The Federal Reserve System has published a paper,
Preventing Deflation: Lessons from Japan's Experience in the 1990s,1 which analyses the limits of monetary policy to cope with situations such as Japan faced after its speculative bubble burst.
The traditional tool used by the Fed to manipulate the financial markets towards stability has been the manipulation of interest rates by raising or lowering the U.S. federal funds rate, also known as the "discount rate," and frequently but inaccurately called the "prime rate." This is the interest rate charged by the Fed to the private banks who are its sole customers for money lent to those banks. Because of the way banks work, raising this interest rate shrinks the money supply; lowering the rate causes the money supply to expand.
There is a limit to the manipulation that is possible by this method, though. How low can you go? The interest rate, no matter what, will not fall below zero.
Those of us who survived the Seventies know what an inflationary spiral was. People became reluctant to save money, because they expected prices to rise: saving money actually cost you in the real things money can buy. The failure to save meant that money for investment wasn't there. In order to provide a real return, interest rates had to be higher than the rate of inflation. The result was a prolonged period of economic stagnation despite constant rising prices.
What Japan suffered in the 1990's was exactly the opposite: a deflationary spiral. Their central bank felt that the economy was becoming overheated in the late eighties; they raised interest rates. The money supply contracted as planned. This burst the speculative bubble: the money to speculate with wasn't there anymore. Prices for land began dropping. Demand for investment funds dropped as well. The financial markets overreacted.
Consumer prices, too, began dropping. This seems a welcome development; it became an expected thing, even as inflation was planned for in the Seventies. People stopped spending; why buy now, when you can get the same thing for less by waiting?
It proved difficult to restart the economy given this expectation. No one was going to lend or invest capital to business in this environment. How would anyone make money when demand is so sluggish? The result was a decade-long slump that arguably still is not over.
All the ingredients to follow this precedent are in place. The current U.S. bear market seems in hindsight to have begun in spring of 2000, when the Fed, feeling that the economy was overheating and that inflation was an immediate danger, raised the discount rate. The effects on stock prices led eventually to the collapse of the "Internet bubble," a speculative phenomenon that gave rise to billions in faery pelf, and whose effects were by no means confined to tech stocks.
One of the purposes of financial markets is literally the flushing-away of excess currency that would otherwise inflate a speculative bubble. Billions in paper losses can occur that merely represent the elimination of these illusory riches. Money, after all, is only worth what it can buy; and there is only so much stuff in the world. Financial systems give rise to paper billions that may not necessarily be backed by real worth.
What happened was more than this, though. The tech bubble was fueled by all sorts of wild and imprudent talk that now seems ironically funny. Unsound practices, first in the go-go industries, and later in other sorts of new venture capitalism, were exposed. As the tech industries matured, lawyers and lobbyists moved in: existing firms claimed various sorts of legal monopoly franchises, enforced them, and paid for and got new and drastic powers with their monopolies to boot. Not surprisingly, the pace of real innovation slowed remarkably.
There was a crisis in confidence that shook the foundations of the whole Japanese business culture. This, too, seems to be occurring in a far more drastic fashion in the U.S., where the papers and the talk shows are now full of plans to jail CEOs and accountants. No doubt, human sacrifices of some sort will be needed to slake the wrath of Democracy.
The prognosis seems grim. The authors of the Fed paper suggest that immediate and drastic stimulus is needed to head off a similar collapse here. Even in that case, though, there isn't much lower you can go before you run into the wall of zero. No one is going to pay you for the privilege of owing them money. And if even that is too little or too late, we may be looking at a decades-long downturn.
1The link contains an abstract. Alas, the main paper is a PDF file. The PDF file can be viewed or downloaded from the abstract page.