Roughly one decade ago, there was a strong debate in India about how we should tackle the problem of education. There were two
views:

Intensification

On one side were those who felt that nothing was fundamentally wrong; all that was needed was more money. So we should just continue building more government schools and hiring more civil servants to act as school teachers, and we’ll be fine.

Reform

On the other side were the reformers, who argued that the basic incentives in Indian education were wrong. Putting more money down a dysfunctional system was pointless.

The Intensifiers won this debate. An informal coalition of educationists (i.e. the incumbent education system) and leftists came
together, supported by the World Bank, which pushed for mere enlargement of Indian education, without questioning the foundations.

All of us are involved in this story at many levels. At the simplest, we are the customers of the education establishment. We pay income tax and VAT and a few other taxes. On top of this, we pay the 2% education cess. In return for this, we get certain educational
services. These influence our kids, and they influence all the young people that we encounter in this young country. Trillions of rupees have been spent, and more than a decade has gone by. It is time to assess the performance of this strategy.

Three blocks of evidence are now visible, which tell us that the Intensifiers were wrong. The old strategy, which was invigorated by a
vast rise in spending, was the wrong one.

Evidence #1: OECD PISA results for India

This story is well told in a recent blog post by Lant Pritchett. Bottom line: The first internationally comparable measurement of what children learn has been done. The sample correctly includes urban and rural children; it correctly includes children going to private or public schools; there are no first order mistakes in what was done. It tells us that Indian education policy has failed miserably: the results have come out at the bottom of the world.

Evidence #2: ASER 2011 results

Pratham has been running surveys which measure characteristics of children and schools in rural India (only). Their latest survey results, for 2011 show the following facts.First, rural kids learn less at public school. Here’s a simple example of what the evidence shows. Surveyors ask kids in class III to recognise numbers upto 100. Here are the numbers, for the proportion of kids in class III who cannot recognise numbers upto 100:

In 2008, the failure rate with private schools was roughly 17 per cent. Government schools were much worse at over 30 per cent. A short three years later, conditions had deteriorated sharply in government schools. The failure rate had gone up to 40 per cent. Private schools had also worsened slightly, to a failure rate of 20 per cent. By 2011, a big gap had opened up between the two: private schools are failing to teach 20 per cent of the kids while government schools are failing with a full 40 per cent of their kids.

Parents in India face the choice between sending their children to a government school, which is free and serves a mid-day meal, versus sending them to a private school where they pay fees. Yet, an increasing fraction of parents choose to send their children to a private school, paying tuition fees from their own pockets, while government schools are free. The relationship between a parent and a private school is a transaction between consenting adults. The relationship between a parent and a government school involves all of us, because we are paying for it.

Given the low income of parents in India, their use of private schools is a striking indictment of what the Intensifiers have wrought:

At class II, the fraction of rural children in private school went up from 19 per cent (2007) to 23 per cent (2011). At class VII, this
rose more slowly to levels slightly above 20 per cent.

Evidence #3: CMIE household survey

CMIE has data for the year ended March 2011 about the behaviour of 169,492 households, about their expenditure on school/college fees and tuition fees. Here’s the picture for the quarter ended September 2011; all values as percent of overall expenditure:

If parents chose to stay within public sector schools, their expenditure on fees would have been zero. The table shows that across
all income groups of India, there is movement towards private provision of education, both by paying fees at schools and by paying
for private tuition classes. These two elements add up to 2.67 per cent of overall expenses of households. (The CMIE household survey separately measures expenses on books, journals, stationary, additional professional education, education overseas, hobby classes and other education expenses. This helps us gain confidence in the extent to which the two fields in the table above narrowly pin down the feature of interest).

These decisions of well intentioned parents are the strongest indictment of education policy in India. The product being given out
by the Intensifiers is such a terrible one, the parents of India are walking away from it even though it is free and the alternative is
not and the parents are poor.

Implications

For more than a decade, the Intensifiers have controlled Indian education policy. They have said: Leave education to the education
establishment, do nothing radical, just give us more money, we will deliver results. Now we know that they were wrong. They took the money, but failed to deliver the results.

Kapil Sibal has said that his ministry should not be held responsible for the stream of bad news that is coming out. This seems to me to be dodging accountability. His ministry is responsible for Sarva Shiksha Abhiyaan, for the Right To Education Act, for blocking OECD PISA from being done in India, etc. The bureaucratic consensus of his ministry represents the education establishment.

This brings us to accountability. If a contractor took money from you, and failed to deliver on building your house, you would sack
him. (You would also take him to court, to recover the money that was paid to him, for services not delivered). In similar fashion,
education is too important to be left to the educationists. We need to start over.

What is to be done

• We need to start over in the field of education, with a fresh management team, one that is not a part of the status quo, one that is rooted in the worlds of incentives, public policy and public administration.
• The flow of public money into the status quo needs to go down sharply. There is no reason to put money into something that fails to deliver the goods. First we must prove that a mechanism delivers results, and only after that should we put money into
  it. This is the common sense that a housewife would apply. She would not spent gigabucks on promises from people who have failed to deliver.
• OECD PISA measurement needs to take place every year at every district.
• The education cess was always a mistake and needs to go. Public expenditures on education should always have come out of general tax revenues; there is no need to have a cess.
• Civil servant teachers, who have tenured (permanent) have no incentive to teach well, regardless of their qualifications or high income. We can’t sack them, but what we need to do on a massive scale is to stop recruiting them. The existing stock can be reallocated to other civil servant functions where staff is in short supply. Through this, it would become possible to whittle away at the accumulated stock over the coming 20 years.

