In the New Keynesian models of the economy falling wages and prices eventually leads to full-employment. Paul Krugman explains the channel by which that happens. Falling wages do not increase the demand for labor. Price deflation increases the real money supply and that causes interest rates to fall. In a sense, price deflation acts like expansionary monetary policies. Wage and price deflation might enable an individual country to increase its exports, and raise employment, but that can't happen if other countries respond by lowering wages and prices. That leads to depressed global demand and global recession.
In a liquidity trap, like we have in the US and Japan, interest rates are already at the zero lower bound. Therefore, monetary expansion is not effective in increasing demand and employment. It only works if it raises expectations of inflation. Expectations of price inflation will encourage business and consumers to spend today in order to avoid higher prices. Deflation is bad because it increases the real burden of debt. Borrowers will have to pay back their debt with more valuable dollars. Wage and price deflation is the wrong medicine for high unemployment. Its a good thing that wages do not fall rapidly during a recession.
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