Specializing in emerging markets, natural resources and global infrastructure, U.S. Global Investors is positioned so perfectly for the times that CEO Frank Holmes might have written its business plan and tag line—"Resourceful Investing for a Developing World"—this morning. All of these areas of expertise at U.S. Global Investors play powerful but somewhat unpredictable roles in the evolving 21st century worldwide economy.

Led by China and India, the emerging markets have placed unprecedented (and growing) demand on natural resources. From gas and oil to Copper and zinc, it takes vast quantities of those natural resources to build infrastructure to accommodate explosive growth in population, upward mobility, urbanization and industrialization. So as the other Holmes once said, "The game is afoot." Meanwhile, the developed world can hardly sit by and watch the action from afar. As Frank suggests in this exclusive Gold Report interview, the key to staying in the game—even as the rules are changing—may lie in adapting nimbly and rationally.

The Gold Report: President Obama recently came out with proposals to limit profit taking in the banking industry, impose salary caps and restrict banking investments. Then in his State of the Union address, he called for a freeze on spending for discretionary government programs. Any comments about that?

Frank Holmes: Wherever it is in the world, it's important to recognize the tremendous impact of governmental policies. Look at Hugo Chavez in Venezuela as opposed to Álvaro Uribe in Colombia. Chavez destroyed Venezuela's economy and judicial system to maintain his power. Bolivia is heading in the same direction, but Colombia and Panama are booming. Policies in those two countries are completely different from Venezuela's.

Basically, government policies break out to either monetary or fiscal. Of course, money supply is on the monetary side, along with real interest rates, while fiscal policies involve taxing and spending. We try to distill the G-7 versus what we call the E-7—the seven most populated emerging-market countries—and look at money supply. We see something very, very important when we create macro models to compare the E-7 to the G-7.

What we see with the E-7 countries is a very different set of policies for capitalism and job creation and social stability. In the G-7, in contrast, we see a sort of socialism being pushed. How it's being done is very significant, too, in part because one of the consequences of such policies is higher unemployment. What starts out as anti-money laundering expands to the point that it becomes anti-money.

Good government policies came to China after Deng Xiaoping came to power in 1978. He started a model based on the old saying that "it doesn't matter if a cat is black or white as long as it catches the mouse." People need a means of getting jobs and achieving prosperity. That's what drives China now. There was a lot of talk about a broker being shot by order of a Chinese court for stealing $19 million because of government concern over the gulf between rich and poor. That wasn't the reason. Chinese policies are designed to produce social stability. Stealing creates social instability. They need social stability and ways for people to realize economic independence.

The big wrestling in the world is to really appreciate urbanization and understand globalization, which—along with access to information—has changed the world dramatically.

TGR: It seems that urbanizing is inevitable whether government policies are good or bad. As populations grow, a society cannot remain agrarian.

FH: Correct. There's no doubt that you get these tipping points in the population, but good government policies adapt to changes as they realize what's taking place. The planet had 1 billion people 200 years ago; 100 years later there were 2 billion people; 50 years after that, it was 3 billion people. The world's population has more than doubled since 1970, when gold became free-trading and there were 3 billion people. Now, 40 years later, we have more than 6 billion people. The number of people on earth becomes very significant and so government policies become very important. In China, India, Thailand, it's all about job creation.

Political parties talk about policies for managing this big sea change and about the urbanization and the information highways around the world changing things dramatically. The movie Slumdog Millionaire, which was filmed in India and won so many awards, starts off with kids living in a slum. At the end the slum is filled with huge high-rises and even though there's so much poverty in India, it's filled with hope too.

Sudan is poor, just like India, but there's no hope in Sudan—only fear. That same type of fear is here, in policies to deal with terrorists, and in Europe, where fear rather than hope drives policies. I think that's really key in looking at how governments deal with huge demographic change. It's not just the fact that the world population is moving toward 7 billion people. What is really important is the rise in the emerging-market middle class, whose needs are not the same as in middle-class America or Canada.

Look at China again. As many as 25% of Chinese—more people than the entire U.S. population—fall into the middle-class category or above now, with a doubling possible by 2020. While most dramatic in China, it is also underway in India and elsewhere. People in this emerging middle class just want a nice home with running water. When they turn on the switch, they want the light to come on. That means massive commodity consumption.

TGR: But isn't the rise in the middle class an outcome of urbanization?

FH: It's a result of good government policy, too. As an investment person, I'm a big believer in what are called "complex adaptive systems." There are complex adaptive systems all around us—our body's brain and immune system, the ecosystem, ant colonies, the stock market and many others. In this sense, the immune system is very similar to the stock market and very similar to how bees swarm. It has a lot to do with the capacity to learn from a new experience and change in response to that experience.

A lot of people—or organizations or governments—can learn something, but they don't necessarily change their behavior. Remember when the Encyclopedia Britannica was sold in malls? Microsoft's Encarta came along and they were wiped out. The Britannica people knew what was happening, but failed to adapt fast enough. A classic example.

Unless you're dealing with a dictator, I believe that the majority of government policies, especially in democracies, begin with good intentions. But they have to adapt. In terms of investments, some of our biggest wins will come from policy change in Colombia versus Mexico, for example.

TGR: So as we look at countries such as India and China, with immense populations and growing middle classes, is it simply the nature of the middle class or are government policies promoting consumerism?

