Scientists define volatile organic compounds as naturally occurring or man-made chemicals with low boiling points, a condition that allows these molecules to easily evaporate into the air, potentially causing irritation and creating an explosive environment. As Global Resource Investments Founder and Chairman Rick Rule predicted last March, man-made volatility has clouded the economic environment for the last month and could continue to do so for the next 12 months, according to his analysis. But volatility doesn’t have to be painful, he says, if you prepare yourself with plenty of cash and courage. “Volatility is like cyclicality. It is really a series of opportunities to buy low and sell high. And, if you understand volatility for what it is and accept it, it could be a tool as opposed to a threat. ”

The Un-Recovery
First, he outlines the reasons for the volatility. Rule doesn’t see a recovery in the United States. “I see government-induced liquidity in the market and I see some recovery in equities prices as a consequence of very, very, very low—make that negative—real interest rates as well as hope on Wall Street and in Washington,” he says. The problem with this paper recovery is that liquidity wasn’t what caused the recession. The issue is that individual and government balance sheets are unbalanced. Many of the assets are ephemeral. Unfortunately, liabilities are almost always real. “As a society, we owe an amount that is unserviceable relative to what we produce,” he says.

By encouraging people to spend more money they don’t have, the government is making the problem worse. Instead, he thinks people should rebalance their balance sheets and invest more in this country. “The idea that we can fix the fact that we owe too much money by encouraging borrowing and spending is an example of the idiocy that comes out of Pennsylvania Avenue and will continue to weigh down the recovery.” He says, “Until we deal with the problems that confront us in society, we are not going to have a U.S. economic recovery.”

Rule points to a war against savers. “The Fed has declared war on productive elements of society in order to distribute the benefits to the less productive elements of society. This is not the key to prosperity.” Drilling down interest rates punishes savers and rewards spenders. “This is perverse, truly perverse,” he says. He equates “quantitative easing” to a fancy way of saying “counterfeiting.” Increasing the nation’s money supply without increasing society’s ability to create utility through the provision of goods and services is simply fraud. You can’t maintain the value of a currency unit if you create it out of thin air far in advance of the society’s ability to generate value. That is true in the U.S. and abroad. “I have always said that the U.S. dollar is the worst in the world except perhaps for all the others,” he jokes. Rule is not alone in his low opinion of paper currency. Casey Research Chairman Doug Casey famously noted that the U.S. dollar is an I.O.U. nothing. The euro is a “who owes you” nothing. “It’s an artificial construct,” Rule says. “Europe truly is the triumph of politics over economics.”

One example of the irrational European economic policy now in fashion is the decision to “bail” Greece out of the trouble it was having servicing debt that was 150% of GDP by requiring the struggling country to service debt that is 165% of GDP. “I defy the European Union to explain to me how by adding a big column of negative numbers they end up with a positive number; very, very, very problematic,” Rule says. And, problems get deeper. “Because of the extremely close ties between the big banks on both sides of the Atlantic with large amounts of primary capital represented by sovereign debt, many of the large private sector banks have multiples of shareholder equity invested in securities by issuers like Italy, Spain, Portugal, Ireland and Greece that are insolvent. This means by real accounting standards most of the big banks in Europe are broke.”

This economic reality doesn’t mean that banks are going to fail any time soon, Rule explains. It simply means that the shareholder’s equity in the bank—the value of assets minus the value of the liabilities—is probably negative if the securities that these banks have in sovereign—as opposed to solvent—issuers were removed. “The test going forward will be the test between those two words,” Rule says. “Sovereign does not make solvent.” He takes issue with the words of the famous CEO of Citicorp, Walter Wriston, who said countries don’t go broke. “That was wrong. Countries do go broke. Countries will go broke. The question in Europe now is whether the savers—Finland, Austria and Germany—will decide that they and their children are going to carry the lifestyle of the rest of the Europe.”

The discussion going on in Europe right now is the same as the one going on in the United States, he says. “Who should benefit from production—the producer or the non-producer?” He points to a war worldwide between these two factions. “Sadly, non-producers outnumber producers and, in a democracy, the war is often won by the non-producer.” He likens democracy to a vote by five coyotes and a lamb over what to have for lunch. “That’s really the nature of the debate that’s taking place in the United States and Europe today.”

Free-ish China
“The good news about China,” Rule says, “is that over the last 30 years the place has become more, as opposed to completely, free. More than 30 years ago, Deng Xiaoping, then leader of the Chinese Communist Party, said ‘to become rich is glorious’ and China has become very glorious as a consequence of that.” Ironically, in this allegedly Communist country, there is no social safety net, meaning that people are on their own in China, Rule says. “As a consequence, savings are extraordinarily high, as much as 40% of a household income. So, China is generating enormous, enormous, enormous savings in direct contradiction to us, of course.”

Rule also points to more capital investment-friendly tax laws in the East. “In the United States if a big producer builds a big piece of manufacturing equipment, it may be required to amortize that equipment for tax purposes over 30 years. In China, that same producer is allowed to expense the equipment, meaning that there is a huge incentive to add the capital necessary to raise the utility of the workers operating that machinery. China is much, much, much friendlier to capital formation. The United States is much, much, much friendlier to consumption.” For these reasons and many more, Rule says “China, India and the frontier markets appear legitimately to be on the road to progress—a very different road than their European and North American cousins appear to have chosen.”

But, all is not bright in China. “Some 10,000 people rule 1.3 billion people and official sector misallocation is always a threat. The government decides what sectors should succeed, what sectors should fail. Expect the road to progress in China to be bumpy,” Rule warns.

The combination of domestic and international challenges on the horizon set the stage for more volatility, Rule concludes. “So many black swan events are looming that they resemble a flock of black swans. The idea that one of those black swans could precipitate an event like the ‘07–’08 liquidity crisis appears to me to be a very, very, very good possibility.” He goes so far as to suggest that in the next 18 months to 2 years, we could see a shut down for some period of time in interbank lending and frozen debt market liquidity. “In that set of circumstances you would want to have some cash,” he warns.

Golden (and Platinum) Opportunities
All of this darkness could shine a light on the metals—gold, silver, platinum and palladium, Rule says. “The most important part of the pricing of these metals is the continued debasement of fiat currencies. Metals prices worldwide are denominated in U.S. dollars. If the value of the denominator itself continues to decline, which I think it will, the nominal price for precious metals should continue to increase.” The increase may not be steady. “I suspect that these prices both up and down will be volatile for a few reasons,” Rule says. “Gold markets in particular, maybe silver markets as well, are determined by both of the primary economic motivators in the world—greed and fear. A raging bull market, which I think we might get into, compels people to buy gold bullion because they are afraid of the depreciation in dollars. This, in turn, stimulates the greed buyer who buys simply because the price went up and he or she understands the thesis. The price escalation in bullion that was driven by the greed buyer reinforces the fears of the fear buyer. And, the prices reverberate higher and higher as fear buyers and greed buyers compete with each other. That’s the market that we saw in 1979–1981—the single strangest bull market that I have experienced in my career. I suspect that we are likely in the early stages of a market that resembles that.”

The second set of circumstances Rule identifies as pushing gold prices up over the next year is supply-based. “In classical economics you are taught that higher product prices lead to increased supply. Because mining is a capital-intensive business, the response of the producers to increased commodity prices is not direct or immediate, particularly if interbank lending dries up debt financing needed for the large capital-intensive projects. There will be supply constraints that are, in some fashion, artificial.”

For supply-side reasons, Rule is increasingly attracted to the platinum business. More than 80% of platinum and palladium—PGM metals—come from three countries: South Africa, Zimbabwe and Russia. He cites local political turmoil as a limiting factor in the continued production in these areas. “Increasingly, South African governments are calling for more social rent—higher taxes, government participation in wage negotiations and, in some cases, outright nationalization. This will absolutely constrain the industry from making the investments in increasing production and sustaining their existing production over the five to seven years. Given that South Africa is the most important platinum producer in the world and it’s highly likely that the South African platinum producers will continue to constrain working capital investments, I would suspect that on a five-year going forward basis platinum production will falter.”

Moving north to Zimbabwe, Rule is no more optimistic. “President Robert Mugabe and his associates stole everything in the country that had any value. Now they have decided that about 150 people should control 51% ownership of the platinum mines in Zimbabwe. If you look at the track record of the black political elite in Zimbabwe managing the assets they have stolen over the last 20 years, you will see that the potential impact on platinum supplies as a consequence of their stealing productive capacity will be catastrophic.”

Rule sees Russia as a bright spot. “Russia gets slowly better over time. Yes, there are problems. The place is corrupt. They tend to attempt to mediate commercial disputes by shooting each other. There are problems with alcoholism. But, gradually things are improving in Russia. The difficulty isn’t Russian politics, but the fact that the big platinum and palladium producer there is running into lower and lower grades and having to go farther and farther down in the mines. Its production problems are organic as opposed to political.”

The bottom line for Rule is that there are going to be supply-side challenges in the platinum business at the same time that demand for platinum both as a precious metal for investment purposes and as an industrial metal for auto catalysts continues to increase. Rule acknowledges that a slowdown in the economy in Western Europe and North America will constrain vehicle demand there, but cites exploding vehicle demand in emerging markets, particularly China and India. Western air quality standards being imposed in both of these countries means that auto catalysts using platinum and palladium have kept pace with vehicle sales in those markets. “Strong demand and declining supplies point to very, very, very interesting opportunities in platinum markets,” he concludes.

