A very good article on the Telegraph site from Ambrose Evans-Pritchard, probably their best columnist. He points out that debt deflation is now occurring in the US. This is a phenomenon where a fall in the price level increases the real value of debt - and hence increases its burden on the debtors. (The debt deflation hypothesis was formalised by the American economist Irving Fisher in the 1930s: Steve Keen's excellent book Debunking Economics (available fairly cheap as an online download here contains an excellent explanation for the non-technical reader.)
The yield on 10-year Treasury bonds (a good benchmark the cost of government debt finance) has risen from 2 per cent to 3 per cent over the last six weeks, despite the initial Paulson bank bailout. And the US price level is falling.
A large increase in debt servicing costs could blow a hole in the reflation strategies which most countries are either toying with or have already initiated. It would seriously increase the risk of governments "doing an Iceland" and defaulting on their debt payments - which is a reinforcing feedback loop, since an increase in the risk of default makes lenders more nervous about lending to governments which in turn increases the risk of default... etc.
But on the other hand, failing to reflate means the economy is likely to just drop of a cliff, with huge losses in output which mean governments would have to borrow more just to keep current levels of public spending going (because of the decline in tax take). It's a real Catch-22 situation.
Is there a way out? There are two possible options. One is the route of just "printing money" (it's slightly more sophisticated than that... the central bank purchases debt, which expands the money supply).
BBC economics editor Stephanie Flanders's Stephanomics blog points out one risk with printing money (or 'quantitative easing' as it's sometimes called): there's no guarantee that an increase in the 'narrow' money supply (notes and coins plus banks' operational balances at the Bank of England) will translate into an increase in the broad money supply, which is what would really drive a recovery. Banks need to lend for that to happen. However, if the Government nationalised the banks - or regulated them into lending money by some other route, although without nationalisation that's difficult - we'd soon see broad money expanding, so I don't see that as a problem.
This may be an option that receives a lot more attention if things really are as bad as Ambrose Evans-Pritchard points out (and they may well be).
Otherwise, the options of letting the banks fail, and starting again under state control or regulation, becomes more attractive the more the costs of servicing the debt which is being incurred under the current policy increase. I'm starting to lean towards the idea that politicians everywhere need to collectively throw their hands up and admit that the game is up, we've been operating with a flawed system for the last 30 years, it's led us down a blind alley and we need a completely different approach. That different approach will have a far greater role for public ownership and regulation than we've had in the financial free-for-all of the last decade. The problem is that the rather disappointing progress of the bailout legislation in the US (which I'll say more about tomorrow) is, as Evans-Pritchard points out, doing very little to plug a deflationary vortex into which the whole world is inexorably being dragged. Things really are f***ed out there, and we are in the abyss. Enjoy the view.