At first glance, falling prices appears to be a boon to consumers as goods and services become cheaper. But, combined with falling incomes and rising unemployment it creates a toxic mix of economic stagnation.
Problems of DeflationPrice Wars. To attract consumers, firms began price cuts that became increasingly aggressive, but, the price wars did little to boost overall spending, it only led to smaller profit margins and caused many firms to go under. The fall in output caused unemployment in Japan to rise from 2% to 5%. 5% may still seem low, but, this official figure ignored a lot of disguised unemployment such as early retirement or temporary work.
Paradox of Thrift. With the threat of unemployment, consumers sought to save and reduce their spending. The incentive to save is increased by falling prices. Falling prices means goods are cheaper in the future therefore people kept delaying purchases, espeically of big ticket items. The combined rise in savings reduces consumer spending. (the Japanese saving ratio did fall in this period, but, this was due to other factors such as an ageing population)
Rising Debt Burden. Deflation increases the real burden of debt. This caused problems for firms and consumers with large debts, discouraging investment and spending. Deflation in the UK and US would be even more damaging because consumers are more exposed to debt.
Difficulties in Dealing With DeflationZero Interest Rates. Even though Japan cut interest rates to 0%, deflation means the real interest rate remained high.
Fiscal Policy. Japan did try various measures of fiscal expansion such as government spending schemes. But, these were often inadequate. Unfortunately, Japan's economic crisis coincided with concerns over an ageing population and the impact on the government finances. Worried over the rising debt burden, the Government increased taxes in 1997 and promptly caused another recession. The recession led to further rises in government debt and Japanese debt now stands at close to 195% of GDP.
Difficulty in Creating Inflation.
We have got so used to worrying about inflation, it seems hard to believe that to create moderate inflation can actually be quite difficult. The Japanese Central Bank did introduce a limited form of quantitative easing, increasing the money supply by upto 12% a year but it struggled to gain normal inflationary pressures.
The recent economic recovery of Japan 05-07 was mainly export based. Thus when the global economy slowed down, Japanese GDP collapsed again leading to a further bout of deflation.
It seems deflation is an ill that persistently dogs the Japanese economy.
Deflation in Japan at BBC