The Gold Report: In the Nov. 4 edition of Hotline, you note that America’s ratio of debt to gross domestic product (GDP) is north of 350%. Our total debt as a society is somewhere around $57 trillion (T). That’s worse than Greece. Is deflation America’s biggest economic threat?

Jay Taylor: I believe it is, however, most of my goldbug friends wouldn’t agree. It is important to realize that the U.S. is not a third-world country. It still has the world’s reserve currency. The central bank, the Federal Reserve, doesn’t put money into the hands of the masses. It puts money in banks. It’s all about credit extension. That is very difficult to do now. With the debt-to-GDP ratio as it is, it’s unsustainable. The markets are telling us that—not only in the U.S., but clearly in Europe as well. We are undergoing one of the largest debt-deleveraging periods in a long time, which may be much larger than what we went through in the 1930s.

TGR: You believe there should be no more bailouts, let this debt wrench itself out of the system and let bankruptcies occur.

JT: Absolutely. Most people don’t understand the reason we’re in trouble is because the good times that we had were false. They weren’t based on savings and investment. They were based on money creation through credit extension. The nice homes, the big office buildings, fancy cars, everything—it wasn’t earned, it was based on debt. Now that the debt cannot be repaid, the expansion goes into a contraction. That process has a long way to go.

TGR: Bob Prechter of the financial forecasting firm Elliott Wave International is predicting that gold and silver “should decline in conjunction with the stock market selloff. Gold should work down toward $1,300 an ounce (oz), while silver should fall into the low $20/oz area.” What’s your position?

JT: If you believe that we’re in a deflationary environment, the nominal price of gold could go down and the purchasing power of it could go up a lot. The real price of gold is most important for gold mining companies. Before the Lehman Brothers failure in July 2008, an ounce of gold would have bought only 17% of the Rogers Raw Materials Fund. It rose to 44% by March 2009, but came back a bit to 30%. It was recently up to a new high of 47.5%. Gold’s purchasing power is rising much more dramatically than its nominal price. Gold has fallen off its highs and is around $1,700/oz. As Ian McAvity has said, an ounce of gold is an ounce of gold. A barrel of oil is a barrel of oil. What is a dollar? It’s a meaningless measure because Federal Reserve Chairman Ben Bernanke can create trillions of dollars out of thin air.

TGR: Silver’s purchasing power on the Rogers Raw Materials Fund hasn’t experienced quite the same gain. In June 2008 it was just below 1%. Now it’s just below 3%.

JT: Silver has done very well, but it’s much more volatile. It has outperformed gold in general since Lehman Brothers’ collapse, however.

TGR: The International Monetary Fund (IMF) has agreed to throw the Eurozone countries a lifeline of about $0.5T. Will that be enough?

JT: My view on Europe is the same as on the U.S.—the kindest, gentlest thing to do would be to allow the debt to implode immediately. We’re allowing sick entities to survive and eat up resources. It’s contrary to free market capitalism. It’s really fascism. Large corporate interests are being protected because of their cozy relationships with government. A half trillion is not going to be enough. Where does the IMF get its money? Is the U.S. going to be asked to pony up more money for Europe? Probably. Are they going to sell the rest of the gold they have? Perhaps. That’s what the Soviet Union did before it collapsed.

TGR: You’re biased toward credit market deflation, but you continue to be partial toward gold and gold mining stocks. What are the reasons for that?

JT: Margins are widening. There is an explosion of profits for major mining companies in production before 2008: Agnico-Eagle Mines Ltd. (AEM:TSX; AEM:NYSE), AngloGold Ashanti Ltd. (AU:NYSE; AU:JSE; AGG:ASX; AGD:LSE), Barrick Gold Corp. (ABX:TSX; ABX:NYSE), Goldcorp Inc. (G:TSX; GG:NYSE), Kinross Gold Corp. (K:TSX; KGC:NYSE), Newmont Mining Corp. (NEM:NYSE) and Yamana Gold Inc. (YRI:TSX; AUY:NYSE; YAU:LSE).

In 2008, those companies recorded $5.77 billion (B) of earnings collectively. In 2009, that jumped to $7.05B. In 2010, it jumped to $13.62B. The analyst consensus is that it’s going to go to $20.22B in 2011 and $28.28B for 2012. Margins have increased in this deflationary environment because the real price of gold has risen relative to the cost of mining it.

Bob Hoy, a technical analyst in Vancouver, figures we are in the sixth large credit contraction in the last 300 years. In every case, the real price of gold has risen over 15 to 20 years. The real price of gold started to rise in 2007. We could be in the early days of a super bull market for gold mining shares.

TGR: Those majors probably average $500/oz in cash costs. However, you have a buy rating on small Australian producer Crocodile Gold Corp. (CRK:TSX; CROCF:OTCQX), which just reported a loss of about $6 million for the quarter. Its cash costs are above $1,400/oz and its stock is down about 80% this year. Why on earth would you still have a buy rating on Crocodile Gold?

JT: I believe in the long-term prospects of this company. It’s had a lot of problems. Its costs were $250/oz higher than projected this year because of lower-than-expected grades from its open-pit projects. Clearly, that’s a black eye for management because something went wrong. But I still believe that this company has extraordinary exploration potential and will get costs under control.

TGR: For example, silver producer Great Panther Silver Ltd. (GPR:TSX; GPL:NYSE.A). As of Nov. 18, it was up 355% since you took your initial position. Great Panther is down almost 20% this year despite a strong Q311, however. What’s your outlook for Great Panther?

JT: Its decline is in line with the general market decline. It keeps improving on a fundamental basis and expanding its resource. It’s a fine operation that’s earning money.

TGR: What other smaller gold and silver miners are you interested in?

JT: My favorite might be Sandstorm Gold Ltd. (SSL:TSX.V), which is a royalty play. It has one of the best looking charts in a horrible market. Sandstorm provides the capital to get companies into production and then it gets a royalty. It usually gets the chance to buy maybe 15% or 20% of a project’s production for the life of that project at cost. It has several properties that are producing now. Its projects are getting bigger and production is growing. This is a company that’s going to continue to earn more and more very rapidly. There are fewer risks involved in this model than if it was an operator, too.

TGR: Its production forecast for this year is from 16–18 thousand ounces (Koz). However, that will increase to more than 50 Koz by 2014. That’s certainly strong growth.

JT: The gold price, where it is relative to the cost of mining and the expansion of production, means that earnings are going to grow very rapidly, if not exponentially.

TGR: Do you think that too many royalty plays kill the goose?

JT: That could be the case. With increased competition, they might be paying too much for the deals that they strike. However, I’m not concerned about that with Sandstorm at this point. Royalty plays, like Sandstorm, Silver Wheaton Corp. (SLW:TSX; SLW:NYSE), Royal Gold Inc. (RGL:TSX; RGLD:NASDAQ) and others, generally sell at much higher multiples than mining companies because there’s less risk involved. An operator can have any number of things go wrong and have to put in more capital to get things moving again.

TGR: It’s more of a matter of vetting these projects and being sure the geological model works and the metallurgy is good.

JT: Yes. I have a high regard for the management of Sandstorm. They’re really sharp. They get involved in projects that have enormous upside potential. It’s not just the ounces that might be in a bankable feasibility study. They look at the exploration potential and the expansion of production, too.

TGR: Let’s move down the food chain to the explorers. The portfolio scorecard in each edition of Hotline doesn’t paint a very kind picture of gold and silver exploration plays lately.

JT: Nope, not this year.

TGR: As of Nov. 18, only 8 of 50 exploration companies on that list, or 16%, were up: American Bonanza Gold Corp. (BZA:TSX), Metanor Resources Inc. (MTO:TSX.V), Prodigy Gold Inc. (PDG:TSX.V), Aurvista Gold Corp. (AVA:TSX.V), Meadow Bay Gold Corp. (MAY:TSX.V; MAYGF:OTCQX), Pretium Resources Inc. (PVG:TSX), Nautilus Minerals Inc. (NUS:TSX) and Rye Patch Gold Corp. (RPM:TSX.V; RPMGF:OTCQX). You still have buy ratings on the other 42 companies, however. Why are you still recommending small-cap companies exploring for precious metals?

JT: I believe in the sector. I can’t explain why the markets have treated the sector badly this year. The majors’ profits are up very sharply, yet the share prices haven’t even begun to keep up. It tells me that most of the players in the equity markets don’t recognize this as a gold bull market and they don’t see the potential for turnaround. They don’t realize, as Bob Hoy points out, that there’s probably another 15 years to go.

Gold is going to be strong for a long time because the financial sector, deleveraging and the loss of confidence in fiat money is going to keep the real price of gold and real earnings high. I told my subscribers when things started to turn that they should build some profits and keep some cash on the sidelines because the entire sector is likely to decline in price along with the general market.

The gold sector is being hurt badly and that’s an extraordinary opportunity. Why would I sell companies that I believe in even if, like Crocodile Gold, they’ve lost 80%? It would be a stupid time to sell. It would be a great time to take some of that cash that I suggested investors put aside and start to buy some of these companies as they decline. I don’t see any reason to jump ship now because I believe so firmly in the fundamentals of this industry.

TGR: The biggest gainer on the list of the companies that are up this year is American Bonanza Gold. It’s up about 70% this year, but about 232% since you took your initial position. Why is that junior performing so well?

JT: It’s on the verge of production at the Copperstone gold mine in Arizona. There were a lot of skeptics and the stock was extremely cheap. The costs are very low. It’s not a big mine and the production levels are fairly small, but it has really good exploration potential that can be built into a much bigger mining operation over the long term.

TGR: When is initial production expected?

JT: I believe in Q112.

TGR: American Bonanza should be generating some cash flow at that point.

JT: It should, with the caveat that more often than not startup operations have some kinks to work out. However, this was a previously producing mine. That reduces some of the metallurgical risk and other risks of a new startup. I’m confident it’s going to get the job done.

TGR: You recently interviewed management from Merrex Gold Inc. (MXI:TSX.V; MXGIF:OTCQX), which is not doing too badly this year. What did you learn about Merrex?

JT: Merrex is exploring the Siribaya deposit mine in Mali with IAMGOLD Corporation (IMG:TSX; IAG:NYSE) as its 50% joint venture partner and largest shareholder. IAMGOLD is there because it believes this is going to be a multimillion ounce deposit. And IAMGOLD is committed—it spent about $10 million to earn a 50% interest.

It has about 460 Koz from a relative high-grade open pit at a quarter grams per ton. However, that’s based on less than 5% of the total strike length of two major zones, plus another zone was discovered, too.

Moreover, some of the assays recently from the south end of the zone that was drilled have been much higher grades. The average grade may be even higher than 2.25 grams.

The only real downside is that the company has to rely on diesel fuel for now. There’s some vulnerability to spiking oil prices.

TGR: IAMGOLD is effectively using Merrex as an exploration arm.

JT: IAMGOLD is the operator of the project. It has a joint committee that decides on the strategy and drill programs. In fact, one of the management members of Merrex who I was with in Switzerland was going to Toronto on his return to talk to IAMGOLD about the next drill program.

TGR: You also have a buy rating on Calico Resources Corp. (CKB:TSX.V; CVXHF:OTCQX), which is drilling the Grassy Mountain gold project in Oregon. Oregon is generally not considered the most mining-friendly state. Why does Calico make your scorecard with a buy rating?

JT: Washington is probably considered one of the most difficult states in the country for mining. California had been very difficult, but it’s getting tougher everywhere. Calico management discovered by doing research that Oregon is no more difficult than any other Western state.

Politicians with common sense know the local people want jobs. Where are the jobs going to come from? Mining is a wealth-creating activity. It’s not going to be easy. Getting permits moved through the pipeline can be difficult, but I have confidence in the management team at Calico led by Chairman Buck Morrow, for whom I have a high regard.

Grassy Mountain was worked on during the last gold bull market. The potential there is extraordinary. It has gotten some really nice assays back.

TGR: What are some other precious metals explorers that you’re following closely and remain excited about?

JT: I love Rye Patch Gold in Nevada. It has 3.1 million ounces (Moz) gold, but it has 3.9 Moz gold equivalent including silver. Rye Patch clearly has a shot at building something much bigger than that with its good management and miniscule market cap.

I also like Metanor Resources a lot. Since Sandstorm provided capital, the company has been focusing on its underground Bachelor Lake mine in Le Sueur, northeast of Val d’Or, Québec. Bachelor Lake is going to be put into production within the next six months to a year. It should do very well with that. It also has the Barry deposit, which has the potential to be a very large deposit similar to Osisko Mining Corp. (OSK:TSX).

Québec is one of the best provinces in which to run, explore and develop projects. Aurvista Gold in Québec has 2 Moz and huge exploration potential. Pretium Resources also has a huge deposit up there next to Seabridge Gold Inc.’s (SEA:TSX; SA:NYSE.A) gold-silver deposit. Pretium is headed by Bob Quartermain and a very strong management team. It’s actually been one of the winners this year.

