He next turns his sights on to a prize system for innovation. His proposed policies are well-intentioned but naïve. He proposes that the government fund sizeable prizes (to the tune of millions or billions of dollars per prize) with specific goals—not methods—in mind. This should work in theory, but the fundamental problem with this method is that it fails to discern how the government would go about setting the most economic goals and prizes. This process could become highly politicized, as anything involving billions of federal dollars tends to. However, venture capitalists and innovation firms should take note of this recommendation and implement it.

Tabarrok closes his short book by looking briefly at education—both public and post-secondary. Regarding the former, he recommends reform. Why this is preferable to privatization is unstated, but perhaps that is beyond the scope of the book. One curious thing about is argument is how he claims that there is a correlation between high school graduation rates and GDP growth. While statistical analysis bears this out, it is worth noting that there is no proven causal relationship between the two. It could be that GDP growth causes increases in the rate of High School graduation as families become wealthier, and better able to secure leisure time for their children, thus reducing teenagers’ need to work.

President Obama today signed into law the Leahy-Smith America Invents Act (H.R. 1249) a bipartisan, bicameral bill that updates our patent system to encourage innovation, job creation and economic growth. Both Houses of Congress overwhelmingly supported the proposal, which was sponsored by House Judiciary Committee Chairman Lamar Smith (R-Texas). The House of Representatives passed H.R. 1249 by a vote of 304-117 earlier this year. The Senate passed the bill by a vote of 89-9. Senator Patrick Leahy (D-Vermont) partnered with Chairman Smith on the legislation. Congressman Smith led the House efforts on patent reform for more than six years.

Much-needed reforms to our patent system are long overdue. The last major patent reform was nearly 60 years ago. The House patent reform bill implements a first-inventor-to-file standard for patent approval, creates a post-grant review system to weed out bad patents, and helps the Patent and Trademark Office (PTO) address the backlog of patent applications. This bill is supported by local companies as well as many national organizations and businesses.

The Critical Metals Report: The rare earth element (REE) space is the most complicated space in the mining and metals sector. Mining these elements is complex, often involving permitting and infrastructure issues. Once mined, separating REEs to high manufacturer purity levels is even more complex. Then selling the isolated REEs often involves highly specialized marketing. Why should an investor place money in the REE space?
Jason Burack: REEs have an amazing amount of innovation upside right now. Because of the innovations coming down the pipeline, the market has the potential to exhibit an annual double-digit growth rate, which offers far more upside than most other commodity sectors. It’s an amazing growth opportunity for investors because the REEs are going to play an important role in making high-end technologies efficient and also in supporting new innovations. In new high-end technologies, REEs are the secret sauce.

Kevin Kerr: These are the metals of the future. There are applications with these metals that we can’t even conceive of yet. It’s very exciting to be involved in these elements. I think part of the benefit of REE mines is that they are limited. There are few players out there that really have all those elements and are innovating. The ones that do have all the pieces in place offer good opportunities for investors. There’s always risk with anything new, but the risk/reward balance is very good in this sector.

TCMR: Can you comment on some of the recent innovations?

KK: For years, REEs were just wasting away; they were not really considered a good investment until engineers realized they were vital to some of the things we use every day—everything from specialized glass to green energy technologies and special batteries to super magnets. The list goes on, including developing technologies like water purification systems, which I believe Molycorp Minerals (NYSE:MCP) is exploring. Prices have exploded.

JB: The primary use for REEs for a long time was the europium in color TV sets. Molycorp, which was supplying much of this demand, had decades’ worth of used tailings sitting around doing nothing. The Chinese saw the potential of this market and spent a lot of time and money to build out uses for the other REEs mined alongside the europium.

TCMR: The United States and Mexico have filed a Memorandum of Understanding with the World Trade Organization over China’s protectionism regarding REEs. China controls about 95% of the world’s REE supply today. The Chinese government increased tariffs and reduced exports, while cracking down on illegal miners. This will further limit the supply and tighten their grip on prices. Do you think the U.S. and Mexico are going to get anywhere by filing complaints against China? Or are we just going to have to wait for another supply of REEs to come to market?

JB: I would prefer a free market solution to government intervention, but REEs are not a free market right now. China has a monopoly on supply and processing, but the government seems to be willing to reduce control. What China cares most about is the high-end value chain products because they saw what oil processing and related innovations did for the U.S. economy. China cares most about the higher value-added product jobs. That is why they are limiting export. They want the manufacturers to come to them.

