More about deflationary spirals

Here's the deal with deflationary spirals. First thing that happens is that a bank collapses for one reason or another. This reduces the amount of currency in the system. Less currency, same amount of goods and services, means prices -- and salaries -- go down. Depressed prices and salaries mean that producers and consumers can no longer pay their debts. This causes more banks to collapse, thereby removing far greater amounts of currency from the economy (thanks to ye olde fractional reserve lending), which in turn furthe reduces prices and salaries. Repeat until done, with no functional banking system and the economy pretty much deflated to 10% of what it once was. The end result of the deflationary spiral is to transfer virtually all real assets in an economy from the debtor class to the creditor class at fire-sale prices. Since the debtor class in our current economy is pretty much *everybody* other than the top few percent, what you end up with is a society that looks an awful lot like a banana republic, with a handful of land-rich mega-plutarchs and hoards of desperate starving peasants.

Even more important is the *political* results of this happening. We already know what happened in Germany and Italy when things hit bottom. It almost happened here too, and the only reason it didn't was because there was still a strain of progressivism extant whose credibility had not yet been completely demolished by Republican chants of "government is the problem, not the solution". That is no longer true here today. Our modern-day Father Coughlans are much more widespread and much more powerful than they were then, not to mention that we don't have a progressive equivalent to FDR (who was a very ruthless man with no compunctions about silencing opponents) today to keep our modern-day Father Coughlans from backing a fascist take-over of the government. When people are desperate, they will cling to anybody who offers hope. When the system has been systematically degraded and its credibility destroyed over the past thirty years by Republican action, the chances that this hope will arise outside the system and end up like Germany/Italy in the 1930's is far greater than I like.

Anyhow, that's why I say that avoiding a deflationary spiral has to be the #1 thing we do here. Yes, the currency was inflated with bogus financial instruments. Yes, this means we're going to have to take the politically risky step of swapping those bogus financial instruments for treasuries in order to prevent deflation from setting in and collapsing the system. But it has to be done or we risk a deflationary spiral and its very unpleasant aftermath. The problem I have is that the administration's proposal appears to be a license to loot, not that it pretty much trades bogus financial instruments for treasuries.

-- Badtux the Economics Penguin