TGR: Do you have any parting thoughts?

JT: It’s painful sitting with stocks in this kind of a market, but that’s the nature of the beast. You hold a junior mining company and all of a sudden it takes off. You just don’t know when. You have to believe in the fundamentals of the story and the chance to come up with something big. A couple of times I’ve walked out of a stock and a day or two later the company made a great discovery—that is really painful.

TGR: How would you respond to someone like Rick Rule who says it’s not about the 80% you lost, it’s about what you do with the 20% that you have left?

JT: I suppose that’s right. Rick is a very conservative investor. He really likes to buy stocks when they’re cheap. He’s a very disciplined trader. You want to protect that 20%. When you get a market that’s on the upside, you can make that 80% back very quickly if you’re in the right stocks.

Of course, I’d never recommend that investors back up the truck and bet the farm on any one company. I have a lot of companies on my list because I believe in diversification. These little penny mining companies, the miniscule market-cap companies, can be tenbaggers in a hurry if they’re successful. Whenever you invest in a deal, you can lose 100%, but you can’t lose 1,000%. The upside is limitless.

With 20/20 hindsight I should have sold everything and waited until now to buy, but I didn’t know for sure how the markets were going to treat gold stocks this year. But I’ve been telling investors to build some cash for this kind of environment. Now is the time to be buying.

TGR: Thank you.

As he followed the demolition of the U.S. gold standard and the rapid rise in the national debt, Jay Taylor’s interest in U.S. monetary and fiscal policy grew, particularly as it related to gold. He began publishing North American Gold Mining Stocks in 1981. In 1997, he decided to pursue his avocation as a new full-time career—including publication of his weekly Gold, Energy & Tech Stocks newsletter. He also has a radio program, “Turning Hard Times Into Good Times.”

The Energy Report: You have said you don’t believe in peak oil, Porter, because as oil prices rise, the entrepreneurial spirit will lead people to find ways to extract oil either in new places or with new technology. With prices running between $80 and $100/barrel (bbl), is the era of cheap oil over? And if so, what will be the impact on economic growth?

Porter Stansberry: I feel the same way about peak oil as I do about deflation. It shows massive ignorance of economics and human nature. In regard to oil prices, you have to separate the price from the currency, because in Swiss francs and gold, oil prices haven’t changed much in 50 years. Yes, the price of crude oil is volatile; it goes up and down. But in 1950, it took 2.5 grams of gold to buy a barrel of oil. Today, 2 grams of gold will buy you a barrel of oil. Thus, if you take the loss of the dollar’s purchasing power out of the equation, you’ll find that the price of oil has remained very flat.

So I would argue that despite massive increases in consumption, the real price of oil has remained unchanged. Going forward, that will almost certainly remain the case. Why? Because geology doesn’t create oil; capital creates oil. The more capital you put toward oil, the more of it there will be.

TER: But the cost to extract the oil is increasing. We don’t have “easy oil” anymore.

PS: No, that’s not true. Just as with any other economic activity, the more experience we have in oil extraction, the more efficient we become at it. In fact, the real price of oil would go up considerably if the true costs of extraction were going up as well, and as I explained, the real price of oil has been flat.

Let’s be very clear—you can’t measure these things in dollars because the dollar has lost 90% of its purchasing power since 1971. It’s lost 50% of its purchasing power since 1990. Measuring the oil industry in dollars gives you a very warped view. Pick a sound currency such as Swiss francs or gold grams and look at the oil business through that lens.

I believe that what’s happened with the U.S. dollar over the last three years has resulted in an enormous mis-pricing of oil. Speculators are rushing into oil and fleeing the dollar, which is producing an unsustainable demand for oil. Because this demand is investment-based and not economy-based, it is stimulating production that exceeds real demand by a wide margin.

TER: And where will that take us?

PS: Over the next 18 months, I expect a major correction in the price of oil and gas, with oil falling back to $40/bbl. It won’t stay there long, but it will be a big correction.

TER: What’s the extent of the stimulated production you mentioned?

PS: What’s happening onshore in the U.S. with oil and gas production is amazing. We’re setting new records for hydrocarbon production in the U.S. this year. Obviously, you can’t have record levels of hydrocarbon production if you’re supposedly running out of oil, so serious proponents of peak oil have their heads in the sand.

One more thing about peak oil. . . Look at a great book, The Prize: The Epic Quest for Oil, Money, and Power, by Daniel Yergin, cofounder and chairman of Cambridge Energy Research Associates. It’s a whole history of the oil industry. For example, war-related demand made oil prices soar during World War II, and lots of production ensued. Then big debates erupted over whether domestic use of oil should be tightly regulated because oil was a scarce, strategic commodity needed more for tanks and battleships than cars. Those favoring the tight controls argued that we were going to run out of oil, that all the major supplies of oil in the U.S—and likely in the world—had already been discovered. That was in 1946, before Saudi Arabia had really ramped up production.

You see this in the oil industry time and time again. Fears that we’ve found the last oil, that we’re going to run out, pop up constantly. And soon afterward, because the price goes up, huge new reservoirs are discovered. Always. They’re discovered because the capital is there for the exploration.

TER: You noted earlier that experience in oil extraction leads to further efficiencies, and U.S. Department of Energy estimates suggest that horizontal drilling alone can lead to increasing reserves from existing oilfields by 2%.

PS: Horizontal drilling is a fantastic technology that’s leading to a renaissance in the oil and gas industry in the U.S., and you’re going to have enormous amounts of new production come online in the decade ahead. That will, of course, force the prices back down. And inevitably, in 25 to 30 years when the prices go back up, we’ll again hear, “Oh no, we’re running out of oil.” It’s a constant cycle. It’s human nature. It’s economics. Really, if people just read a little bit more history, they wouldn’t fall for such antics.

TER: If we’re now at a point in this constant cycle where capital infusion will find additional oil supplies, will oil equities drop correspondingly?

PS: Obviously. As oil and gas prices fall over the next 18 months, it will reduce oil and gas company earnings and their stock prices will fall. They may not drop as much as they ordinarily would, however, because many of these companies are in the midst of enormous expansions of their proven reserves. Oftentimes, as you know, oil and gas companies are valued more on the basis of reserves than on current earnings.

TER: So is this the time to short them?

PS: No. There are too many other easier targets to short—European banks, newspaper companies, hard-drive stocks are some of my favorite shorts. I wouldn’t short oil and gas companies now because, as I said, they’re in this period of massive discovery. If you’ve been following the onshore shale companies the last six months, you know they’ve been doubling and tripling proven reserves, which is making their stock prices jump even though oil prices have been falling for the last several months.

TER: Shifting to natural gas, one of your recent newsletters points out that U.S. natural gas is 75% cheaper than oil, with prices at roughly half of the world’s prices. Extrapolating from there, you say that such a dramatic difference in the price of the same commodity—that commodity being energy in this case—won’t remain for long, because somehow traders will arbitrage and either oil will come down or natural gas prices will go up.

Why would the spread between oil and natural gas, which has existed for quite a few years, begin to reach equilibrium now?

PS: The spread between oil and gas, and between onshore gas and foreign gas, really began to widen in 2008 and basically has continued to widen for the last three years. It hasn’t been arbitraged away yet because it takes a long time for various consumers of energy to make those kinds of changes. Many coal-fired power plants are being decommissioned or switched over to natural gas, but that takes a long time.

It will take five to 10 years to arbitrage away that spread. Meanwhile, the biggest fortunes in oil and gas over the next decade will be made by efforts to arbitrage the global price of energy from America to the rest of the world. These spreads presage a massive change in the oil and gas business in America from acting as a large energy importer to becoming a net energy exporter. This must make peak oil people tear their hair out because why in the world would we export any if we’re running out of it? But enormous efforts are being put toward exporting energy.

Big liquefied natural gas (LNG) export facilities are being built, and there’s some irony to this. One company that I’ve shorted successfully and mocked for almost a decade is Cheniere Energy, Inc. (LNG:NYSE.A). Cheniere Energy existed to borrow a billion dollars and build an LNG import facility. Then it decided that maybe we’re not running out of energy in America after all and changed its port from an import facility to an export facility. That gives you an idea of the sea change that’s happened in the domestic onshore oil and gas business. I haven’t heard any other analyst talking about that kind of change yet, but the realization will soon dawn on the market that America has vast energy resources and will have vast energy surpluses going forward.

TER: We’ve fought wars over the fact that we’re importing energy.

PS: I’m not saying we’ll stop importing energy. We may continue to import oil, for example, because it’s cheaper to produce it in Saudi Arabia and ship it here than it is to produce it here. That doesn’t mean that we can’t be a net energy exporter, though, especially if we export an even larger volume of natural gas.

TER: The Casey organization, Marin Katusa, in particular, follows natural gas, LNGs and its use in Asia. Marin’s recommendations for LNG companies include many located in Indonesia, for instance, because it’s so close to the primary user, China. Given that the U.S. isn’t yet exporting natural gas and that dollars are going into Southeast Asia to build all of these natural gas LNG facilities, have we missed the opportunity?

PS: I don’t think so. Marin is a very good energy analyst, but I think the best way to play Asian energy demand will be American natural gas. I’m not saying that his stocks won’t do well or that there won’t be foreign competitors to American natural gas—there surely will be.

Nevertheless, America’s natural gas infrastructure is an order of magnitude larger and more sophisticated than any other of our competitors in this business. Even though the U.S. doesn’t have export facilities completed yet, that’s a minor piece of the puzzle. What we do have is tremendous amounts of supply and very low prices compared to the rest of the world. We have enormous storage and production facilities that can guarantee supply for decades at fixed prices. No one else will be able to compete with that.

TER: You mentioned earlier Cheniere Energy is part of the shift from building LNG facilities for import to export. Are some other companies interesting to you in the energy export market?

PS: Yes, but first I have to tell you one more thing about Cheniere because it’s so ironic. Guess how many LNG import facilities have been built in the U.S. throughout history? Four. Guess how many of them eventually went bankrupt? All of them. And why?

Because America is the Saudi Arabia of natural gas. We have the world’s largest reserves of natural gas, and the world’s most sophisticated production and storage facilities, by a wide margin. Coming up with a business model to bring natural gas into the U.S. would be akin to a sheik in Dubai importing sand from Chile. It just doesn’t make any sense. It never made any sense, and yet banks gave Cheniere a billion dollars and investors gave it hundreds of millions in equity. When I wrote about it, the newsletter headline was “Madness.” It was completely insane, but it was manna for a short seller because there was no possible way the business could succeed.

Getting back to your question, I know of only two publicly traded ways to play this export LNG business. I’m sure that more of these endeavors will be launched in the next 12 months. For now, ironically, Cheniere is one of the two publicly traded companies in that space, but I’d advise against investing in Cheniere because its capital structure is so impaired by the billion dollars it lost trying to build an import facility.

The other company is Dominion Resources Inc. (D:NYSE), a large integrated power company that has both regulated and unregulated subsidiaries. One of the unregulated subsidiaries owns a facility in Cove Point, Maryland, originally built in the 1960s as an LNG import facility. Of course, it went bankrupt; they all do. Now, Dominion is retrofitting Cove Point to be an LNG export facility. It’s also connecting pipelines from the Marcellus shale in West Virginia and Pennsylvania directly to this export facility. As a result, it’ll be able to take very, very low-cost natural gas out of the Marcellus and export it to the world.

TER: In what timeframe?

PS: The export facility is scheduled to open in either 2014 or 2015. The construction timeline was like five years. These are very massive facilities.

TER: Moving on to nuclear energy, what’s your outlook? Does the post-Fukushima controversy translate into a contrarian investment opportunity in uranium?

PS: I’ve been a big fan of nuclear power, although not necessarily a uranium bull. In fact, I was very bearish on uranium in the 2006–2007 timeframe because I thought it was a bubble. It eventually did collapse, so I was right about that. I can’t say that I’m part of the nuclear bull crowd now, either, but it’s because I’m more and more convinced that growth in conventional energy resources will be greater than people expect, which will continue to marginalize the nuclear power footprint in the world. I’m not saying that it’s going away, but I don’t think there will be as much growth there as everyone else expects.

TER: What does that mean for uranium prices then?

PS: I’d be neutral on uranium, and relatively neutral on large users of nuclear power such as Exelon Corp. (NYSE:EXC), which is a stock I’ve owned in my portfolio and covered in my newsletter for almost a decade. It’s a very safe and sound company, a good way to get a 5% dividend yield. It’s not a bad investment, but I’m just not particularly bullish on it the way I was prior to Fukushima.

Quite frankly, I’m surprised and disappointed that the modern safety standards that we have across these power plants throughout the world didn’t perform better. There’s s no margin of error. You cannot afford to have an accident at these plants.

