What is deflation?

If there is one word to get an economist quaking in their boots, it is deflation.

Many major Western economies are in recession and others are heading towards it.

Some experts are warning that deflation could be next.

It is what happened in the Great Depression of the 1930s and in Japan in the 1990s.

"Deflation is, as it sounds, the opposite of inflation," said economist Diane Coyle on BBC World Services' Analysis programme.

"It means that the general level of prices is falling consistently over quite a long period of time.

"They're not just one-off price cuts, and we've seen those for a long time now in things like computers or electronic games.

"If it's just a few types of item, or it only happens for a short period, nobody's very worried.

"It's if it's longer lasting and more widespread than that, and then it's deflation."

Falling prices


Some 25% of people were unemloyed in the US during the depression

Falling prices might sound great for consumers, but in fact this is bad news for everyone.

Economist and author of 'Credit Crunch', Graham Turner, says it can lead to a vicious circle of decreased spending and increased unemployment.

"People wait as prices fall for goods to get cheaper before buying and in fact they become the buyers' strike.

"Then that creates more deflation, more job losses and so on.

"The reason why economists also worry about deflation is because it's much harder to combat than inflation.

"If inflation rises there's no limit to how far you can raise interest rates, with deflation there is a limit to how far you can cut interest rates," he added.

The most memorable deflation was during the Great Depression of 1929.

"The 1920s was the first time in which a real mass production economy requiring mass consumption arose, and that's where the rub comes in," said Professor Robert McElvaine who is a leading expert on the Great Depression.

Credit had pretty much been exhausted and that starts a downward spiral

Professor McElvaine

"The masses of people certainly didn't have enough share of the income to be buying all the goods and services that were out there.

"The basic way in which that was kept going for a number of years was by letting people buy things they didn't have the money for, extending them credit, very similar, again, to what's been going on here.

"So you had a bubble increasing and you finally reach the point before the stock market crash in 1929 where goods and services were not being sold at the level that was needed to keep the economy going.

"Credit had pretty much been exhausted and that starts a downward spiral," said Professor McElvaine.

This deflation spiral, where buyers go on strike is what leads to growing levels of debt.

"If you allow deflation you may find that you're busy trying to write off all your bad debts, but actually in real terms they grow because you've got deflation, and that becomes what we call a 'debt trap'," said economist Graham Turner.

As debts grow in real terms they become more difficult to pay off, because as prices fall so does income.

"A debt trap is the ultimate manifestation of deflation," added Mr Turner.

Lesson learnt

During the Great Depression unemployment soared to over 25% in the US and had huge ramifications for the rest of the world, which lasted almost a decade.

However, with swift and deep cuts in interest rates globally, economist Diane Coyle says that lessons have been learnt from the past.

"The thinking behind policy now is to do it quickly to prevent us getting into that kind of spiral at all, and that's the lesson from the 1930s and the lesson from Japan in the 1990s," she said.

Japan's central bankers cut short term interest rates to combat the deflation there a decade ago.

"That option is on the table for all central banks today in the West, and we may well see that over the next few months, one or two years, but that may not be enough," said Mr Turner.

He feels that long term interests rates also may need to go down, to encourage spending and discourage buying up of government debt.

The idea is to push investors away from safe investments such as government debt and encourage them to look elsewhere for a better return on their money and hence start investing in businesses that provide employment and goods and services thereby leading to a re-flation of the economy.

The experience of the Great Depression has scarred a generation of policy makers and fear of a crisis of such proportions has already prompted an unprecedented coordinated global response.

"Deflations of this kind are pretty rare and you must remember that we still have inflation," said Diane Coyle.

"I think the response and the talk at the moment is more about making sure it doesn't happen, preventing it rather than having to cure it later.

"On balance I don't think we are going to have a deflation now."

Source: http://news.bbc.co.uk/2/hi/business/7754487.stm, 01 Dec 2008