John Mauldin: Instead of doing an annual forecast, I’m going to look out about five years, which may be five times more foolish. What I want to do rather than try and figure out where the stock market is going to be at the end of 2012 or what gold is going to do, is look at the choices we have around the world.

In most cases, political events don’t change the economic world all that much. It’ll probably annoy partisans on both sides, but if Clinton had lost to George Bush senior the first time, we would have still had a bull market. We were already in recovery. Yes, we would have had different Supreme Court Justices, but that’s not the economic world. We were set on a path. If Gore had beaten Bush 2, economically I don’t think much would have changed. We still would have had the end of a bull market and a recession in 2001. We would have had a housing bubble. Greenspan would have probably been reappointed either way. We would have had a credit crisis because we were in the process of building up debt that started in the ’50s. Europe was building its debt up. Japan was building its debt up. That is the reality.

Now the private sector is deleveraging, but sovereign debt is in a bubble. The air is coming out. My view is that the wheels are going to fall off Europe this year. I have been researching the Mayan codes and I have determined that the ancient Mayans were not astrologers; they were economists. They weren’t predicting the end of the world; they were simply predicting the end of Europe. That is a humorous way of saying this is the year Europe is going to have to make some very difficult choices. Greece gets to choose what kind of depression it wants, hard and fast or slow and long. It can’t avoid depression completely. It has borrowed too much money. The government is too big. It has come to the end of the ability to raise money at low rates. Italy and Spain are well on that path along with the rest of Europe. So, they have to make a decision, a political decision that is going to have major economic consequences.

Does Europe want to be a political union that looks more like the United States, where the individual entities have to run balanced budgets and can’t print their own money and have some kind of fiscal controls or they go back to a two-tiered Europe with multiple currencies. One way or another, this is the year that Europe is running out of road to kick the can.

Fortunately, in the U.S. we are not there yet. We have some room to make a decision. That decision is going to be made in 2012 because by 2013 we are going to have to decide how we deal with the deficits and debt. After 2014, the bond markets will start to raise rates. Total U.S. debt is continuing to grow because governments are growing debt faster than private citizens are decreasing debt. The bond markets are starting to rebel long before you would think they would for a country that’s the world reserve currency. The key is whether debt is excessive relative to income. If you can make your debt service, people will still lend you money. When they don’t think you can, they will stop. That’s when you have a crisis. It’s a debt super cycle. And, when you reach the end, you have to deal with the debt. You can pay it down. You can default on it. You can print the money, extend it out with lower rates or financial repression, which are all other ways to look at default. But, nonetheless, that debt is there.

The problem we are facing in the U.S. is that gross domestic product (GDP) is consumption plus investment plus government spending plus net exports. If we decrease government spending over time, we decrease GDP. That’s the problem that Greece is going through right now. It has to decrease government spending by 4.5%, thus shrinking the economy. But it can’t increase government spending without increasing debt or taking taxes away, which decreases consumption. Nothing the government does will make things better. The U.S. is on the same path. We can become Greece by continuing to borrow or be proactive and say we are going to get our deficits under control over a period of five or six years. The economy is still going to be slower than we would like and unemployment higher than we would like. That’s just the rules. We’re at the end game. We are at the end of the debt super cycle and that’s what happens.

Printing money doesn’t increase the GDP in actual real terms, but it makes everyone holding gold happy because the value of natural resources goes up. That is why I buy gold every month. I take those coins, I put them in a vault and I hope I never need them. I quite frankly hope gold goes back to $300/ounce (oz) because that means the economy is in wonderful shape. I’m actually afraid that gold is going to go up in value, which means we are not getting our act together.

That leads to questions about fault. Did the banks do things they shouldn’t have? Yes. Were they the cause of it? No. Was Greenspan the cause of the bubble? No. He was part of the cause. I mean, we did a lot of things as a country that weren’t good choices. Should we have allowed our banks to go to 30 and 40 to 1 leverage? No. Should we have repealed Glass-Steagall? No. The problem is that real median household income hasn’t moved for 15 years because real private GDP hasn’t changed. The only thing that has grown is government spending.

John Derrick: In 2011, the European financial crisis moved from the periphery to the core. Central bank policies were big drivers of the decline. The European Central Bank and China raised rates early in the year and again in July as fears of a China slowdown grew. That early tightening to fend off inflation had a big impact on the course of events throughout the year. The other big events were the U.S. credit downgrade in August and currency intervention, particularly in the Japanese yen.

Frank Holmes: There is a huge amount of borrowing around the world in Japanese yen because it is so inexpensive. That includes investing in commodities, resources and emerging markets. And, every time we see this huge signal move by the yen, you get this rippling effect that takes about six weeks to resolve itself with commodities being sold down. Therefore, a lot of fund managers borrowing in Japanese yen are long energy stocks, resource stocks and emerging markets, which leads to a lot of selling.

JD: The second half of last year was very volatile, but the market ended essentially flat. In fact, much of the volatility was concentrated in the last month, which made for a very difficult psychological environment, as the market has been somewhat schizophrenic with weekly rallies and selloffs.

Spikes in the yen caused market selloffs. This hit commodities especially hard. So the secret for 2012 is to use the volatility. Buy on the volatility spikes. Unfortunately, what most people do is just the opposite. Another thing to look for in 2012 is a positive fourth year of the presidential election cycle as the government tries to implement policies that will get them reelected.