I’m not saying that we can’t get there, but the facilities we’ve built over the last 40 years have proven to be unsafe. The public is right to be skeptical, and that’s generally going to reduce the construction of new plants. Less construction will cause demand for uranium to disappoint, probably over the next several decades.

TER: What will replace nuclear though?

PS: I’m very, very bullish on natural gas consumption, incredibly bullish, because I think the price is going lower. As the price goes lower, people will use more and more of it. The conventional wisdom now is that natural gas will go from around 20% of global energy consumption to maybe 25% over the next decade. I’m more optimistic than that—I think we’ll see natural gas go to 35–40% of all energy consumption. It could even go higher. It really depends on how cheaply it can be delivered around the world. The greatest opportunity the energy complex has over the next several decades lies in exploiting the technologies that are enabling shale gas production.

TER: And on that good-news note, Porter, thank you so much for taking the time to share your insights and opinions with us.

After serving a stint as the first American editor of the Fleet Street Letter, the oldest English-language financial newsletter, Porter Stansberry began Stansberry & Associates Investment Research, a private publishing company, 11 years ago. S&A has subscribers in more than 130 countries and employs some 60 research analysts, investment experts and assistants at its headquarters in Baltimore, Maryland, as well as satellite offices in Florida, Oregon and California. They’ve come to S&A from positions as stockbrokers, professional traders, mutual fund executives, hedge fund managers and equity analysts at some of the most influential money-management and financial firms in the world. Porter and his team do exhaustive amounts of real world, independent research and cover the gamut from value investing to insider trading to short selling. Porter’s monthly newsletter, Porter Stansberry’s Investment Advisory, deals with safe value investments poised to give subscribers years of exceptional return. You can learn more about Porter and his ideas by clicking here.

The Gold Report: You’ve written a lot about the gold standard recently, and an article in your S&A Digest argues that we should greatly prefer gold-backed money because it would limit the ability to increase the money supply. It goes on to point out that increasing the money supply essentially causes inflation. If regulations prohibited governments from expanding the money supply, would fiat currency be as good as the gold standard?

Porter Stansberry: In theory, it could be, but in practice that’s never happened. I suspect that the market wouldn’t have much faith in such rules, and they’d be abused eventually. During the Volcker and Greenspan Federal Reserve periods, from roughly 1981– 2006, two central bankers created a de facto gold standard because they remained relatively consistent vis-à-vis money supply targets.

Volcker absolutely targeted money supply, as did Greenspan up until about 1999. He moved away from that stance due to Y2K fears and then the 2001–2002 recession. So we’ve seen long periods in fiat systems where money supply growth was targeted and fairly reliable.

The problem, of course, is that the gold-standard rules don’t apply across the banking systems. When the Fed was targeting money supply, bankers lobbied for all kinds of changes related to reserve ratios, which allowed them to massively increase the leverage on their balance sheets. Famously, the investment banks—Bear Stearns, Lehman Brothers and others—went from, say, 15:1 to 50:1. That had a tremendous impact on the amount of credit in the economy, which ultimately led to the collapse we well remember. Then the Fed started to radically increase the money supply to help reduce the impact of those bad loans.

That’s a long way of saying that efforts to mirror a gold standard by rule have never been effectual in history, and they haven’t worked in America over the past 40 years.

TGR: So changing the reserve requirements, in essence, increased the money supply.

PS: Let’s talk definitions. When I’m talking about the monetary base, I’m talking about the size of the Fed’s balance sheet, which is the foundation of the U.S. fractional reserve banking system. When you increase the size of the Fed’s balance sheet, you can have multiple increases of the actual money supply from that base. By targeting that base, Volcker restrained credit growth in the economy. Greenspan was less successful at that because he chose to expand the monetary base for political reasons.

In any case, just controlling the monetary base did not control the impact of increases to banks’ balance sheets and leverage ratios, simply because they lobbied successfully to change the rules. They got permission to increase their leverage. The monetary base didn’t change, but the money supply increased due to the actions of the banks. It would have been impossible under a gold standard for the simple reason that the banks would be subject to runs on their gold. That doesn’t happen in a paper system.

I’m not saying that there would never be another run on a bank, but bankers would have a palpable fear of losing control under a gold standard because the market discipline is so much fiercer now. They never would have leveraged 50:1 under a gold standard. It would have been completely implausible.

But as long as there’s this notion that they can get a bailout of any size by turning on the printing press, maybe the discipline isn’t quite so sound. That’s exactly what we’re seeing. So rather than allowing runs on the bank or rather than allowing banks to default and for depositors to lose, the government is printing as much money as is required and is giving it to the banks.

TGR: Is expanding the money supply actually a bad thing?

PS: In a healthy economy, the money supply would increase naturally by exactly the amount of increases in productivity. In fact, one of the main features of the gold standard is that it creates a balance between creditors and debtors. Creditors are more willing to lend money because they know the money they’re going to be repaid will be sound. Likewise, borrowers are more reluctant to take on debt because they know there’s not an easy way to repay it.

One of the main reasons you should prefer a gold standard is that it limits increases in the money supply to real increases in productivity. A second reason is that it simultaneously limits the availability of credit. Those limits mean that powerful interests in the economy and/or the government can’t simply create whatever credit they need to buy whatever assets they want. In a true free market, credit is relatively difficult to come by and can’t be manipulated by the various interest groups.

But in a free market that uses paper currency, it’s very difficult to actually maintain ownership of key assets because competitors in the marketplace may have access to political capital that allows them to buy whatever they want. You see this all the time in various industries, particularly those influenced by the government. In media, for instance, a very small number of vested interests end up owning and controlling all media properties because they have access to credit that their competitors don’t. That’s very difficult to pull off in a gold-standard system.

TGR: When you say they have access to credit that their competitors don’t, are you talking about on a worldwide basis?

PS: I’m talking particularly about the U.S. system, where the well-connected, money center banks—J.P. Morgan, Bank of America, etc.—essentially have access to unlimited amounts of credit, and they can finance almost any kind of takeover they choose, especially if it’s favored by the government that they do so. They can do that because, again, there’s so much flexibility in the monetary base, and credit is so easy to come by. It can be printed. You can’t print gold, so under a gold standard, the government wouldn’t allow the banks to have that much credit because it wouldn’t be able to bail them out.

TGR: So if the U.S. went to a gold standard, wouldn’t international companies have an advantage over those based in the U.S?

PS: No, not at all. If our currency were backed by gold, it would be very difficult for foreign investors to buy U.S. assets. One of the big calamities of our current situation is that by devaluing the dollar by 20% over the last three years—which is what’s happened—our government has made everything in the U.S. 20% cheaper for foreign investors. We’re burning the family furniture to keep the heat on in this country.

It doesn’t make any sense to devalue an economy the size of the U.S. by 20% merely in the hopes of making the stock market or employment go up a couple of percentage points. Giving away your country by devaluing your currency in order to produce economic activity is madness. That couldn’t happen under a gold standard.

TGR: One of your articles drew the link between devaluing the currency and calling it what it is: inflation. Your great chart, the CRB Futures Index Growth since 1955, shows a spike in 1971 when the U.S. went off the gold standard, and then bounces around rather wildly, never going back to the ‘71 levels. Presumably, that shows how the dollar’s purchasing power has declined, and you relate it to inflation. Interestingly, you also wrote that well-known economists—including some at Stansberry & Associates—continue insisting that there’s no inflation. What arguments do they use to support their viewpoints, and why are those arguments flawed?

PS: The most well-known person in the deflationist camp is Robert Prechter, but there are many others, including some who work for me who are persuaded by those arguments. We have a running debate because I think these people are foolish to be able to look at any long-term chart of the dollar’s purchasing power and claim any deflation’s going on.

TGR: When did this trend in decreasing purchasing power begin?

PS: Pick your date, and the dollar has lost 90% of its purchasing power from that day. A good way of thinking about this is to think about being a millionaire in 1900. To be a millionaire in 1900 was just unheard-of rich. At the time, gold was worth $20 an ounce, so to be a millionaire then, you’d have been worth 50,000 ounces of gold. And today? That amount of gold is worth about $100 million.

So gold’s supply-and-demand dynamics haven’t changed that much, and its intrinsic value, I would argue, hasn’t changed at all. What has changed, of course, is that the value of our dollar has collapsed by almost 100%. If you go through history and you realize that in 1971 gold was worth $35 per ounce, you can see that it’s declined 97% since then.

Just during the time Greenspan was at the Federal Reserve, the purchasing power of the dollar fell by about 50%. There’s no deflation in our money supply, and therefore no real lasting decline in prices. For people to say otherwise, I think, is incredibly stupid. No evidence whatsoever suggests that a fiat-backed currency system will ever cause a lasting deflation. And to believe that a short-term decline in prices in one market or another is tantamount to deflation is simply bad economics. It’s not true at all.

You have to look at broader measures of prices to see the impact of inflation, and you have to understand the impact of increasing the monetary base. If you increase the monetary base threefold, over time you’re going to see a very large increase in prices. Then, beyond all these nuts-and-bolts aspects, just look at history. Where is the fiat currency that collapsed because it became too valuable?

TGR: Part of the logic in going to a gold standard is to eliminate the inflation or eliminate the devaluation of the dollar. Isn’t some level of inflation a good thing?

PS: Why? Why should the monetary system favor one party over another? Why should debtors have an advantage over creditors? Doesn’t that retard lending? Doesn’t it retard economic growth when creditors constantly worry what the inflation rate’s going to be?

TGR: Speaking of economic growth . . .

PS: The fastest period of wealth creation in American history happened in the decade of the 1880s, during which the U.S. was on the gold standard. If you go back all through history, you find that economies do better with sound money. It’s no mystery why. You can’t make long-term investments without stability in the money. The instability does nothing but increase the prestige and power of the vested interests who control money supply, interest rates and the inflation rate. It makes it impossible for everyone else to do business.

Why isn’t a gold standard automatically the status quo in a democracy? Why would anyone ever want to get away from that, allowing the government to have both the swords of justice and the scales of money under its control? The outcome is always the same disaster. Credit grows uncontrollably and eventually the printing presses have to get turned on to pay back all the debt. Needless to say, we’re in the midst of one of those scenarios now.

TGR: Were any economists in 1971 warning that at some point down the road, abandoning the gold standard would trigger these credit problems and massive inflation?

PS: Absolutely, and some great economists were raising these issues as early as 1933, when FDR began to really move the U.S. away from the gold standard by making gold inconvertible, meaning that you couldn’t go exchange your dollars for gold at the bank. From that point forward, we were really on a pseudo-gold standard. All the economists who warned about what would happen were right.

TGR: And people apparently didn’t know the history of fiat currencies.

PS: True. Also, of course, it takes a lot longer for paper systems to break down than people expect because they’re completely reliant upon the confidence of the people using the system, and it’s in everybody’s best interest to play “hear no evil, see no evil”—nobody wants to see the whole house of cards crumble. But eventually it does crumble and people hedge their potential inflationary losses by buying gold and silver. That’s happening now.

TGR: A common argument is that there isn’t enough gold either in vaults or in the ground to return to the gold standard. The amount of gold above the ground was estimated at 158,000 tons in 2008, or 5 billion ounces. The nominal gross domestic product (GDP) in the U.S. is $14 trillion.

PS: The nominal GDP has nothing to do with the monetary base, which is where to look in terms of understanding a healthy ratio between gold and the dollar. The monetary base in the U.S. is a fraction of the GDP—about $2.865 trillion. Even so, if you tried to back every single dollar with an ounce of gold, you’d have an astronomical price of gold—that won’t work.

You want a gold standard that you can get to without taking 50 years or without greatly reducing the amount of money in circulation in your economy—a sensible transitional period that isn’t so deflationary that everyone goes bankrupt. Going from a situation in which we’d had inflation of 4–6% a year over the last 40 years to a period where you’re actually having deflation of the monetary base by 4–6% a year in order to get back on the gold standard would devastate debtors. You want a transition that treats creditors and debtors fairly and gets the economy back on a fixed standard, from which point we can move forward.

But you don’t need an ounce of gold backing every single dollar to maintain the standard in the vault. You need good lines of credit so that demand can be met. That was done over long periods of time, hundreds of years, very safely, very effectively, with relatively small amounts of gold in reserve.

Obviously, you need more reserves during times of crisis when people are nervous about the system. But what makes the system work is that the price at which people can demand gold remains unchanged. And people need faith that balance will return even if there’s a disruption in the demand system. After the Civil War, for instance, it was important that the greenback returned to its prewar value, that the gold standard was reinstated at the same price. And that price remained in effect all the way until 1933. So it’s not important to have an ounce of gold to back every single dollar; it is important, however, to have a reserve system that works, confidence that it works, and the political will to stick to the price to ensure that it keeps working.

TGR: That good credit you mentioned, especially when you hit economic bumps—where does that credit come from?

