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“Inflation is the senility of democracies”

-- Sylvia Townsend Warner

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If you ask the average person to define inflation, you get this response: “Rising prices.” Similarly, the same person would likely define deflation as falling prices. But both answers are incorrect -- in fact, they’re gross misrepresentations of the words, and this simple, but popular misconception is the root of every single economic problem we face today.

Rising prices do not cause inflation, nor are they inflation. On the contrary, rising prices are the result of inflation. Specifically – speaking in terms of the entire economy (as differentiated from individual goods and services) -- rising prices always result from an increase in (or inflation of) the money supply – through printing currency, and/or the manipulation of interest rates by any entity controlling the money supply (like the Fed, The ECB, or whatever).

Simply put, inflation is always monetary. Likewise, pulling currency out of circulation constitutes the deflation of the money supply. Falling prices are not, in and of themselves, deflationary. Indeed, if prices are falling, but the government is printing more money, then the economic environment is properly described as inflationary.

And so here we are.

You may be unaware of the fact that the authorities controlling the status quo – namely Ben Bernanke, Barack Obama, and all their little elves – actually want you to use the words inflation and deflation incorrectly. You might also make the claim that I’m merely splitting semantic hairs – that these definitions are insignificant in the grand scheme of things. But that’s not really a good argument, because if the majority of people believe we are in a deflationary period, despite the fact that the Fed is printing money at the fastest rate ever, well, then we’re not preparing for the inevitable. We are certainly not in a deflationary period – nor have we been for many, many decades. And the “inevitable” to which I am referring is an incalculably rapid rise in prices across the globe.

If you think about it, it makes sense: more dollars in the economy mean less valuable dollars. Money is just like everything else -- it has value, and the laws of supply and demand are every bit as applicable to currencies as they are to everything else: the larger the supply of money, the lower its value.

In the midst of all this misapplied talk about deflation, one of the main arguments I keep hearing is that the main reason prices are dropping -- on everything from real estate to electronics – is that consumers are waiting for bargains; as such, they won’t spend now.

In the last twelve months, I’ve heard and seen my share of specious arguments, fantastical predictions, moronic conclusions, and positively farcical objectives -- from all measures of wannabe (and practicing) politicians and economists. But this idea that consumers aren’t spending because they are waiting for lower prices is just absurd. And the ensuing leap of logic, that consumers are responsible for a so-called “deflationary” environment is positively imbecilic -- for at least two reasons.

First, it’s a misapplication of the word deflation -- as I pointed out above. Second, while it is true that the average consumer isn’t (and won’t soon be) spending as much as he used to, it’s not because he’s waiting for bargains. No, it’s because he’s out of credit, he’s unemployed, his house, car, motorcycle, boat, and plasma television have all either been repossessed or foreclosed upon, and his wife just left him. He’s not exactly in the mood for shopping. He’s not waiting for bargains. He’s waiting for a miracle. And I don’t think they sell those at the mall.

You think consumers really stop spending in anticipation of lower prices later? Really? Ever heard of Moore's Law? The one that says the price of technology will be halved every 18 months? Buy a computer today, it will be worth 50% of that value in a-year-and-a-half. So, in an industry like technology -- where real prices consistently fall -- do you really believe that most people put off buying products in anticipation of lower prices? I mean, it happens, but it’s not the exception, not the rule.

Consumers, for the most part, do not postpone purchases -- even in an industry like technology. This is only borne out by the fact that the technology industry has been one of the fastest growing and profitable in our economy for decades. People will pay today – even in the face inevitable obsolescence.

So let the pundits talk about deflation all they want, but we know (or should know) the truth: the money supply is not shrinking. And even if the prices of most asset classes are still falling – which is arguable, at best, in real dollars -- consumers do not postpone purchases in anticipation of lower prices. And they are not causing “deflation.”

Say it with me: we are in an inflationary environment. How do you think the government is going to pay for all of the trillions of dollars it has promised to spend over the next two (or more) years? I'll tell you how: it’s printing dollars. Lots of them. The money supply has been increasing for decades -- lately, at a faster clip than ever. In fact, the line just went vertical -- as you may remember from a chart I posted in another article about inflation, earlier this month.

And what did we just say about supply and demand? That's right -- the value of dollars is going down, not up. It may not feel like we're in an inflationary environment, but I promise you we are, and even if you don't feel it now, you will. You can rest assured, the very nanosecond Ben Bernanke suspects that the effects of this rapidly increasing money supply are causing upward pressure on prices in our economy, he and his gang of calculator-toting dandruff eaters are going to start jacking up interest rates every way they know how. Then they’re going to huddle in the middle of the room and start praying it works. Which it won't.

Welcome back to the early 1980s, everyone. Only it’s going to be a lot worse this time. Do yourself a favor. Short Treasuries. Now. You can thank me later.

Still not convinced? Have you seen what precious metals, agriculture, and oil have been doing for the last twelve months? They’ve been going up. And it isn’t because consumers are expecting prices to fall. Commodities are the best predictors of future prices. I don’t care what the Dow 30 are doing; look at commodities. That’s where the story is.

The Fed – by way of John Maynard Keynes -- is the main instigator of this preposterous idea that we must fight falling prices with everything at our disposal. Lately, they've even attacked the long end of the yield curve by buying long-term Treasuries in the open market. Some of you may not understand the implications of this behavior, so I'll give you a little help: if the Fed thinks it can maintain lower long-term rates by buying Treasuries, it's going to have to use dollars, and those dollars will have to come from somewhere. Can you hear the printing presses groaning?

So this brings us to four final questions (as well as their answers, which I am thrilled to provide at no extra charge):

1. If the Fed is going to (attempt to) hold down long-term rates by using printed money to buy Treasuries, isn't that going to cause downward pressure on the value of the currency? (Yes!)

2. And as the dollar loses value, won’t U.S. creditors be reluctant to loan us more money – or even to hold existing American debt? (Yes!)

3. And won't that necessarily mean rising interest rates? (Yes!)

4. So how, exactly, is that going to keep long-term Treasury rates lower? (It won’t!)

Look, if you ignore everything else I’ve said, try to remember this: the Fed is comprised of a decidedly small number of people, who make decisions that will affect you, your job, your family, and your life for years to come. They are not gods; they are human beings, and their perception of reality is just as subject to error as yours and mine. Your currency is more vulnerable than at any other time in history, and you should be scared. Actually, you should be terrified. I know I am.

Disclosures: Paco is long TBT and Gold. He also holds U.S. dollars by necessity, pending the advent of private gold-backed currencies.

Source: Consumer-Driven Deflation? Not Even Close