demand to continue—anywhere from 6–11% by 2020. So that’s a fairly healthy growth in demand. If you look at Talison Lithium Ltd. (TLH:TSX; Not Rated), for example, it is saying that the lithium market will almost double by 2020, and that’s even excluding the EV component that you hear so much about. So that’s definitely positive, and there’s growth absolutely happening there.

TER: What lithium equities are you recommending to investors?

MK: When you’re looking at the juniors, we believe that only companies with quality assets that are in advanced stages or have strategic backing will have a reasonable chance of making it to production.

I would highlight Nemaska Lithium Inc. (NMX:TSX.V; NMKEF:OTCQX). We have it rated Buy, Speculative Risk with a $1 target price. Unlike the brine developers in Argentina and Chile, this is a hard-rock developer based in Québec. Its Whabouchi property project has a Measured and Indicated resource estimate of 25 million (M) tonnes (metric ton or mt) grading at 1.54% lithium oxide. It also has an Inferred resource of 4.4Mmt grading at 1.51% lithium oxide.

The company is envisioning a two-phase strategy. Phase one will see production of 200K tonnes per year (tpa) of lithium concentrate. This is concentrate, not carbonate, at about a 6% Li2O grade. The operating cost is about $138/t of concentrate. And the preliminary economic assessment (PEA) from last year had an initial capex of $86M for the project.

Phase two essentially envisions a chemical conversion plant that would produce higher-value downstream chemicals, and in particular they’re looking at lithium hydroxide. The PEA on this option was just commissioned. It has also done some pilot-level testing that shows some innovative departures from the conventional process used to produce lithium hydroxide, and the company is going to be filing for a patent on this pretty soon. This could be an interesting development.

Both the definitive feasibility study (DFS) of the concentrate production and the PEA are expected to be out in Q3/12. The company has a strategic partner behind it, Chengdu Tianqi Industry Group Co., the largest lithium battery material supplier in China, which owns 20% of Nemaska. Tianqi recently entered into an agreement with Targray Technology for international distribution of lithium compounds in North America and Europe. We see Nemaska fitting in quite well with this strategy.

Another thing we like about Nemaska is that it’s located in a mining-friendly jurisdiction of Québec, which is trying to build a world-class EV industry by supporting R&D and bringing mining companies and strategic partners together. And of course you could argue that the open-pit conventional mining process has less mining and processing risk. Also, there are a couple of upcoming milestones, the DFS and the PEA. So we like that name.

TER: Another company?

MK: Going over to the brine-developer world, I would highlight Rodinia Lithium Inc. (RM:TSX.V; RDNAF:OTCQX). We have it rated Buy, Speculative Risk, with a target price of $0.80. This is a lithium brine developer with its flagship 100%-owned Diablillos project in the province of Salta in Argentina, which hosts resources of about 5 Mmt of LCE and is adjacent to one of the largest lithium producers in the world, FMC Lithium Corp.’s (FMC:NYSE; Not Rated) Hombre Muerto project, which has been producing for decades.

Diablillos is also adjacent to Lithium One Inc.’s (LI:TSX.V) Sal de Vida project. As you know, Lithium One is currently in the process of being acquired by Galaxy Resources Ltd. (GXY:ASX; Not Rated), which has a wholly owned lithium carbonate plant in China. So that’s definitely an interesting development in the area. Diablillos has high lithium and potassium grades and low impurities that could enable economic extraction, and the PEA put out last year suggests robust economics. With cash costs coming in at a bit over $1,500/t of LCE, along with a strong potash byproduct credit potential, the company is envisioning production of 15K tpa of LCE. Aside from the flagship project, Rodinia also has a brine project in Nevada adjacent to Chemetall Foote’s [subsidiary of Rockwood Holdings Inc. (ROC:NYSE)] existing project there.

But despite all this, the company trades at a large discount to its brine-base developer peers. We estimate an enterprise value of about $3/t, compared to the average of about $10/t. We would say that part of this has to do with Rodinia’s relatively early-stage project and tight cash position. That’s a risk, given the nature of current markets. Management is being prudent with cash, but it is steadily moving the project forward. Also, it does have the Chinese company Ningbo Shanshan Co. at its side.