Brian Hicks: There has been a lot of concern about money supply growth in the emerging markets, particularly in China, which reduced bank reserve requirements last year. A reacceleration of global money supply can be particularly constructive for commodities going forward as there has been a high correlation between money supply growth and commodities.

If you were to take all the global money and back that by gold, the price of gold could go to $10,000/oz. If you just use half of the global money supply, gold would trade at about $5,000/oz, up from approximately $1,600/oz right now. The more U.S. dollars in circulation, the higher the price of gold. This has been the main factor increasing the price of gold since 1998 and will continue to be the case in the years to come. Gold has a lot of running room to go.

Another driver for the price of gold has been federal deficits. Government spending is way above revenues. We hit a point in 2000 where spending as a percentage of GDP greatly exceeded taxes as a percentage of GDP. This could be a point of no return and could potentially drive the price of gold even higher. There has been a large bifurcation between the price of gold and gold equities, particularly in the last couple of years as risk aversion has prompted many investors to buy the bullion as opposed to gold equities. This is creating opportunity. We feel like there’s going to be a catch up in gold equities, many of which are trading at very low multiples to cash flows and earnings. Stocks such as Newmont Mining Corp. (NEM:NYSE) look like value stocks now paying high dividend yields and trading at sub 10-times price to earnings ratios. This could really present an attractive opportunity in 2012.

JD: Just a comment on all the takeovers. We were seeing 6% premiums on takeovers in ‘06. Now we are talking 60+ premiums. That’s another reflection of how undervalued the stocks are relative to commodities.

BH: That’s a great point. We have seen tremendous value creation based on mergers and acquisitions.

Shifting gears a little bit, crude oil and refined product inventories ended the year at the lowest level on record (about 685 million barrels). That’s 6% below the prior year. It’s particularly interesting when you consider some of the geopolitical factors that have arisen with Iran talking about blocking off the Strait of Hormuz. This is a primary factor behind oil price supports despite the tenuous economic environment. Many investors don’t realize that Russia is very important for non-OPEC (Organization of Petroleum Exporting Countries) supply, a key factor in containing oil price spikes. Russia is increasing production while other non-OPEC production in Mexico or in the North Sea have been declining significantly, which has helped to bolster OPEC’s market share. It has also limited the ability of oil markets to increase production out of the Middle East due to the inability to invest in those troubled areas. In fact, Russian production has been quite steady since 2006, increasing anywhere from 100 to 400,000 barrels per day (bpd), mid-single digit growth. But, forecasters predict in 2012 we will see flat production growth, which is troubling given the fact that we continue to see demand increase in other areas of the world, mainly out of China. This will be a driving factor going forward for crude oil prices.

Evan Smith: Oil supply threats include geopolitical problems at a time when oil supply and spare capacity at OPEC is rather low—a little over 2 million bpd. Nearly 40% of global supply is under autocratic rule. Iran has threatened to disrupt the supply of crude oil and products through the Strait of Hormuz where about a third of global oil supply passes. So, any disruption, even temporarily, would cause a severe spike in oil prices. We think oil prices could support $100/barrel. One of the things we like in 2012 is higher exposure to master limited partnerships partly because of their steady cash flows. They are becoming a growth business now. The capital expenditures here in the United States have grown from $3.5 billion (B) in 2005 to nearly $16B this year. This is partly because of the growth in many of the shale plays, which require increased infrastructure. We think this is an excellent investment opportunity. We also see a big opportunity for the global oil services. We can see that capital expenditures have been rising. We expect them to rise from about $500B to nearly $.5 trillion this year, an increase of 15%. So, we see tremendous opportunity for some of the oil services contractors and equipment providers. Another key driver is the impressive amount of money that has been invested in North America. Just over the last three years nearly $129B in mergers, acquisitions and joint ventures has occurred. Global companies are coming to North America to invest in these shale plays because the economics are so attractive due to improved technology. They want to learn that technology and take it home. So, we think there is continued opportunity for investors in the resource play here in North America.

Shifting gears, one of the base metals we will target is copper. It is our favorite base metal. The demand side is holding up relatively well compared to some of the other base metals. Even in China, which is the largest market for copper growth, the build out of the grid is really a key driver. That is holding up quite well. On the other side of the supply/demand equation, supply has been a problem. Through most of the boom in copper prices, mine output has lagged forecasts. Causes included weather, labor strikes and just poor grade. The bottom line is that supply has not kept up with demand. We have not solved that problem so we think 2012 should be a relatively good year for copper prices.

Another theme we like is the agricultural space. Global population continues to grow. The emerging middle class continues to consume more grains, principally through the production of more meat as people consume more protein in their diets. There has been a huge surge in the need for the production of grains, yet no more land is being created. One of the key ways we’re seeing increased yields out of croplands is through higher applications of fertilizers. That has created a fairly tight situation for potash, specifically. But, other fertilizers such as nitrogen and phosphate are also benefiting from this trend.

FH: I would just add that the world’s population has doubled from the ’70s when we had rising commodities. There’s a very different factor and China and India have a global footprint that they didn’t have.