PS: The various large bullion banks would have swap lines with one another. If there’s an economic problem in Germany, for example, the Fed might lend gold to the German Central Bank to meet requests for the redemption. You can do it any way you want.

TGR: Would other countries also have to return to the gold standard to have that international credit option?

PS: The U.S. could do it alone, but it would certainly work a lot better if more of our trade partners agreed to the same standard. The economic area would be larger, too, so there would be more diversification of labor and more economic growth.

TGR: You’ve suggested that we could return to a gold standard by setting a target date 10 years in the future and then allowing the market to reach the appropriate price level. Taking only 10 years to get it back in balance sounds optimistic.

PS: It really depends on what you want the price to be. After the Civil War, it took 14 years because it was important to the bankers at the time that we return to the right price.

You probably could set the price easily between, let’s say, $5,000 and $8,000 per ounce of gold, and have the reserves necessary to make the system work today at the Treasury. People could go exchange dollars for gold as much as they wanted, and have confidence in the system at that price. You could do it right now.

TGR: What would be the catalysts to spark the move to return to the gold standard?

PS: I think the catalysts will be the destruction of the dollar and the ongoing inflation. Look at corn prices. When people around the world can’t afford food because the U.S. dollar has lost its purchasing power, it leads to revolutions, unrest, violence, people abandoning the dollar, failures of banks, collapsing markets and all these volatilities that we see. In my mind, returning to the gold standard is inevitable because nothing in human nature has changed in 4,000 years. As long as there is paper currency, it will be debased, and it will cause problems. Sooner or later, people will tire of it and return to gold. I think we’re in the middle of that transition as we speak.

TGR: If we’re in the middle of it, when do you suppose we’ll actually have a plan to go back to a gold standard? Steve Forbes says it’ll happen within the next five years.

PS: I think it’ll happen during the next Administration. At some point, to get people back to work, to get the country moving in the right direction, we’ll have to make a big economic readjustment. We’re going to have to get rid of the large overhead costs of government, return to lower taxes, and return to sound money.

TGR: Do you really think anything like that can happen, considering the recent debacle over the debt ceiling in Congress?

PS: I personally think we’re going to have an enormous dollar crisis, and that we’re only in the very beginning of it. The dollar has lost 20% of its value since 2008. I think it will lose another 20% over the next 12 months, and the population in America will get really tired of that very quickly. I expect a big political change in this country when people are fed up and say, “We’ve had enough—enough bank bailouts, enough of the money printing, enough of our wages being stolen by inflation. We want a system that doesn’t depend upon the good graces of politicians for its value. We want to use gold as money so that our savings are protected.”

TGR: So the people rather than the politicians will provide the political will needed to return to the gold standard?

PS: Absolutely. Politicians are never leaders in political thought. They follow the polls.

TGR: You’ve made it pretty clear that had we been on the gold standard we wouldn’t be struggling with this economic crisis. You mentioned people’s wages being stolen by inflation. Millions of Americans aren’t even making wages these days because they’ve lost their jobs. And we still have that tremendous debt load hanging over us.

PS: There’s no doubt at all that if we had been on a gold standard we would have never seen a credit bubble the size of the one we have now. It would have been very difficult for us to have the kind of economic problems we’re having.

As for the debt, there’s 400% of debt-to-GDP in the U.S. right now—not future liabilities, not Medicare out to 100 years from now. We can’t get people back to work and jumpstart our economy because we cannot afford to pay these debts. These debts are also the reason why we have to keep printing more money. We’re absolutely drowning in debt, and the only way out is to paper those debts over by printing enormous amounts of money that will devalue people’s wages through inflation and also, of course, diminish their net worth by lowering the value of everything they own.

The total debt in our country right now is $56 trillion, and the Fed has monetized roughly only $3 trillion of it through quantitative easing (QE) so far. We haven’t even begun to see this happen yet. We’re going to see QE3, then QE4, and on and on. And, in general, each level will be larger than the previous, so the numbers will get bigger and bigger as the Fed races against the market to devalue these debts.

TGR: Then how do we get back on the gold standard?

PS: Sooner or later people will say, “Enough!” I can’t tell you when that day will arrive, but I’d be surprised if the next Administration comes and goes without a return to gold.

TGR: This has been a pretty compelling conversation, Porter, and a lot of our readers will want to watch your video/read your essay that goes beyond what we’ve talked about today.

But before we let you go, you’ve said that unless investors are willing to speculate and start shorting equities, they probably should stay out of the equity market because you’re looking at a long, serious bear market. You advise these people to put 50% of their money into short-term Treasuries and 50% into gold. What’s the logic of the Treasuries if you expect the dollar to be devalued?

PS: One-year Treasury bills offer some protection from inflation because they have such a short-term duration. You won’t lose a lot to inflation with such instruments. They pay you something to hold them, too—although not very much.

The reason for holding these instruments is to reduce the volatility of the gold holdings. If you’re not going to hold other securities, all you want is to keep the value of your account stable. Taking half of the uptick in gold over the last year—a gain of maybe 20% and there’s no way that price inflation has been 20% in the last year—you’ve made a net gain in real terms.

If people are simply able to retain the purchasing power of their savings in the midst of this massive global monetary crisis, they’ll have done a great job. The thing to do now is not to lose, and the safest way not to lose is to go half gold, half cash.

On the other hand, investors who are in a position to be able to speculate can look at my newsletter’s portfolio and see that we’re long certain stocks that are positioned to profit from these problems and we’re short the stocks that are positioned to suffer from them.

After serving a stint as the first American editor of the Fleet Street Letter, the oldest English-language financial newsletter, Porter Stansberry began Stansberry & Associates Investment Research, a private publishing company, 11 years ago. S&A has subscribers in more than 130 countries and employs some 60 research analysts, investment experts and assistants at its headquarters in Baltimore, Maryland, as well as satellite offices in Florida, Oregon and California. They’ve come to S&A from positions as stockbrokers, professional traders, mutual fund executives, hedge fund managers and equity analysts at some of the most influential money-management and financial firms in the world. Porter and his team do exhaustive amounts of real world, independent research and cover the gamut from value investing to insider trading to short selling. Porter’s monthly newsletter Porter Stansberry’s Investment Advisory, deals with safe value investments poised to give subscribers years of exceptional returns. You can learn more about Porter and his ideas by clicking here.

The Gold Report: After the protracted battle in Congress over the debt ceiling and budget cuts, there were some expected consequences and some unintentional ones. What trends in precious metal equities have developed as a result of the activity in the last few days?
Frank Holmes: After the recent sell-offs, almost every equity market is in bear territory and deeply oversold. According to our mathematical models, gold is the only exception. There is a huge fear trade going on—a flight to safety.

The rhetoric surrounding the debt ceiling proved that politicians are not serious about balancing the budget. This is alarming to investors. Add to that unease the European contagion potential where many German and French banks have been selling their gold for the past five years to buy sovereign debt. Gold was not considered Tier 1 capital and was carried at a discount. These central banks sold their gold at $500, $600, $700, $1,000/ounce (oz.) to buy Greek, Portuguese, Italian and Spanish bonds in an attempt to earn a higher interest rate. If any of those countries were to default, then German and French banks would not be able to lend. This fear is very significant.

TGR: What do you see as a resolution? Or is there a resolution?

FH: The most significant factor in our capital markets is regulations, or “oppressive regulations,” as Bill Gross, founder of Pacific Investment Management Co. LLC (PIMCO), calls it. The cost of regulation is so expensive; it’s like injecting cholesterol into the veins of the economic system. Blood has to flow freely through an economy to get growth. Right now, all we see is an exponential growth of regulations. The Dodd-Frank Act regulations are only supposedly 10% implemented. That leaves a lot of blockage yet to come.

The financial sector, which is the second biggest sector of the S&P 500, is leveraged 12-to-1. Federal Reserve Chairman Ben Bernanke can inject capital into the market, but if it is overwhelmed with regulations, there is not going to be turnover of that money supply. We will see continued deflation.

You can see how it’s creating a traffic jam. It’s not just political. It’s not just an issue of Democrats versus Republicans. Runaway regulations on steroids are jamming down every aspect of the economic system.

TGR: Gold stocks should have some significant positive fallout as investors clamor for safety. Are exchange-traded funds (ETFs) going to see the bump first?

FH: Gold equity bullion ETFs have made it easy for investors to get gold exposure. However, I think that gold has gone up exponentially and is due for a correction. It’s up more than 36% over 12 months. Any time it makes a move like that over 12 months, there is a 90% probability of an 8% to 15% correction.

But there are themes in play that are favorable to gold, such as the “love trade.” The world’s population has doubled since the 1970s. Half of that population gives gold for religious holidays, weddings and birthdays. There is a high correlation of the gross domestic product of countries that follow these practices and growth to the consumption of gold. The World Gold Council said that rural housewives in India hold roughly twice the amount of gold that the U.S. has stored in Fort Knox.

We have noticed in our financial models that any time a government pays less on their Treasury bills than inflation, gold starts rising in that country’s currency. Of the seven most industrialized countries in the world, only one has a positive real rate of return above inflation. China, India, Russia, the U.S., Europe—they all have negative real rates of return. They are all offering a negative real rate of return in short-term deposits and bonds. Gold will start to rise on that financial aspect. Add in the deficit spending taking place and that gold is in a secular bull market, and investors should want to add to their positions.

TGR: How do banking regulation and models like the international bank capital accords, Basel I and II, play into this?

FH: Now we are going to Basel III, which is basically banking requirements for how much capital they have to lend against. If a bank has $1 billion (B) in capital, that means that it can take deposits and have a debt portfolio of $12B, or 12 times that. But what do they put up for $1B of capital? Gold was always classified as a lower tier asset class, meaning it had to be carried at a discount. It was never treated as money. Basel III, coming out in the fall, will treat it as sovereign debt.

Central bankers sold their gold to buy junk debt. Now there is going to be a shift in central bank buying. During the past eight years, emerging markets have been buying gold. India bought $6.7B in gold in 2009 from the International Money Fund. Recently, South Korea and Mexico bought tons of gold. Once Basel III goes through, central bankers in Europe along with commercial banks will likely become net buyers of gold. That will change the landscape as gold will be treated equally with sovereign debt.

Along with the backdrop of rising GDP-per-capita in emerging countries, gold has a probability of doubling over the next five years. The last bit of math that has a high correlation to gold from a financial point of view is money supply growth. The G7 countries have money supply growth on a year-over-year basis of around 4%. Emerging countries have slowed down to 18%. I think that money supply in these emerging economies will continue to be strong. They haven’t been cancelling huge infrastructure projects such as the mega-railway project in China. The country earmarked $300B to connect 700 million people with high-speed trains. I think that will add to the gold consumption because this is highly correlated to rising GDP-per-capita.

TGR: Wouldn’t new construction also have a positive effect on base metals?

FH: Yes, it will. There is no doubt. Fear of a slowdown and a recession could cause copper prices and other metals to correct 10% or more, but they won’t collapse like in 2008. This build-out will continue. Investors should use this type of correction to their advantage. We tell investors that volatility is only dangerous if you are borrowing against it.

In any 12-month period during that past 10 years, it has been a non-event for gold to go up or down 15%. Any time it goes up twice that then there is a 90% probability of a correction. During the last nine months, gold stocks have been underperforming bullion. I think the greatest opportunities are picking gold stocks where investors can get dividends that are higher than a five-year government note. Franco-Nevada Corp. (TSX:FNV) is a classic example. It pays a monthly dividend. The yield is higher than any government debt. It has no debt on its balance sheet and management owns a big piece of the company. Since 2007, it has a growth rate of more than 30%.

TGR: Franco provides good diversification and a kind of mutual fund approach through various royalty interests.

FH: It’s a brilliant model with high profit margins. Since it went public as a spin-out from Newmont Mining Corp. (NYSE:NEM), Franco-Nevada is up about 300%, while Newmont is up about 6%. It just goes to show that having growth, revenue-per-share and high profit margins and returns in capital do work for any long-term investment theme.

Royal Gold Inc. (TSX:RGL; NASDAQ:RGLD) has grown about 25% compounded during this time. Even through the crash of 2008 and back up, some of these stocks have done spectacularly well.

The most important aspects of a gold-producing company are production-per-share and reserves-per-share. Underperforming gold stocks destroyed their production-per-share with acquisitions. Even though gold has gone up to over $1,700/oz., these gold stocks have not participated in the upside because they kept issuing stock and diluting production-per-share.

TGR: Normally companies get better movement in the shares than in gold. Yet it seems most stocks are underperforming. Some of them are down much further than you would expect. Why?

FH: There are two reasons for that. One is this fear of owning any equities. I think the real bubble is putting your money into CDs where investors are going to lose money on interest. Investors will get an interest payment below the inflationary rate and their money is locked up. It just shocks me. Right now, Mellon Bank charges to park cash with them. It’s charging investors a fee. It’s not paying. It’s charging.