As a result, you are going to see these other deposits, like Mountain Pass, coming back online. You are going to see Lynas Corporation’s (ASX:LYC) Mount Weld and Great Western Minerals Group Ltd. (TSX.V:GWG; OTCQX:GWMGF) come online. The supply problems, at least in the light rare earth elements (LREEs), will start to resolve themselves over the next couple years. The problem with the heavy rare earth elements (HREEs) is in supply. China is going to guard their higher-end jobs because they want that value-added industry.

KK: China certainly has a monopoly on HREEs. The question is how long will it take to build the next HREE processing facility outside of China? The answer is a long time, mainly because of environmental and regional problems. Also, who’s going to partner up to build this facility? The red tape, whether it’s in the EU or the U.S. or Mexico, is far more extensive than it is in China. They are years and years ahead of us in the game of producing HREEs.

TCMR: Kevin, you’ve spent 23 years as a commodity trader. What does that experience tell you about the REE space? And what’s the path for investors to make money here?

KK: This is one of the opportunities that a trader will see only once in a lifetime. A lot of people say, “This is just a bubble.” I don’t agree. I’ve seen many contracts and future markets come and go, but with REEs, it’s different. These are vital commodities that we are all using every day. We don’t want to lose our ultra-light cell phones and go back to the Gordon Gekko–style phones with the big battery. These things are only going to be more in demand, especially as the world population grows.

Investors can see it as a monumental opportunity. There’s certainly risk, and that’s important to stress. Anytime you’re trading in something new, you have to look out for those risks. But ultimately these markets are going to be some of the leaders in the 21st century.

JB: Because of the innovation upside as more people switch to newer smart phones and to alternative energy technologies, as the military becomes more efficient with less manpower and more unmanned vehicles, REEs play an important role. And the REEs market can grow a lot per year as the pie gets bigger with new innovations.

TCMR: You suggest in your Dragon Metals Report that three metals reign supreme among REEs. What are those and what are their primary uses?

JB: Well, if I was rewriting the Dragon Metals Report today I would actually expand the three to six: three lights and three heavies. The number-one LREE is neodymium, which is used in the neodymium-iron-boron magnet, a permanent magnet technology. Neodymium-iron-boron magnet technology has allowed for miniaturization of a lot of high-end electronics. It has literally made everything smaller, thinner and lighter. Consumers just love the fact that their iPad is so thin now. People talk about the operating systems and the processing speeds and all their applications, and they love them. They wouldn’t have any of this without the neodymium-iron-boron magnets.

The next two are lanthanum and cerium. Lanthanum will have a humongous industrial demand increase in petroleum refining. Oil and REEs are linked in this aspect. You will see a humongous increase as lanthanum is used very heavily in the refining process to crack heavy sour crude oil. The other one is cerium, which is used in car catalytic converters. Also, you’re going to see Molycorp bring on this XSORBX water filter, which combines cerium and nanotechnology. It’s the only filter that’s capable of removing pathogens and pharmaceuticals that the modern municipal water filtration systems cannot remove.

The heavies tend to be more prevalent on the Department of Energy’s Critical Metals Strategy list, so they have even better supply/demand fundamentals than the lights. Dysprosium is used in a trace amount in the neodymium–iron–boron magnet, but the magnet wouldn’t be as good as it is without the dysprosium in it. Dysprosium is not very common in terms of the percentage amounts in most REE deposits. It’s the most critical on the entire Department of Energy’s Critical Metals Strategy list because it’s rare and it’s very important to clean energy. The other couple of heavies that people should learn the names of are terbium and europium. Terbium is used in compact fluorescent light bulbs as well as in smart phones. Europium is going into smart phones too.

TCMR: In many cases REE production in China has caused vast environmental degradation. Some Chinese farmers can’t safely plant crops near the mine sites, and drinking water in these areas can sometimes be deadly. Nonetheless, Molycorp plans to mine 20,000 tons per year of REEs in California, which is not considered a “mine friendly” state. What makes you think Mountain Pass will be permitted?