Xian Liang: China remains the biggest driver of world demand for energy due to a rising middle class, but it is in a very early stage when it comes to discretionary spending. Take for example passenger cars. Despite a tremendous growth in auto consumption in the last decade, only 18% of Chinese households own a car. Car ownership in China is just one-tenth of U.S. levels or the same level it was in the U.S. in 1914. Air travel remains at the U.S. equivalent of the 1950s. This illustrates a great growth potential going forward. Urbanization is one of the most significant trends driving consumption. In 2011, the number of urban residents in China exceeded rural residents for the first time in Chinese history. But, China won’t stop at this 50% urbanization rate if the historical trajectory of its richer neighbor, South Korea, is any guide. We could have another 30% of growth by the year 2013. South Korea outgrew its urbanization rates in a 40-year time span. And, if China continues to urbanize, there will be about 200 million new urban households in China, which creates enormous demand for consumer staples, durable goods and housing.

China’s government policies signal the trend will continue. China raised reserve requirement ratios 12 times since January 2010. We view that as an early signal for the next easing cycle. The last time China eased reserve ratios in October 2008, that triggered a big market rally in Chinese stocks. This should bode well for stocks. We don’t think the Chinese auto boom is over. Actually, in the last couple of days, officials in China hinted that new measures may be introduced to support auto and home appliance sales.

Outside of China, we see government policies remaining very positive in southeast Asia, especially in Indonesia and Thailand. The money supply in the past two years has not deteriorated in these two countries, in fact, it is growing at a healthy 16% year over year. This is part of the reason why we remain positive on southeast Asia. Indonesia is rich in natural resources, but it doesn’t depend as much on exports. In fact two-thirds of its GDP is driven by domestic consumption, which is how it managed to escape a recession in 2008 and 2009. Favorable demographics is a factor. It is a very young country. More than 45% of the population is under 24 years old and 2 million people a year are joining the work force. Second, urbanization is creating new consumer demand. Just like China, Indonesia’s household debt is low. Total mortgage loans outstanding account for only 3% of GDP. Consumer credit is still at a very early state. I see tremendous growth potential going forward.

FH: The money supply is growing very rapidly in the entire region. I think it’s not just a China story. It’s a whole emerging market. And, I like to characterize it as the American dream trade as all these countries want the American dream. They all want a house. They want a car. They want all the lifestyle that we have.

John Derrick joined U.S. Global Investors Inc. in January 1999 as an investment analyst for the U.S. Global Investors money market and tax free funds. In March 2004, he was promoted from portfolio manager to director of research and now manages the day-to-day operations of the investment team. Prior to joining U.S. Global Investors, Derrick worked at Fidelity Investments. He has appeared on CNBC and Bloomberg TV and has also been a guest on Marketwatch Radio and NPR. Derrick has been featured in stories for BusinessWeek, The New York Times, the Associated Press and USA Today. A graduate of The University of Texas at Arlington, Derrick earned a Bachelor of Arts in finance. He sits on the board of directors for the CFA Society of San Antonio.

Frank Holmes is CEO and chief investment officer at U.S. Global Investors Inc., which manages a diversified family of mutual funds and hedge funds specializing in natural resources, emerging markets and infrastructure. In 2006 Mining Journal, a leading publication for the global resources industry, chose him as mining fund manager of the year. Holmes coauthored The Goldwatcher: Demystifying Gold Investing (2008). A regular contributor to investor-education websites and speaker at investment conferences, he writes articles for investment-focused publications and appears on television as a business commentator.

John Mauldin is the author of New York Times Best Sellers list four times. They include Bull’s Eye Investing: Targeting Real Returns in a Smoke and Mirrors Market, Just One Thing: Twelve of the World’s Best Investors Reveal the One Strategy You Can’t Overlook and Endgame: The End of the Debt Supercycle and How it Changes Everything. He also edits the free weekly e-letter Outside the Box. Mauldin also offers The Mauldin Circle, a free service that connects accredited investors to an exclusive network of money managers and alternative investment opportunities. He is a frequent contributor to publications including The Financial Times and The Daily Reckoning, as well as a regular guest on CNBC, Yahoo Tech Ticker and Bloomberg TV. Mauldin is the President of Millennium Wave Advisors, an investment advisory firm registered with multiple states. He is also a registered representative of Millennium Wave Securities, a FINRA-registered broker-dealer.

Evan Smith joined U.S. Global Investors Inc. in 2004 as co-portfolio manager of the Global Resources Fund (PSPFX). Previously, he was a trader with Koch Capital Markets in Houston where he executed quantitative long-short equities strategies. He was also an equities research analyst with Sanders Morris Harris in Houston where he followed energy companies in the oil and gas, coal mining and pipeline sectors. In addition, he was with the Valuation Services Group of Arthur Andersen LLP. Smith holds a Bachelor of Science degree in mechanical engineering from the University of Texas in Austin.

Frank Holmes, chief executive and chief investment officer at U.S. Global Investors, will focus on the upside of massive Chinese modernization and growth. He is the recipient of both Mining Fund Manager of the Year Award from Mining Journal and International Citizen of the Year Award from the World Affairs Council of America and has a long-term investor’s view of international geopolitics.

Author and Commentator Gordon Chang literally wrote the book on why investors should be wary of China’s growth. His book The Coming Collapse of China has attracted attention from the likes of the LA Times and Asia Times and many other publications in between. He has made appearances on Fox News and regularly contributes to Business Insider, Barron’s, National Review and Forbes magazines. When he lived and worked in China and Hong Kong for almost two decades, most recently in Shanghai as counsel to the American law firm Paul Weiss, he saw the ghost cities and environmental challenges up close.

“The debate is a direct response to attendees who need to know if China is on a course to grow, slow or blow,” said Nicole Evans, president of the Cambridge House International Conference Division. The Gold Report called these two experts to find out the numbers behind why they have such different predictions about how this enigmatic country will fare in the coming years.