It is just bizarre that people are so fearful when you can turn around and buy gold. I think there will be a wakeup call and the companies that will be the beneficiaries of that cash will be the gold mining companies that have not diluted the share-of-production factor. When there is a banking scare, equities as a whole get punished and gold equities as a whole get dragged into that market. Secondly, there is a failure to appreciate the importance of protecting the reserve-per-share and the production-per-share in acquisitions and building out mines.

Randgold Resources Ltd. (NASDAQ:GOLD) was a huge winner for us, then it had a slow down. Its production-per-share dropped because its production dropped. Immediately, the stock went into the penalty box, but now it has reversed that. The stock has been a spectacular performer this past week.

TGR: Would you say that the mid caps are a better shot at this point than the smaller caps?

FH: I think that the mid caps are the most overvalued. The Market Vectors Junior Gold Miners (GDXJ) ETF has over $2.5B in mid caps and it just jams up all these silver and gold stocks. One reason you’ve seen money going into these products is that gold analysts can’t recommend a junior gold stock without research coverage on the company, however, they can recommend an ETF like the GDXJ without research on all of the companies it holds.

I think any big-cap company is going to have to end up looking for those companies that have 10 million ounces (Moz.) in reserves and acquire them. One of the companies that we have taken a big position in is Gran Colombia Gold Corp. (TSX.V:GCM), which has over 10 Moz. of reserves and one of the best valuations. You are only paying $45/oz. of gold in the ground. Gold producers trade at six to seven times that level. That makes it a takeover candidate. It has a higher grade and is producing over 100 thousand ounces (Koz.), with plans to ramp up to 400 Koz. of gold production. We like to buy where we get a big bang for our buck—lots of gold-per-share.

To increase production and not dilute the shareholders, the company just raised $80M by issuing a 5% silver note. It is convertible at $15/oz. of silver, which allows you to buy silver at a massive discount. That gives them the cash to ramp up production for the final build out phase. This is brand new and very interesting. We like to invest in those types of companies. We like those companies that are very protective of themselves on a value-per-share basis.

The other one that we think is very exciting is Romarco Minerals Inc. (TSX:R) in the Carolinas. It continues to have a high grade. It likes to spend its dollars on increasing its reserve profile. That is always beneficial for shareholders.

TGR: People forget that gold mining in this country started on the East Coast and in the Appalachians in pre-Revolutionary War days. Romarco’s in an area where there has been gold production for 300 years.

FH: Yes, for centuries. We like to look at how much bang for a dollar we are getting for a ton of rock. When we look at silver companies, we look at Silvercorp Metals Inc. (TSX:SVM; NYSE:SVM) to get the most dollar-value/ton of rock moved. That makes Silvercorp an attractive silver play. It also pays a dividend. It is a fascinating way to play the silver market and get a dividend. When I compare it to the Coeur d’Alene Mines Corp.s (TSX:CDM; NYSE:CDE) of the world, it just has more value.

TGR: Any final thoughts you would like to share with us?

FH: We are in a secular bull market in gold. It’s like the 1930s—fighting deflation, not inflation. It will eventually become inflationary, but right now there are negative real interest rates and deficit spending, and that always bodes well for gold. When the love trade and the fear trade show up together—bingo! Higher highs. I don’t think it is like 2008. Governments have shown they are going to print money when push comes to shove. That’s important for investors to recognize and gold should be a key component in a diversified portfolio.

TGR: Greatly appreciate your time, Mr. Holmes.

Frank Holmes is CEO and chief investment officer at U.S. Global Investors Inc., a registered investment adviser with $3.1B in assets under management for the quarter ended March 31, 2011. Its 13 no-load mutual funds, which offer a variety of investment options, have won more than two dozen Lipper Fund Awards and certificates over the last 10 years. The company’s World Precious Minerals Fund was the top-performing gold fund in the U.S. in 2009–it was the second time in four years that the fund has achieved this distinction. Frank has been CEO since purchasing a controlling interest in the company in 1989. He co-authored The Goldwatcher: Demystifying Gold Investing, which was published in 2008. A regular contributor to a number of investor-education websites and speaker at investment conferences around the world, he maintains an investment blog called Frank Talk, writes articles for investment-focused publications and appears as a commentator on business channels such as CNBC, Bloomberg Television, Fox Business Channel and CNN’s Your Money. Frank, who has been profiled in Barron’s, Fortune, the Financial Times and other publications, was named Mining Fund Manager of the Year by The Mining Journal, a London-based publication for the global natural resources industry, in 2006. The World Affairs Council’s chapter in San Antonio, Texas—where U.S. Global Investors is based—named him 2009 International Citizen of the Year. In addition to achievements as an investor in international markets, the award recognized his involvement with the William J. Clinton Foundation to provide sustainable development in emerging nations and with the International Crisis Group to avoid and resolve armed conflicts around the world.

The Gold Report: You recently wrote that these are not normal times. Perhaps the current macroeconomic picture is the new normal?

Jay Taylor: The new normal is being shaped. We haven’t seen the final product yet. The new normal will be a world in which most Americans do not enjoy the standard of living that they have enjoyed in the past. I think this directly results from a situation in which the people who are able to create money out of nothing wrestle wealth away from those who create it. The miners, the manufacturers, the investors, the farmers—people who actually do things that are good for people—are not getting their fair share because the banking class attached to the politicians has control of the system. This is one of the reasons that I think we should go back to a gold standard. The new normal will be a decline in the general standard of living for most Americans. And I don’t think we’ve seen the bottom of that yet.

TGR: Your Inflation/Deflation Watch (IDW) chart is up about 53% since you launched it on Jan. 31, 2005. However, you believe that the chart’s current neutral direction suggests that the market is running on speculative money, not growth. Can you explain your rationale for that?

JT: By “neutral,” I mean that it is just a momentum gauge. We actually saw a decline in the IDW, or a real deflation, for a few months after the Lehman Brothers crash in 2008. Huge amounts of money, trillions and trillions of dollars of stimulus pumped into the economy, have managed to get it back up to the positive 50%-plus you noted. Now, it seems that we could be topping out. What we’ve seen is a rise in commodity speculation and games played by Wall Street—not a substantial rise in the real economy globally.

TGR: Recently, companies like Apple, Morgan Stanley and AT&T have all posted really strong earnings. That sounds like growth to me.

JT: Look at the economic statistics. Look at the unemployment numbers. I’m not saying that that top 20% isn’t going to do better. They are. Quite frankly, we have a fascist economic system and it’s becoming more and more so because the people who are really calling the shots are getting stronger.

TGR: Do you worry about marginalizing yourself by labeling this system a fascist economy?

JT: Go to the definition of fascism: government and corporate entities in bed together. What about the bankers getting bailed out at the expense of the poor? Is that good for poor people? Is that good for middle-class people? You might think it is. That’s the game. That’s the propaganda that we’ve been fed. I don’t buy it. The top banks, those that are “too big to fail,” know full well that they can enter into the next risky business and always get bailed out.

TGR: You had a conversation with Ian McAvity, the author of the Deliberations on World Markets newsletter, who suggested that we are in a secular bear market that dates back to 2000. He believes the Dow Jones Industrial Average will ultimately fall below its March 2009 lows. What do you make of Mr. McAvity’s projection?

JT: I think we are in a secular bear market. I’m not absolutely sure that we’ll see the nominal lows of 2009. In fact, if you look at what the equity market has done via gold, you’ll see that we are in a heck of a bear market right now in terms of the Dow Jones. In terms of purchasing power, there’s going to continue to be a decline in the wealth of the Dow.

TGR: What will be the impact of all this on gold and silver? There’s certainly been an unusually good run in July.

JT: I focus on the bigger picture. I look at the long-term secular moves. There have been 10 straight years of bull markets in silver and gold. I don’t know how much longer it’s got to run, but I think that it will keep running as long as the global economic picture remains unstable. The whole global system is in disarray right now. We have a system that’s broken. That’s why I don’t care whether the economy goes into a hyperinflation or deflation—gold has to be the cornerstone of a portfolio to preserve wealth. Investors want to own real money. They want to own what the markets have determined to be money over centuries: gold and silver. Fiat currencies have always failed. The U.S. dollar will eventually fail. This is a perfect storm for gold and silver.

TGR: Your model portfolio recently consisted of about one-third speculative mining equities. Why do you dedicate such a large position to one of the riskiest sectors of the market?

JT: I don’t think it is one of the riskiest sectors in this market. During the last 10 years, we’ve had triple-digit gains very frequently in those kinds of securities. Yes, we’ve had a soft patch in gold and silver stocks, which have not kept up with bullion markets. But they will. I remain very bullish on this sector because the majors need the juniors to replenish their resources and reserves. The large companies produce many millions of ounces of gold per year. They are not very good at replacing those ounces.

I caution my subscribers not to back up the truck and buy one or two of these stocks, but to spread out their portfolios and limit their allocation to about 5% of any one name. Taken as a basket, these types of companies will enhance returns very significantly, as they have over the last 8 to 10 years.

TGR: Another financial collapse could force some mining companies lacking adequate cash reserves to go out of business. You suggest searching for companies with plenty of cash, low burn rates and good management.

JT: I prefer companies that are project generators or prospect generators. Riverside Resources Inc. (TSX:RRI), Millrock Resources Inc. (TSX.V:MRO) and Yale Resources Ltd. (TSX:YLL) are very careful about how they spend their money. Yale uses its intellectual capital to find good prospects. Then it lets other companies take those risks and put money in the ground to pull out these deposits.

I like the new producers that are producing cash flow. Dynacor Gold Mines Inc. (TSX:DNG) is a new producer doing custom milling for companies in Peru. It is selling at about three times cash flow, but has lots of growth potential. It also has some exploration potential that looks extremely good.

Among the silver mining companies, Alexco Resource Corp. (TSX:AXR; NYSE.A:AXU) in the Yukon is earning very nice profits with huge upside right out of the gate. It has exploration and production potential.

Great Panther Silver Ltd. (TSX:GPR; NYSE.A:GPL) is also cash flow positive.

TGR: Great Panther is a company that would see immediate benefits from a rise in the silver price. It recently acquired new concessions near its existing mines in Mexico. Do you have any idea how long it might be before it starts drilling those?

JT: I’m not absolutely sure what the company’s plans are right now. I do like the management though. They do a great job of executing and lowering costs. The big things there are underground mines and there are some limitations on how much ore can be pulled out. If the company is able to pull up some more ore in that vicinity, it could bode very well for longer term profits.

Another company that is ready to take off is San Gold Corporation (TSX.V:SGR). It’s a long-term favorite of mine. It has a new management team that is really starting to execute its business plan of under-promising and outperforming.

It’s taken awhile for the company to get the operational side of its business in place, but it is going to drill. The new chief executive, who was a top operating guy at Placer Dome Inc., said that it is the most aggressive drill program he’s ever seen on a single project. The company can finance all this from cash flow, so it doesn’t have to dilute shareholder interest any further.

Timmins Gold Corp. (TSX.V:TMM) is another new producer with good cash flow and the ability to grow; it has great exploration potential.

These are new gold producers that have the opportunity to grow organically.

TGR: Do you know anything about Merrex Gold Inc. (TSX.V:MXI)?

JT: Merrex is a good exploration company. I have a very high opinion of it. The management is outstanding. IAMGOLD Corp. (TSX:IMG; NYSE:IAG) owns about 11% of Merrex’s stock. However, I like the fact that its management owns something like 15% of the stock, too.

Merrex has the Siribaya Gold Project in western Mali. Its latest NI 43-101 resource number is 315,000 oz. (315 Koz.). However, I could see that growing to 500 Koz. with a very extensive drill program; if that is the case, it could have upwards of 5 Moz. Moreover, we’re looking at 3 g/t. I’d caution that this is really forward-looking. Nobody knows until the company drills it out. However, the possibility for a very high-grade, open-pit deposit is certainly what attracted IAMGOLD, which is earning 50% interest by spending $10 million to fund this exploration.

The stock has not done well since I put it in my newsletter. We recommended it at nearly $0.60 and it’s down to $0.49—and there are more shares outstanding than there were before. I just think this is an excellent exploration program. IAMGOLD is very successful. This stock is certainly worth a couple of percentage points of a portfolio because it could come up really big. If the markets were to perceive that possibility of 500 Koz., it could lift share prices considerably.

TGR: Is Siribaya near any other noteworthy gold deposits?

JT: A couple of other properties nearby are in production: the Sadiola Gold Mines and the Loulo Gold Mine. Geologically, they are considered to be very similar to the Siribaya.

TGR: Another company you’ve discussed in your newsletter is Crocodile Gold Corp. (TSX:CRK; OTCQX:CROCF). The guidance there for 2011 is between 85 Koz. and 100 Koz. Do you think that it’s going to meet those expectations?

