""First, unlike Japan and Germany, we still have a growing population. Younger people buy more stuff and borrow money more readily"".........which was true in the 30's as well.I think you don't give enough thought to investor psychology,Keynes "animal spirits".People didn't borrow or invest then due to fear.My fear is politics,the Dems will see it as a chance to re-elect Roosevelt and due the "New Deal" again.But the conditions then(low debt and tax levels)don't apply now.

Stephen,

Third World nations may produce cheaply, but they have low productivity as well. That limits the amount of stuff they can produce and producing isn't all that cheap with low productivity. If it were, more US and European companies would move their manufacturing to the Third World.

Consider this example: India's procductivity is about 15 % of US productivity. If an American company ends up paying 20 % of American wages, it's more expensive to produce there, not less.

It's odd that in all these discussions contrasting Japan and the U.S. few people highlight the most crucial difference -

IN JAPAN, THE BANKS ARE INSOLVENT!

Without banks functioning normally in the money markets, monetary policy can't function effectively. Krugman raised a stir on this point (and then conveniently forgot it because it didn't suit his column) by suggesting that in Japan, they might actually have to send out helicopters to drop money on the population as the interest rate-setting mechanism was ineffective.

There are many other misconceptions about deflation, as we spent the last twenty years thinking about inflation. Michael Woodforde of Princeton is creating some of the definitive analysis. He directly addresses your point about productivity-based deflation and he considers it fallacious:

This widely heard argument (that the combination of global competition and increased productivity will generate price declines making deflation inevitable) is quite fallacious, although the reason why is not at all obvious at first glance. Essentially the reason is that improvements in productivity and increases in competition merely impact the equilibrium of relative prices, without having any necessary implications for what the absolute dollar price of any goods should be. Both of these types of improvements imply that the prices of final goods relative to the prices of inputs (labor and raw materials) should be lower.

But this need not have any implication for the fate of nominal prices of either inputs or outputs in terms of money. This depends on monetary policy. And the mere fact that relative prices need to change in a certain direction does not prevent monetary policy from either speeding up or slowing down the rate of growth of dollar prices on average, and hence achieving the target inflation rate that the central bank deems appropriate.

Thus, if the ongoing IT revolution is expected to stimulate steady productive gains, deflation will only result if the monetary authority acts explicitly to prevent input prices (wages and raw materials prices) from rising. If zero inflation in input prices were to be targeted, then the only way that the relative prices of final goods could fall in response to productivity growth would be through a deflation of final goods prices. But note that the only reason for this deflation would lie in a monetary policy decision - one preventing nominal increases in input prices.

In other words, monetary policy can control this phenomenon - provided monetary policy can be effective.

Friedman used to argue that the optimal policy goal should be modest deflation, such that cash provided a modest real return. (Megan may have heard this argument from Robert Lucas at U Chicago).

It can also be argued that inflation damages savings and investment due to the lack of inflation indexing in the tax code - depreciation allowances, for instance, themselves depreciate due to inflation. If you want people to make investments, the present value of the depreciation should be at least as large as the investment.

There were thirty years after the Civil War when prices fell but real economic growth was quite healthy.

Finally, Woodforde notes that deflation is correlated with low/negative growth, but thast should not be confused with causality. He argues the causality runs the other way.

On the one hand, one is tempted to blog all this, on the other, you may have noticed that the world of monetarists is confusing and dry as dust. I save Woodforde and his ilk for bouts of insomnia myself (unfortunately he is not a dynamic speaker, either).

So, do you still want to hear about it?

I should say Michael Woodford. Sorry.

"Mindless",

Stephen was referring to Third World countries in his entry, so your comment may be a bit off topic.

I have read some of what Friedman wrote, but I paid more attention to his comments on inflation than to those on deflation.
Even so I can say that deflation in the US and EU will only happen if there is a prolonged crisis of confidence. As long as people think that it can only become worse or at least not better, they are not going to spend money on goods and services, which sees to it times get worse.

As long as people are caught in this economic and psychological vicious circle monetary policy won't be effective, because there's no place where the cheaper capital can go.

To break out of the vicious circle there have to be events that positively influence the mood of consumers and businesspeople alike.

This is analogous to the way the monetarists describe of bringing rampant inflation to a halt: A government that makes a credible commitment to monetary stability.

What kind of commitment would you propose to bring feflation under control?

Sorry, of course Stephen mentioned Japan. Wasn't thinking straight for a moment.