JB: Molycorp is using innovative technologies in their processing facilities now. Yes, California does have environmental concerns, but California wants to transition to clean energy and the state has been subsidizing that. Molycorp has to demonstrate that it can operate in an environmentally responsible way and that they can do it at scale. The company has the capital and the know-how to be able to do it. It’s already a previously mined ore body with decades of data, so that’s an advantage. The infrastructure is there.

There is new technology to process the REEs safely and do all the refining. It’s going to cost a little bit more money up front, but Molycorp management is saying their production costs are going to be even lower than China’s costs. It’ll be an impressive feat if Molycorp management actually delivers on these promises.

TCMR: It’s possible that these companies spending hundreds of millions of dollars to bring their mines into production and build the facilities to properly separate those metals from one another could be jeopardized if China opens the tap, floods the market with heavies. How are companies going to deal with that?

JB: We don’t have a free REE market. Governments will probably buy REEs for a secure supply to protect REE miners bringing production online. In fact, Japan, the U.S. and the EU have all recommended that their governments start stockpiling a safe and secure REE supply to protect themselves from the Chinese monopolizing the industry.

KK: This is a real concern. China could dump pretty much anything on the market, and they do once in a while. They’re shrewd traders. No one can say for sure what they will do, but the stockpiling that’s gone on will have some effect as well.

TCMR: In early August, we witnessed a massive selloff of REE names. On August 8, names like Quest Rare Minerals Ltd. (TSX.V:QRM; NYSE.A:QRM) and Avalon Rare Metals Inc. (TSX:AVL; NYSE.A:AVL; OTCQX:AVARF) fell at more than 10% and 13% respectively. Are these so cheap now that it’s time to fill your boots?

JB: If I was building a model REE portfolio and I had to concentrate the majority of my money into three companies, they would be Neo Material Technologies (TSX:NEM), Molycorp and Great Western Minerals. Then I would sprinkle some of the other top juniors like Quest, Avalon, Tasman Metals Ltd. (TSX.V:TSM; OTCPK:TASXF; Fkft:T61), Stans Energy Corp. (TSX.V:HRE) or Ucore Rare Metals Inc. (TSX.V:UCU; OTCQX:UURAF). Lynas and Rare Element Resources Ltd. (TSX:RES; NYSE.A:REE), which might have some more heavies in the deposit, are wait and sees.

Investors really need to be discriminatory with their capital. If they are going to put a model REEs portfolio together, I think the heavy concentration should be in Neo Material Technologies, which is already profitable. They don’t have to worry about the prices of the supply, and they make a value-added product so their profit margins are safer. Molycorp has the funding in place already, and it already knows its ore body. I think Molycorp and Great Western Minerals Group Ltd. are going to end up consolidating the sector with some of these other juniors.

TCMR: You’ve said “for this industry to flourish over the longer term it will have to consolidate.” What are consolidators going to be looking for in companies that are just below them on the food chain?

KK: The race is on to figure out who’s going to team up and create the next HREE processing facility outside of China. Everyone is looking for who has the cash, who has the supplies and the infrastructure. We’ve already seen some consolidation in the last nine months, and we’re going to see a lot more.

JB: If I was looking to consolidate the industry, I’d stick with my vertical integration strategy, focus on those making the higher value-added products. There aren’t a lot of people around that have the technical know-how to do it. And there aren’t a lot of these facilities in the world. Only a handful of facilities exist outside of China. I think one of them in France just sold for a big amount of money. Great Western Minerals has a couple of them and so does Neo Materials Technologies.

So, if I was looking to acquire and consolidate the space, I think Molycorp is going to end up being the control stock here, like PotashCorp (TSX:POT; NYSE:POT) has become in the fertilizer industry. I think Molycorp will go after Ucore for some of the heavy deposits and then the processing facilities like Stans Energy. Then maybe they’ll go after some other processing companies or do a joint venture with Neo Material Technologies further up the value chain.

TCMR: Ucore was just given “priority permitting assistance” from the U.S. Department of Agriculture. What does that mean for the stock?

JB: Ucore is going to be a big winner. I project the supply crisis in LREEs will be solved by the 2014-2015 timeframe depending on what true demand turns out to be. Then only the heavies will be in true supply deficit/crisis mode. For a company like Molycorp, which is going to be a lower cost producer, that’s going to be fine. Some of these other juniors that are planning on bringing production online from 2015 to 2017, primarily with light and very little heavies, are going to see a lot of trouble. Ucore has an infrastructure advantage, so they can be online and producing probably before 2015, probably the end of 2013 if everything goes according to plan.