Disconnected Equities
Good news for commodity prices has not always translated to rising junior mining stock prices. Rule sees four reasons for this disconnect. The first is historical. He credits the dramatic rise in precious metal stocks five years ago to an anticipation of the increase in bullion prices. “Some of the reaction that you might have expected in the equities prices might have occurred before the event took place,” he explains.

The second reason is what he calls “dismal corporate performance” over the last 10 years. “One would expect with the gold price increasing from $260 an ounce (oz.) to $1,800/oz. and silver increasing from $4/oz. to $40/oz. would result in absolutely skyrocketing free cash flows generated from the companies, but that didn’t happen. The operating response relative to the increase in product prices was, to be charitable, anemic.” The financial services industry, which had spectacular cash-generating expectations based on the returns of the 1970s, has been particularly disappointed. “There has been widespread disgust among gold share investors to the cash-generating performance of the companies relative to the escalation in their product prices,” Rule says.

The third factor is sector market-cap explosion. “Issuers—the mining companies and their cohorts in the financial services community—were engaged in inflation in the same way that governments around the world have issued lots of paper. Mining companies have issued billions of shares so that although the share price escalation has not been dramatic, the combined market capitalization of the precious metal sector producer, developer and explorer has grown at an extraordinary pace. There are many more issuers now than there were 10 years ago and every one of those issuers has many, many, more shares outstanding. You have to be very careful when you buy these things.”

The fourth point Rule makes is another cautionary one. “In the junior exploration sector, as many as 90% of market participants have absolutely no value. They are worth nothing. So, the sector as a whole can’t experience dramatic price appreciation when 90% of the paper in the sector is counterfeit or valueless. In fact, the gold shares are suffering from the same type of value depreciation as the U.S. dollar. You need to pay particular attention to defending yourself and your portfolios from these valueless, zombie security issuers.”

Rule stresses the importance of carefully evaluating a portfolio now, before the precious metals equity markets start experiencing price appreciation in the next three to six months. Why now? “Any price appreciation anticipation is over,” he says. “There is no premium built into the metals prices relative to the commodity anymore. In fact, this disparity has been noted. We think for the first time in some time the precious metals equities are reasonably priced relative to the metal itself,” Rule says.

Rule is also more positive on the issue of executive competence. “Corporate performance, which has lagged terribly over the last five years has begun to increase,” he says. For the last two or three years, the industry as a whole has generated about $2 billion (B)–$2.5B a year in surplus cash. This year, he expects the industry to generate between $4.5B–$5B, a clean double in 12 months. “The performance that hasn’t occurred hitherto is beginning to occur now,” he says. This cash on company balance sheets will enable them to do many things—greenfield and brownfield developments in their own portfolios along with mergers and acquisitions.

These are all positives for company prospects, Rule says. “We are now truly in a discovery cycle. For the last nine years the exploration industry has been well funded and well staffed. That spending cycle is beginning to yield discoveries. There is nothing, nothing that adds both liquidity and courage to junior equities markets like discovery.” Rule points to the last discovery cycle in ‘95 and ‘96 when some stocks went from $0.30 to $30.00 in 19 months. “My suspicion is that the underperformance of select precious metals equities for the next three to six months is over. Will it be volatile? It will absolutely be volatile. But, the fact is anticipation is no longer in the market; there isn’t a bullish outlook, which perversely is good. There is liquidity in the system. There is the will and the urge to merge so consolidation will take place. And, all of this will be punctuated by discovery.”

Rule also advises balance when it comes to choosing between seniors and juniors. “For those of you who are investors, for those of you who look at a return on capital employed rather than praying for a return of capital employed, you would go to the senior producers and the senior producers would do well. We particularly favor acquisition strategies that involve buying select seniors and your global broker can help you in that selection. And, then selling puts and calls against core positions. That is, allowing the market to pay you to buy low and sell high or acquiring the position simply by selling a put. We think the seniors are uniquely priced. We don’t think, by the way, that you pile in and build 100% position right now. We think you take a third position or a half position relative to where you want to end up because we are going to experience incredible volatility. But, we think this is the time to begin to establish positions.”

Rule cautions that investors need to be willing to take more risk with juniors. “The volatility will be more pronounced the farther out the quality scale you become. But the potential for reward is outsized too.” He anticipates a lot of mergers with juniors acquiring each other and juniors being acquired by the intermediates and intermediates and juniors being acquired by the seniors. “Given the relative underperformance of the juniors this year to last year, in November and December of this year—during tax-loss selling seasons—could be a once-in-a-decade acquisition opportunity.”

Rule ends by reiterating his words of warning about the volatility in the air. “This will not be stair steps to heaven. This market will not go straight up. The buzz word and I’m going to say it again and again and again in this broadcast is going to be volatility.” Again, he looks to the past to illustrate what could happen in the coming year. “Some of you will remember the 1970s bull market in precious metals when the price advanced from $35/oz. to $850/oz., a truly breathtaking ascent. You need to bear in mind that in 1975, in the middle of that ascent, the gold price fell from $210/oz. to $104/oz., a 50% decline. And the share price decline in the mining shares was even more dramatic. Did it matter over the course of a decade? No. Did it matter to people who suffered through the decline personally? Absolutely. So, while we think the sector is a good place to be don’t think of it as a place without risk.”

Founder and CEO of Global Resource Investments (GRI), Rick Rule began his career in the securities business in 1974 and has been principally involved in natural resource security investments ever since. He is a leading American retail broker specializing in mining, energy, water utilities, forest products and agriculture. Rule’s company has built a sterling reputation for its specialist expertise in taking advantage of global opportunities in the resources industries. Last month, Rule closed a landmark deal with Eric Sprott, another famous powerhouse in the arena. With GRI now a wholly owned subsidiary, Sprott, Inc. manages a portfolio of small-cap resource investments worth more than $8 billion and boasts a workforce of more than 130 professionals in Canada and the U.S. This article is based on Rule’s August 31Global Resource Investments webcast. Listen to the entire webcast.

1. The 2011 deficit (estimated at $1.5 trillion) and the accumulated national debt (over $14.3 trillion) are not the most pressing economic issues facing the country right now. They are important, but several notches down from the top of the list. This year’s deficit is just over 10% of GDP, which is high, but not crushing. There are ways to deal with these issues, as I’ll share further down. They are presented as a crisis only because the Republican Party and the Tea Party are using them to push a small government agenda. While I don’t agree with that goal, it’s fine for some to support it, but holding the economy hostage by manufacturing a crisis tied around the debt ceiling makes no sense.
2. Investment in economic growth has slowed dramatically. This is particularly true in education – at all levels. It is also true in basic research. Up until the last 20 years or so the U.S. has surfed the wave of economic change, by investing in new thinkers, and making infrastructure and other investments that will improve productivity. These seem left out of current debate options.

3. The slow recovery and weak demand for goods and services is the number one problem facing the country. The Federal stimulus is winding down, the Federal Reserve has decided that they don’t need more quantitative easing, and government at all levels is cutting employment. All the while personal consumption dropped in the most recent quarter, along with the fixed asset portion of Investment (inventories increased as a partial offset.) The uptick in unemployment and the very slow growth in employment drags down demand for goods and services. We are sliding down the same hill that the U.S. economy did in 1937-38, when Congress and President Roosevelt worried more about public concern for the debt than about sustained growth. Then we slid into a quick, nasty recession. That’s a danger now, too.
4. Inflation is not a pressing problem. The inflation we have seen this year is in food/commodities and energy. The food price spiral might well continue for awhile – I don’t have an independent sense of the true drivers. Even if food prices rise there are other elements of the Consumer Price Index that are holding steady. The rising energy prices are probably related to uncertainty about political conditions in the Middle East. Those concerns should soften soon. Inflation is something to watch out for, particularly with all of the money created by the Federal Reserve in the last three years – money created to help stabilize the economy. It is important that the Fed watch for signs of incipient inflation, driven by very high money supply, but I am confident they will act correctly and aggressively when that happens. That point is not now.
5. Bond investors are not abandoning US Treasuries for fear of default. US bonds respond to typical market forces, though they have an element of future gazing in them. If you hold a 10 year bond, and a potential buyer thinks the US might default on that bond, then the buyer will expect a higher yield (lower price/higher interest rate). That isn’t happening now. The bond market for US Treasuries is not showing signs of investors being worried about US debt.

So, what to do….

1. To tackle the most pressing problem – the slow recovery – the Federal government should be stimulating demand, through more government spending (on the part of Congress) and more quantitative easing (on the part of the Federal Reserve). Tax cuts can be part of this but they should not be across the board. The most effective, stimulative tax cut on the Federal level is the payroll tax for Social Security and Medicare. Those funds need help, and there are ways to fix them, but a payroll tax benefits mostly working people who will use the increased take home pay to consume.
2. To help with the deficit, we should remove the Bush tax cuts, and speed our exit from Iraq and Afghanistan. The Bush tax cuts disproportionately benefited higher income families, who use the extra money for non-consumption activities. When some politicians complain that raising taxes on the wealthy takes money away from job creators, there is no empirical evidence and scant theoretical basis for that claim. Along with repealing those tax cuts there are plenty of opportunities to strengthen the tax code and reduce the dreaded loopholes. Despite what many politicians say and the media parrot, this is not hard. It just takes clear headed thinking and political courage.
3. The real budget deficit challenge, at the Federal and State levels primarily, is the cost of healthcare. Increasing costs and inefficient uses of services put pressure on Medicare, Medicaid (which impacts states as well), the VA, the Dept. of Defense, and government employment costs at all levels. We should be strengthening and extending the healthcare reform efforts beyond just extending coverage – to include incentives for cost efficiency and efficacious treatments.

