Seven decades have passed since the monster that is deflation last stalked the West. Only the elderly will remember how terrible its effects can be. Fear of deflation was one reason why the world's governments and central banks flooded the markets with money as the credit crunch took hold. But they may not yet have slain the beast.
And deflation is an ogre that is widely misunderstood. A popular misconception is that deflation just means falling prices. But there's much more to it than that.
In its worst form, deflation means a widespread fall in the amount of money and credit available. In turn, this leads to falling prices, as less money is chasing fewer goods. If deflation takes hold, it can turn into a vicious circle of shrinking credit and falling economic growth.
As prices fall, so may the profit margins that companies make. In response, they cut their spending on new projects, lay off workers and pay off their debts. If enough firms are doing likewise at the same time, this makes the overall economic situation worse.
With the economy shrinking, the value of assets like companies' shares and bonds falls. The owners of these become worse off because their assets are worth less, while the value of their debts is fixed. To pay off debt, they therefore sell off more assets, depressing their prices further.
Like all good monsters of yore, deflation dwells in a dank cave at the foot of a mountain – the debt mountain. During the good times, firms and households furiously add to this giant pile of borrowings. As well as paying for new business projects, much of the borrowed money goes into speculation or consumption.
Eventually, there comes a point where the weaker borrowers are not in a position to repay what they’ve borrowed. Society begins to reflect whether it was actually such a great idea to grant whopping mortgages to people with no proof of income or other assets. The process goes into reverse, with borrowers paying off liabilities and others simply defaulting.
