* The money they earn is spent and flows into other parts of the economy, creating phantom demand in, effectively, all sectors.*

No, only the money spent near the entry point into the market is distortionary. The counterfeit money that was created five, ten, twenty years ago, acts like any other money. Think of it this way, imagine the counterfeiting had stopped fifty years ago, but the counterfeit bills had remained circulating for all that time. Are they causing distortions? No they are not, at this point they are just like any other bill. Likewise, if you are on a gold standard, it does not matter whether the gold was original stolen from the Incans hundreds a year ago. Once it's in circulation for a while, its origins do not cause distortions.

Or think of it another way. The vineyard and brothel workers spend their counterfeit bills on food, rent, and movies. Let's say the inflation stops. Now, seniors with savings have more money to spend, since they are not losing money to inflation each year. So they spend more on travel and nursing homes. The brothel workers now find jobs on airlines and in nursing homes. What do they spend their wages on? Food, rent, and movies. Thus the demand for food, rent and movies was perfectly real. Only the demand for brothels and vineyards was false.

A properly functioning market, by definition, knows how to trim the phantom demand from all sectors immediately and reallocate the remaining capital. This is the path of least collateral damage.

This is simply not true. Remember, the government already injected itself in the free the market when it declared Federal Reserve Notes as the standard fiat currency across the land. Every market contract is written assuming there are are $10 trillion Federal Reserve Notes in the world. Every entrepreneur assumed $10 trillion in notes when they planned their years production. Thus when the Federal Reserve allows the money to supply to drop in half, it is creating a tsunami sized market cataclysm. Like it or not, the government instituted fiat currency many years ago. It made a promise to the market that it would not allow hyperdeflation or hyperinflation. This is not only a promise, it's also good policy. If you are going to run a fiat currency, you should keep your dollars like gold - make the quantity as stable as possible. The market wrote its contracts based on that promise. The government needs to keep its promise, otherwise it will throw the markets into chaos as every contract gets totally fubarred.

That is the part of the spiral we're in. Until the government enforces existing laws universally and removes it's monetary distortions from the markets, private capital will stay in the proverbial mattress -- which makes all this Keynesian-vs-Austrian monetary policy talk into just a bunch of masturbation.

You are simply wrong on the facts. Much of the private capital as simply evaporated. People refuse to trade their dollars for stocks or bonds because in a massive deflation stocks and bonds are bad bet. Dividends are falling, companies failing, bonds are defaulting.

The basic problem is that there only $2 trillion actual Federal Reserve Notes in the world, but before the crisis there were $100 trillion assets in the world. The is an extraordinaryly high ratio. The only reason this ratio got to this point is through a lot formal asset guarantees ( FDIC, treasuries ) and informal guarantees ( Greenspan put, "too big to fail", government encouragement of 401ks, FreddieMac, subsidized loans for homeowners, being complicit as regulated funds put money into AAA bonds, etc,etc). Essentially, the government was winking and nodding as Wall St. pumped counterfeit bills into the economy. When Lehman failed, the government basically said, "Actually, these counterfeit bills are not tradable for Federal Reserve Notes." Then there was a panic as everyone dumped their money market funds and stocks in order to get their hands on FRN's, treasuries and FDIC insured bank notes. The Federal Reserve saw the panic, realized that this could cause cataclysmic deflation, and started guaranteeing assets.

Now, I do not approve of a lot of the government's policy. The "stimulus" is awful. I think they should also stop propping up zombie banks. Home prices need to fall, GM needs to renegotiate its obligations. What the government should be doing is preventing deflation in the most non-distortionary ways possible, such as back stopping the money market funds, declaring a payroll tax holiday and funding it with printed money, or even just mailing every American some newly printed bills. Or if you want to do a clean reboot of the whole thing once and for all, you could try Plan Moldbug: http://unqualified-reservations.blogspot.com/2009/01/gentle-...

If you were running the Fed, you would you remove the backstop on the money market funds? Why? What do you think would happen if you did?