4. Restore and enhance funding for education at all levels. Resist the temptation to make education accountable on a short term basis, while hobbling it from producing the long term benefits derived from basic research and liberal arts education. This is an area in particular where Federal spending, even if they result in deficits, is a good investment. Cutting taxes on the wealthy is not a good use of a deficit. Deficit spending should support short term stimulative needs and long term productivity enhancements.

Some politicians have gone “green” in the name of curtailing “dependence on fossil fuels” and “foreign oil.” It’s a sham. Why not promote a certain type of underwear in the name of curtailing dependency on a foreign brand?

The fundamental problem is that most politicians and central planners view the economy as a blob to be manipulated, rather than a complex capital structure involving individuals making choices in exchanges, a process of production, and a price mechanism.

The reason why the United States is so dependent upon foreign oil is due to policies that have already been put in place. The solution, then, is to repeal and correct these policies – not creating new legislation.

Artificially low interest rates, brought on by loose monetary policy at the FOMC, drives capital overseas (by deploying unearned income from a printing press, disconnecting consumption from production, capital is also consumed). Capital naturally gravitates to cheaper, more efficient, higher-yielding economies. Rather than generating revenue and income, the nation spends beyond its means.

If a person, firm, or nation is dependent upon inflationary credit expansion (as opposed to credit expansion from savings), then that person, firm, or nation is insolvent and inefficient. We are spending beyond our means, which – yes – engenders dependence upon cheaper markets to supply us with production.

If you want to reduce dependence upon foreign “anything,” then the Fed has to lift interest rates and Washington has to abandon the spending orgy. Dollars that have been accumulating in foreign reserves will then come flowing back into the system.

I know “clean” energy sounds so nice, so attacking it is very “environmentally-incorrect.” I will put everything I possibly can into layman’s terms. Let’s start with the following axiom: we consume energy in everything we do. If you’re that environmentally-conscious, you shouldn’t be online reading this right now because you’re using electricity which is consuming energy.

Solar energy sounds so nice. After all, it comes from the sun. But let’s not forget that there is a process of production here. Take, for example, the solarization of a house. Solar energy requires panels, charge controllers, batteries, inverters, etc. And then let’s not forget capital asset depreciation. Energy is consumed during the process of production.

If “clean” energy has a positive yield, then it will be profitable and private enterprise will pony up the capital. The government need not encourage this. If “clean” energy has a negative yield, then this means that it is unprofitable and dependent on so-called “dirty” energy for its sustenance. It would be akin to consuming 1,000 blueberries for every 500 you’re growing – nobody in their right mind would pursue that course absent government subsidies. Somewhere, you have to make up the difference.

This leads me to the following axiom: the most profitable and economically-efficient form of energy, within the construct of the unhampered market, is also the cleanest form of energy.

The best ecological hygienist is the unhampered market. Suppose a logging company owns a forest. That logging company can clear-cut the forest, say, tripling immediate income. However, this must be weighed against diminishing future income, or the capital value of the forest as a whole. Suppose, however, this is government property. This calculation no longer needs to be made, and the objective is going to be rapid extraction of resources.

No shocker, then, that government is the biggest abuser of the environment and waster of resources. Look at the atomic weapons tests done in the Nevada desert – and right on top of our own military service members.

The government does not sustain itself by satisfying consumer demands, but through compulsory taxation. Government subsidies to, and control over, industry diminishes the need to set prices pursuant to supply vs. demand. Why? Because sustenance is no longer dependent upon having to satisfy consumer demands. Sustenance is disconnected from the satisfaction of consumer demands.

It’s the price mechanism that ensures resources are allocated and managed efficiently. The price mechanism can only function within the construct of the unhampered market, allowing for producers to set prices pursuant to supply vs. demand (i.e. market-clearing prices). The scarcer the supply, the greater the demand, the higher the price. Consumption runs inversely with prices.

Government subsidies distort prices, interfering with the price mechanism, and cause prices to be set above, or below, market-clearing prices. There is a paradox in government policy in that the government encourages consumption without production (in the name of economic stimulus), tells us that we should conserve resources, while simultaneously punishing “price gouging.” Within the construct of the unhampered market, there can’t be price gouging any more than there can be wage gouging, since vendors can’t short inventories at prices beyond what consumers are both willing and able to pay.

Prices send signals to entrepreneurs, telling them where to deploy capital. Prices tell consumers what to buy and what not to buy. The price mechanism can only function within the construct of an unhampered market. There’s no need for the government to encourage or discourage the use of any kind of energy. And let’s not forget that tax credits are subsidies camouflaged as tax cuts. A tax credit merely allows a person to use a portion of income for a specific purpose (i.e. indirect subsidy). (See: http://www.businesstaxrecovery.com/articleupdates/definition-tax-credit)

I write as a native-Minnesotan. Minnesota is one of the first states that employed the use of ethanol-blend fuels. Let me say that if I see anything with ethanol in it, I avoid it like the plague. It’s “cheap” for a reason; it’s inefficient.

Only can politicians get away with turning efficient food into inefficient fuel. If politicians keep at it, we will soon be filling our automobiles up with corn and drinking motor oil. Maybe after installing those solar panels, the government can begin shooting those pollution particles (See: http://www.telegraph.co.uk/earth/environment/climatechange/5128109/Shoot-pollution-particles-into-atmosphere-to-cool-Earth-says-Obama-adviser.html) – which supposedly ”clean energy” is designed to prevent – into the atmosphere in order to block the sun and “save” us from “global warming.” Sounds like the perfect plan. It’s a plan only a politician in D.C. could dream up.

Soon, we will not only be dependent upon foreign sources of “fossil fuels,” but also so-called “clean energy.” Unless you get out and support Ron Paul for president.

The Gold Report: Intel Cofounder Andy Grove wrote an article in BusinessWeek bemoaning the fact that U.S. entrepreneurs in both the hightech and cleantech realm have become inefficient in the return of jobs created per investment dollar basis. He said companies hire fewer employees as more work is done by outside contractors, usually in Asia. He suggested this is a problem not only for low-grade production jobs but also robs the U.S. of its innovation edge, hurting the country’s overall economic prospects for the future. Your economic research illustrates this manufacturing decline and shows the value of gold stock values over the last four decades mirroring the U.S. GDP. Why is consolidating manufacturing and research important for U.S. and global growth and how is it linked to the price of gold?

John Kaiser: A lack of physical manufacturing stifles innovation because without access to support facilities, machine shops, test labs and other resources normally associated with a full-scale manufacturing operation, creative people don’t see problems, quickly test solutions and have the ability to bring products to scale in a controlled environment. Cut off from manufacturing operations, development stalls.

The American economy is still the largest in the world with a $14.7 trillion dollar GDP followed now by China at nearly $6 trillion. The problem is that the employment structure of the U.S. economy has, in the last 30 years, shifted very much to service jobs in the healthcare, retail, financial and professional sectors, away from making physical goods, that are increasingly imported. We also have a serious oil addiction, which contributes significantly to the trade deficit as we import oil to keep our cars moving. So what are we actually shipping abroad that allows us to offset all the stuff that we import? The jobs we see in the United States today produce less exportable output. That has not hurt economic growth, but it has been achieved through a drawdown of the wealth accumulated during the last century, a drawdown that accelerated during the last decade when a huge debt expansion party bubbled through the economy. But that party ended in 2008. We have now had two rounds of quantitative easing designed to keep the economy from collapsing. In order for the United States to deal with its long-term structural debts and deficits, it needs to demonstrate that there is something American workers can do that is of value to the rest of the world. The core has to be manufacturing.

TGR: Is your argument that we should ignore the lower cost structure we can achieve overseas, bring assembly jobs back to the U.S. and start manufacturing here? Wouldn’t the cost of goods go up and spur on inflation at a more rapid pace than we’re expecting just because of quantitative easing?

JK: There could be some interim higher costs from bringing manufacturing back to the United States. However, inflation with regard to imported goods due to increasing transportation costs, higher Chinese workspace and emission standards, generally higher wages and the rising value of the Chinese Renminbi is coming anyway. We can’t wait to react until we are stuck paying their higher prices with no domestic alternative because we have lost the manufacturing and R&D infrastructure at home. We need to anticipate this higher overseas cost structure and act now.

TGR: Won’t those jobs just go to another lower-cost Asian country like Vietnam or Thailand?

JK: Those countries have considerably smaller populations and without super-automation they don’t have the capacity to absorb a large-scale influx of manufacturing capacity. If the solution is super-automation, then you are reducing labor costs anyway so why not do it in the U.S. and avoid the political upheaval that could disrupt the production? Two outcomes of the 30-year decline in U.S. manufacturing are that the power of labor unions has diminished, and much of the legacy manufacturing infrastructure has disappeared. To a large degree American legacy production methods were simply shifted overseas where there was an abundance of cheap and willing labor. If manufacturing is to make a comeback in the U.S. it will be in a highly automated form with newly trained employees drawn from the younger generation, not the current boomer generation or their near-retirement parents. If boomers hope to receive their entitlements when they retire, it cannot be paid for by taxing young workers doing little more than fulfilling those entitlement expectations through service jobs.