TER: You said your target on Rodinia was $0.80. You have just taken that down from $0.90, is that right?

MK: That’s correct. We put out a commodity update at the end of every quarter where we go back to the drawing board and look at foreign exchange (FX) rates and commodity assumptions. So part of the discount was about the FX, and the other part is that we are applying a slightly higher discount to the brine developers in Argentina due to the investment climate resulting from expropriation of Argentina’s largest energy company, YPF from Spain’s Reposol.

TER: You mentioned Rodinia’s neighbor producers. You must be implying potential M&A.

MK: Yes, and overall, what we like about this story is that the company has a salar that it is not sharing with anyone else, and it will potentially have two large lithium producers right in its backyard, FMC and potentially Galaxy, both of which have talked about expansion. The company has a strong management team, and both CEO Will Randall and head of exploration Ray Spanjers have extensive experience in managing projects. And Ray actually was previously with FMC’s lithium division.

TER: Another company?

MK: The second brine company that I would highlight is Lithium Americas Corp. (LAC:TSX; LHMAF:OTCQX). We are rating it a Buy, High Risk with a target price of $2.60. Now this is a more advanced brine developer, located in the province of Jujuy. Its Cauchari project hosts a high-grade resource of 8Mmt LCE. It’s had extensive pump tests, pond- and pilot-level tests, as well as hydrological work done, and the company is currently on the verge of putting out a DFS on the project. It’s also interesting to note that the DFS will trigger a decision by its strategic partners, Mitsubishi Corp (8058:TYO) and Magna International Inc. (MG:TSX, Not Rated), who have the option to secure 37.5% of lithium production in exchange for financing up to 37.5% of capital costs. So that’s definitely a good arrangement to have in this kind of market.

Lithium America’s PEA from last year had estimated low cash costs of about $1,434 per ton, based on 20K tpa of phase one production. And of course one common theme with these brine projects is that, given their low impurities, there’s strong byproduct credit potential. There’s good infrastructure in place. And as I said they’re currently working through the final project approval from the province of Jujuy, which should be another catalyst for the stock. By the way, the province of Jujuy had essentially designated lithium as a strategic metal last year, and both Lithium Americas and Orocobre Ltd. (ORL:TSX; ORE:ASX) are currently working out approvals here.

Orocobre will be the last one I’ll mention today. We have it rated Buy, High Risk with a target price of $2.80. This is the most advanced brine development project in our universe of coverage. Immediately north of Lithium Americas’ Cauchari project is Orocobre’s flagship Olaroz project, which also hosts a high-grade lithium resource of 6.4 Mmt of LCE. The company already has a DFS out on the project, and the cash costs are estimated at $1,512/t of LCE, and once again, given the low impurities, there is potential for byproduct credit.

A production rate of about 16K tpa is expected by the second half of 2013, and at the end of last year Orocobre finalized terms with its strategic partner, Toyota Tsusho Group (TYHOF:OTCPK). This will essentially enable Toyota to take an equity stake of up to 25% based on the project’s net present value (NPV) estimated from the DFS. This also includes debt financing by a Japanese consortium for 60% of the project capex, which is a bit over $200M. So the final sign-off on these financing agreements would occur once the Jujuy provincial approval comes through.

TER: I’ve enjoyed meeting you very much, Mansur.

MK: Thank you very much, George, I really enjoyed the interview as well.

Mining Analyst Mansur Khan joined Dundee Capital Markets in 2007 as an associate covering the industrial, aerospace and special situation sectors. In late 2010, he switched into Dundee’s mining group, where he covers a range of exploration and production companies in the uranium and lithium sectors. Since 2012, he has been providing lead coverage on the lithium sector. Prior to Dundee, Mansur worked for a number of years at a private design engineering company on various information systems and operations projects. He holds an MBA from the Rotman School of Management, University of Toronto and a Bachelor of Commerce in systems development from Ryerson University.