Frank Holmes: This veteran investment advisor based his positive prognosis for China and its Eastern neighbors on a combination of tacit knowledge learned firsthand through travel and observation of geopolitical conditions along with explicit knowledge of history and the markets.

He studies S-curve patterns, modeled on economist Simon Kuznets’ 20-year long cycles. For example, the world’s population has grown from 1 billion in the 1800s to 7 billion today, which has drastically affected commodity consumption and infrastructure buildout. “Nowhere is this more evident than in the emerging markets, such as China,” Holmes said.

“When governments have invested in infrastructure, there has been a powerful impact on gross domestic product (GDP) numbers.” For example, he pointed to the 1950s, when Eisenhower signed the Federal Aid Highway Act, allowing commerce to expand across the nation, with restaurants including Dairy Queen and McDonald’s experiencing tremendous growth over the next several decades. “Paved roads from coast to coast helped sustain a more than tenfold increase in U.S. GDP,” Holmes said.

“Whereas the U.S. connected 160 million people with nearly 47,000 miles of freeways, by 2020 China will connect 700 million people across 250 cities, spanning more than 47,000 miles of interstate and 18,000 miles of rail,” Holmes explained.

Holmes estimated that over the next 25 years, about $41 trillion will be spent on global infrastructure—$6 trillion has been approved for the 2011 through 2013 timeframe with China projected to spend half of that $6 trillion. He believes these investments will result in rising GDP per capita and trigger a consumption economy.

“Once China connects its super cities, it will enable more Chinese to travel around the country, resulting in a completely different consumption pattern. You will see train stations with 50-story condominiums along with U.S. restaurants that have already been expanding in China, including McDonald’s, Dairy Queen and Starbucks. Major hotel chains, such as Wyndham, Starwood and Hilton, along with luxury goods businesses including Cartier, Hermes and Gucci will compete for market share. Infrastructure will change the face of the economy in China just the way it did in the U.S.,” said Holmes.

“We are big believers that government policies are precursors to change, so our investment team continuously tracks the fiscal and monetary policies of the world’s largest countries in terms of economic stature and population. The G-7 (industrialized) countries are 15% of the world’s population but 50% of the world’s GDP and growing only about 1%. Western countries seem to be focused on cutting back infrastructure spending and raising taxes to pay for entitlements. At the same time, E-7 (emerging) countries comprise 50% of the world’s population with 20% of the world’s GDP. However, these countries are growing at 7% to 8% and include a rising middle class of some 60 million people out of a total 2.2 billion people. But, 60 million people making $30,000 a year is very significant. Think about the movie “Slumdog Millionaire”—this is what is happening throughout Asia. That is why companies such as Gap and GM and KFC are focusing on expanding in China where its residents love American products and pack the stores in Beijing.”

Holmes also saw important policy changes in the works that could improve China’s economic outlook. “Over the past 10 years, we have seen a slow migration of more property rights being given to people in China. The largest transfer of real estate in the history of mankind took place in China seven years ago when more than $500 billion of real estate value was basically transferred to farmers. That was followed by condo building. Additionally, to attract public companies, Shanghai adopted the Hong Kong Stock Exchange listing and bankruptcy systems, which are based on common law. This is significant because if you look at all the countries that have had financial problems over time, no common law system has ever gone bankrupt. Civil law has. China is slowly adopting a rule of law system.”

Not all of the changes have been smooth. “One of the biggest things that China has been wrestling with is the fear of inflation,” Holmes said. “The government raised the minimum wage and that resulted in a big spike in food inflation. Then it had to deal with real estate inflation in Shanghai and the cities along the ocean. It required banks to keep more reserves, up to 20% in some cases, to avoid the problems now occurring in European banks. A tax on speculative real estate slowed the economy and it showed up in the psychology of the stock market.

“The spike is slowly reversing and rates are falling. Because there is so much less borrowing generally in China than in the rest of the world, prices rebound much faster,” Holmes said. “Only 25% of homes have mortgages so the impact of bankruptcies is much smaller. Also, I don’t think they’re going to print money the way they did in 2008. The Chinese government will move slowly to make sure the country doesn’t get hurt by Europe’s slowdown.”

Based on money supply, debt levels and the weakness of the dollar, Holmes predicted economic activity in the emerging countries should double over the next five years. “It is going to be between 8% and 9% this year and it has another 10 years of growth ahead of it,” Holmes said. “Investors need to understand volatility and not be fearful of it. If you are trading futures where your leverage is 10 to 1 and you have a big correction, you can get wiped out. But, if you are a cash business, you understand when these markets go through these corrections. Solid companies paying dividends can be an attractive investment over the long term.”

Gordon Chang: This China-watcher recently wrote an article for Forbes that said what others considered positive November trade numbers—exports up 13.8%, imports up 22.1% year-over-year—was actually an indication of flat consumer demand once the commodities were factored out. His conclusion was that the government was taking advantage of low prices to stockpile things like soybeans, copper and iron ore while domestic demand remained stagnant. “Since September, we have seen essentially flatlining growth,” he said.

