How do we manage deflation?

The old bogeyman of deflation has re-emerged as a worry for the U.S. economy.

Here's something else to fret about: After studying more than a decade of deflation in Japan, economists have slowly realized they have no idea how it works.
Deflation is usually associated with a Great Depression-like drop in demand.  Consumer prices, incomes and asset prices fall.  Interest rates go to zero, as low as they can go.  As prices and incomes fall, the cost to borrowers of servicing debt does not, sucking life out of the economy and pushing prices down further.  A bad situation, in short, gets worse.
In 1932, U.S. consumer prices fell 10% and between 1929 and 1933 they fell 27% in all.
But Japan's experience has looked nothing like this. Rather than being deep, destructive and concentrated in a few years, deflation has been a surprisingly mild, drawn-out affair. Consumer prices have been falling in Japan for 15 years, but never by more than 2% in any single year.  Japan's deflation has been a morass, but not the destructive downward spiral many economists predicted.  Why?  And what does it portend for the rest of the world today?
Economists don't have good answers.
"We don't know how deflation works," says Adam Posen, a member of the Bank of England's monetary policy committee who has been studying Japan since 1997. "We don't have a way of rationalizing steady, several-year flat deflation," he says.
This is a pressing issue for the U.S. Federal Reserve and other central banks.

Source: The Wall Street Journal, July 26, 2010

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