The economic slowdown on the financial crisis, combined with rapidly declining asset values, put the economy at risk of deflation. For reasons I discussed in the last post, the Federal Reserve (Fed) is actually trying to create inflation as a preferable alternative to deflation.

There is not a lot in the way of breaking news today, which is a good thing, but I think two articles are worth a look. They illustrate that there really is a healing process under way and that, despite all of the kvetching (of which I am certainly guilty), we really are making progress.

In part 1 of this post, I talked about what inflation is and how a moderate level has actually been good for the economy over the past couple of decades. That changed in 2008. Asset prices, particularly in housing, had inflated to an unsustainable level. The inflation measure the Federal Reserve (Fed) had been watching was based more on consumer consumption prices and less on asset prices. The asset price inflation got out of control and eventually collapsed. Because much of the financial system at that time was exposed to those asset prices, a financial crisis ensued.

I’ve said it before and will say it again: the debt ceiling debate, coming shortly, is the real thing we need to worry about. The deal over the fiscal cliff settled the immediate risk to the economy—although everyone’s taxes went up, they went up much less than they could have, and spending power was therefore preserved. Spending cuts, which will hit at the same time as the debt ceiling, will also be a headwind to the economy, but they are necessary and can be phased in to cause minimal harm. The one thing that could really blow us up is failure to resolve the debt ceiling issue. This is why it is actually encouraging to see active planning for failure. Given the risk, we should have a plan.

I talked in a previous post about the political options —how the Senate has, twice now, cut a deal with White House approval and essentially dared the House to vote it down. That remains, in my opinion, the most plausible option, but there are others, which range from the serious to the absurd. Let’s start with the serious:

1. A Senate deal forced through the House. This has been done successfully before, but it looks more questionable this time, as the House will be expecting it. Each time, it has been more difficult and resulted in a shorter-term solution. There may be one more bite on the apple, but it is not certain. Feasibility: Medium to high, but any solution would be short term and probably partial.
2. Scrip could be issued instead of actual cash payments once the Treasury hits the wall, enabling operations to continue despite the debt ceiling. The scrip would not be debt because it would not pay interest and would not mature, but it would be a cash alternative that would be transferable, probably to financial institutions, at a high percentage of face value. This method was used by California in 2009. Although there would certainly be problems with this solution, there is precedent—it worked in California—and there appear to be no insurmountable constitutional problems. This proposal is detailed in an article in today’s New York Times. Feasibility: Pretty high.
3. The trillion-dollar coin. Among others, Paul Krugman has proposed that a platinum coin with a denomination of $1 trillion be issued and deposited at the Federal Reserve, which would then transfer the money to the Treasury’s account. Voila! No more problem. There is apparently a clause (intended for commemorative coins) that allows the Treasury to mint platinum coins of any value it wants. It’s tough to know even where to start discussing the problems with this option, but it does seem to be legal, and economically it is not that different from what we are doing now. The problems would be political, and they would be big. Feasibility: Low.
4. The president could plausibly invoke the 14th Amendment to lift the debt ceiling, based on the language “the validity of the public debt of the United States . . . shall not be questioned.” The White House recently ruled this out, but it could remain an option if necessary. The downside? The questionable legality, the almost certain legal challenge, and the potential constitutional crisis would not really reduce the uncertainty. Feasibility: Very low.
5. A grand bargain. Both sides could come together on a deal that raises the debt ceiling and has a credible mix of spending cuts and tax reform to create a sustainable solution over time. Feasibility: Very low, unfortunately.

There has been a lot of uncertainty in the economy and a lot of volatility in the financial markets. Recently, that has been good; the bump after the fiscal cliff deal took us to a five-year high. Clearly, the expectation in the stock market is that uncertainty has been reduced, problems have been solved, and we have clear sailing ahead.

One question that has come up repeatedly when I talk with advisors and clients is whether inflation is coming. The answer is simple, if perhaps unexpected: hopefully, it is. What? Why on earth would we want inflation?

Over the past couple of weeks, significant progress in financial regulation has been made at both the U.S. and international levels, and most people don’t care. (Nor should they, in many ways.) Yet, there have been a couple of developments that are relevant to the average person.

First, though, let’s look at a broad picture of why banks matter. If the country had to operate with each individual or business using its own assets, growth would be very limited. Banks (or other lending institutions, but let’s keep it simple) allow those with extra capital to provide it, for a fee, to those who need the capital and are willing and able to pay for it. The bank acts as an intermediary and takes its own fees. Everyone benefits: the depositor, who gets paid; the borrower, who gets access to capital; and the bank, which also gets paid.

[youtube=http://youtu.be/vEkJUlE8-CI?rel=0hd=1]

“The tax issue is finished, over, completed.” — Mitch McConnell

“The tax issue is resolved.” — John Boehner

— Guest post from Peter Essele, senior investment research analyst

Traditionally, to make prognostications concerning the direction of the economy, investors and economists alike tend to look at the total change for nonfarm payrolls on a monthly basis. Commonwealth’s Asset Management team has developed the metric shown here, which is a slightly different way of looking at the same data.