TGR: Is supply chain and geopolitical security part of what’s driving this consolidation of research and the manufacturing?

JK: Yes. Long term, as China becomes stronger, it will flex its muscles. It’s just refurbished an old Soviet aircraft carrier so that it can park itself in the South China Sea and exert its military presence. If the United States ceases to produce anything, it will become irrelevant and lose influence anywhere in the world.

TGR: Are major companies bringing manufacturing back based on the reasons you just outlined?

JK: Yes, one example is Boeing, which is way over budget and delivery deadline on its new generation of composite materials-based 787 Dreamliner airplanes. Because the company had outsourced construction of every component, including design, the pieces didn’t fit during the assembly process in Seattle. It didn’t work. The company is now looking at changing its outsourcing strategy by developing a centralized industrial park in which its subcontractors will be required to have a physical presence. That way engineers can see first hand if a piece fits.

TGR: Does that mean consolidation of design and manufacturing domestically will be driven by private enterprise operating in their best long-term interest rather than the government mandating it though trade tariffs?

JK: Yes. Protectionism in the old style is not going to fly. Instead, individuals and companies will have to voluntarily adopt total cost accounting. Instead of just looking for a cheap price, consumers will have to consider all the costs associated, including safety standards, environmental factors and sustainability. By adding in the costs that have literally been dumped on somebody else, we do the responsible thing. We have to stop being parasites, hurting others for our own cheap goods. This total cost view will create jobs and make the country stronger in the long run.

From a corporate perspective, the opportunity cost posed by supply chain disruptions needs to be factored into the cost-benefit analysis before they happen, not just ignored and then suffered when natural disasters or political upheavals happen overseas such as recently happened in Japan. If we stop assuming eternally cheap transportation costs, building and operating factories close to destination markets starts to make sense. It’s also time to ditch the narrow-minded self-interest of the libertarian school and borrow a page from Henry Ford’s book of enlightened self-interest: if you want consumers to buy your product, they need to pay with money earned through productive jobs, not entitlement spending.

TGR: While we’re talking about consolidation and the global shift, please comment on the Barrick Gold Corp. (TSX:ABX; NYSE:ABX)/Equinox Minerals Ltd. (TSX:EQN; ASX:EQN) deal. You predicted gold in the thousands last year. Why do you think Barrick Gold purchased Equinox Minerals, a copper play in Chile, when gold is at an all-time high right now?

JK: First, gold is not at an all-time high in inflation-adjusted terms, which would be about $2,300 using the $850 peak in 1980 as a base. It is only two-thirds of the way to an all-time high. But if we use $400 where gold settled in 1980 as a base, the inflation-adjusted price is about $1,024. That means today’s gold price of $1,500 is about 50% higher than in 1980 in real price terms. But rather than look at the gold price, I look at the value of the above-ground gold stock. About 3.2 billion ounces (Boz.) existed in 1980; today that number is about 5.8 Boz. It is remarkable that during a 30-year period the mining industry nearly doubled a gold stock, which had taken several thousand years to build. This was possible because between 1970 and 1980 gold underwent a tenfold price increase. That equaled a 500% real increase for a mining industry locked in a $35/oz. mindset. Once gold was released from its monetary prison, it established a new relationship to the value of the global economy expressed in U.S. dollars, which I have graphed.

Models are based on each country’s GDP converted into U.S. dollars. While a 50% devaluation of the U.S. dollar should not change the nominal U.S. GDP, the U.S. dollar GDP of all other countries would rise, boosting global U.S. dollar GDP sharply to $110 trillion without any real growth. That would translate into a $2,100/oz. gold price if the gold stock stays valued at 10% of global GDP. Of course, the cost of everything would increase correspondingly and gold companies would be no better off than they are now at $1,500 gold. The model also accounts for the inflation of the gold stock through mine supply. A higher real price will boost gold production, which CPM Group projects as growing from 83 Moz. in 2011 to 103 Moz. by 2016.

I took the above-ground stock of gold that existed in each year and multiplied it by the average price of gold during that year to get the value of all the gold that existed in each year. Then I divided it by the nominal GDP of the world for each corresponding year. That produces an interesting chart. It shows gold going from about 3% of GDP in the 1970s to a peak of 20% during the 1980 bubble and then crashing all the way back down to 4% in 2002 at the bottom of the gold market. Now it is 10%, which is about halfway to what you might regard as a bubble peak. I think gold will stabilize at these levels and go up as GDP grows.

The International Monetary Fund is predicting that our $62 trillion GDP from last year will be almost $90 trillion globally by 2016. So, if you take 10% as the norm, gold should be stable within a $1,400/oz. to $1,700/oz. range over the next six years. That’s a sustainable price assuming the world is growing. Growth would also result in increased copper demand. Barrick is diversifying its revenue base and treating both gold and copper as commodities. Copper, because it is mined to serve as a means to an end rather than as an end in itself as is the case with gold, does not have the arbitrary price volatility of gold. If suddenly the world decided it didn’t need the gold anymore and wanted to convert it into some other form of asset, it would be worth a lot less. Because copper is useful for construction, there is a limit as to how low it can go. Barrick sent a signal that it thinks the global economy is going to grow, that we are not dealing with either a looming depression or hyperinflation. I welcome that because it means gold and copper will have a strong future for the next five years.

TGR: Do you foresee more mergers and acquisitions in precious metals? Is this the start of a trend?

JK: Yes. As companies focus on advancing projects, it will take large capital investment. It will be difficult for a stand-alone project to raise $500M+ without being absorbed by a bigger company that already has production in place and is generating cashflow. This is an opportunity for large, liquid companies to acquire these assets without paying a big premium, particularly if it uses its paper as currency. It is a one plus one equals three situation because as the acquiring company diversifies its revenue base, its catastrophe risk declines. As the market gets more comfortable with gold at current levels, we will see mergers and acquisitions step up and more money coming into the market.

TGR: So, you see economic growth as price drivers for both gold and copper?

JK: In the case of gold, yes. In the case of copper, the question is whether $4 copper is the new reality on which we can base mine development decisions, given a low inflation scenario. The key thing that has happened in the last decade is that China has become a significant economic force. It has now displaced Japan as the second-largest economy with a billion-plus population base and relatively low per-capita GDP. It could grow substantially and eventually become larger than the U.S. economy. But, China is still an unusual political entity; it is a hybrid communist-capitalist country. As they get stronger, we have no idea how they will behave on the global stage. Therefore, people are shifting capital into gold as part of their long-term security plans. As GDP grows, it will probably grow faster than the ability to bring new gold supply on stream. Therefore, gold will rise in price as it tracks the strength of the global economy.

TGR: If you’re expecting the price of gold to track nominal GDP, which is growing 2% to 4%, won’t you see money coming out of gold and going into equities that would probably represent a higher potential return?

JK: All the gold in the world is about 5.3 Boz., worth about $8 trillion. That’s really a fraction of the estimated net worth of all other assets, which is about $130 trillion. Most gold is held as a long-term asset. So even if the crazy gold bugs start selling to buy stocks, they are a small minority and won’t make a huge difference. I believe the value of gold stock as 10% of GDP is a reasonable level. Make it a lot higher and gold owners will look to convert it into other assets such as land, buildings, resources and dividend- or interest-yielding instruments capable of generating a cash flow as opposed to a capital gain. What would the new owner’s reason be for buying? The only return generated by gold is psychological stress relief. However, if gold prices surge to 20% of GDP as it did in 1980, it will be because of an unstable global situation. Under such conditions, gold ownership is not likely to offer much stress relief, especially if government confiscation or a breakdown of law and order become risks. At 20% of GDP, the value of the gold stock would imply a price of about $2,400 in real terms (as opposed to a price rise generated by excessive inflation or a major devaluation of the U.S. dollar against other currencies). In 1980, when gold was 20% of GDP, some thought the United States had reached the end of the line. But the United States survived that crisis and went on to win the Cold War, unleash globalization and accelerate time through the Internet communications revolution. Short of a calamitous collapse in China, I see the center of gravity for global economic and military power gradually shifting away from the United States during the coming decades. On the other hand, I do not see the value of the gold stock dropping back to 5% of GDP because this would require a major decrease in our uncertainty about the future global order.

TGR: What does this mean for silver? Both gold and silver had a setback recently.

JK: Silver has been the worst performing metal for decades. What it’s doing now is a bit of a catch up. Although most of the above-ground silver stock of 46 Boz. is fabricated into some useful form, unlike gold, silver is gaining popularity, especially in emerging economies. The above-ground silver stock value went from 1.5% of GDP in 1970 to a peak of 6% in 1980. But by 2002 the silver stock was worth only 0.5% of GDP. Right now it’s between 2% and 3%. I believe silver can parallel gold’s role as a hedge against the uncertainty associated with the long-term relative decline of the United States and the gradual disappearance of the U.S. dollar as the world’s reserve currency. If we assume the silver stock will establish a value as 3% of global GDP, the price will base out in the $30–$40 range this year, which will grow to $47–$57 by 2016. If it goes to $100/oz., that would indicate a bubble reflecting the inflation-adjusted equivalent of the $50 peak in 1980. Because the recent price growth looks exponential, the markets have fought back and a bear attack is pushing silver back down. But I believe $30–$50/oz. will be the new long-term reality, which opens up some good buying opportunities among silver companies in the next couple of months.

