Here is a rough bullet point set of arguments for why deflation has a near zero probability of occuring in this country, despite the economic collapse.
- Foreign central banks -- Due to its 'special' status as global reserve currency, the US has inflated uncheked for decades, leading to an enormous balance of payments problem with its creditors. If the US were still on a gold standard, China, Japan, and other creditors would have redeemed their dollars in gold, and we would have very quickly run out, preventing further inflation. Rather, due to continued trade deficits, the coffers of the central banks of foreign nations are bursting at the seams with dollars, and, given the dollar's deliberate overvaluation to other currencies such as the RNB, continue to accumulate overseas. This artficical overvaluation of the dollar has kept the symtoms of inflation, rising prices, in check for decades. However, with the American consumer unable to continue personal deficit spending, the Chinese and other countries will no longer be able to use the currency peg to keep their exports competitive without sparking massive inflation domesitcally. Therefore, the Chinese and other creditor banks will have to pare down, or stop completely, their support of the overvaluation of the dollar. When this happens, many of the dollars sitting overseas will rush back home, causing prices to rise on all imported goods in the US as the dollar loses its purchasing power. In fact, this is simply the result of the previous inflation of the past decade delivered all at once. We've already heard the rumblings out of China about adopting SDR's...
- Massive government stimulus and spending -- as the private sector tries to deleverage and reinforce its preferences on the balance of savings and consumption, the government has rapidly increased its borrowing. In fact, we've seen that net indebtedness in this country has remained essentially flat, even though the savings rate has jumped to 6%+! What this means is that for every dollar that the private sector refuses to borrow, the government is borrowing it on its behalf. The problem is, the government isn't really involved in much productive enterprise, so it's unlikely they'll ever be able to pay the debt back that they take out on our behalf. This will probably stoke the fires already lit in the foreign central banks to dump the dollar (stop buying our debt) and lead to massive price increases on imports as the dollar collapses. So what will the government have to do? Reduce its deficits. Since it can only do that through cutting government or raising taxes, it will almost certainly raise taxes, since cutting government jobs will lead to increased unemployment and fear of civil unrest. The rise in taxes in the future will make our economy even less competitive, decreasing further the chances that we will be able to pay the debt back in real terms.
- Monetization of debt instruments -- if the government can't find foreign buyers for its debt and finds it politically unpopular to raise taxes, for the sake of empolyment they will instruct the central bank to monetize their debt (probably under the guise of some appropriately confusing acronym), allowing the government to simply spend new money into existence. Since the government is on a crash course to borrow as much as the public saves, it will spend trillions of dollars into existence as industrical capacity the the overall productivity of workers (since gov't employees aren't productive) goes down. The result? Well, in this scenario, foreign governments have stopped buying our debt, which will causes prices to rise anyway, but the direct monetization of future debt will surely lead to a surge in prices as more dollars chase fewer goods domestically and foreigners don't want to accumulate our paper. The monetization of our government debt has already begun, so these things don't necessarily have to hapen in order, or all at once.
- Monetization of MBS and other illiquid crud -- The fed has already agreed to purchase $1.2 T in mortgage backed securities, 'liquifying' the housing market and allowing the bankrupt entities Fannie and Freddie to continue buying MBS paper. This will attempt to re-flate the housing market, making housing continue to be unaffordable to anybody who doesn't already have one. To counter this unaffordability, the government will increase subsidies to lure new buyers into the market. Since they don't have any money to subsidize purchases legitimately, they will simply deficit spend the money into existence, keeping housing prices up and eventually pushing the cost of everything else up along the way. Even if the economy 'picks up steam', the fed will NEVER be able to unload the MBS paper for what they bought it for, since they overpaid for it to keep Fannie and Freddie solvent. So they can't possibly dump this paper in the market to soak up the extra dollars they created, they'll only get $.10 on the dollar for it! The fed seems to think it will be able to issue its own bonds to soak up liquidity, but this will have the same effect as rasing interest rates, which will kill their very inflationary efforts.
- Banks won't fail -- The government has drawn the line in the sand saying that systemically important banks won't be allowed to fail. Well, failure of banks is precicely the MECHANISM for deflation, the destruction of previously printed money as banks fail and deposits vanish. Rather, the government will continue to 'top off' the banks coffers until they can notionally meet their obligations, and all this with borrowed or printed money. Therefore, the monetary base won't contract. In fact, it will continue to expand. The creation of the FDIC insures that we can't have deflation, since money can't be destroyed via bankruptcy anyway.