This sounds scary: the very word 'deflation' triggers images of the Great Depression of the 1930s. In truth, though, it might not be as unpleasant a prospect as you might imagine.
To see why, let's first consider why it does worry some people. There are four reasons:
• The very fact that deflation is so unfamiliar means it would create uncertainty – and uncertainty usually causes consumers to save more and firms to invest less.
• Deflation adds to the real burden of debt. Indebted businesses must sell a greater volume of goods and services to repay the same nominal amount of debt. This could cause a wave of bankruptcies.
• Deflation can't be combatted by conventional monetary policy. Nominal interest rates can’t fall far below zero so as prices fall, real interest rates rise. Many regard this as a monetary tightening.
• If consumers expect deflation to continue, they'll postpone spending in the expectation of getting greater bargains later.
All this seems nasty. But there are some offsetting considerations.
One is that deflation doesn't just increase the real value of debt. It also increases the real value of our cash holdings; this is the so-called Pigou effect. Many of us would therefore enjoy an increase in our real wealth if prices fall. This wouldn't wholly offset the rising value of debt, simply because households' aggregate debt is bigger than their bank deposits. But it's a large mitigation.
Also, deflation can be a sign of lower costs of production and technical progress, both of which are wholly good things. If the oil price were, say, to halve, overall consumer prices would probably fall. Few of us would mourn this.
What's more, we have seen lots of deflation in large parts of the economy. Prices of goods such as smart phones, sat navs and e-readers have fallen from an infinite level - you couldn't have bought them at any price a few years ago - to affordable ones now. That's a massive rate of deflation, and a very welcome one.
This experience also tells us that falling prices don't cause consumers to delay spending. People rush to buy iPhones even though they know that a better version will come out a few months later. In fact, deflation might even boost spending; if consumers believe it is only temporary, they'll increase their buying to take advantage of temporarily low prices.
So, theory tells us that inflation might or might not be a bad thing.
But theory isn’t everything. We also have history. Before 1939, deflation was common. According to the Bank of England’s database, there were 50 calendar years between 1830 and 1939 in which consumer prices fell.
To get an idea of the consequences of this, I looked at what happened to GDP in the year after these deflationary years. And the results are encouraging. On average in the year after a fall in prices, real GDP grew by 2.6 per cent. By contrast, in the years after non-deflationary years (when consumer prices were flat or rising), GDP grew by an average of only 1.1 per cent. Taking all the years from 1830 to 1939 together, there's a statistically significant negative correlation (of minus 0.36) between the inflation rate in one year and real GDP growth the next.
Yes, deflation sometimes led to recession; it did so in seven of the 50 years. But inflation was more likely to do so; GDP fell in 15 of the 59 years in which prices did not fall.
History, then, is clear. Deflation doesn't do great harm. If anything, the opposite. Our fear of it might be because we are mistaking symptoms for the disease. The big problem is weak demand and mass unemployment in the euro area, and deflation would be an effect of this.
You might object that this inference is too hasty. In the 19th century deflation was much more familiar than it is now and so it created little uncertainty. And levels of consumer debt then were lower. On both counts, deflation could do more damage now than it did then.
However, there's one contemporary fact that's also consistent with the UK's historic experience. There are five countries in the EU where consumer prices are now falling: Greece, Bulgaria, Hungary, Poland and Spain. On average, these five economies are actually doing slightly better than average; in the last 12 months, industrial production in them has risen by an (unweighted) average of 0.9 per cent, compared to 0.6 per cent for the EU as a whole. On its own, this isn't terribly significant. But taken with other evidence, it should lessen our fear of deflation.
But even if you disagree, and believe deflation is a threat, there is a simply policy solution to it. Oxford University's Simon Wren-Lewis says: "We have a tried and tested alternative means of getting output and inflation up besides monetary policy, and that is called fiscal policy." The danger, however, is that governments – in both the euro area and UK – might respond to the falling nominal tax revenues caused by deflation by tightening fiscal policy rather than loosening it.
This danger, though, merely tells us that what we have to fear is not so much deflation as idiotic policy-making.
