Deflation is now the biggest, persistent threat to Western economies. Inflation, recently the major enemy, has swiftly retreated, as widely predicted.

In Britain, many are now waking up to the gravity of the situation. Former Chancellor of the Exchequer, Ken Clarke, has dismissed comparisons with the 1970s, ’80s and ’90s, likening current conditions explicitly with 1929/30.

Normally cautious Bank of England Governor, Mervyn King, forecasts a 2 percent contraction in the British economy next year, with interest rates falling rapidly to nought percent for the first time in history.

Deflation is now the enemy we must all factor in to our expectations in the near-to-medium terms. So why is deflation necessarily worse than inflation?

In an era of massive indebtedness, both private and public, deflation increases the burden. As incomes decline, debts remain the same — at levels signed for in better times. It’s the exact opposite of the apparent wealth created during periods of rapidly rising house prices.

Professor Peter Spencer of York University says, “It is going to be absolute murder in Britain if inflation turns negative. The big difference with past episodes is that we are now much more heavily indebted. Few people owned their own houses in 1930s. Debts were miniscule.”

Another symptom of deflation is that consumers wait for lower prices before shopping, causing job-losses in the High Street and yet more bad economic news. Japan’s “lost decade” of the 1990s is the technically-perfect example of this psychology of fear taking hold. It is still suffering.

So what can be done either to pre-empt or cure the curse of falling prices across the board?

Curiously, Keynesianism which, in its misinterpreted version is disastrous in normal times, does hold out some hope in depressive conditions. Expect central banks to start printing money soon and dropping it from helicopters, if they haven’t started already. Want to buy some rising stock? Buy helicopter shares. [This is not financial advice.]

If you’re one of those noble souls who saved assiduously during the asset bubbles, you will just have to stand by and watch the profligate oafs who caused the problem clean up, while your own responsible hoard of value drains away.

It’s just not fair, but it will probably have to happen “for the greater good”.

You have only one consolation: you can give the politicians who presided over the madness a good kicking at the next electoral opportunity.

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A dollar default is unthinkable in these affluent modern times. Or is it?

Last week a “flight to safety” of investors in America’s $3.5 trillion Treasury money market was only halted by Secretary Henry Paulson’s swift action in nationalising the banking sector’s bad debts.

Read The Great Harvard Sausage Scandal 2008 over at Syntagma.

Of course, most of the movers and shakers have already salted away their massive bonuses and are probably even now relaxing with a cocktail or two on their yachts in Monte Carlo harbour.

They have left us with a colossal mountain to climb. In the UK, house prices have a further 25-30 percent to fall, according to Roger Bootle, and already Britain’s largest mortgage lender, HBOS, has failed. How many other banks will go before we hit bottom?

Read the rest of the article.

Can we really have witnessed the demise of three top investment banks in so short a time? Bears Stearns, Lehman Brothers and Merrill Lynch have all disappeared off the radar in quick succession.

What is happening to the world’s — and especially the American’s — financial system?

It started with the slicing, dicing and splicing of U.S. mortgages of sub-prime customers. The structured financial instruments that were sold off around the world became known as CDOs (Collateralized Debt Obligations).

They have poisoned the world’s financial system, like seeping toxic waste. Now a new danger is forming on the horizon.

CDSs (Credit Default Swaps — insurance policies for bonded commercial IOUs), which are out there in their trillions and trillions, are beginning to crumble in the face of massive defaults.

The world’s biggest insurer AIG is already in Lehman territory — its shares plummeted by 70 percent in early trading yesterday. The long-foretold CDS crisis is with us at last.

So what precisely are CDSs and how will their demise affect most of us in coming days, weeks, months and years?

George Soros estimates that the value of CDSs now equals half of U.S. household wealth, an almost unimaginable number — let’s call it $23 trillion.

CDSs are hedges made by investors in case a company defaults on its debts. In effect you bet on a company failing to protect your investment in the event it does just that. The problem arises when large numbers of companies go bust and the CDSs themselves become worthless since no-one can pay them out.

A CDS seller undertakes to compensate a buyer if a corporate bond defaults. Since there is no limit to the size of cover taken out, the value of CDSs often exceeds a company’s debts. Moreover, many CDSs are bought with borrowed money so the infection of the system drives deep into the financial heartland like veins in a blue cheese.

The danger now is debt deflation: a rapid reversal of debt issuance, or deleveraging as it is called.

Tim Congdon of the London School of Economics says, “Banking system capital is being wiped out. The risk is that this could lead to a contraction of credit and set off a self-reinforcing downward spiral, leading to the sort of debt-deflation we saw in the 1930s.

“It is already clear that money growth has ground to a halt over the past three months. We must prevent it from actually contracting. If the Fed and European Central Bank don’t cut interest rates soon, it is going to be a problem.”

The Bank of England’s rigid inflation target, set by Gordon Brown when inflation was low, is now a millstone round Mervyn King’s neck at a time when energy, food and commodity price rises are being imported from global markets.

The Eurozone is similarly caught in a time warp relating to Germany’s neurotic fear of hyperinflation. Add the growing divergence between euro economies and a far deeper than necessary downturn is guaranteed for Western European countries.

America is already suffering a double blow: the fading of the effect from the summer tax stimulus and a loss of export competitiveness as the dollar rises.

What began as bad government, worse regulation, grasping banks, financial structures that lacked resilience because they were built on sand, have left us with a perfect storm that is about to come ashore and swallow large parts of the economy.

Yesterday the U.S. Treasury Secretary, Henry Paulson, nationalized the underwriters of half of America’s vast mortgage industry, now in precipitate decline.

Secretary Henry Paulson at news conference yesterday

Two government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, have had their books underwritten in the short term by the Government.

Fannie and Freddie are curious institutions. They don’t lend money but underwrite half of U.S. mortgage lending. This amounts to a staggering $5.2 trillion (£2,940 billion) of debt. The two companies are a kind of buffer zone between mortgagees and the real world of finance.

Since the Great Depression, the Government has tacitly made it known that it will support Fannie and Freddie through any adversity. Now that wink has become explicit — until the end of 2009.

So the managers of these enterprises are out, and the shareholders are sent to the dogs, losing 79.9 percent of their holdings to the Treasury. The bondholders — most central banks and commercial banks around the world — are safe, by Government decree. The alternative would have been a liquidation of dollar holdings on an unimaginable scale.

Predictably, bank shares have risen sharply around the world, while the dollar has lost some of its recent glitter in the markets, reflecting the new self-imposed straitjacket binding the Government’s hands for the foreseeable future.

Henry Paulson explained the thinking behind the move. “Fannie Mae and Freddie Mac securities are held by central banks and investors around the world. Investors have purchased securities of these enterprises in part because the ambiguities in their congressional charters created a perception of government backing. Because the U.S. Government created these ambiguities, we have a responsibility to both avert and ultimately address the systemic risk now posed by the scale and breadth of the holdings of GSE debt and mortgage-backed securities.”

He has also committed the Treasury to pumping up to $100 billion into each of the GSEs in the event that their capital ratios fall short.

Fannie and Freddie will now be able “moderately” to increase their lending.