A Wall Street Journal article, “Japan Worries It Faces the Return of Deflation,” contained an argument I found unconvincing:
In the U.S., some economists say deflation may occur if market conditions deteriorate much further and job losses proliferate. But Teizo Taya, an adviser for Daiwa Institute of Research and a former policy board member of the Bank of Japan, says it’s unlikely that the U.S. will experience Japan-style deflation.One reason: Japan faced an unusual situation, where wages remained stagnant even though companies posted higher profits because they were keeping costs low to compete with rivals in China and other nations.
That discouraged consumers from spending. Wages in the U.S. and some European nations have been rising and higher expectations of inflation are built into the economy. “One, two, three years of recession won’t change that,” Mr. Taya says.
There may be reasons to think the US won’t suffer from deflation, but this is not one of them. The US has had stagnant real wages since the mid 1970s, and inflation has dropped sharply of late as commodities prices have fallen. However, a decline in the dollar or a resumption of agricultural goods inflation (consumers are seeing some effects on a delayed basis because some packaged foods makers held off as long as possible passing on price increases) could revive inflation worries.
Nevertheless we have in fact seen a pattern that in many respects already resembles Japan’s. Our last upturn was the first postwar expansion ever to have less than half of GDP growth going to labor in some form. The normal level is slightly above 605; the lowest in any previous growth period was 55%. The latest stats I saw were that the labor share this time was an unprecedentedly low 29%. And what was taking up the balance? Again, like Japan, corporate profits.
The US, like Japan, faces competition from cheaper emerging economy labor and also has a workforce with very little bargaining power. We masked that with massive consumer borrowing, so the average Joe had a rising standard of living without a true increase in income. Now that access to the consumer credit machine is highly restricted, and households are learning how hard it is to pay down debt, they will be less likely to be as profligate even if banks become more generous when the credit crunch is past (and we also have the possibility of the implementation of stricter bank regulations to hinder banks from lending too much to reckless or naive consumers, such as usury ceilings and tougher rules on not letting people borrow more than they can realistically repay).
And the idea that labor can get wage increases during this slump is wishful thinking. My brother works for a Cerberus owned paper mill, one of the lowest cost in the industry. Their contract proposal is for four years with no wage increases, a reduction in conditions that call for overtime, a cutback in health benefits, and an end to the Christmas shutdown (this isn’t a sop, by the way, mills need shutdown for maintenance, Canceling the shutdown is bad operational protocol.). In other words, this is tantamount to a pay cut. I am sure he is not alone.
Now there are reasons to think we won’t have deflation, just not the ones stated in the article. First, the standard prescription for actual or threatened deflation is to devalue the currency, as Roosevelt did. That produces substantial reflation. Second, labor is pushing for a reversal of some of the restrictions on collective bargaining implemented over the last 26 years. If workers do secure more rights relative to management and shareholders, that makes deflation far less likely (they will not, for instance, accept a Japan type situation where corporations reap large profits and employees see no pay increases).
Third, many economists believe that deflation can be averted. Jim Hamilton gives a typical argument:
Some of my colleagues still talk of the possibility of a liquidity trap, in which the central bank supposedly has no power even to cause inflation. Their theory is that interest rates fall so low that when the Fed buys more T-bills, it has no effect on interest rates, and the cash the Fed creates with those T-bill purchases just sits idle in banks.To which I say, pshaw! If the U.S. were ever to arrive at such a situation, here’s what I’d recommend. First, have the Federal Reserve buy up the entire outstanding debt of the U.S. Treasury, which it can do easily enough by just creating new dollars to pay for the Treasury securities. No need to worry about those burdens on future taxpayers now! Then buy up all the commercial paper anybody cares to issue. Bye-bye credit crunch! In fact, you might as well buy up all the equities on the Tokyo Stock Exchange. Fix that nasty trade deficit while we’re at it! Print an arbitrarily large quantity of money with which you’re allowed to buy whatever you like at fixed nominal prices, and the sky’s the limit on what you might set out to do.
Of course, the reason I don’t advocate such policies is that they would cause a wee bit of inflation. It’s ridiculous to think that people would continue to sell these claims against real assets at a fixed exchange rate against dollar bills when we’re flooding the market with a tsunami of newly created dollars. But if inflation is what you want, put me in charge of the Federal Reserve and believe me, I can give you some inflation.
I am not at all certain that solutions are anywhere near so simple. One clever reader called Hamilton’s remedy equivalent to saying you could cure cancer with a bullet to the head. And I suspect that observation is correct. There are conditions where the cure for deflation may be every bit as unpalatable as the disease.
But the broader point is our experience with deflation in the modern era is limited (mild deflation was common in much of the 19th century, and England also had a short and nasty episode after World War I) and generalizations should probably be made with a great deal of caution.
EvilHenryPaulson 
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Yves, I have a difficult time understanding the mechanisim that would be used in a devaluation of the dollar since it is an entirely floating currency; ie, not backed or pegged to any other currency or commodity.
From Wiki: ‘Executive Order 6102 is an Executive Order signed on April 5, 1933 by U.S. President Franklin D. Roosevelt “forbidding the Hoarding of Gold Coin, Gold Bullion, and Gold Certificates.” It required all persons to deliver on or before May 1, 1933 all gold coin, gold bullion, and gold certificates owned by them to the Federal Reserve. Under the Trading With the Enemy Act of October 6, 1917, as amended on March 9, 1933, violation of Executive Order 6102 was punishable by fine up to $10,000 ($166,640 if adjusted for inflation as of 2008) or up to ten years in prison, or both. Because of this forced immediate sale of gold to the Federal Reserve at the government set price of $20.67 per ounce, this Executive Order is often referred to as the Gold Confiscation of 1933. Shortly after this forced sale, the price of gold from the treasury for international transactions was raised to $35 an ounce; the U.S. government thereby devalued the U.S. dollar by 41%.’
Perhaps the problem is that we are really discussing a possible depreciation of the dollar, not a devaluation of the dollar?
‘Devaluation is a reduction in the value of a currency with respect to other monetary units. In common modern usage, it specifically implies an official lowering of the value of a country’s currency within a fixed exchange rate system, by which the monetary authority formally sets a new fixed rate with respect to a foreign reference currency. In contrast, (currency) depreciation is most often used for the unofficial decrease in the exchange rate in a floating exchange rate system. The opposite of devaluation is called revaluation.
Depreciation and devaluation are sometimes used interchangeably, but they always refer to values in terms of other currencies. Inflation, on the other hand, refers to the value of the currency in goods and services (related to its purchasing power). Altering the face value of a currency without reducing its exchange rate is a redenomination, not a devaluation or revaluation.’
‘Currency depreciation is the loss of value of a country’s currency with respect to one or more foreign reference currencies, typically in a floating exchange rate system. It is most often used for the unofficial increase of the exchange rate due to market forces, though sometimes it appears interchangeably with devaluation. Its opposite is called appreciation.’
Great post and thanks for taking up the discussion of this subject.
http://en.wikipedia.org/wiki/Devaluation