TGR: Since the pullback is happening right now and it has been pretty dramatic, wouldn’t the buying opportunity be now? What will be different in two months?

JK: I’m not a big fan of catching falling knives and anvils. I like to see them bounce around first so I know they’re not going to hurt me. Especially this time of year, it might be best to see where silver and gold stabilize.

TGR: What do all these new economic drivers mean for gold, copper and silver mining companies? And what companies could capitalize on these changes?

JK: Well, the pessimism embedded in the market right now about the U.S. economy and, ultimately, the global economy that still very much depends on the U.S. economy, has discouraged the market from taking current metal prices seriously. If you plug in $1,500/oz. gold and $4/oz. copper into the discounted cash-flow models for these development projects, you get some very sexy numbers compared to what the stocks are trading at. For example, take Geologix Explorations Inc. (TSX:GIX). It has the Tepal Project, a copper/gold play. It’s not super high grade or very large. But, right now the stock’s trading below $0.50. Conservative numbers like $2.75/lb. copper and $1,100/oz. gold result in a value of about $1.10 a share, which is not very exciting. But plug in current prices, $4/lb. copper and $1,500/oz. gold, and the target blossoms into the $3/lb.–$4/lb. range.

We see this across the board, an unwillingness to plug current metal prices into the valuations because of an assumption that we’re going to see copper back below $2/lb. or gold back to $1,000/oz. And, yes, if we end up in a global depression we will certainly see the metal prices go back down. But I see the global economy trending upward, causing gold and copper to stay strong, thereby leading to an inflection point when the market realizes this pessimistic attitude is all wrong. Then the market will take these prices seriously and put capital into mining projects to mobilize new metal supplies. The problem with mine development is it takes three to five years to realize. That is why we need to start going after these huge profit margins now instead of perpetually waiting for signs of an enduring recovery. The irony of the inflation we are seeing in raw material prices today, which threaten to destabilize emerging market economies, is that it is due to the reluctance of capital markets to take the IMF GDP growth projections seriously and deploy capital to mobilize new mine supply.

TGR: What companies are making those investments today?

JK: Sandspring Resources Ltd. (TSX.V:SSP) is an example. It started off as an alluvial gold operation in Guyana. The company ended up going public and raising capital to focus on the bedrock potential, thereby developing a large gold resource with a minor copper credit. Sandspring just completed a preliminary economic assessment using current pricing that suggests the project is worth about $900M. Yet the market valuation is about $300M. That gives you three to five times upside potential if there are no glitches in the pre-feasibility study and current metal prices get nailed to the wall.

Exeter Resource Corp. (TSX:XRC; NYSE.A:XRA; Fkft:EXB) is another example. The company discovered the Caspiche deposit in Chile. It has a large copper resource. It also has a low-grade gold-oxide resource on top. The copper resource is too big for Exeter to develop on its own and in view of the capital cost escalation being suffered by similar large deposits bought out before the 2008 crash and the skepticism that $3–$4 copper is the new reality, Exeter will have a hard time attracting a buyout by a major in the near term. So, to create value while it bides time, the company is now focusing on developing a gold-oxide leaching operation to take advantage of the 1.4 Moz. resource sitting on top of this system.

TGR: Any other companies that could take advantage of the new pricing reality either in the gold, the copper or the silver area?

JK: Grade is very important in the gold sector. Last year Osisko (TSX:OSK) took over Brett Resources Inc. (TSX.V:BBR) and its Hammond Reef Deposit in Ontario, which is just under 1 g/t and about 7 Moz., at about $4. Now that the market is getting more comfortable with the idea of gold north of $1,200/oz., other similar low-grade projects are looking attractive.

Northern Gold Mining Inc. (TSX.V:NGM) is an example. The company’s 700 Koz. Garrcon Project wasn’t very interesting when gold was below $1,000/oz. But, at current prices, the company has an incentive to do step out drilling and lower the cutoff grade in an effort to boost that resource to a 2 to 4 Moz. Open pit mineable. This $40M market cap company could undergo a fivefold increase if Northern Gold triples the resource and delivers a positive prefeasibility study.

TGR: Are you saying that whether we are in a depression as some believe or a recovery as you have outlined, we’ve already seen the floor of $1,200/oz. for gold and these companies are a low-risk return investment?

JK: Not exactly. In the scenario where gold rises because the American economy is in a death spiral, the solution is to pursue a hyperinflation strategy that results in costs rising in conjunction with the price of gold. So, that is of no benefit to the companies. If the alternative is to just curl up in a fetal position and suck one’s thumb and prepare for the end, that will result in gold prices going down. The best alternative for resource juniors is if the world avoids both a deflation-linked depression and hyperinflation scenarios, the American economy gets back on track with a revival of manufacturing on U.S. soil and the global economy continues to grow. That will be good for raw material demand and gold and silver prices.

TGR: Thanks, John. Enlightening as always.

John Kaiser, a mining analyst with over 25 years’ experience, is editor of Kaiser Research Online. He specializes in high-risk speculative Canadian securities and the resource sector is the primary focus for an investment approach he developed that combines his “bottom-fishing strategy” with his “rational speculation model.” Kaiser began work in January 1983 as a research assistant with Continental Carlisle Douglas, a Vancouver brokerage firm that specialized in Vancouver Stock Exchange listed securities. In 1989 he moved to Pacific International Securities Inc., where he was research director until April 1994 when he moved to the United States with his family. He launched the Kaiser Bottom-Fishing Report (now Kaiser Research Online) as an independent publication in October 1994 and developed it into an online commentary and information portal. He has written extensively about the junior resource sector, is frequently quoted by the media, and is a regular speaker at investment conferences. Since 2008 he has developed a focus on security of supply issues and how they relate to critical metals such as rare earths.

The U.S. has a temporary reprieve on the debt ceiling limit – tax revenues have come in higher than expected in the early part of the year, reducing the needed pace of borrowing by the U.S. government. While this has pushed the deadline for Congressional action back by a month or more, the rhetoric in Washington continues to be intense. As quick background…Congress periodically authorizes  new limits to borrowing to cover new debt. Public radio’s Planet Money has a good, short description of the ceiling. That ceiling needs to be adjusted upwards by Congress in order for the Treasury Department to sell more U.S. bonds (i.e. borrow more).

The coming vote on raising the debt ceiling is giving the Republicans a chance to push for a less-government/less-spending program. Speaker Boehner issued a challenge earlier this week, as reported in The New York Times,

‘Without significant spending cuts and changes to the way we spend the American people’s money, there will be no debt limit increase,’ Mr. Boehner told members of New York’s business and finance community. ‘And cuts should be greater than the accompanying increase in debt authority the president is given.’ Mr. Boehner said those cuts should be in the trillions of dollars, not billions.

So, what would happen if trillions, or even just $100 – $300 billion was cut from Federal spending? University of Oregon economics professor, Mark Thoma, was asked this question and wrote about it in MoneyWatch.

Thoma’s bottom line is

Even a much smaller cut, say $100 billion over the next year, would still wipe out 500,00 jobs over that time period — 2 months of job creation at present rates — and set the recovery back considerably.

For students in macroeconomics there are some good reminders of basic economic forces. I recommend reading the MoneyWatch posting. Look for these important uses of macroeconomic theory:

• The multiplier (AKA the Keynesian Multiplier). When the government spends money, that initial increase in spending adds directly to GDP. Government spending is one of the four main elements of GDP, along with Consumption, Investment, and Net Exports. Then, depending on how that money is used (spent vs. saved) those funds cascade through the economy, prompting more spending (usually personal consumption). That means the original government expenditure has an impact on GDP that is a multiple of the original amount. In theory that multiplier could be as high as 5, but applied research suggests figures between 1 and 2. Thoma makes a point that was new to me, that the multiplier can be different depending on the state of the economy – lower when the economy is closer to full employment, and higher during recessionary times. (Note to self – look this up.)
• Okun’s Law. Okun saw a relationship between changes in GDP and changes in unemployment. He observed empirically that a two percent drop in GDP was associated with a one percent rise in unemployment.

Putting it all together – Thoma estimates that a $600 billion drop in government spending over two years ($300 b in one year) will reduce GDP by two percentage points and raise unemployment by 1 percent. That is about 3 million workers losing their jobs. That would rip the guts out of our recovery.

On a side note.. PG has taken up the issue of the toothlessness of the real estate transfer tax in the City of Pittsburgh.  and finally there is some note that this does not have to be this way and that Philadelphia has made significant changes to their real estate tax statutes to limit the shenanigans.  As I said earlier (or earlier, or earlier), fix this now and there could be significant revenue gains for the city in the future.  Even if there are significant legal or political issues to making such a change, you really have to wonder why this has no more than a very passing public debate over the decades as Pittsburgh lost money Philadelphia likely would have been collecting from similar transactions.

