Perhaps in answer to his critics (or, more likely, simply because he sees the issue as pertinent right now) Paul Krugman has written a piece about the possibility of a liquidity trap, and the danger of deflation. This isn't new, of course... explaining the idea of the liquidity trap was the main idea behind several of his Slate articles and featured in more than a few of his books... but it's always useful to see it laid out in a forum as high-profile as the Times.

The key idea behind the piece is that the United States' economy now looks like the Japanese economy of the mid-90's. This is a huge problem:

In fact, it's striking how gradually Japan's catastrophe unfolded. When the stock bubble of the 1980's burst, Japan's economy didn't fall off a cliff. By and large the economy continued to grow, if slowly, and the nation didn't have a severe recession until 1998. But year after year, Japan underperformed, growing less than its potential. Though the Japanese government tried to stimulate the economy using the usual tools — deficit spending, interest rate cuts — it was never enough. By 1995 or so the economy had slid into a liquidity trap; by the late 1990's it had entered into a deflationary spiral.

Our own situation is strikingly similar in some ways to that of Japan a decade ago. Like Japan circa 1993 or 1994, the United States is now facing the aftermath of a huge stock market bubble — the Nikkei and the Standard and Poor's 500 both tripled in the five years before their respective peaks.

Also like Japan, we face a problem not of sharp downturn but of persistent underperformance — an economy that grows, but too slowly to prevent rising unemployment and falling capacity utilization.

What's different is that we have Japan as a cautionary example. Is forewarned forearmed?

The key to understanding the situation is that concept of "underperformance". It's not that either the Japanese economy then or the American economy now is failing to perform, or to grow. The key problem is that productivity gains (normally so welcome) are outstripping the efforts of economic actors to take advantage of them. It's kind of like the old cartoon cliche of a fast racecar zipping along, with the driver's body hanging back, holding on only to the steering wheel. Sure, he's still moving along, but it's only a matter of time before it just becomes too much, and the car leaves him behind. With that in mind, it becomes apparent that the political debate largely misses the point, and (as Prof. Krugman points out) ignores the necessity of dealing with the situation if and when things go in a direction that hadn't been planned. Sure, it's probable that things will be ok, but the question is whether or not the unplanned will sink things.

As Prof. Krugman said, "Like the Fed, I hope that [deflation] doesn't happen. But hope is not a plan."