JT: I think it will. Last year was a bit of a disappointment. The share price has come down significantly. I recommended the stock at $1.56, and it’s at something like $0.68 now. It’s not one that I like to brag about. But fundamentally, the company is in a position to grow over the long term. It is a high-cost producer at around $875/oz.–$975/oz., but with gold selling at $1,600/oz., that still creates a pretty nice margin. The company is going into an underground mine with higher grades; that should help them bring their costs down as well.

Crocodile had its wettest rainy season in many decades last year, and that virtually halted its open-pit production. Mother Nature was the company’s biggest enemy last year. It did try to stockpile ahead of time, but no one had any idea that it would be such a wet season.

If the company is able to produce 85 Koz. to 100 Koz. as expected this year, it will generate enough cash flow to possibly allow the company to start producing.

TGR: Are there any other names that you’re excited about?

JT: Northern Gold Mining Inc. (TSX.V:NGM) has the potential to come up with a multimillion ounce, open-pittable deposit. The Garrison Project is in the Timmins Gold Camp, located along the Destor-Porcupine fault system. The Garrcon property within the Garrison claim area is a bulk-mineable target that would definitely appear to have open-pit, multimillion-ounce potential. Its Jonpol deposit is a high-grade underground target. The company has come up with a couple of very spectacular drill intercepts. It has enormous upside potential.

TGR: Vishal Gupta at Dundee Securities thinks the resources at Garrcon and Jonpol could go from about 1.1 Moz. to between 3 Moz. and 5 Moz. Do you agree?

JT: That would seem to be in the cards, but you never know until the truth machine tells you. I think that’s very well within reason, however, and it could possibly be much bigger than that over the long term.

TGR: Any parting thoughts on a macro level?

JT: We are in a bull market of a lifetime for gold mining companies, caused by the macroeconomic situation, the loss of confidence in fiat money, the deleveraging that needs to take place in the credit markets and the need to go back to honest money rather than the fake stuff that we’ve been conned into using by the policymakers. Gold has gone from $250/oz. to $1,600/oz. within the last 10 years. This is probably the sixth major credit-deleveraging episode over the past 300 years, with the first four being U.K.-centric and the fifth being the U.S. in the 1930s. In deleveraging cycles, what an ounce of gold will buy rises dramatically. That’s good news for gold mining profits.

Before Lehman Brothers’ demise, an ounce of gold would have bought 17% of the Rogers International Raw Materials Fund, which is a fund that has all manner of commodities in it. By March 2009, an ounce of gold would have purchased 44% of the Rogers International Raw Materials Fund. Now it’s around 40%. The real price of gold is up dramatically and that is not a fluke. That is the overriding theme that makes me extremely bullish—we are in a secular bull market of a lifetime for gold mining companies.

TGR: That sounds great, Jay.

A baby boomer born in Ohio, Jay Taylor was drawn to the world’s financial capital in 1973, when he went to New York to work for Barclay’s Bank International after earning his master’s degree in finance and investments. As he followed the demolition of the U.S. gold standard and the rapid rise in the national debt, Jay’s interest in U.S. monetary and fiscal policy grew, particularly as it related to gold. This led to his first investments in junior gold shares toward the end of the 1970s. Sometimes called “the buy and hold guy,” he began publishing North American Gold Mining Stocks in 1981. He was involved in the first modern-times gold loan made in the U.S. (to Amax Minerals, a 250,000-ounce loan facility led by Citicorp). To better understand the potential of the mining stocks he researched, Jay added a BA in geology to his C.V. in 1988. Pursuing his interest in researching and writing about mining companies as a sideline, Jay maintained his full-time banking career for nearly 10 more years. In August 1997, he left his position in the ING Barings mining and metals group to pursue his avocation as a new full-time career—including publication of his weekly Gold, Energy & Tech Stocks newsletter.

The Gold Report: What is your perspective on the price of gold and your forecast for 2011?

Mike Niehuser: Based on gold’s recent price history, it looks like we were a little conservative. Our forecast for 2011 included the price of gold ranging from $1,300/oz. to $1,500/oz. with the potential in the wake of a catalyst to go over $1,600/oz. by year-end.

TGR: With gold prices at record levels, do you attribute weakness in mining stocks to seasonal weakness or is the market forecasting lower gold prices in the near to midterm?

MN: The accuracy of the forecast is not as important as providing a more or less arbitrary gauge for assessing the buoyancy of mining stock prices against the primary metal underlying these companies’ assets. Considering sustained gold prices and softening mining stock prices, we can draw a number of conclusions: One, that gold prices are ahead of themselves and ready for a seasonal correction, or two, markets are signaling lower prices, implying that higher metal prices may not materialize in later years when projects accelerate production. On the contrary, we remain confident in our earlier forecast and see few forces mobilizing to take gold prices lower in the mid to long term.

TGR: Why are you bullish on gold prices?

MN: In normal times, if there is such a thing, we might see a seasonal correction in the spring or following a period of excitement, much like we recently saw with silver approaching record levels a couple months ago. I find it interesting that gold has long since moved through record levels of the late 1970s but has yet to produce a price chart like silver peaking just a couple months ago. Gold prices have been remarkably resilient and appear to be setting a new normal. Considering the excitement for gold at half the price just a couple years ago, and gold stabilizing at record levels, it is somewhat amazing that investors seem almost indifferent.

TGR: What do you credit for breaking seasonal patterns?

MN: We are living in historically uncertain times. A populist uprising against the banks has not taken place in Europe, as banks appear more willing to restructure debts and kick the can down the road, rather than discipline member countries’ loose financial behavior. China appears to be facing both inflation and limits to growth, a new concept for them in recent history, and it’s unclear how they will deal with a discontented population if they increase interest rates. It would appear that the strategy here in the states is to manage interest rates and inflation, at least as they are measured globally, but high commodity prices, high rates of long-term unemployed and anemic growth expose the limits of monetary policy and increasing regulations. In all three instances, government intervention is likely to increase misallocation of resources that will lead to a more extreme correction.

TGR: Are higher gold prices inevitable?

MN: Not necessarily, despite loose monetary policy. With weak demand for credit and investment, and QE2 ending, in the near term we see interest rates declining and unemployment increasing. An uncertain regulatory and tax environment may reduce the velocity of money leading to lower gold and commodity prices in the near term. But the only tool at the Federal Reserve’s disposal, the only one that they appear to understand, is loose monetary policy. It is hard to see how they can back away from a QE3 with indifference toward deficit reduction and the willingness of the Chinese to continue to buy Treasury bonds.

TGR: So you see modest increases in gold prices until inflation becomes a concern?

MN: Yes, as long as low-cost imports from China, financed by Treasury purchases, continue to roll in, deflation rather than inflation remains a concern. Lower growth or production in the United States is eventually inflationary without free trade or allowing wages to fall. “Money illusion” temporarily placates the masses, but only temporarily. In the meantime, should legislators cap the debt or foreign investors require higher rates on Treasuries, the blindfolds will drop from their eyes. Systematic risk and moral hazard have gone global and we are all now “Too Big To Fail.” Gold prices measure the progress of political and market economies. Sustained higher gold prices suggest global failure to maintain confidence or to protect the essential element of currency to be a store of value. The direction of gold prices appears inevitable so it is only a matter of time and severity.

TGR: If gold prices are, on average, ahead of your forecast and in your opinion moving higher, what accounts for the recent softness in demand or prices of mining stocks?

MN: Good question, the easy answer is uncertainty. Not only do we have excessive government intervention, but the world almost daily appears more unstable. Pollsters used to ask people if they felt less secure after 9-11. Now the question is do people feel more secure after Bin Laden’s death? Democracies are inherently unstable. In the nuclear age, lessons may be final. Whether in the Middle East or in the United States, it is not the outcome, but an uncertain journey that increases the risk premium component of interest rates. This clearly decreases the present value of future cash flows. While this may push stock prices down, at some point they bottom and reach equilibrium, and investors may expect abnormally high returns for risk taking. Investors buying in early 2009—deep value investors and true contrarians that held through the spring of 2011—have been richly rewarded. It is starting to feel a lot like the fall of 2008.

TGR: What do you mean?

MN: In the second half of 2008, it seemed like fundamentals didn’t matter. Management teams that executed on guidance for developing projects or production seemed to be punished for any news. Following silver peaking in April, most mining companies have taken a significant haircut. This appears to be from a lack of demand or buying, rather than fundamentals or investors liquidating positions. This has created a similar buying opportunity, not as extreme as 2008, but possibly quite significant. Should gold prices strengthen through the end of the year, lower stock prices should increase the demand for industry consolidation, acquisitions, stock repurchases or value investors. Major mining companies or the Chinese wanting to secure pipelines of production may set off a rally in 2011.

TGR: What are you recommending investors consider when analyzing a company’s prospects?

MN: We believe markets should eventually recognize value and investors should focus on companies with potential to build value that may be recognized. This would include competent management and a balance sheet sufficient to execute on its strategy. Should metal prices provide for positive margins—and $1,500/oz. gold is arguably sufficient for projects to be economic—advancing projects up the value curve should lead to higher stock prices. Because the market may favor production or exploration, we look for companies with near-, mid-, and long-term upside. We believe this may provide the greatest opportunity for companies to gain recognition and secure and retain a shareholder base—in other words, build market capitalization. This characterization of near- to long-term upside fits the full range of producers, advanced development and exploration companies.

TGR: What companies fit this profile?

MN: Minefinders Corp. (TSX:MFL; NYSE:MFN) provides a good example of a producer that has rewarded patient investors by moving into production of gold and silver in Mexico. The company has capable management and has consistently improved the balance sheet by creating additional opportunities. This includes planning to build a mill at their Dolores project, which will increase recoveries and expand the resource, leading to production growth in the near to midterm. The company is also moving closer to a decision on constructing a low-cost La Bolsa gold project and exploring La Virginia. The company is progressing down the path of building near-, mid- and long-term value.

We also were on Brigus Gold Corp.’s (TSX:BRD; NYSE.A:BRD) analyst day visiting their Black Fox gold mine and mill near Timmins, Ontario. Management has succeeded in eliminating the hedge book and reducing debt. Brigus has about $29M in cash and expects to produce over 73 Koz. of gold in 2011 at about $625/oz. As the company ramps up underground outputs with higher grades, production is expected to increase to over a 100 Koz. in 2012 and costs should drop. In addition to this scheduled upside in the near term, the area is known for deep underground gold mining. Brigus has had great exploration success near surface down the trend in the Contact and 147 Zone. Together, this indicates good potential to increase production and the life of the mine. Improving prospects in the near and midterm should lead to Brigus achieving an entirely new investment profile.

While on the subject of producing mines, I would like to mention one interesting deep value company, Kent Exploration Inc. (TSX.V:KEX; OTCPK:KXPLF), which is putting into production its Flagstaff barite mine north of Spokane, Washington. Barite is used as a weighting agent for drill mud. This is important for preventing blow outs like in the Gulf of Mexico. It is really a simple crushing operation of high-grade barite for operations in Canada. The company anticipates cash flow of over $2M/year. Cash generated from this operation should be deployed in advancing the Alexander River gold project in Reefton, New Zealand. This project has a potential historic resource of over .5 Moz. gold. Kent plans to upgrade and expand the resource, which may provide feed for depleting mines in the area. Here again, we see near-term value and mid-term upside. Cash flow reduces dilution typical of exploration companies, and the resource in New Zealand appears to have little recognition in the market.

TGR: What advanced development companies fit your profile?

MN: Geologix Explorations Inc. (TSX:GIX) is rapidly advancing its gold-copper project in Mexico. The company has established a 3.8 Moz. gold equivalent resource supporting an 18-year mine life and has $20M in the bank. It has seven drill rigs turning, which are likely to lead to upgrading the resource classification, if not resource size and grade. It will take about $8.5M to bring the project to prefeasibility in the spring of 2012, and feasibility by year-end. In addition to this near-term upside and expansion of the existing resource, the company has only explored 15 square km. of a 172 square km. land package. It appears to us that they are well positioned to locate additional low-cost gold oxides at surface, which should lead to higher production in the mid to long term. If investors believe in copper along with gold, the substantial amount of news flow coming out over the next 12 months should increase the visibility of the company.

We also think Inter-Citic Minerals Inc. (TSX:ICI) fits this growth profile. The company is advancing its 3.4 Moz. Dachang gold project in Western China to feasibility in late 2011. China has been in the news a lot lately, but Inter-Citic appears to have strong backing from two significant Chinese investors and is well aligned with the largest gold producer in China. Inter-Citic has a long history of development in China, and a manageable political risk. We see good likelihood that the Dachang project will advance to feasibility with low operating and capital costs. There is a good opportunity the company will establish a central operation that could scale with discoveries and other potential mines on their 279 square km. land package. Inter-Citic plans to complete at least 15,000m of exploration drilling, again combining near-, mid- and long-term upside.

TGR: Lastly, what exploration companies do you see having both near- and long-term upside?