The excuse that state law inihibits this is misleading.  2nd class city code can be changed as can 2nd class county code in Pennsylvania.  The question is has anyone in Harrisburg even suggested this over the years?  Maybe we could get some more attention for this if we called it a tax in lieu of a tax on electronic billboards tax?

Ni!

Seriously, if you do a NPV calculation of all the future revenue that could be collected, you might be talking significant amounts.  In fact, someone ought to go fund a study looking back at how much has potentially been lost over the last decade because of the differences in how Pittsburgh can tax these transactions compared to Philadelphia.   Wouldn’t that be an interesting number?

More likely there will be no follow up and this will all be lost in the shrubbery until the next big real estate transaction.

The Gold Report: Standard & Poor’s (S&P) has given a warning to the U.S. government that it may downgrade its rating by 2013 if nothing is done to address the debt and deficit. What’s the real impact of this announcement?

John Williams: S&P is noting the U.S. government’s long-range fiscal problems. Generally, you’ll find that the accounting for unfunded liabilities for Social Security, Medicare and other programs on a net-present-value (NPV) basis indicates total federal debt and obligations of about $75 trillion. That’s 15 times the gross domestic product (GDP). The debt and obligations are increasing at a pace of about $5 trillion a year, which is neither sustainable nor containable. If the U.S. was a corporation on a parallel basis, it would be headed into bankruptcy rather quickly.

There’s good reason for fear about the debt, but it would be a tremendous shock if either S&P or Moody’s Investor Service actually downgraded the U.S. sovereign-debt rating. The AAA rating on U.S. Treasuries is the benchmark for AAA, the highest rating, meaning the lowest risk of default. With U.S. Treasuries denominated in U.S. dollars and the benchmark AAA security, how can you downgrade your benchmark security? That’s a very awkward situation for rating agencies. As long as the U.S. dollar retains its reserve currency status and is able to issue debt in U.S. dollars, you’ll continue to see a triple-A rating for U.S. Treasuries. Having the U.S. Treasuries denominated in U.S. dollars means the government always can print the money it needs to pay off the securities, which means no default.

TGR: With the U.S. Treasury rated AAA, everything else is rated against that. But what if another AAA-rated entity is about to default?

JW: That’s the problem that rating agencies will have if they start playing around with the U.S. rating. But there’s virtually no risk of the U.S. defaulting on its debt as long as the debt’s denominated in dollars. Let’s say the U.S. wants to sell debt to Japan, but Japan doesn’t like the way the U.S. is running fiscal operations. It can say, “We don’t trust the U.S. dollar. We’ll lend you money, but we’ll lend it in yen.” Then, the U.S. has a real problem because it no longer has the ability to print the currency needed to pay off the debt. And if you’re looking at U.S. debt denominated in yen, most likely you would have a very different and much lower rating.

TGR: Is there a possibility that people would not buy U.S. debt unless it’s in their currency?

JW: It is possible lenders would not buy the Treasuries unless denominated in a strong and stable currency. As the USD loses its value and becomes less attractive, people will increasingly dump dollar-denominated assets and move into currencies they consider safer. And you’ll see other things; OPEC might decide it no longer wants to have oil denominated in U.S. dollars. There’s been some talk about moving it to some kind of basket of currencies—something other than the U.S. dollar, possibly including gold. This would be devastating to the U.S. consumer. You’d get a double whammy from an inflation standpoint on oil prices in the U.S. because the dollar would be shrinking in value against that basket of currencies.

TGR: Different countries are starting to discuss the creation of an alternative to the USD as reserve currency. How rapidly could an alternative currency appear?

JW: That would involve a consensus of major global trading countries; but just how that would break remains to be seen. Let’s say OPEC decides it no longer wants to accept dollars for oil. Instead, it wants to be paid in yen. It’s done. It’s not a matter of creating a new currency—it’s a matter of how things get shifted around.

TGR: What other commodities or monetary issues would that create?

JW: Again, the dollar’s weakness is doubly inflationary. It is the biggest factor behind the ongoing rise in oil prices. Let’s say you’re a Japanese oil purchaser. Oil, effectively, is purchased at a discount in a yen-based environment due to the dollar’s weakness. Usually, the market doesn’t let such advantages last very long. As the dollar weakens, you see upside pressure on oil prices. If, hypothetically, you’re pricing oil in yen, there’s no reason for anybody to hold the USD. The dollar would sell off more rapidly against the yen and oil inflation would be even higher in a dollar-denominated environment.

TGR: You’ve mentioned that hyperinflation will happen as soon as 2014. If that is true, wouldn’t OPEC want to shift off dollar pricing as quickly as possible?

JW: From a purely financial standpoint, that would make sense. Other factors are at play, though, including political, military and unstable times in both North Africa and the Middle East. Those who are able to get out of dollars, I think, will do so rapidly and as smoothly as possible.

TGR: And how will they do that?

JW: They will sell their dollar-denominated assets. They will convert dollars to other currencies. They will buy gold. Generally, they will dump whatever they hold in dollars and sell the dollar-denominated assets they don’t want. There’s a market for them; it’s just a matter of pricing. As the pressure mounts to get out of the USD, the pricing of dollar-denominated assets will fall, which in turn would intensify that selling. The dollar selling will intensify domestic U.S. inflation, which is one factor that picks up and feeds off itself and will help to trigger the hyperinflation.

TGR: The U.S., even in recession, is still the largest consuming economy. If the U.S. continues in, or goes into a deeper, recession, doesn’t that impact the rest of the world?

JW: If the U.S. is in a severe recession, it will have a significant negative economic impact on the global economy. That doesn’t necessarily affect the relative values of other currencies to the USD. If you look at the dollar against the stronger currencies, a wide variety of factors are in effect—including relative economic strength. The U.S. is probably going to have an economy as bad as any major country will have, with higher relative inflation. The weaker the relative economy and the stronger the relative inflation, the weaker will be the dollar. Relative to fiscal stability, the worse the fiscal circumstance in the U.S., the weaker is the dollar. Relative to trade balance, the bigger the trade deficit is, the weaker the currency. As to interest rates, the lower the relative interest rates in the U.S., the weaker will be the dollar.

Part of the weakness in the dollar now is due to the way the world views what’s happening in Washington and the ability of the government to control itself. That’s a factor that may have forced S&P to make a comment. So, even having a weaker economy in Europe would not necessarily lead to relative dollar strength.

TGR: If the U.S. experiences a continued, or even greater, recession, doesn’t that impact spill over into Canada?

JW: The Canadian economy is closely tied to the U.S. economy, and bad times here will be reflected in bad times in Canada. However, I’m not looking for a hyperinflation in Canada. Its currency will tend to remain relatively stronger than the U.S. dollar. Canada is more fiscally sound; it generally has a better trade picture and has a lot of natural resources. Keep in mind that economic times tend to get addressed by private industry’s creativity and, thus, new markets can be developed. For instance, you’re already seeing significant shifts of lumber sales to China instead of to the U.S.

TGR: What about the effect on other countries?

JW: The world economy is going to have a difficult time. You do have ups and downs in the domestic, as well as the global, economy. People survive that. They find ways of getting around problems if a market is cut off or suffers. I view most of the factors in Canada, Australia and Switzerland as being much stronger than in the U.S. Even when you look at the euro and the pound, they’re generally stronger than in the U.S. Japan is dealing with the financial impacts of the earthquake. There’s going to be a lot of rebuilding there. But, generally, it’s a more stable economy with better fiscal and trade pictures. I would look for the yen to continue to be stronger. Shy of any short-term gyrations, the U.S. is really in the worst condition of any major economy and any major country in the world and, therefore, in a weaker currency circumstance.

TGR: Then why are media analysts talking about the U.S. being in a recovery?

JW: You’re not getting a fair analysis. There’s nothing new about that. No one in the popular media predicted the recession that was clearly coming upon us, and the downturn wasn’t even recognized until well after the average guy on Main Street knew things were getting bad. We have some particularly poor-quality economic reporting right now. The economy has not been as strong as it advertised. Yes, there has been some upside bouncing in certain areas, but it’s largely tied to short-lived stimulus factors.

Let’s look at payroll numbers and the way those are estimated. In normal economic times, seasonal factors and seasonal adjustments are stable and meaningful. What’s happened is that the downturn has been so severe and protracted it has completely skewed the seasonal-adjustment process. It’s no longer meaningful, nor are estimates of monthly changes in many series. The markets are flying blind—it’s unprecedented, in terms of modern reporting.

Are we really seeing a surge in retail sales? If so, you should be seeing growth in consumer income or consumer borrowing—but we’re not seeing that. The consumer is strapped. An average consumer’s income cannot keep up with inflation. The recent credit crisis also constrained consumer credit. Without significant growth in credit or a big pick-up in consumer income, there’s no way the consumer can sustain positive economic growth or personal consumption, which is more than 70% of the GDP. So, you haven’t started to see a shift in the underlying fundamentals that would support stronger economic activity. That’s why you’re not going to have a recovery; in fact, it’s beginning to turn down again as shown in the housing sales volume numbers, which are down 75% from where it was in normal times.

TGR: But we were in a housing boom. Doesn’t that make those numbers reasonable?

JW: Housing starts have never been this low. Right now, they are running around 500,000 a year. We’re at the lowest levels since World War II—down 75% from 2006—and it’s getting worse. I mean the bottom bouncing has turned down again. We’re already seeing a second dip in the housing industry. There’s been no recovery there.