TCMR: What about Ucore’s Bokan Mountain in terms of its HREE versus LREE content? Is this the kind of play that might suit a Molycorp?

JB: Yes, Bokan has higher heavies than lights compared to some of the other deposits. The infrastructure advantage is so good that the capital expenditure (capex) to get Bokan Mountain back into production is going to be minimal compared to some of these other mining projects.

TCMR: Molycorp, Lynas and Great Western are projected to be the first REE miners to reach production. But what are some companies that you think could surprise you and our readers?

JB: Commerce Resources Corp. (TSX.V:CCE; Fkft:D7H; OTCQX:CMRZF) and Medallion Resources Ltd. (TSX.V:MDL; OTCQX:MLLOF) could surprise along with Greenland Minerals & Energy Ltd. (ASX:GGG).

Greenland is a developing country. Most of the country’s revenue is coming from fishing and it is just starting to develop natural resource plays. If it is done environmentally responsibly, I think there will be less red tape in Greenland. And the deposit in Greenland is absolutely massive. The question is about the infrastructure because it’s a developing country.

In general, though, I wouldn’t risk putting a lot of capital into the plays below the cuff, the top two tiers of companies I suggested in my model REE portfolio, because the supply issues are going to solve themselves, especially in the lights, by 2014 or 2015.

TCMR: Kevin, what are you hearing about Stans Energy in Estonia and about the feasibility study on the Kutessay II project in the fourth quarter?

KK: It depends on who you talk to and when you talk to them about Stans. The concerns are legitimate about how much control Russia has over Stans and what they want, what the facility’s condition is, et cetera. I’m holding my judgment until I see it for myself. They are certainly one to be watched.

JB: The positives include a tremendous infrastructure advantage. Stans has the processing facility there; it just needs to be renovated, so the capex is not going to be absolutely massive. The company can probably keep the capex below a couple hundred million bucks. That’s a big advantage. And, it also has a technical advantage because the people who used to work at the facility still live around there. The company also has an innovation deal with a renowned Russian laboratory that specializes in REEs to separate them and innovate with them.

On the negative side, the company’s total grade of the ore body is low. That means the margin for error is very low on the mining side. Stans will have to make up for it on the processing side. And then you have the geopolitical risk on top of that. Investors are going to have to weigh these risks and rewards to determine if they are comfortable with Stans.

TCMR: Are you following any other companies that you think investors should be interested in?

JB: I think the most undervalued one right now is Great Western Minerals. It just announced a breakthrough deal with an already established and successful Chinese REE processor to team up to build another REE processing facility in South Africa closer to its Steenkampskraal Mine. Great Western Minerals is the only non-Chinese future REE miner to announce such a deal. It adds a lot of credibility to the company.

TCMR: How can people get your Dragon Metals Report and find out more about you both?

KK: We actually have our own website, dragonmetalsreport.com, where people can pick up the report and watch a video interview. They’ll be able to see samples of the report before they purchase it.

TCMR: Do you have some parting thoughts on the REE space before we let you go?

KK: I really believe this is a once-in-a-lifetime trader’s opportunity. I’ve never seen a market that has so much innovation potential that we can’t even conceive of yet. I probably won’t see a market like it again in my lifetime.

TCMR: Thank you for your insights.

Kevin Kerr has had over two decades of intensive industry and trading experience as a floor trader and broker as well as an OTC derivatives broker in New York and London. He travels the globe in search of resource opportunities and is the author of A Maniac Commodity Trader’s Guide to Making a Fortune: A Not-So Crazy Road Map to Riches, which was published by John Wiley and Sons. Kevin has appeared on Cavuto on Fox, Kudlow & Co. on CNBC, The Daily Show on the Comedy Channel, Fox Business News, NBC, ABC, CNN, and many more. He has acted as an analyst and trading advisor for publications at prestigious publishers like Weiss Research, Dow Jones Newswire, and Agora Financial. Kevin’s website, www.kerrtrade.com, offers visitors his blog and video blog, media page and events schedule, and political and economic commentary.