MN: These are typically companies with historic or modest resources or with large land positions. Kiska Metals Corp.’s (TSX.V:KSK) Whistler project is about 150 km. northwest of Anchorage, Alaska. Kiska has established a copper-gold resource of over 5 Moz. gold equivalent at its Whistler target and has about $20M in the bank. This could be the first of several copper-gold porphyries discovered on its large 527 square km. land position. We think Kiska is well underway to doubling the resource, is well into a 35,000m drill program, and is approaching the project as if it was a major mining company. The company continues to organize the camp for ongoing exploration, and we suspect that by the end of the day it will be competing with other large gold deposits in Alaska and British Columbia.

Antioquia Gold Inc. (TSX.V:AGD) also is pursuing a rather large land position in Colombia like an experienced mine builder rather than a junior explorer. Antioquia controls over 37,000 hectares in Colombia, but the focus has been on Cisneros, which is about 5,600 hectares. Antioquia has methodically explored Cisneros with mapping soil samples and geophysical surveying that has led to ongoing drill success. The company has also taken on a strategic investor with extensive gold mining experience in similar host rock in Peru. Altogether, Antioquia should enjoy near-term exploration success at Cisneros, as well as other targets over the wider Cisneros project. Over the long term, Antioquia will work to establish strategic partnerships over the balance of its properties.

We also recently visited Revolution Resources Corp.’s (TSX:RV; OTCQX:RVRCF) project in the Champion Hills Trend in the Carolina Slate Belt near Greensboro, North Carolina. Revolution is exploring in an area of the U.S. that is known for the first gold rush, first silver mine and the primary producer of lead for munitions in the Civil War. The project follows the success of Romarco Minerals Inc.’s (TSX:R) 4.2 Moz. Haile gold project in South Carolina. Revolution’s land position of 7,500 acres is second only to Romarco with 9,700 acres. Revolution’s land position is also on private land with similar host rock. The area is economically depressed and is surprisingly welcome to mine development. While relatively early, it appears that Revolution is well positioned to repeat Romarco’s experience, now about a $1B market cap, and may become an integral part of Romarco’s growth strategy.

TGR: Thanks for sharing your insights with us, Mike.

Mike Niehuser is the founder of Beacon Rock Research, LLC, which produces research for an institutional audience and focuses in part on precious, base and industrial metals, oil and gas and alternative energy. Previously a vice president and senior equity analyst with the Robins Group, he also worked as an equity analyst with The RedChip Review. He holds a B.S. in finance from the University of Oregon.

In a seminal paper [1] from 1958 Franco Modigliani and Merton H Miller showed why investors should not care about whether firms were financed with debt or equity. This led to the idea of the the debt irrelevance proposition and although the DIP is a theoretical benchmark rather than a real world rule the 1958 paper by Modigliani and Miller remains a key contribution to the finance literature. We should not however extend the same role to the recent attempt by researchers [2] to re-invent the DIP in a new guise replacing “debt” by “demographics”. Allow me to explain why.

Demographics, Just Forget About It …

My point of departure is Edward Chancellor’s recent GMO letter in which he tackles what he considers to be the non-issue of Japan’s dire demographics. He emphasizes two things; firstly, that economists are notoriously poor at predicting demographic variables and secondly he notes that whatever relevance demographics might have for macroeconomic analysis at large (of which Mr Chancellor appears skeptical) it is irrelevant for the investor;

Besides, long-term demographic forecasts aren’t particularly relevant for equity investors. It’s true that changes in the population have a sizable impact on GDP growth. But stock market returns are not positively correlated with economic growth. Returns from equities are a function of valuation and future returns on capital – a subject to which I will return later – rather than changes in GDP. Nor is there a positive correlation between population growth and stock market returns. In short, investors should not get too hung up on inherently unreliable long-term demographic projections for Japan.

It is important to underline, in fairness to Chancellor, that the points are made with specific focus on Japan but the the argument seems to have a more general hue. This is even more obvious in relation to one of Chancellor’s main references in the form of Morgan Stanley analyst Alexander Kinmont’s note entitled The Irrelevance of “Demographics”? Kinmont puts up the following four points which I will use as my points of reference;

1. It is not clear that demographic estimates are accurate over long time frames. In fact, while spurious specificity is one of the attractions of demographics as a talking point, the fact that neither death rates nor birth rates have proven predictable should caution one against accepting any assertion about demographics.

2. It is not clear that demographics are the critical variable in determining the level of economic growth. That role falls to the growth rate of TFP.

3. It is not clear that equity returns are related to absolute levels of growth. Equity returns are an issue of valuation. Nominal returns are greatly affected by inflation too.

4. It is not clear that demographic change, even if it is allowed as a negative for economic growth, is necessarily negative for stocks, as certain forms of demographic change may be associated with a rising equity market multiple. Demographic change could in fact represent a benign environment for stocks.

On the first point Kinmont makes points to the irony in that the worry about Japanese demographics seems to be peaking just as Japanese fertility is on the mend. This is a cheap shot though and not one which stands up to scrutiny. First of all on the fertility trend itself I get the same chart as Kinmont’s below using data from the World Bank showing a rebound in Japan from a low point of 1.29 in 2003 and 2004 to 1.37 in 2009. However, Indexmundi which takes its data from the CIA World Factbook has fertility much lower and actually declining in Japan. The latest data point from the CIA World Factbook reports an estimate of TFR in 2011 is 1.21. This is a pretty steep difference and I invite comments as to suggest the right number or at least the right trend.

(click on picture for better viewing)

All this is of course underlines Kinmont’s point that we don’t know the future and that economists have a proven track record for abysmal forecast performance. Still, we should get our concepts right at the offset. Long term projections in age structures are likely to be robust as they are a function of people already being born and while migration may change the course of ageing in any given country the fact that we are all ageing at one at the same time means that there are fewer migrants to go around. I would then claim that ageing does matter and that understanding how an economy such as Japan adapts to the ageing of its population remains one of the most vexing and important issues for social scientists and investors alike.

So when Kinmont implies that low fertility in Japan is a non-issue I have to strongly oppose. Just take a look at the chart above Kinmont himself uses. Fertility has been below replacement levels in Japan since 1970 and on current growth rates (assuming a constant growth rate of fertility which in itself is dubious to the extreme) fertility levels would reach replacement levels some time in 2030-40. So, that would be 60 years with below replacement fertility. Even if fertility in Japan (and again in most of the OECD) took a discrete jump to replacement levels it would do very little to change the outlook for ageing in the immediate future.

In claiming that demographics do not matter Chancellor are Kinmont are taking a very wide brush over the general recognition in the academic literature that our economic systems tend to hit a snag once fertility falls below a certain level (a TFR of 1.5). This is also called a fertility trap and what it means is that it becomes very difficult to escape negative population dynamics once they set in. I emphasize this since it highlights that we are not, as a friend of mine likes to point, simply shooting arrows into the void when we point to the importance of these issues. I recommend the following presentation by Wolfgang Lutz et al and the paper that goes with it or this old post at AFOE by Edward if you are still not convinced.

In terms of the postulated increase in Japanese fertility since the mid 2000 it is a positive development, but as is evident from the data this rebound is extremely uncertain. In addition, we need to know whether this is just an echo of the tempo effect (and thus how large the rebound is likely to be) or whether it reflects a real change in attitudes on quantity. I am open to contributions here but the only thing we can for certain is that ageing, in Japan and the rest of the OECD, will continue its march onwards. Here I also feel that Kinmont puts up a straw man when he invokes the idea of Japan’s population going to zero;

The unrevealed assumption, then, behind the mathematics used to arrive at widely-used population estimates is that the Japanese population will drop to zero. One cannot help but suggest that the logic of demographic pessimism is circular.

I want to re-emphasize that the issue here is not predicting fertility and death rates but recognizing the effect that the current and past trends have on ageing today and tomorrow. Try the recent work by Wolfgang Lutz, Warren C. Sanderson, and Sergei Scherbov if you want to see the cutting edge here and while uncertainty is still a key variable ageing remains a tangible reality. The main question issue I would like to get across is then that the demographic transition manifests itself in a transition of ageing and that this essentially becomes our main unit of analysis.

Growth and Demographics, No Connection?

Kinmont and Chancellor argue that demographics are likely to be less important for growth over time as total factor productivity (TFP) growth tends to be the main driver of growth.

Japan could quite easily grow at a good rate, especially in per capita terms, for a high-income developed country even in the face of a falling population (or more precisely a falling working age population). All that is required is for TFP growth to accelerate back to the level of growth enjoyed by Japan prior to the bursting of the Bubble in 1989. TFP slowdown preceded the population peak. Variation in TFP performance not in labour input growth is likely to be larger than the negative effects of population change.

This is an important point and more importantly, Kinmont offers an argument to explain the declining labour input in Japan’s economy which links in with the fact that Japan has been stuck in deflation and at the zero lower bound for the best part of two decades (my emphasis).

Labour input has in fact fallen at an accelerating pace over the past 20 years. It is clear that the fall is principally a decline in man-hours. This cannot be simply a function of a decline in the working age population because that decline only began in 2000. Instead, its origins must lie in rising unemployment and under-employment. A persuasive new paper, The Paradox of Toil, by a researcher at the NY Fed [3] argues that a decline in labour input is a natural consequence of a deflationary economy with zero (or effectively zero) interest rates.

In short, the declining labor input in Japan is a function of deflation and being stuck at the zero lower bound. In addition, this Fed Researcher Kinmont refers to is Gauti Eggertson who studied under Krugman at Princeton and did most of his initial work on the liquidity trap and the zero lower bound. So, I would be careful getting in his way without a strong look at the argument.

I think however that we might be dealing with the problem of a missing link in the sense that demographics may be one of the primary sources of deflation and the liquidity trap in the first place. This is an argument that has been pushed in Japan’s case in the sense that it was a lack of pent up demand that held Japan back in the 1990s as well as deleveraging. Indeed, Japan may hold a cautionary tale on the effects of a balance sheet recession in an economy where fertility has been below the replacement level for an extended period. The Eurozone periphery (ex Ireland) who have even ceded monetary policy to Frankfurt are case studies to this theory I think.

I would also emphasize that as labour input declines so does, obviously, consumption (aggregate demand) input which again feeds into the the paradox of thrift in the closed economy (or perhaps even a realisation crisis?). In an open economy it leads to export dependency as domestic investment actvity responds to foreign demand as well as the excess income you earn from a positive net foreign asset position (if you are so lucky as to have one) becomes a crucial source of growth.

Another more fundamental point is that if the total factor productivity growth (TFP) is a residual what is actually hidden in this residual? Well, I had a wack at the whole argument a while ago from the perspective of the academic armchair.

Technology and productivity are famously assumed exogenous in the Neo-Classical tradition while New Growth theory as it was developed in the 1980s and 1990s emphasised the need to specifically account for the evolution of technology. Today, I would venture the claim that there is a consensus that productivity and technology is a function of what we could call, broadly, institutional quality which encompass almost anything imaginable from basic property rights to the level of entrepreneurship. Indeed, a large part of research is still devoted to pinning down exactly which determinants that are most important here both across countries and through time. Now, I would argue that, in the context of standard growth theory, this is where the scope for the study of the effect of population dynamics is largest. Thus I don’t think it is unreasonable to expect the level and evolution of productivity growth and technological development to be a function of the current population structure but also its velocity which is a function of e.g. migration (new inputs?), future working age size etc. Also, this is also where human capital and the evolution of technology is joined at the hip through the idea of innovative capacity and readiness.

Once we venture into the notion of endogenous growth theory and thus the attempt to directly explain the sources and components of total factor productivity growth there is growing evidence that age structure/demographics alongside a host of other variables are important. Try this one for a recent literature review, and for the general link between growth and demographics the list of contributions is long. You just need to read around a bit.

I would argue then that growth and prosperity of the modern capitalist welfare state is highly conditional on some form of demographic balance and Japan has long since moved beyond into unbalanced territory. Basically, Japan is stuck in a liquidity trap as well as a fertility trap. The latter works along the lines of depressing consumption demand and making it very difficult to maintain key economic structures such as e.g pension systems. In addition, ageing affect the growth path of an economy and leads to export dependency, this last point however which I concede is not yet an established fact in the literature.

What about stocks then?

We seem to have two intertwined arguments here. Firstly, the extent to which demographics may have an influence on growth it is irrelevant for the investor since you can’t buy GDP growth anyway. Secondly, the evidence of a correlation between demographics and equity prices is weak and indeed, if anything, should be bullish for Japan (this last point is made by Kinmont).

Thus the FT summarized the latest findings of the London Business School team of Dimson, Marsh and Staunton, as published in the Credit Suisse Global Investment Returns Yearbook, 2010. The LBS academics examined all the available data (83 markets), and concluded that “99 per cent of the changes in equity returns could be attributed to factors other than changes in GDP”. (…) Growth is not all that it is cracked up to be. This analysis underscores previous academic findings showing that growth
per se to be of only small importance to stocks.

