Good explanation on inflation/deflation

According to Paco Ahlgren, a financial analyst:

The majority of analysts today believe Treasury prices will fall when the appetite for risk returns. That is certainly one way to justify the fact that the price of Treasuries hovers at historical -- and dangerous -- highs. But there is another more volatile, yet less scrutinized potential outcome to this tale: Treasury prices may succumb, not because an appetite for risk drives capital to other asset-classes, but because Treasuries -- the yields of which are commonly referred to as the "risk-free rate of return" -- are finally exposed as, perhaps, the riskiest assets around.

Treasury prices move inversely to their yields, which are at record lows. How can a "risk-free" asset that returns, at best, 3% for 30 years be considered "risk free" if that asset's value will fall dramatically should interest rates even approach the historical average? Said another way: why would investors place capital in an asset that only pays a maximum of 3% per year, for 30 years, with almost no possibility of capital appreciation?

Shouldn't that mean yields are almost certainly going higher?

I'm going to digress a bit. A few days ago, a reader commented that she didn't understand why I keep insisting that inflation is not defined as rising prices, but that it is the result of rising prices. To some of you, this might seem difficult to comprehend -- probably because you are so used to the usage popularized by media and government propagandists. Let me assure you, however that rising prices are not inflation; rising prices are resultant -- universally-rising prices are merely the products of inflation, which is defined as an increase in the supply of money in an economy.

Paper money is not scarce -- governments can print it at will, and therefore it is inherently inflationary. It is difficult, however, to increase the supply of gold in the world. Yes, the supply increases marginally each year, but it cannot be created out of thin air; it must be discovered and mined, which carries tremendous costs, thereby contributing to gold's scarcity.

Let's suspend disbelief for a moment and pretend we have an economy whose base currency is gold only. In this hypothetical economy, while it might be conceivable that prices could rise because of the immutable laws of supply and demand -- within asset-classes -- it is inconceivable that gold could become less valuable because of increased supply (it is very difficult to increase the supply of gold, as we said). And this is the heart of my point: currencies -- whether based on gold, paper, or pigs -- are not immune to the laws of supply and demand. If gold is the base currency, It can certainly become more valuable with increased demand and/or decreased supply, but it cannot become less valuable because of increased supply (or not much, anyway).

When fiat paper money is printed, however, it can and does become less valuable as supply increases, because it is easy and relatively cheap to print money -- especially electronic money.

Let's put it another way. Let's say Apple (AAPL) cut the supply of iPhones in the economy over the course of a month, and the price of an iPhone doubled. Would you say that the iPhone was inflationary? Of course not! You'd say the the supply had been halved, so the price doubled!

If gold were our currency (or if we issued currency carefully backed by some appropriate amount of gold), rising prices would be strictly a product of supply and demand. "Inflation" would cease to exist -- for all intents and purposes -- because there would be no way to increase the supply of money. And this is why I say that universally rising prices in an economy based on fiat currency are not "inflation;" they are the product of increasing the supply of money. It's true that some goods and services might become more valuable as demand increases, or as supply diminishes, but universally, prices would not increase as a result of increased money supply, because there is no way to meaningfully increase the supply of gold in the world!

There is an argument that credit is part of the money supply -- that is to say, every time a person or institution uses credit, more money is created because no cash has actually changed hands. On the surface, the proposition seems sound; after all, when you use your credit card, for instance, to buy a television, the money goes into the vendor's account, and yet you haven't actually given the store any of your money, per se. You still have your money. The store has its money. More money.

This, however, is nothing more than the abuse of an obscure form of accounting called cash basis, which says that revenue is earned only when cash is received, and expenses are incurred only when cash is paid out. I'm sure cash-basis accounting has a place somewhere in the world, but the vast majority of businesses adhere to another convention called accrual-basis, which says that revenue is earned and expenses are generated at the moment of the transaction -- not when cash changes hands. The reason this is important is that it allows for convenient accounting of receivables and payables, and if you've ever tried to run a business, you know how incredibly difficult it would be to survive if you weren't using receivables and payables.

This is why I think its absurd to say credit increases the money supply. Going back to our example above: when you pay for a television with your credit card, you are actually incurring debt at the same time you acquire the television, and that balances the equation. No wealth has been created out of thin air -- the debt you owe is balanced by the equity you received when you purchased the television.

Now I'm not going to sit here and tell you that leverage isn't dangerous -- even in an economy whose currency is backed by gold. But leverage does not increase the money-supply. Leverage increases debt. Thus, I will make the argument that inflation only exists when a government prints money. And just to hammer the point home, I will remind you that the imminent subsequent rise in prices and interest rates are not inflation, but rather they are the results of inflation.

In this crisis, the Fed is printing money at an unprecedented rate to battle what it is calling "deflation." But it's not deflation; it's de-leveraging. Just like inflation is defined by the printing of money, deflation can only be defined as the removal of money from the economy. The Fed, however, wants to print enough money to stimulate prices and get people spending again. In effect, the Fed is, yet again, encouraging exactly the type of behavior that causes bubbles in the first place. It's a vicious cycle: create cheap money out of thin air, thereby encouraging spending and investment, which in turn creates artificially inflated prices, which ultimately results in a bust, which the Fed battles by creating cheap money out of thin air... and so on and so forth.

So here's the real question: how many times can the carousel go around before it falls off its axis and destroys itself with its own momentum?

And now, finally, we can complete our own little rotation and return to Treasuries. Perhaps the most unfathomable part of this game is the newest tactic the Fed is employing: quantitative easing. Essentially, the Fed intends to escalate its printing spree in order to buy longer-maturity Treasuries. The idea is this: Treasury prices are inversely related to yield, so if the Fed buys those bonds, it can drive yields lower, thereby encouraging yet more cheap loans, followed by more spending and investment. But here's the rub: the Fed -- which is nothing more than an illegitimate wing of the government -- is printing money which it will use to buy debt issued by the Treasury -- yet another wing of the government. Are you starting to see what I'm getting at?

Here, I'll simplify it: your government, through Legal Tender laws, is forcing you to use dollars to navigate the economy in which you reside. It is then printing this currency with reckless abandon. Finally, the same government is issuing more debt than ever before in history, which it will loan to itself (or borrow from itself, depending on how you look at it) by employing the nearly innumerable dollars it has printed.

It used to be that a dishonest person had to rob Peter to pay Paul if he wanted to get ahead in life. But times have changed; the old way of doing things just isn't sophisticated enough to fool, say, an entire globe. No, these days, apparently Peter must first print a bunch of cash, then borrow it from himself, and finally dump it from a helicopter in Paul's front yard.

Do you still think Treasuries are "risk-free?"

I'm done here. I'm going to go buy some gold.