Jason Burack is an investor, entrepreneur, financial historian, Austrian School economist, and contrarian. Jason co-founded the startup financial education company Wall St for Main St, LLC, to try to help the people of Main Street by teaching them the knowledge, skills, research methods, and investing expertise of Wall Street. You can also find Jason’s work at his blog website at www.jasonburack.com

In the rare story that ends with George Lucas not getting money, George Lucas has lost a copyright case before the British Supreme Court in which he sought to stop his former Star Wars prop designer Andrew Ainsworth, who came up with the original iconic Stormtrooper helmets, from selling replicas of his most famous work online. Lucas had successfully blocked Ainsworth from doing business in the U.S., arguing that profiting from a decades-old George Lucas creation should be the sole province of George Lucas. However, while the British court recognized that selling the helmets in America would be a copyright violation, according to the judgment there, it ultimately decided that ruling shouldn’t also apply in the U.K., as the props were considered functional, rather than artistic works.

Similarly, the kinds of innovation activities and intellectual property rights that make sense depend on available institutions and technologies. I’m happy to admit that today intellectual property (IP) is not obviously a good idea. Such property can create large “anti-commons” transaction and enforcement costs that greatly raise the cost of combining old ideas into valuable new ideas. Such costs often outweigh the social benefits of the incentives to create IP, in order to sell it. Today, it is often better to rely on other social incentives to innovate, incentives that don’t require such expensive support.

But if true, this is a sad fact about our limited abilities, not a fundamental natural law or right. You have no fundamental right to enjoy the innovations produced by others without compensating them. You owe them, at least your gratitude. Yes for now it may be best to let you take innovations freely without paying, since the alternative seems too expensive. But you have no right to expect that situation to last forever, any more than ranchers had a right to expect they could forever let their animals trample nearby farms.

We are richer than our ancestors mostly because of innovation. But most of the innovation benefits we receive are externalities – we only pay our ancestors (or those to whom they transferred their property rights) for a small fraction of that benefit. If we instead had better property rights for innovation, we’d pay a large fraction of our income as compensation for past innovation. That would increase incentives to innovate, the rate of innovation, and the fraction of the economy devoted to innovation. With good institutions, I could imagine more than half of all income being paid to the innovation industry.

Alas, it is devilishly hard to design good innovation property rights. Patents are supposedly the best we have now, and they are often terrible. But over the next few centuries, we might just create better institutions (e.g., futarchy) to better encourage institution design, and within those institutions, folks may well come up with better designs for institutions to encourage innovation. Optimist that I am, my best guess is that we will succeed at this.

Of course in the long run innovation must run out, and then we’ll have a long stable future with little innovation. But I expect the innovation era to last a few more centuries at least, with the best innovation yet to come.

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 weight that we can place on exchange and specialization as explanations of human progress depends importantly on the extent to which advance of knowledge and innovation can be attributed to exchange and specialization. It is possible to go some distance in explaining technological progress as a consequence of specialization. As Bill Easterly points out in his NYT review, however, many breakthroughs come from creative outsiders who combine technologies generated by different specialties.

Ridley mentions that government actions of various kinds in different countries have often inhibited innovation, particularly the introduction of new products and new ways of doing things that threaten the survival of established patterns of production. The implication is that freedom is a necessary condition for progress comes through clearly in Ridley’s recent contribution to Cato Unbound:

I can’t help thinking that this sounds more like rational pessimism than rational optimism. According to Ridley, the industrial revolution is largely a story about coal – and progress since then has been possible mainly because of abundant cheap energy from fossil fuels. He notes that his optimism wobbles when he looks at the politics of carbon emissions reduction and the potential this has to load economies with further rules, restrictions, subsidies, distortions and corruption (p. 347).

Cartoon by Nicholson from “The Australian” newspaper: http://www.nicholsoncartoons.com.au/

The optimistic note on which Ridley ends his book comes from his view that innovation is such an evolutionary, bottom-up phenomenon that it will continue as long as exchange and specialization are allowed to thrive somewhere in the world.

In the end, it would seem that the gains from innovation, exchange and specialization all depend on liberty – liberty is the key to human progress.

