Deflation in Japan
Deflation in Japan started in the early 1990s. The Bank of Japan and the government tried to eliminate it by reducing interest rates, but this was unsuccessful for over a decade. In July 2006, the zero-rate policy was ended. There were several reasons for deflation in Japan which are explained below:
1. Bust of Asset price bubble: There was a rather large price bubble in both equities and real estate in Japan in the 1980s (peaking in late 1989). When assets decrease in value, the money supply shrinks, which is deflationary.
2. Insolvent companies: During the boom time (1980s) Japanese banks lent aggressively to companies and individuals that invested in real estate. However, when real estate values dropped, people were not able to pay back these loans to banks. The banks tried to collect the collateral (land or properties), but this wouldn't pay off the loan because their prices had fallen significantly. Banks delayed their decision to foreclose these loans hoping asset prices would improve. These delays were also allowed by national banking regulators. This continuing process is known as maintaining an "unrealized loss", and until the assets are completely revalued and/or sold off (and the loss realized), it will continue to be a deflationary force in the economy. Improving bankruptcy law, land transfer law, and tax law were suggested by leading economists as methods to speed this process and thus end the deflation.
3. Insolvent banks: Japanese banks had a larger percentage of their loans as "non-performing" i.e. they were not receiving any interest payments on them, but have not yet written them off. With high non-performing loans or assets, they were unable to lend more money; thus, their earnings declined significantly and risk of insolvency increased many a fold.
4. Imported deflation: Japan imports Chinese and other countries' inexpensive consumable goods, raw materials (due to lower wages and fast growth in those countries). Thus, prices of imported products were decreasing with the rise of economy of scale in China. Domestic producers had to lower their prices in order to remain competitive. This decreasing in prices of domestic products over a period of time led to deflation.
5. Fear of insolvent banks: Japanese people were afraid that banks might collapse so they preferred to buy gold or (United States or Japanese) Treasury bonds instead of saving their money in local bank accounts. Thus less money was available for lending and therefore economic growth. This meant that the savings rate depresses consumption, but did not appear in the economy in an efficient form to spur new investment.

Deflation alarms in the US?
With the fed fund rate at a historic low (0.00-0.25%), there is a growing fear of deflation in the US. Many economists believe that USA could face short term period of deflation. With the bust of housing bubble, acute shortage of credit and falling consumption, USA has more or less similar conditions that were prevalent in Japan in early 1990s. However, I believe there are some basic yet crucial differences.

Firstly, Japanese companies were far more dependent on commercial banks for financing than are today's U.S. multinationals, which have stockpiles of internal capital as well as broader access to capital markets. Moreover, US Treasuries are still considered as the safest investments in the world. This keeps the flow of money into the US economy.

Secondly, Bank of Japan’s exceptionally poor monetary policymaking was a big reason for the country's protracted problem. The central bank's failure to lower interest rates in the early 1990s ultimately drove the economy into a deflationary death spiral. They were just too slow and conservative to react to the situation. However, US Fed has been quite aggressive and proactive in taking sound monetary decisions and ensuring that they do not repeat those mistakes. In 1992, for example, amid negligible inflation and a comatose economy, the Bank of Japan's key interest rate was still nearly 4%. In contrast, after the tech bubble burst in the USA, the Fed quickly slashed its benchmark rate to 1 %. Also, the current fed rate is between 0.00-0.25%.

Thirdly, though both USA and Japan faced housing trouble and mortgage crisis, Japan's central bank was too slow to act. The country's banks hid their bad loans beneath opaque corporate structures rather than absorb the losses. But rather than write off the loans, Japanese banks extended additional credit to borrowers, allowing them to at least make minimal interest payments. Those made banks look healthier than they were, at the cost of impairing the flow of credit to new businesses. However, American banks have been forthcoming in absorbing the losses on their books and writing off loans. This has given fed a clear picture of true losses and subprime crisis in the economy.

Having said that I believe the US economy may bleed for some time and enter a period of deflation. However, that period would be short lived and not as prolonged as that of Japanese economy in 1990s. As per an estimate, avoiding a long period of deflation and recession might cost the US a staggering $3 Trillion.

Will India face deflation?
Let’s examine Indian economy vis-à-vis Japanese economy of 1990s. In the last five years BSE exchange went up from 5,000 to 21,000, an increase of 400% while real estate prices in Indian witnessed an increase of over 300%. This is phenomenal increase in prices and asset prices looked highly inflated. After the global financial crisis, Indian stock exchange plunged by over 60% and real estate values dropped by almost 30-40% in less than six months. Some welcomed this fall while majority believed Indian global dream is finally over. The mayhem still continues with stock prices and real estate prices further going down.

Compare this with that of Japan - In the five years before its 1989 peak, the Nikkei (Japanese stock exchange) stock average rose 275%. Property prices became so inflated that the tiny spit of land surrounding the Imperial Palace in central Tokyo was briefly worth more than the entire state of California. At the time, Japan's seemingly unstoppable rise inflamed fears among Americans that the United States had slipped into permanent economic inferiority. When the bubble finally busted in late 1989, stock and property prices nose-dived in tandem. In less than three years, the Nikkei stock average fell 63% from its peak of 38,916. It didn't hit bottom until April 2003 and a total decline of 80%. Do these two stories sound similar? Yeah they do!

Inflation figures for the last week was 3.92% which is far less than the peak rate of 12% less than six months back. Are we going into a period of negative inflation or deflation? We are currently in a state of disinflation which is a decreasing value of inflation as the inflation rate is still positive. However, this may lead to a situation where downward price movement continues and we enter a period of deflation. I believe this is highly unlikely because we are a growing economy with very young population. Moreover, we are not an export oriented economy and hence do not depend too much on external demand. Our economy is mostly driven by domestic demand and consumption, which is somewhat insulated from other countries and global events. We still have lot of room to maneuver our policies to regenerate demand and spending. Yet, with the growing globalization we too run a risk of deflation if our monetary and fiscal policies are not handled well.

How deflation can be avoided?
To counter deflation we have to revitalize our growth story, reignite demand and create confidence among people. Compare to the inflation rate, 3.92%, lending rates in India are still close to 10%, which is quite high. Unless lending rates do not come down people won’t buy properties, automobiles or other consumer goods. Moreover, corporate won’t be able to borrow money to launch new innovative projects, spend on infrastructure or build capacity. Thus, to create demand and investments, government as well as RBI has to bring down this lending rate by implementing ways to reduce cost of borrowing funds.

Hence, only monetary policy won’t be sufficient to tackle this menace; fiscal policy too has to play a significant role here. Government has to be more aggressive in implementing reforms and speeding up infrastructure spending. Let us hope better sense will prevail among our political class.