“The growth over the last three decades has been absolutely stunning, but that was then, and this is now,” Chang cautioned. “After 35 years of virtually uninterrupted growth, the Chinese economy hit an inflection point, probably in September of this year. I think we are going to see a long-term cycle down. There are a number of reasons for it, some of them short term, some of them long term. The reasons that created this growth either no longer exist or are disappearing fast. Deng Xiaoping’s policy of reform paired with the end of the Cold War and expansion of globalization triggered growth in the 1980s. However, under current leader Hu Jintao, China has seen the reversal of reform, with the government partially renationalizing the economy. Today, we are in the second part of a global downturn, which will be much worse than what started in 2008. A trade-dependent economy like China’s is going to have real problems. Additionally, China was aided by the demographic dividend, an extraordinary bulge in the Chinese workforce, which by most estimates will level off between 2013 and 2016, leaving a demographic tax where one worker supports two parents and four grandparents.”

Chang pointed to stagnant electricity consumption, flat car sales, plunging industrial orders and collapsing property prices. “For example, in October, we saw property prices collapse 30% in places like Shanghai and Beijing, and actually across the country. That has to eventually trigger a negative wealth effect.

“Domestic growth is vital for a sustainable economy,” Chang said. “Last year, domestic consumption comprised less than 34% of Chinese GDP and it has been dropping in recent years. That means China is not restructuring its economy because the problems go to the core of the political model. The government would have to let the Renminbi float, allow banks to offer market rates of interest to depositors and state enterprises, allow workers to bargain collectively to get higher wages and provide a better social safety net, especially in the health care area. These are things that Beijing didn’t do a half-decade ago when it was growing at 9.9% and they’re certainly not going to do so now in a very difficult environment.”

On the manufacturing side, Chang referred to the December HSBC/Purchasing Managers’ Index (PMI). “It showed an absolute, outright falloff in industrial orders domestically. I think that is a really important indication of the problems,” Chang explained. Technically, the Chinese economy went from expansion in October to contraction in November when it crossed the critical 50 line. Any number above 50 shows expansion; any number below 50 shows contraction.

The fact that China is reporting negative numbers is telling in itself, according to Chang, who said often government-issued statistics conflict with reports from other sources. Beijing reported 13.8% export growth in November. However, during that same period factories went bankrupt, factory owners fled because they couldn’t pay their debts and some of them took their own lives. Even more damning are container and freight statistics, including reports from mega-container shipper Cathay Pacific that showed November cargo shipments down 13.8%. “Exports to Europe have fallen off the cliff and the EU was China’s largest trading partner so something doesn’t add up,” he said.

For the final blow, Chang pointed to the actions of the Chinese government. “If China really does have robust, 8–9% growth as everybody says, why is the central government starting to stimulate the economy again? That just doesn’t make any sense. If we look at things like imports and exports, I think the economy is really in trouble.”

Chang warned of political consequences if the country is not growing at least close to a double-digit rate. “I don’t know if China can stand 3% growth—or the other very real possibility, contraction. The American government bases its legitimacy on the nature of its political system. The legitimacy of the Communist Party is primarily based on the continual delivery of prosperity. Already, the number of protests in China has increased dramatically from maybe 70,000 mass incidents a year in 2005, to as many as 280,000 last year. In addition to strikes, riots, insurrections and bombings, the standoff between villagers and the authorities in Guangdong province are threatening the future of the Communist Party.”

One solution is for the Chinese government to continue to spend millions on infrastructure to create growth as it did when it spent $1.1 trillion after the 2008 downturn. “This tactic is of limited usefulness the second time around,” Chang warned. “It may be able to play out the game for 18 months, maybe two years at the outside, but it’s pretty much done. Plus, the artificial stimulus also created a stock market bubble, inflation, ghost cities, banking weakness and property bubbles. Massive spending didn’t avoid problems, it just postponed them and made them bigger and more difficult to solve.”

Chang said that people in China are starting to see the reality of the problem. “There is a sense of pessimism. Starting in October, we saw large, unexplained transfers of money out of the country.”

The bright spot, according to Chang, is that while China will not be able to fuel a global recovery with a consumer-driven middle class, a Chinese meltdown won’t be a major blow to the U.S. either. “We have the world’s largest internal market; 70% of our GDP relates to consumption. Exports don’t really play that much of a role in the U.S. as it does in other major economies. So China can fall off the cliff in a sense, and it would have some negative effect but not very much. In fact, we might benefit from it.”

Chang’s conclusion? “People say the Chinese economy is the global engine of growth, but that’s not true. The engine has been the American consumer because we are taking every other country’s exports, and the Chinese, through predatory and mercantilist policies, have been grabbing growth from other countries. For the last 200 years, China has been a potential source of customers for other countries. Still, domestic demand isn’t that significant. China’s imports lately have been commodities and that is going to fall off because China’s exports of manufactured goods, to Europe and the U.S., are going to be stagnant or lower than they have been in the past. So China really reacts to the rest of the world. If the changes over the next couple of months are as dramatic as they’ve been for the past two, then we’re going to be looking at a very different China. The Chinese economy could fall into a big black hole with 1–2% growth or even contraction. Can the government turn it around as it has in the past? That’s the money question.”

Frank Holmes is CEO and chief investment officer at U.S. Global Investors Inc., which manages a diversified family of mutual funds and hedge funds specializing in natural resources, emerging markets and infrastructure. In 2006 Mining Journal, a leading publication for the global resources industry, chose Holmes as mining fund manager of the year. Holmes co-authored The Goldwatcher: Demystifying Gold Investing (2008). A regular contributor to investor-education websites and speaker at investment conferences, he writes articles for investment-focused publications and appears on television as a business commentator.

