We lay awake last night wondering if we’d made a terrible mistake warning notes readers of the coming “Great Inflation.” We know that the government is spending unprecedented sums of borrowed and printed cash to ‘fix’ the economy… the money supply as measured by M2 is shooting up (at an annualized rate of 14% over the past six months)… but the threat of deflation remains.

What was giving us nightmares was Japan. If fiscal stimulus is so stimulating, then Japan would have experienced on the of the biggest economic booms of all time after its government ramped up the debt-to-GDP ratio there from 50% to almost 170% to ward of the recession that struck the former Asian powerhouse in the 1990s.

Instead, as Van Hoisington and Lucy Hunt put it recently in John’s Mauldin’s Quarterly Review and Outlook, Japans economy “is in shambles.”

After two decades of repeated disappointments, Japan is in the midst of its worst recession since the end of World War II. In the fourth quarter, their GDP declined almost twice as fast as that of the U.S. or the EU. The huge increase in Japanese government debt was created when it provided funds to salvage failing banks, insurance and other companies, plus transitory tax relief and make-work projects.

In 2008, after two decades of massive debt increases, the Nikkei 225 average was 77% lower than in 1989, and the yield on long Japanese Government Bonds was less than 1.5%. As the Government Debt to GDP ratio surged, interest rates and stock prices fell, reflecting the negative consequences of the transfer of financial resources from the private to the public sector. Thus, the fiscal largesse did not restore Japan to prosperity. The deprivation of private sector funds suggested that these policy actions served to impede, rather than facilitate, economic activity.

It seems fiscal stimulus, by sucking investment into government spending, can actually be deflationary rather than inflationary.

Another problem is monetary velocity. Although the Fed can increase monetary base, it cannot force the banks to lend out this money and thus create the credit necessary for inflation to occur. Right now, banks would rather sit on their reserves rather than lend it out and risk default due to deflation. And as long as banks hold onto their toxic assets, they will need all the cash they can get to cover the costs of writedowns and credit losses.

In this way, the banks in their current state are more like vampires than zombies: they are sucking the lifeblood (money) out of the economy and perpetuating the deflationary spiral the feds are stuffing them full of money to avoid.

It continues to amaze us here at Notes that the Obama administration has so far gotten away with protecting banks’ unsecured creditors at the expense of the economy as whole. Of course, this can’t last forever. And once the banks do start lending again… we could be in for a serious inflationary surprise.