For many, the inability of Japan's economy to recover remains a mystery. This inability to assess the situation arises from misjudgments concerning the nature of the malaise and can be traced to the application of faulty economic theory.
Besides the human suffering, one of the worst effects of Japanese economic stagnation is that it helped revive the old, discredited concept of a "liquidity trap," which supposedly occurs when interest rates are very low. English economist John Maynard Keynes envisioned this phenomenon in order to understand the Great Depression. But Japan's economic misery is due neither to excessive savings nor to a liquidity trap as suggested by Professor Paul Krugman of Massachusetts Institute of Technology, among others.
The fallacies of the liquidity trap are blurred by claims that seem to be logically intact. For example, the sort of low interest rates associated with Japan's "zero-interest" policy lead to expectations that interest rates can only rise. Since higher interest rates cause bond prices to fall, households and businesses avoid capital losses that would occur from purchasing bonds by holding cash balances instead.