Gordon G. Chang is the author of Nuclear Showdown: North Korea Takes On the World. His first book is The Coming Collapse of China. He is a columnist at Forbes.com and The Daily and blogs at World Affairs Journal. He lived and worked in China and Hong Kong for almost two decades, most recently in Shanghai, as counsel to the American law firm Paul Weiss and earlier in Hong Kong as partner in the international law firm Baker & McKenzie. His writings on China and North Korea have appeared in The New York Times, The Wall Street Journal, the Far Eastern Economic Review, the International Herald Tribune, Commentary, The Weekly Standard, National Review, and Barron’s. He has given briefings at the National Intelligence Council, the Central Intelligence Agency, the State Department and the Pentagon. Chang has appeared before the House Committee on Foreign Affairs and the U.S.-China Economic and Security Review Commission. He has appeared on CNN, Fox News Channel, Fox Business Network, CNBC, MSNBC, PBS, the BBC, and Bloomberg Television. He has appeared on The Daily Show with Jon Stewart.

Join the forum discussion on this post - (1) Posts

The Gold Report: Richard, last month, you made a presentation at the Casey Research/Sprott Inc. “When Money Dies” Summit entitled “The War that Will Kill the Dollar.” You explained that the corrupting influence of power had sent our country’s leaders shopping for war, disregarding Westphalian respect for sovereignty and hastening the collapse of society. What are the signs that we are reaching a critical point? And, is there any way we can change course?

Richard Maybury: You can see the signs very clearly in the Middle East and North Africa. The Federal government is involved in several wars there that have nothing to do with America. One of the best examples is Libya. U.S. officials are taking credit for Moammar Gadhafi’s death just a year after they were bragging about having tamed the threat. Now Libya is a mess. It will very likely be taken over by some sort of Islamic government that isn’t going to be very friendly to America.

TGR: Why do we, as a country, do this? If it’s not going to end well for us, what’s the economic or political reason to get involved?

RM: The U.S. government gets into wars in far corners of the world that have nothing to do with America because the leaders like getting into wars. That is how presidents achieve greatness in the history books. A president has no prayer of going down in history as great unless he has won a war. Look at Mount Rushmore. All four presidents featured there won wars. That seems to be the number one criteria historians use for deciding whether someone is a great president. It constitutes an automatic incentive to go out looking for wars.

TGR: What is the incentive for the American people to go war shopping?

RM: Nothing. It’s absurd. During the First Gulf War, people had a tremendous good feeling about going to war with Iraq. They would come home from work, order a pizza, sit in front of their TV sets and watch the war like it was a football game. War became a form of entertainment.

TGR: Is there anything we could do to incentivize our presidents to act peacefully?

RM: I doubt it very much. People go into politics because they seek political power. Once they get the power, they naturally want to use it on somebody. What is the point of having power if you can’t use it? So, no matter what kinds of controls you put on, future presidents will find a way around it.

The ideal situation would be one where war is used as a last resort. Westphalian sovereignty, a set of agreements dating back in the 1600s, established the precedent that the European powers would only go to war in self-defense. You had to have a clear and present danger before you could go to war. And, even then, it was supposed to be the last resort. That was the basis of international law up until this year. That isn’t to say that the Westphalia treaties weren’t violated a lot of times, but they helped. After Iraq, Serbia and now Libya, it is pretty clear that the policy is we can just go out and hit anybody we want for any reason we want as long as we believe the other guy is up to no good.

TGR: If this is the new reality, then let’s talk about some of the economics around it. War is expensive. You have pointed out that since the Federal Reserve was created in 1913, the dollar has lost 95% of its buying power. You said, “War destroys currencies.” It usually leads to governments printing more dollars to pay for guns and tanks. How much debt and overprinting can the country take before the velocity of economics, which is something that you also talked about in association with how quickly dollars are exchanged, catches up with reality and the dollar loses that last 5% of its value?

RM: Velocity refers to the speed at which money changes hands, and it is a measure of money demand. When people don’t really want the money, they start trading it away faster, trying to get their hands on things they do want, things that have value that they trust. The cost of this war in the Islamic world will continue going up. At some point, it’s going to be a major contributor to people losing what confidence is left in the dollar and people all over the world will start dumping it. This is a psychological thing. It’s about emotions, so it is hard to pinpoint when they will lose all confidence in the dollar.

TGR: What would it look like if that last 5% were gone? Are we talking about hyperinflation? Are we talking about banks collapsing? Are we talking about bartering? What would it look like?

RM: We are talking about all of that. It would be chaos. We saw it in Zimbabwe when the Zimbabwean dollar became worthless because the government printed so many that people wouldn’t accept them anymore. The country experienced enormous runaway inflation where prices were rising 50% a day before the Zimbabwe dollar collapsed.

It would probably start with someone somewhere in the world selling off his dollars and begin trading them for whatever it was he had confidence in. The foreign exchange value of the dollar would fall. Other people would notice; they would get scared and start selling their dollars. The foreign exchange value of the dollar would drop more. This process would continue until you have panic around the world to get out of dollars. Americans would be the last ones to get involved. We are always the last to know what is happening to America. Suddenly Americans would wake up one morning and find that a gallon of milk that cost $4 the day before costs $6 today. The next day they would find that it costs $12. And the next day they would find that it costs $36. That is when Americans would realize that they are in deep trouble; their dollars are about to become worthless.

