I reprinted an essay here yesterday from Chris Laird that explained why the Fed would not be able to prevent deflation. One of the more interesting responses came from a reader, Hal Muller, who wrote as follows:

“A few thoughts concerning your quote from Chris Laird on the ongoing Inflation/Deflation debate. At times you two seem to be beating a straw man.  The Inflationist camp doesn't claim that hyperinflation would lead to prosperity, good times, and more "economic activity"; nor does it claim that hyperinflation can be prolonged indefinitely.  Of course, the economy would seize up like an engine drained of oil, if the currency became shunned by all.  What you two call a deflationary ultimate outcome actually incorporates the inflationists' scenario of how we get there.

Debt Is 360% of GDP

“The question is: Can we have a repeat of 1980-82, when sky high interest rates restored credibility to the dollar, and people once again wanted to hold and accumulate dollars. Since our society's indebtedness has gone from 120% to 360% of GDP since 1982, it's hard to imagine how the economy could cope with the high interest rates required to shore up the dollar.

“When people speak of a deflationary outcome, generally the implication is that it's safe right now to hold dollars and T-Bonds.  You say deflation is inevitable, but admit the dollar may become null and void along the way.  What kind of a deflationary outcome is that?  The dollar worth nothing!   Any people who sell their precious metals or other hard assets for dollars, expecting a repeat of the early 80's, would end up ruined.

“In short, do you believe dollars earned today and put into the bank will buy more goods and services 2 years from now, 5 years from now?  That would qualify as deflation, but I don't see it.”

Post-Collapse Landscape

My response:

You’re the first skeptic I’ve heard from who seems to understand that a hyperinflationary bailout would be unsustainable and, probably, fleeting. The question then becomes, what would we be left with after the financial system implodes? Here we seem to agree on an answer: an economy in total wreckage. But then you ask, would the dollars that deflationists are socking away now still have value? That’s a tricky question, since there is no historical precedent for deflation occurring on a global scale or in a currency that has been rendered fundamentally worthless, as the dollar already has been.

However, I’ve argued here before that when cascading defaults reduce the supply of credit dollars effectively to zero, the relatively few physical dollars that remain in vaults and under people’s mattresses will retain their purchasing power. Admittedly, that scenario implies that the central bank would do nothing to bail out debtors as the system implodes around them. It’s not that the Fed would not want to bail out each and every deserving one of us, or even that it would not deign to try. Rather, it seems entirely likely that the collapse would unfold so swiftly and with such power as to overwhelm any remedies the Fed might have in mind. Remember, benevolence, especially the wholesale kind, will require Congressional sanction each step of the way – just like Katrina repairs -- when the numbers start tallying in the hundreds of billions, never mind trillions.

‘Slow’ Hyperinflation

I will grant that, in theory, there is a slow route to hyperinflation. In fact, we started down that path when the Pension Benefit Guaranty Corp. relieved bankrupt airline carriers of their pension obligations. The auto manufacturers are surely next, and then hundreds of other big companies will simply have to get in line. But big as this bailout is going to be, it is small potatoes compared to propping a tottering global financial system that presently has hundreds of trillions of dollars worth of leveraged debt instruments in play. Nor should we kid ourselves that that’s merely the “notional value” of the game, or that much of the debt is redundant. Trust me on this, a mile-long conga line of lenders is depending, each in his turn, on the collateral value of every one of  those “notional” dollars.

So, will the tens, twenties, fifties  and hundreds stuffed in deflationists’ mattresses still have purchasing power? Not if the government, in the futile throes of a months-long administered hyperinflation, issues manageable piles of “new” dollars to replace mountains of old ones. Of course, it is because we cannot be sure what will occur that we have socked away not only cash, but bullion and junk silver. That last item, come hell or high water, is going to have purchasing power no matter what.