I'm guessing it's a flashback too. I hope. Too bad the cops couldn't wait a little longer to come bustin' in.
I'm thinking that the merchant's story is supposed to be instructive or in contrast to (not sure which yet) the lies Yakumo told Konatsu. In the story, the lie made their lives better, and the truth yielded forgiveness. Not sure if that's also the case for Konatsu. Did it make her life better? Instead of coping with it, she ended up hating her surrogate father and becoming bitter. Will the truth now allow her to forgive him? Even in Yakumo's version, he took the blame for everyone's misery, if not the deaths.
The other interesting tie-in is the story about the Inari brothel, where the three characters were bound so that they had to leave together. Miyokichi and Sukeroku can't move on until Yakumo is ready to go, and he can't go until they're at peace (see Sukeroku barring his path to the gate before sending him back), which I think will only happen when the whole story comes out. Neat Catch-22...
I really felt bad for Yakumo though - over and over and over he kept getting hit with finding out what everyone has been doing behind his back. That totally sucks. And the scene on the bridge was just devastating. And omg is Akira Ishida giving the performances of his life week after week. This show... ::sigh::
On a lighter note, if you're also watching Gintama, a couple of weeks ago they did a gag with several of the main characters (including Ishida's Katsura) repeatedy spitting on another one. There was just something ineffably sublime about going directly from Ishida's exquisite performance in Rakugo to his gleeful impersonation of a snarky llama in Gintama. And the week after that in Classicaloid, hearing him as Pad-kun cussing up a storm at a bird that just shit on him. The man is definitely showing his range this season!