TGR: Of course the Fed wants to avoid that scenario. You describe yourself as a follower of Austrian economics made famous by the Nobel laureates Friedrich Hayek and Ludwig von Mises. They describe financial systems as complex processes run by billions of constantly changing individuals rather than something that can be manipulated from a central point, which seems to be what is being attempted right now. If that is the case, what will be the outcome if the central government tries to force a more Keynesian control of the flow of money?

RM: They will mess it up even worse than they already have. The world has been living under Keynesian economics since 1971 when Nixon took the dollar off the gold standard. John Maynard Keynes was a semi-socialist. He believed that the way to fix the economy was to print a whole bunch of dollars and dump them out there. This has been standard procedure for the past 40 years. All currencies have been dropping in value during that time. Another round of quantitative easing (QE) could further speed the rate at which the money circulates, something that has the same effect as increasing the supply of dollars, creating a larger demand for goods and services and having an inflationary effect. I think Fed officials are dropping hints about the next QE because they are trying to cause velocity to rise, a secret QE if you will.

TGR: What if the stealth QE campaign doesn’t work? What form might a real QE3 take?

RM: It is hard to tell what they will do. One of the myths that everyone is taught is that the government has some sort of tremendous understanding of economics and the ability to make adjustments to economic activity. The term fine-tuning is used sometimes. Actually, we are talking about a group of human beings who don’t know much more about real economics than anybody else. They think they do, but they don’t. They just bounce around from one attempt to control things to the next, making a mess of the country. The economy is not a machine. It is people, human beings. It is a biological system, not a mechanical system. But, the government treats it like a mechanical system, so they are always making mistakes.

TGR: If war and hyperinflation are the inevitable future, how can investors survive or maybe even thrive during a time like this? What are the opportunities? Natural resources? Commodity equities? Where can we be safe other than putting that $100 bill under the bed?

RM: Well, I wouldn’t put $100 under the mattress, at least not for very long, because it will soon become worthless. But commodities, stocks of raw materials firms, gold and silver and platinum coins have value. Generally, I try to see the world in terms of two kinds of investments: dollars and non-dollars. You definitely want non-dollars, things that do not have their value tied to the value of the dollar. An example of a dollar asset is something like a bond or bank CD. Their values are tied directly to the value of the dollar. If the dollar falls, then their values fall.

Gold is a non-dollar asset. When the dollar falls, usually gold rises. The same is true with silver and oil. All of these things have values that are not tied to the dollar. My advice is to invest in non-dollar assets. Gold would be at the top of the list, silver and platinum and then oil.

TGR: In your Early Warning Report Newsletter, you predicted that gold will top $3,000/ounce (oz), silver will hit $50/oz and oil will exceed $300/barrel. Gasoline will go to $9/gallon. When will we see these rises? And what will be the catalysts that take them there?

RM: The next QE, which I expect to come along no later than March, could set off a flight from dollars. Then we could see those predictions realized within 18 months.

TGR: You said that once we have had this loss of the entire value of the dollar and people are looking for another way to trade, money could be based on some collection of metals with currency acting as a receipt for the tangible gold, silver, platinum and whatever else happens to be in that basket. What would that transition look like? How painful would that be? How would it be orchestrated?

RM: It doesn’t have to be painful. The markets are moving in that direction. People trade exchange-traded funds (ETFs) for practically everything now. I can envision a mutual fund or an ETF that is a collection of various things. It could be gold, silver and platinum. It could have oil in there. It might include Swiss francs. It could even have various patches of real estate. The ETF itself would then become a currency, not because anybody has it planned that way, but because the markets will see that there will be a demand for something that is a non-dollar asset that is easily tradable and seen as a store of value. There would probably be hundreds of these baskets of assets at the start. Some would work better than others would; the less workable ones would shake out. You might wind up with maybe a half dozen ETFs or mutual funds that are baskets of various assets circulating in the world. They would essentially become the currencies.

TGR: Would investing in ETFs now be a good way to prepare?

RM: No. I don’t know of any that are arranged that way. It may be a while until somebody catches the idea and decides to give it a try.

TGR: What about the precious metal equities? Would that be a good way to prepare?

RM: Yes. There are lots of good precious metal stocks. I own quite a few. That is another way to protect yourself. However, be sure to deal with a broker who really knows natural resources. You have to have some skill in picking those stocks. It’s not like going down and buying a gold coin where you just walk into the coin dealer and tell him I want a handful of American Eagles or Canadian Maple Leaves. You really have to know what you are doing when you are buying gold stocks.

TGR: Any final thoughts you want to leave with The Gold Report readers?

RM: The world has changed. When you look at the news and you say to yourself, “My God, America isn’t what it was; the world isn’t what it was,” have the confidence to know you are right. We are probably not going back to what America or the world was anytime in my lifetime. Therefore, you want to start learning everything you possibly can about this new condition and adapt to it.

TGR: Thank you for sharing your thoughts.

RM: Thank you, JT. I appreciate being here.

Richard Maybury, the author of the U.S. & World Early Warning Report, has written 22 books, including the Uncle Eric series, which focuses on economics, law and history. He has been interviewed on more than 250 radio and television shows. He is a Vietnam War veteran who served in the Air Force’s 605th Air Commando Squadron, a special operations unit involved in covert warfare in Central and South America. He has since lived and traveled the world, visiting 47 states and 45 countries. He considers himself a “juris naturalist” who believes in a natural law higher than any government’s law. You can visit his website at or phone 1-800-509-5400.

Want to read more exclusive Gold Report interviews like this? Sign up for our free e-newsletter, and you’ll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Exclusive Interviews page.

Join the forum discussion on this post - (1) Posts