After fourteen months of big declines, global investors are desperately searching to find a floor to this credit crisis. Since stocks peaked last October the S&P 500 Index has plunged more than 24% while the MSCI World Index is down almost 27%. The purge in stock values has not escaped non-Treasury bond investors, either. Corporate investment-grade bonds, high-yield debt, municipal bonds and convertible bonds have also been trashed.

Will the Paulson proposed Troubled Asset Relief Program (TARP) finally put a floor on this bear market? Many investors think so. Yet, as Congress delays passage, the economy and especially the mortgage-backed market continues to haemorrhage.

According to investment research courtesy of Merrill Lynch, however, previous government orchestrated bailouts of the financial system have not resulted in immediate stock market gains. In fact, history suggests there’s more pain ahead before a major bottom is established.

The S&L Crisis

Following the establishment of the Resolution Trust Corporation (RTC) in 1989 to bail-out the Savings & Loans in the United States, stocks didn’t form a bear market low until late 1990. The economy didn’t bottom for another two years and housing values kept declining until 1993.

But in 1991, the S&P 500 Index powered ahead with a 30% gain and the MSCI World Index rallied 18%. U.S. stocks didn’t go too far beyond the 1991 rally as they stalled again from 1992 until a bull market started in earnest from 1995 to March 2000.

The U.S. market needed several more years to really find its footing following the S&L bailout. The problem with this historical examination is that the current credit crisis is far more lethal than the S&L debacle and, before it’s over, will cost American taxpayers at least $1 trillion dollars, possibly much more.

In inflation adjusted terms, this bailout will cost at least three times more than the S&L rescue ($350 billion in 2008 dollars) and possibly more since real estate prices are still declining. That’s an important caveat because the Paulson plan aims to provide a fund to pool all distressed mortgage-backed securities; it’s impossible to peg a price tag for this bailout until real estate prices bottom, suggesting the cost is likely to be higher.

The proposed rescue now is ultimately highly inflationary for the United States; the expansion of credit will be massive as the Fed and eventually other central banks flood the system with dollars. Yet the short-term battle is against deflation and rapidly declining asset values delay any meaningful recovery for stocks aside from a big “relief” rally, possibly in 2009. Beyond that, it’s hard to make a case for a new bull market in U.S. equities.

Japanese Deflation and the Failure to Inflate

Similar trends in Japan show the long-term effects of price deflation and the Japanese government’s inability to grow inflation during the 1990s “lost decade.”

In some ways, Japan has been “lost” since the Nikkei peaked in early 1990. The Nikkei Index remains almost 70% below its all-time high almost 20 years ago. Currently, the Dow Jones Industrials Average is down 22.5% from its all-time high.

Can the same phenomenon occur in the United States following the credit crisis?

The United States is fighting an incredible bout of deflation today, similar to Japan in 1990. Real estate deflation is especially difficult to arrest because it affects the entire economy, including individuals, corporations and especially the banking system. This is exactly what transpired in Japan. The only major difference now is that Congress might be willing to throw everything they’ve got at deflation whereas the Japanese government vacillated for years before tackling their crisis.

The Japanese economy didn’t bottom until 1999. Stocks have staged several unimpressive rallies over the last decade and remain well below their all-time highs. Despite incredible printing and money-supply growth over the last 15 years, the Japanese haven’t completely licked deflation.

What’s shocking about the Japanese financial crisis is that it took another five years for the stock market to bottom following the 1997 passage of their RTC model and the introduction of broad-based financial services reforms.

Japan is by far the world’s premier example of failed monetary expansion. One could argue that Japan has never really emerged from deflation with price levels barely above 0% over the last few years and new signs pointing to renewed deflation as the economy slumps yet again.

Just because a central bank expands credit doesn’t guarantee deflation will be entirely eliminated across all facets of finance, consumption and industry. This process might take years to eradicate. Japan’s experience might not be repeated in the United States, yet it does portend to difficult economic times ahead for America as the fight to kill deflation takes every last drop of inflation-inducing monetary expansion.

The Nordic Crisis

The Scandinavian countries of Norway, Sweden and Denmark also suffered gut-wrenching deflation and busted financial services industries in the late 1980s and early 1990s.

In the Swedish case, even when accompanied by an effective government solution to solve the crisis, the process of extinguishing bad debts vis-à-vis government intervention was painful. The Stockholm OMX Index suffered a bruising 28-month long bear market that saw stock prices dive a cumulative 45% before bottoming in 1993. Similar travails occurred in nearby Denmark, Norway and Finland.

Print Fast, Print Hard

Paulson, unlike Congress, wants to throw everything the United States has to fight the deflation afflicting American banks right away. The Treasury Secretary and Fed chief, Ben Bernanke, understand the policy errors that occurred during the 1930s Great Depression and the failure of the Federal Reserve and the U.S. government to address deflation until the latter half of that decade. They also know what happened in Japan.

History strongly suggests that any delays or lack of sufficient funds committed to blasting away at deflation can be painful. Investors should appreciate this formidable policy challenge, the time necessary to quash the crisis and reluctantly commit new funds to stocks and other risky assets.

Instead, dollar-cost-averaging for the long-term is a great value-based strategy now, especially for younger investors. For others, stick to income-producing or equity-linked investments that spin off income. Also, as credit markets eventually stabilize, look to huge values in investment-grade corporate bonds now yielding almost 7%.

This is not the time to bet the farm on stocks as deflation or an environment of rapidly falling prices and the contraction of lending inhibit earnings growth and domestic consumption for the next several months or longer. Deflation is here and it’s real.