In March, all the gain in retail sales was in inflation. Retail sales are turning down. You’re going to see a weaker GDP number for Q111. The GDP number is probably the most valueless of the major series put out; but, as the press will have to report, growth will drop from 3.1% in Q410 to something like 1.7% in Q111.

TGR: You’ve stated that the most significant factors driving the inflation rate are currency- and commodity-price distortions—not economic recovery. Why is that distinction important?

JW: The popular media have stated that the only time you have to worry about inflation is when you have a strong economy, and that a strong economy drives inflation. There’s such a thing as healthy inflation when it comes from a strong economy. I would much rather be in an economy that’s overheating with too much demand and prices that rise. That’s a relatively healthy inflation. Today, the weak dollar has spiked oil prices. Higher oil prices are driving gasoline prices higher—the average person is paying a lot more per gallon of gas. For those who can’t make ends meet, they cut back in other areas. The inflation of Q410, which is now running at an annualized pace of 6%, was mostly tied to the prices of gasoline and food.

You also have higher food prices. It’s not due to stronger food or gasoline demand—it’s due to monetary distortions. Unemployment is still high, even if you believe the numbers. I’ll contend the economy really isn’t recovering. At the same time, you’re seeing a big increase in inflation that’s killing the average guy.

TGR: Why isn’t there more pressure on the U.S. government to reduce the debt deficit?

JW: When you get into areas like debt and deficit, it’s a little difficult to understand. The average person, though, should be feeling enough financial pain that political pressure will tend to mount before the 2012 election; but whether or not the average person will take political action remains to be seen. I don’t think you have until 2012 before this gets out of control and there’s hyperinflation. It could go past that to 2014, but we’re seeing all sorts of things happening now that are accelerating the inflation process.

TGR: Like the dollar at an all-time low.

JW: If you compare the U.S. dollar against the stronger currencies, such as the Australian dollar, Canadian dollar and Swiss franc, you’re looking at historic lows. You’re not far from historic lows in the broader dollar measure.

TGR: In your April 19 newsletter, you stated, “Though not yet commonly recognized, there is both an intensifying double-dip recession and a rapidly escalating inflation problem. Until such time as financial market expectations catch up with the underlying reality, reporting generally will continue to show higher-than-expected inflation and weaker-than-expected economic results.” What do you mean by “until such time as financial market expectations catch up with the underlying reality?”

JW: A lot of people look closely at and follow the consensus of economists, which is looking at (or at least still touting) an economic recovery with contained inflation. I’m contending that the underlying reality is a weaker economy and rising inflation. I think the expectation of rising inflation is beginning to sink in. Given another month or two, I think you’ll find all of a sudden the economists making projections will start lowering their economic forecasts. Instead of looking at half-percent growth in industrial production, they’ll be expecting it to be flat; if it comes in flat, it will be a consensus—and the markets will be pleased it wasn’t worse in consensus. But the consensus outlook will have shifted toward a more negative economic outlook.

TGR: Do you think economists will shift their outlooks before we get into hyperinflation or a depression?

JW: In terms of economists who have to answer to Wall Street, work for the government or hold an office like the Federal chairman, by and large, they’ll err on the side of being overly optimistic. People prefer good news to bad news. If Fed Chairman Ben Bernanke said we were headed into a deeper recession, it would rattle the market. People on Wall Street want to have a happy sales pitch. What results may have little to do with underlying reality.

TGR: In your April 15 newsletter, you mentioned that a signal of an unfolding double-dip recession is based on the annual contraction of the M3, which was the Fed’s broadest measure of money supply until it ceased publishing it in 2006. Recent estimates show that the annual contraction of M3 went down from 4.3 in February to 3.6 in March. Is this good news?

JW: No. It doesn’t have any particular significance as a signal for the economy. You do have recessions that start without M3 going negative year over year. In the last several decades, every time the M3 went negative, there followed a recession—or an intensifying downturn—if a recession was already underway. If you tighten up liquidity, you tend to tighten up business conditions. Again, though, you’ve had recessions without those signals. When it goes positive, it does not signal an upturn in the economy. It doesn’t make any difference if it continues negative for a year or two, or if it’s negative for three months. The point is—when it turns negative, that’s the signal for the recession.

We had a signal back in December 2009, which would have indicated a downturn sometime in roughly Q310. We already were in a recession at that point. According to the National Bureau of Economic Research, the defining authority in timing of the U.S. business cycle, the last recession ended in June 2009. So, this current recession will be recognized as a double-dip recession. The Bureau doesn’t change its timing periods.

I’ll contend that we’re really seeing reintensification of the downturn that began in 2007. Although it’s not obvious in the headline numbers of the popular media, you’ll find that September/October 2010 is when the housing market started to turn down again. That is beginning to intensify. We’ll see how the retail sales look when they’re revised. When all the dust settles, I think you’ll see that the economy did start to turn down again in latter 2010. Somewhere in that timeframe, they’ll start counting the second or next leg of a multiple-dip recession.

TGR: Does M3 have anything to do with calculating potential inflation or hyperinflation?

JW: It does; but when you start looking at the inflation picture, you also have to consider that we are dealing with the world’s reserve currency and the volume of dollars both outside and inside the U.S. system. Right now, M3 is estimated at somewhat shy of $14 trillion. You have another $7 trillion outside the U.S., which is available for overnight liquidation and dumping into the U.S. markets. It’s not easy to measure how much is out there, but that has to be taken into account to assess the money supply related to inflation. Again, that’s where the Fed chairman’s policies come into play.

Efforts have been afoot to weaken the U.S. dollar. Usually with the weakening of the U.S. dollar, you see increased repatriation of dollars from outside the system. If everyone is happy holding the dollars, the flows can be static; but when they start shifting and the dollars are repatriated, you begin to have currency problems. That’s when you have the money supply and the inflation problems we’re beginning to see.

TGR: This has been very informative, John. Thank you for your time.

Walter J. “John” Williams has been a private consulting economist and a specialist in government economic reporting for 30 years, working with individuals and Fortune 500 companies alike. He received his AB in economics, cum laude, from Dartmouth College in 1971 and earned his MBA from Dartmouth’s Amos Tuck School of Business Administration in 1972, where he was named an Edward Tuck Scholar. John, whose early work prompted him to study economic reporting and interview key government officials involved in the process, also surveyed business economists for their thinking about the quality of government statistics. What he learned led to front-page stories in the New York Times and Investor’s Business Daily, considerable coverage in the broadcast media and a joint meeting with representatives of all of the government’s statistical agencies. Despite a number of changes to the system since those days, John says that government reporting has deteriorated sharply in the last decade or so. His analyses and commentaries, which are available on his ShadowStats website have been featured widely in the popular domestic and international media.

The Gold Report: When the average investor turns on the news, even on financial channels, they hear that the U.S. economy is in the best shape it’s been in for three or four years. While the experts say the recovery is slower than anticipated, they expect its slow recovery will equate to a long, slow growth cycle similar to that after World War II. You have a contrary view.

Doug Casey: The only things that are doing well are the stock and bond markets. But the markets and the economy are totally different things—except, over a very long period of time, there’s no necessary correlation between the economy doing well and the market doing well. My view is that the market is as high as it is right now—with the Dow over 12,000—solely and entirely because the Federal Reserve has created trillions of dollars, as other central banks around the world have created trillions of their currency units. Those currency units have to go somewhere, and a lot of them have gone into the stock market.

As a general rule, I don’t believe in conspiracy theories and I don’t believe anything’s big enough to manipulate the market successfully over a long period. At the same time, the government recognizes that most people conflate the Dow with the economy, so it is directing money toward the market to keep it up. Of course, the government wants to keep it up for other reasons—not just because it thinks the economy rests on the psychology of the people, which is complete nonsense. Psychology is just about the most ephemeral thing on which you could possibly base an economy. It can blow away like a pile of feathers in a hurricane.

TGR: So, you’re saying we’re confusing the market’s performance with the economy’s performance?

DC: Yes. The fact is that the economy, itself, is doing very badly. The numbers are phonied up. I spend a lot of time in Argentina. Anybody with any sense knows you can’t believe the numbers coming out of the Argentinean Government Statistical Bureau, nor can you (any longer) believe the numbers that come out of Washington D.C. The inflation numbers consider only the things the government wants to look at and are artificially low. It’s the same with the unemployment numbers. None of these things is believable.

TGR: Isn’t the unemployment figure a lagging indicator of a rebounding economy?

DC: If you look at the way unemployment was computed until the early 1980s—something that John Williams from ShadowStats does—the numbers would indicate about 20% unemployment today. Besides, even while the population keeps rising, the number of people reported as actually working is level or even lower. Most indicators of the economic establishment, in my view, don’t really make any sense. GDP, for instance, includes government spending—much of which amounts to paying some people to dig ditches during the day and other people to fill in for them at night. So-called “defense” spending is almost totally wasted capital. The practice of economics today is pathetic and laughable.

TGR: So, the economy is not rebounding?

DC: No. My take on this is that we entered what I call the “Greater Depression” in 2007. And now, because the government has printed up trillions of dollars in the last couple of years, we’re in the eye of the hurricane. We’ve only gone through the leading edge of the storm. People think this will just be another cyclical recovery like all the others since WW II. But it’s not. It’s going to wind up with the currency being destroyed. It’s going to be a disaster. . .a worldwide catastrophe.

