Is the US headed for a lost decade? (Deflation rides a pale horse.)

The last large bubble to burst in a Western economy was in Japan in late 1989. Remember how Japan’s economy was the marvel of the world in the 1980’s? They were the export driven model of modern economics; faster, smaller, more efficient. It was brilliant to watch. But, as we know, the bubble burst.
The bubble that burst in Japan was at first an asset inflated one. During the 1980’s equity and commercial real estate prices inflated, this caused a tremendous amount of speculation in real estate and equities (stocks, etc) that was in part driven by a high savings rate in the banks and easy credit because the interest rates were so low. The banks and the speculators needed to put the money somewhere, so they gambled on commercial real estate and stocks.
Granted, we don’t have a high savings rate here in the US, we didn’t need one to get where we are. All it took was easy credit that drove the ever inflating residential real estate market. The money taken out of re-finances by consumers went for a huge spike in consumption. Paper wealth was created and spent on the actions of people using their houses like ATM machines. We over-spent fake housing equity, the banks in Japan did risky speculation with savings while simultaneously investors took cheap loans to speculate in the equities and commercial real estate markets. Both  Japan then and the US now are in the same situation; post-bubble economics.
In 1989 the Finance Ministry in Japan recognized the bubble and raised interest rates, effectively shutting off the fire hose of Yen that was fueling growth. With the flow of Yen effectively shut off, good money stopped being thrown after bad money and the stock market and commercial real estate market crashed taking many banks and companies with it. Equity values (stock market) lost 60% from late 1989 to 1992, commercial real estate and land values dropped by 70% in the 1990’s. While this collapse was occurring, the Finance Ministry then cut rates to near 0 to try to re-inflate the economy. This was too little too late, Japan then entered what Krugman calls a liquidity trap where “A situation in which prevailing interest rates are low and savings rates are high, making monetary policy ineffective. In a liquidity trap, consumers choose to avoid bonds and keep their funds in savings because of the prevailing belief that interest rates will soon rise. Because bonds have an inverse relationship to interest rates, many consumers do not want to hold an asset with a price that is expected to decline”.
How does this effect the US? We don’t have a high savings rate. Well, actually we will. As people become more frugal and learn the lessons of this bubble, they will spend less and save more. I have seen this happen with my own eyes. Everyone has fear, people are buying gold, stashing money in the mattress, paying down debt, and making/spending less money per family unit than before. The end result of this is decreased demand, which on the supply side looks the same as a high savings rate. When there is no demand, printing all of the money in the world wont cause inflation if the money just sits there and has no velocity.
Prime interest rates are near 3.25%, the Fed Fund Rate and Fed Discount rates are both <0.75%.
The flow is full on if anyone wants to borrow or lend. The problem here is that the economy is in a choke hold by the current administration. Companies are sitting on billions of dollars for expansion but wont move to expand until they see some sort of restraint from Washington DC on spending, new regulations, and confiscatory taxes. With rates this low, the Fed looses leverage in one direction, the direction of deflation. They could cut the rate to 0% like the Japanese did and still there would be no lending/borrowing. The Fed has room to move the rate upward if it sees inflation, but inflation is a very long way off.
The US could very easily enter a Lost Decade of its own. This is where the lack of a high savings rate will be more painful. In Japan the high savings rate and traditional frugality assured that consumption would be steady throughout the 1990’s. In the US, we didn’t save, so consumption will go down as a matter of course. I would argue that because of the lack of prior savings coupled with massive consumer debt and the fear that consumers have over spending now that we will see deflation well before any inflation. Deflation is caused by falling asset prices, hoarding of cash/frugality/non/less-consumption, then the collateral for backing of loans fall, which then leads to bank losses, which lead to reluctance to loan money which is compounded by borrowers fearing the unpredictable future and not borrowing to expand anyway. The economy does not expand and goes stagnant or contracts, then consumers and businesses are unable to spend, resulting in deflation.
In order to break our own trap, we have to have stability from DC and a better business climate. The monetary supply is huge, but there is no velocity of that money, so there is no inflation. The oxygen of a capitalist economy is calculated risk. That means capital is risked to expand business and create jobs. It would be nice if while we are at the FedGov could cut some regulations and taxes and pave the way for some manufacturing sector growth. If the Fed sees inflation, it can raise interest rates to kill it, Paul Volker proved that in the early 1980’s.
Be prepared for a decade of very slow growth and limited jobs until we claw our way back to the asset price and GDP peaks of a few years ago unless there is radical change from the Federal Government.

Background articles:

Saturday Morning Lecture: Milton Freidman, on the American Economy, 1977

Sometimes inflation is a good thing