It would be unwise to disagree with the gist of this point. Even if I can make a connection between demographics, growth and investor performance it is very likely that buying into such a story at too high a valuation will lead to poor returns. Buying at the right value is the most important aspect of any investment decision.

This however is not the same thing as saying that just as you make sure to “buy cheap” poor demographics, low growth etc are completely irrelevant. Rather, I think that the extent to which the modern investor needs to understand a decidedly more complex macro picture with lingering deflation, heightened risk of sovereign defaults and zero lower bounds the understanding of demographic dynamics is key. We are then again discussing the question of deflation and low interest rates in Japan;

The origin of Japan’s problems is falling valuation when compared with the rest of the world. When we note in addition that it is excesses of inflation or the arrival of deflation (that is, monetary phenomena reflecting policy errors) which tend to reduce market average valuations, we feel it safe to conclude that demography will have next to nothing to do with the longer-term return profile of the Japanese market either in nominal or real terms.

I feel this is a very dangerous claim to make because it assumes that the deflation dynamics of Japan and indeed the problems facing the Bank of Japan in reviving credit growth are unrelated to demographics. In addition there is the unintended consequence of BOJ having to monetize an ever greater amount of JGB issuance in the future which in itself becomes more paramount as Japan ages.

On the second point regarding a direct relationship between demographics and stock prices (asset prices in general if you will) I think Kinmont does better especially because he does not fall into the asset meltdown hypothesis trap. In short the asset meltdown hypothesis states, in a US context, that as the baby boomers retire they will dissave and thus need to sell off their financial assets to a market which cannot support the flow, because the generation in the working age years is smaller, and that this will lead to an “asset meltdown”. Generalized, this is then the classic (and naive) nexus between life cycle economics and financial markets which postulate that dissaving into old age is rapid and imminent.

There are two problems here. Firstly, the empirical (and indeed theoretical literature) has found it very difficult to verify that dissaving occur among elderly cohorts to the extent postulated by the standard life cycle theory. Secondly, the relationship between asset prices and broad demographic aggregates appear weak. Results differ from country to country and most studies take place in a US and Anglo-Saxon setting which tend to bias the results further.

Kinmont does however point to a study by Geanakoplos, Magill and Quinzili [4] which show how the ratio of the 45-54 age group to the 25-34 age group is closely related to P/E ratios. As this ratio is set to increase in Japan, Kinmont ventures the idea that, if anything, perhaps you would want to buy Japan on the basis of demographics.

I have read the research by Geanakoplos et al and I find it intriguing, but my problem is that it does not control for the old age dependency ratio which suggests that the key ratio will be correlated with ageing in general. But I should be hesitant disregarding it on the basis of this hunch. I am preparing a large panel data set at the moment on demographics and stock prices with the aim to essentially rejuvenate a literature which seems too focused on the asset meltdown hypothesis noted above.

On a more general level, demographics and investment has been a core theme in the post crisis flow into emerging markets which, by and large, share the characteristics of being in the middle or at the end of their demographic dividend. Again, this does not nullify the importance of valuation and certainly, the recent soft patch notwithstanding, many emerging markets are still looking expensive.

Where goes the DIP then?

If you build your story up around the notion that investors buy value and not GDP growth you can easily come to the conclusion that demographics are irrelevant for the investor at large. This however would be a mistake.

I would be the first to wish for a return to a state of affairs in which investors needed only to look at valuation and firm fundamentals to make their decisions. Today however, you need to understand the macro backdrop and in order to do that you need a firm grip on how demographics affect macroeconomics. Pointing out that we are poor at predicting birth and death rates as well as pointing to weak evidence between growth and demographics do not cut it. We need not predict fertility and mortality but instead we need to understand the effects of ageing already present and there is plenty of evidence that demographics affect the growth rate and growth path of the economy.

I am more sympathetic to the strict relationship between stocks and demographics which is fickle and not well understood. Clearly, there is not presently any convincing model or framework which suggests how and why you might be able to buy sound demographics on a beta level. My main bet is that demographics should, at least, be used to qualify the notion of the global market portfolio and especially that demographics be used to re-balance such a portfolio over time.

In conclusion, Kinmont and Chancellor bring up some valid and good points in their attempt to brush away demographics as an important input variable to investment and macroeconomic analysis but you shouldn’t be fooled. Just as was the case with the original DIP you accept this new version at your peril.

—

[1] – Franco Modigliani and Merton H Miller (1958) – The Cost of Capital, Corporation Finance and the Theory of Investment, American Economic Review 48 (June 1958) pp. 261-297.

[2] – GMO White Paper – After Tohoku: Do Investors Face Another Lost Decade from Japan?, Edward Chancellor and  Morgan Stanley Japan Strategy – The Irrelevance of “Demographics”?, Alexander Kinmont.  I realise that I have lately been referring to sources and pieces of research which by nature of their origin (banks, research firms etc) are behind subscription walls. I am sorry, but I will make sure to produce relevant quotes so that my readers can follow the issues and arguments. I cannot upload full PDF versions of the reports for obvious reasons and I hope my readers will understand.

[3] – The Paradox of Toil, Gauti Eggertsson, Federal Reserve Bank of New York Staff Reports, no. 433, February 2010

[4] – Demography and the Long-run Predictability of the Stock Market. John Geanakoplos, Michael Magill, and Martine Quinzili; August 2002, Revised: April 2004. Cowles Foundation Discussion Paper No. 1380 ]]> http://www.citizeneconomists.com/blogs/2011/04/18/debunking-the-demographics-irrelevance-proposition/feed/ 0 http://www.citizeneconomists.com/blogs/2011/03/11/random-shots-return-of-the-deflation-trade/ http://www.citizeneconomists.com/blogs/2011/03/11/random-shots-return-of-the-deflation-trade/#comments Fri, 11 Mar 2011 20:34:27 +0000 Claus Vistesen http://www.citizeneconomists.com/blogs/?p=6879 I recently asked the opnion of my readers regarding the question of whether the global economy is in for inflation, deflation, or stagflation. Given the obvious issue that it may be all three at different points in time it seems as if recent market action suggests that we should be looking at the . . . → Read More: Random Shots – Return of the Deflation Trade?]]>

I recently asked the opnion of my readers regarding the question of whether the global economy is in for inflation, deflation, or stagflation. Given the obvious issue that it may be all three at different points in time it seems as if recent market action suggests that we should be looking at the d-word.

QE1 + QE2 +…+QEn = Deflation?

Even if macro soothsayer’s favorite comparison between Japan and the US is misleading because the former has decidedly more miserable demographics than the former, it is clear that US policy makers are steering into largely uncharted waters.

Consider then Atlanta Fed President Dennis Lockhart’s recent comments before the National Association of Business Economics that the Fed would contemplate cueing in QE3 in the event that the current oil price shock proved to be more severe. On the face of it this makes sense in so far as goes the idea that the main effect from sharply rising oil price is a relapse into recession and thus deflation. Indeed, the Fed can hardly be blamed for acting in the context of events which are essentially geo-political in nature.

Yet, it is much more complicated than that.

It then stands to reason that while the Fed should certainly be forward looking in conducting policy the primary effect of ongoing measures of quantitative easing is exactly to put pressures on headline inflation and commodities in general. As I noted recently at this space;

Given that we seem to be looking at a re-run of 2008 it must be factored in that the volatility and speed (and subsequent decline) of commodity prices are a problem in itself. The famous loss function which must then be metaphorically minimised is the one which plots the trade-off between the cost of recurrent flares of commodity prices and the need to act as a counter trend to the destructive forces of a balance sheet recession. Here, it becomes a rather serious issue if one of the main collateral effects of providing buckets of liquidity is to engender strong commodity melt-ups with a subsequent deflationary outcome.

And perhaps this is what is running through the mind of Dallas Fed President Richard Fisher who, in the same picece as linked above, is quoted of voicing oppositon towards QE3 and indeed that he would like QE2 to be phased out sooner rather than later.

Which way the tide will turn at the Fed is not a trivial question. There are plenty of signs that after the SP500 having tested the 1350 level, and failed, the market is running on the evaporating fumes of QE2. As one of my many market spies noted today:

(…) it is definitely possible that the market will discount the end of QE2 ahead of time this time around. This is what happened in Japan too – the market began to rally as soon as their QE2 was announced (since it had rallied smartly on QE1) , but halfway through the implementation the Nikkei began to fall, ultimately losing 45% from the interim peak and ending below the level of the day QE2 was announced. Mind, I’m not saying it will play out in the exact same manner, this is just to point out that there can be leads and lags between QE and its effect on the stock market – the QE1 experience is not necessarily a road map that needs to be repeated.

Again, we have that comparison with Japan which is then only to say that repetitions in the market rarely occur the way you expect them to, but there is definitely an unwinding narrative emerging. Team Macro Man gives their list of bearish omens today and I find it difficult disagreeing with them on the general idea that the reflation trade might be in for a stutter; at least until the next round of QE.

To their list I would add that another favorite punt of the reflationistas, gold, is finding it mightly difficult to reach new highs above the 1420s (today, Thursday, getting a right beating back to 1405ish). Now, we should always remember that the market can move three ways, where sideways is the third. Yet, the fundamentals of the gold trade kind of black or write so the ongoing difficulty reaching new highs will be rightly worrying the g-bugs.

More generally however the SP500 is only now coming down to the 50dma (at pixel time) and I would wait to see whether it forcefully breaches that level before putting on the tin foil hat.

(click image for better viewing)

As you can see dear reader, the chart is telling you to buy the dip, but chartism on such short time scales can make plenty of widows too, so be careful out there.

Looking into the rearview mirror at the ECB

I wasn’t really sure whether to cry or laugh last week when Trichet mounted himself in front of the microphones to deliver an almost sure signal of future rate increases by invoking the idea of strong vigilance. Indeed, the ECB let it be known that it was perfectly possible that their April meeting would be accompanied by a rate increase. Game set and match then!

As I have noted before at this space, stranger things have happened than the ECB raising rates just before a global slowdown. I even ventured to call it a leading indicator. Soc Gen’s always enjoyable Albert Edwards dryly noted recently (HT: FT Alphaville); “all we need now to push the world back into the recession is an ECB rate rise.”

This seems an apt take on the situation and my good friend Edward Hugh similarly notes that all this has an alltogether well expected outcome invoking the idea of the Chronicle of a Policy Error Foretold.

Now the problem with this latest policy initiative is not only that it represents something akin to the chronicle of an early death foretold for a much troubled and highly fragile Spanish economy, where around 90 percent of mortgages are variable rate ones.

It also draws attention to an area which it would be much better for the ECB not to draw attention to at this delicate moment in its history: the convenience of having a single-size monetary policy applied to such a diverse group of economies.

I heartily agree that it is due time that we, yet again, try to evaluate what it means to have a single interest policy in the eurozone. More specifically, there is the question of divergence of fortunes when it comes to deflation and inflation;

Inflation on the periphery has much more to do with rising commodity prices and the application of a misguided policy of consumption tax increases as a way of reducing fiscal deficits than ever it has to do with economic overheating.

I think it is pretty obvious that there will be no second round effects in the eurozone periphery and if the ECB is seriously suggesting this to be the case, I would dearly like to see the empirical evidence for such a claim (even a theoretical would do actually!).

Finally, we should never neglect to mention that all this might be a bluff and that the ECB like most other rational institutions can change direction based on the evidence before them. Yet, herein also lies the rub because the current vigilance comes on a backdrop which smells a lot like the last time the ECB raised only to see the deck of cards fold before their eyes. Perhaps they ought to look closer into the rear view mirror.

Random Shots indeed

The immediate conclusion here would seem to be that Trichet should get on a plane and relieve Bernanke of his post in Washington and leave the tower of Frankfurt to Benny. As FT Alphaville (see link above) quotes from Gavekal;

Since its inception, the ECB has typically been slow to cut rates (famously rising them in July 2008!) and slow to raise them. So is the fact that the ECB is now considering a tighter monetary policy before the Fed a sign that the ECB is making a mistake? Or a sign that the Fed is starting to really fall behind the curve?

I am not sure that it is either really. Core inflation in the US is still nudging down but I think that ongoing loose monetary policy will run the risk of replicating the UK more than Japan. Put differently, I think the US economy is in a position where inflation expectations might take hold which is not the case in the Eurozone periphery at large.

At the time of writing it seems an awful lot as it the deflation trade is back and thus that the market has already sucked QE2 dry and now awaits the third version. A spike in oil prices helps no-one too, but oil at current levels is not the problem, but a quick zoom to 150ish and we would have grave problems. This would then be ample catalyst for QE3 and even if this would not prevent the correction which seems evident now, it would setup another meltup in all things unprintable and risky.

We can only hope then that central banks, on either side of the pond, are taking more than random shots at our current problems.