This is along the lines of the Barron’s interview. Private indebtedness increased 300% faster than GDP from 1970 on. Total public and private sector debt is over 355% of GDP. This debt cannot be serviced out of current cash flow; we either need to restructure the debt on a massive level (bankruptcies, refinancing of short term to long term debt) or inflate so nominal GDP increases fast enough to service existing debt.

Still, given the commodities induced inflation scare in the middle of ‘08, the path of inflation might not be a given or a free lunch either. High inflation would probably squeeze margins for companies in the face of weak demand and increase the amount of money needed for living expenses, leaving less for debt servicing by consumers.

I imagine the Fed really is trying to walk a fine line between deflation and inflation. Either course would wreck the economy for years to come. However, the Fed will feel real pressure from congress. What congress wants is another matter altogether. Treasury and the administration I think understands that you can’t keep gorging banks on loans to get it out of this mess. That’s why the Geithner TARP revamp didn’t have specific requirements for increased bank lending from government money. But they’re hesitant to take decisive action on this. People know some of the largest banks are insolvent but we’re still playing the Fannie and Freddie game of last summer with them. Congress of course wants increased lending and wants Fannie and Freddie and FHA to swallow or guarantee every defaulting loan out there and for the Fed to drive mortgage rates down to 0. The administration also had to reign in their own party in the overreaching salary caps put into the economic stimulus bill.

The question is not just economic anymore, but also political so I don’t know if massive private bankrupcties will be tolerated well either. I think I heard something like 2000 economists signed a letter against Smoot-Hawley during the great depression but that peice of protectionism went through anyway.

What’s your vote – deflation or inflation or do we get a series of bankruptcies and write downs first?

Courtesy of Yi