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As the subtitle (How You Can Drive Revenue and Profit Growth) of The Game-Changer indicates, this recent volume by A. G. Lafley and Ram Charan is meant more as a business book, even a business how-to manual, than as an economics text. The stature of the two authors may make this a moot point; Charan is a highly influential analyst of corporate America, corporate consultant and author of books such as Boards That Deliver (2005) and Execution (2002), while Lafley is chairman and CEO of Proctor & Gamble (P & G). Between the two of them, these men regularly make decisions that fundamentally affect the economy. However, that’s not why this book was selected. Rather, The Game-Changer will be discussed for what it shows about the nature of the corporation in a changing economy.

The Game-Changer blends two distinct purposes. It tells how Lafley turned Proctor & Gamble around after being appointed CEO in 2000. The Game-Changer also explains how to innovate, and, as the subtitle suggests, how to use innovation to transform a business and make it more profitable. Since Lafley sees innovation as central to the transformation executed, these two purposes are definitely linked. Often, a challenge at P & G is used as a platform to develop general principles of innovation. What’s more, since Lafley is exceptionally open about how decisions were made, how ideas are developed and what mistakes were made, the sections on P & G are a worthy extended case study in themselves.

The Game-Changer has a number of strengths and weaknesses; like its purposes, these are often interwoven. The co-authorship provides an example. On one hand, it provides opportunities to switch perspectives usefully, moving from inside P & G to outside. On the other, switching points of view from chapter to chapter can be jarring, and it isn’t always clear why the switches occur as they do. (In some cases, I was more interested in the other perspective than the one given. This is especially true when Lafley was discussing things like P & G’s values; he was so caught up in emotionally charged language that he drifted away from reality.) The text doesn’t limit itself to P & G but gives examples from numerous companies—a definite plus. On the other hand, they aren’t as fully realized, and so they become mere sketches or hints at times.Central to the multi-faceted value The Game-Changer offers readers are two definitions. The first is the definition of “game-changer” itself, found on page vii. “Game-changer” is defined seven different ways. All are positive, and it’s clear the definition is meant to be sweeping. However, it also reveals the many potential paradoxes in their endeavor. Are these authors discussing the work of “a visionary strategist” who would reshape things unilaterally? Or the “hardheaded humanist” of the seventh definition “who sees innovation as a social process”? The tension between these two is part of what fascinates about this book and about innovation today; who controls the changing game? The economy?

The second essential definition is of innovation: “An innovation is the conversion of a new idea into revenues and profits” (21). The book goes to draw the distinction between invention and innovation and to explain that, without customers and success in the market, an innovation “is, at best, a curiosity.” From a business standpoint, that sounds pragmatic and perhaps even self-evident. However, notice what this does; it focuses solely on the successful innovations. It removes the learning process, and, because no time scale is provided, is likely to pressure firms to focus on the short-term.

Other tensions define the book and P & G’s struggle. On one hand, Lafley can sum up situations simply, saying, “P & G prices were too high” (9). On another hand, he can discuss his organization’s corporate cultures with phrases that are so cliché they are almost dim. What does it mean to say “P & G is purpose-lead and values-driven” (11)? Seriously. Are their organizations out there that are saying, “We’re proudly purpose-free”? And yet, there’s the much needed third hand on which we must recount the intense complexity of reorganizing an entire corporation, one with highly profitable brands, and realigning how business is done. There is a tremendous gap between the overly simple statements and the deeply complicated information sorting P & G, or any innovative company, must engage in. If you read The Game-Changer, you won’t just be studying Proctor & Gamble or innovation. You’ll get a glimpse at how an organization, even an immensely successful organization, must redefine itself as the economy shifts.

Two details of this redefinition deserve special attention, both for their centrality to the process and because the authors deal with them explicitly: unlike many of us, Lafley & Charan recognize the forces at work on them. The first is a push towards commoditization, a transformation that has blindsided too many firms who thought they’d differentiated themselves in the market. The Game-Changer explains how P & G used innovation to differentiate themselves in a market defined by commoditization. Second, and perhaps the most fascinating part of the book, Lafley describes the lengths to which researchers at P & G go to understand their customers. My favorite is “Living It,” a program developed after 2001 as part of P & G’s “consumer closeness program” (38), in which employees actually live with customers. The description of what they learned from living with lower-income customers in Mexico is striking, and it’s hard to imagine learning such a visceral respect for these specific values any other way. It’s clear that in an information economy, successful organizations may have to become economic anthropologists to get the information they need, and that is changing the game indeed.

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