FH: I think it's a combination of three things— population density plus rational, intelligent government plus resources. Cities need proper infrastructure to function. Otherwise, you get slums. You get chaos. You're wiped out if an earthquake or a hurricane hits.

TGR: But China still imports a lot of the resources required to build the infrastructure.

FH: China is a very pragmatic country with long-term thinking along the lines of, "Okay, we're going to need all this Copper and Steel and oil." So they go out and acquire. Not long ago, I read that China's December imports of unwrought and semi-finished copper products were up 27% over November's, while scrap copper imports were up 46%, and that there's a strong expectation that China would be buying a lot of copper from international markets early this year. I also saw where China's reserve targets are said to be one million tons of aluminum, 400,000 tons of copper and Zinc and 20,000 tons of nickel.

TGR: Nouriel Roubini, the economist credited with having seen the economic meltdown coming, says a lot of people are talking about investing in China because they expect China to pull the world out of recession. He argues that China isn't the panacea that people think it is. He claims that the government needs to implement certain social programs that motivate people to stop saving and start spending. He's talking about unemployment insurance and other safeguards against lost income. From your viewpoint, looking at these policies, how much of the growth in China will come from consumerism evolving naturally or must the government intervene?

FH: It'll come and it won't be because Roubini wants to give it a European-style socialist perspective. It's going to come because the government does not give the free health care. China has basic health care and the technology to do all the x-rays and MRIs, but if people want anything special, they have to pay for it. China also offers basic education, but if people want the better schools, they have to pay.

The high savings rates in China are predominantly so people can take care of their families if something happens to them physically. At this stage, the government is not much worried about that; they're worried about job creation. They don't want a bunch of people on unemployment insurance and food stamps. They'd prefer to have them cleaning up dirt on the highways and debris on the streets. They recognize 800 million people still live in rural areas, so they have to manage urbanization and employment methodically and rationally. They can't force consumer spending. But they've found, for example, that when they gave farmers tax credits and made schooling easier, the farmers used their higher disposable incomes to acquire more products made in China.

TGR: In your recent article, "The Case for Commodities in 2010 (and Beyond)," you say that an investment in natural resources is a vote of confidence in global economic growth. You also talk about how demand and growth of the middle class in emerging countries will fuel the commodity supercycle. Is the commodity supercycle dependent on the emerging countries' growth exclusively? Or does continued demand in developed countries dictate a big part of that?

FH: We've created a matrix to try to explain it. There's never a single factor; it's a summation of several factors. A big one is the last supercycle's pattern of infrastructure spending. It started in 1955 with Eisenhower building up America's interstate highway system—a job that had the U.S. consuming 55% of all the world's commodities at the time. Then Japan, Taiwan and Korea had significant buildouts. Then the Vietnam War put heavy demand on resources. So this supercycle that started out from deflation and ended with inflation lasted 25 years.

Then we went through a 20-year drought from 1980 until 2000. During this period there was significant underinvestment in schools for engineers and geologists. Kids were going to become electrical or technology engineers, not go into mining or into the resources. There was minimal investment in the technology of energy or in raw resources. Right now in America all the kids want to go into CSI or Law & Order. But 10 years from now they will be taking degrees in petroleum engineering and mining engineering. We'll see that shift when they start to see that they can make much more money that way.

In the meantime, General Electric Company (NYSE:GE) has a huge new R&D center in Bangalore. I recently visited this center, which almost doubles GE's global research and development staff. GE went to India because U.S. colleges produce more sports trainers (75,000 of them a year) and lawyers than engineers—while India's producing 400,000 scientists and engineers.

TGR: Wow.

FH: Financial Times recently reported that China is the leader now in filing for patents. If you go to grad school in America, you'll see it dominated by Indians and Chinese.

TGR: Although technology seems to be getting more attention in North America nowadays, the resources industry here seems to be struggling more and more with environmental issues.

FH: That's right. The EPA, which was created in 1973, became a force around the world for clean air and clean water, which I'm a big believer in. But if you're not exploring and developing, and barriers to entry grow while the populations also continue to grow, where does that put you? In a situation where you have insufficient supply to meet the demands of a population that's doubled—and a growing middle class. Based on previous cycles of 20 years, I think we're halfway through the current increase in growth of the middle class, and I don't think the big inflation will hit for another five years.

TGR: So five more years before inflation becomes problematic?

FH: Everyone keeps talking about big inflation. So why are real interest rates negative? Interest rates have been negative, not positive, in E-7 and G-7 countries 80% of the time since the year 2000. Governments are trying to ensure cheap cost of capital to create jobs and spur economic activity. After our recent credit crisis, year-over-year money supply (M-2) in the U.S. is up only 3%, and down dramatically from its peak. But the monetary base has increased massively. That's supposedly money that's gone to the banks for lending, but in fact they're not using it for loans because it's not showing up in the velocity of money supply.

At the end of the day, we're still wrestling with deflation. It's something we're going to live with. We'll get pockets of inflation, commodity by commodity. Zinc will rise and fall. Then copper will rise and correct, and so on. But we won't see the across-the-board inflation we had from 1975 to 1980 until probably 2015 to 2020.

Bear in mind, too, that natural resources are one of the few asset classes that benefit from inflation. If prices for fuel or other commodities rise, one way to hedge against the impact of those price increases is to invest in those commodities, or commodity-based equities, either through an actively managed natural resources fund or a passive vehicle such as an indexed fund or exchange-traded fund (ETF).

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