TGR: You indicated that the government is using these mass infusions of made-up money to prop up the stock market due to the psychological factor—that people will think the economy’s doing well because the market is doing well. However, we hear that a lot of that money has been caught up in the banks. Would you comment on that?

DC: As I said, that money has to go somewhere. The banks have been borrowing from the Fed at something like 0.5% and investing it in government securities at 2%, 3% or 4%, depending on the maturity. So, much of that money has been a direct gift to the banks; and they’re basically making an arbitrage spread of 2%–4%. So, yes, that’s happening with some of the money. Still, it doesn’t all just sit in these Treasury securities. A great deal of it, inevitably, goes into the stock market.

TGR: You also said that psychology isn’t the only reason the government wants to see the stock market go higher.

DC: Right. Pension funds have a great deal of their assets in stocks. Certainly, many funds run by government entities, such as the state and city employee pension funds, are approaching bankruptcy despite the fact that the Fed has driven interest rates to historic lows, artificially pumping up both stocks and bonds. And, I might add, keeping property prices higher than they would be otherwise. When interest rates rise eventually—and they will go up a lot—it’ll be something to behold in the markets.

TGR: You mentioned John Williams who’s in your speaker lineup for the Casey Research Summit, The Next Few Years. Another of your speakers is Stansberry Associates Founder Porter Stansberry, who’s been making two points about the devaluation of the U.S. dollar. One point he makes in his The End of America video concerns the quantitative easing (QE) you mentioned—those trillions of dollars. But Porter also anticipates the U.S. government announcing a devaluation of the currency similar to what England did in 1970. Do you see that type of scenario occurring, as well?

DC: When the U.S. government last officially devalued the dollar in August 1971, it had been fixed to $35 per ounce to gold. In other words, before that, any foreign government could take the dollars it owned and trade them in at the Treasury for gold. Nixon devalued the dollar by raising it to $38/oz., and then to $42/oz. It was completely academic, anyway, because he wouldn’t redeem gold from the Treasury at any price.

But because the dollar isn’t fixed against anything now, the government can’t officially devalue it. It’s a floating market. The government’s going to devalue the dollar by printing more of the damn things and letting them lose value gradually—actually the loss will no longer be gradual, but quite fast from here on out. But it’s not going to do so formally by re-fixing the dollar against some other currency or against gold. I’m not sure Porter’s phrasing it in the best way, but he’s quite correct in his conclusion and his prescriptions as to how to profit from it. At this point, the dollar is nothing more than a floating abstraction, an IOU nothing on the part of a manifestly bankrupt government.

TGR: Another abstraction is the fact that the Treasury says the money it is printing has a multiplier effect when it gets into the U.S. economy, so it can pull those dollars back when the time comes. Is that a viable alternative to offset the devaluation caused by printing more money?

DC: You have to look first at the immediate and direct effects of what the government’s doing, and then at the delayed and indirect effects. And sure, just as it’s injecting all this money into the economy—mainly by the Fed buying U.S. government bonds—theoretically, it can take it out of the economy by doing the opposite. But I just don’t see that happening.

TGR: Why not?

DC: One of the reasons is that the U.S. government, itself, is running annual trillion-dollar deficits as far as the eye can see. I think those deficits will go higher—not lower. So, where’s that money going to come from? Where will it get trillions of dollars to fund the U.S. government every year?

China isn’t going to buy this paper and Japan will be selling its U.S. government paper because, if nothing else, it’ll need to buy things to redo the northeast part of the country. Nobody else is going to buy that trillion-dollar deficit either, so it’ll have to be the Federal Reserve. In fact, the Fed will have to buy much more and, therefore, create more money. That’s what happens.

TGR: This currency crisis isn’t unique to the U.S. You just brought up Japan. And aren’t all the European countries doing the same thing?

DC: The U.S., unfortunately, is not unique. This is going to be a worldwide catastrophe. It’s been a disaster for every country that’s done this in the past—Zimbabwe, Germany, Hungary, Yugoslavia and countries in South America—but those were within only those particular countries. In most of those cases, people never trusted their governments; so, they had significant assets outside the country in a form other than the local currency. The problem now is that the U.S. dollar is the world’s currency and all of these central banks own USDs as the backing for their own currencies. All these other countries will wind up finding that they don’t have any assets after all. That’s going to happen all over the world.

TGR: With countries around the globe facing the same issue, should anyone hold currencies?

DC: No. Sure, you need local currency to go to the store and buy a loaf of bread. But for liquid assets you’re trying to save, it’s insane to own currencies at this point because they’re all going to reach their intrinsic value. I’ve been recommending for many years that people buy gold and own gold for their savings—serious capital they want to put aside in liquid form. With gold now over $1,500/oz. and silver at $48, people who followed that advice have made a lot of money. That’s the good news. The bad news is that very few people have done so. Newbies to the game are paying $1,500/oz. for gold. It’s going higher, but it’s no longer the bargain that it was. The important thing to remember, though, is that gold is the only financial asset that’s not simultaneously someone else’s liability. That’s why it’s always been used as money and why it’s likely to be reinstituted as money.

TGR: From your viewpoint, how does a person with any wealth preserve it during this tumultuous period other than by investing in gold?

DC: Frankly, I don’t know. I own beef and dairy cattle, which are a good place to be; but that’s a business, and it’s not practical for most people. I think it boils down to gold.

TGR: But what investments should they be looking at these days?

DC: There really aren’t investments anymore. With trillions of newly created currency units floating around the world, things will become very chaotic and unpredictable shortly. It’s very hard to invest using any kind of Graham-and-Dodd methodology when things are that chaotic. Whether you like it or not, you’re going to be forced to be a speculator in the years to come. A speculator is somebody who tries to capitalize on politically caused distortions in the marketplace. There wouldn’t be many speculators, or many of those distortions in the marketplace, if we lived in a free-market society. But we don’t.

TGR: So, speculation will supplant value investing?

DC: Well, investing is best defined as allocating capital in a way that it reliably produces more capital. The government is going to make that quite hard in the years to come with much higher taxes, much higher inflation and draconian regulations. You will actually be forced to speculate. That’s a pity, from the point of view of the economy as a whole. But I kind of like it, in a way. Few people know how to be speculators, so I should be able to make a huge amount of money in the next few years. Unfortunately, it’ll be at a time when most people are losing their shirts. But I don’t make the rules. I just play the game.

TGR: As you look over the next year or two with your speculator hat on, what sectors do you expect to experience the most distortion and, therefore, offer the most opportunity for the speculator?

DC: One sure bet is the collapse of the U.S. dollar. Always bet against the USD and you’ll be on the winning side of the trade. A very direct way to make that bet is by shorting long-term U.S. government bonds because, eventually, interest rates will go to the moon, which means bond prices will collapse.

You can also look at the precious metals because, at some point, when people panic into them, their price curves will go parabolic. Mining stocks are likely to draw a lot of money, so they could go wild as they have many times over the last 40 years.

TGR: Your summit has presentations scheduled on silver, gold, currencies, Asia, real estate, agriculture and even more. What do you expect to be the major takeaway this time?

DC: What we’re facing now is something of absolutely historic importance—the biggest thing that’s gone on in the world since the industrial revolution. Many things will be completely overturned in the years to come. What’s happening now in the Arab world, with all of these corrupt kleptocracies being challenged and overthrown, is just the beginning. We haven’t seen the end of this in any of these countries—Tunisia, Egypt, Syria, Algeria. Of course, Saudi Arabia will be the big one. Everything’s going to be overturned. And all these stooges that the U.S. government has been supporting for years could very well lose their heads. It’s going to be the most tumultuous decade for hundreds of years, bigger than what happened in the 1930s and 1940s.

TGR: Any last things you’d like to tell our readers?

DC: Yeah. Hold on to your hats. You’re in for a wild ride.

Editor’s Note: For more of Doug’s views—from his take on nuclear power in the wake of the tragedy in Japan to niche investing in upscale agricultural enterprises—check out his 4/28/11 interview with The Energy Report.

For the complete audio collection of the Casey Research Summit, click here.

Doug Casey, chairman of Casey Research, LLC, is the international investor personified. He’s spent substantial time in over 175 different countries so far in his lifetime, residing in 12 of them. And Doug’s the one who literally wrote the book on crisis investing. In fact, he’s done it twice. After The International Man: The Complete Guidebook to the World’s Last Frontiers in 1976, he came out with Crisis Investing: Opportunities and Profits in the Coming Great Depression in 1979. His sequel to this groundbreaking book, which anticipated the collapse of the savings-and-loan industry and rewarded readers who followed his recommendations with spectacular returns, came in 1993, with Crisis Investing for the Rest of the Nineties. In between, his Strategic Investing: How to Profit from the Coming Inflationary Depression broke records for the largest advance ever paid for a financial book. Doug has appeared on NBC News, CNN and National Public Radio. He’s been a guest of David Letterman, Larry King, Merv Griffin, Charlie Rose, Phil Donahue, Regis Philbin and Maury Povich. He’s been the topic of numerous features in periodicals such as Time, Forbes, People, US, Barron’s and the Washington Post—not to mention countless articles he’s written for his own various websites, publications and subscribers.