In fact deflation has been largely absent from the world economy in the period since the end of world war two. The only episode of note has been the Japanese experience which stretched from 1999 well into the new millennium. In the period to 2005, the rate of inflation was negative or zero each year, barely in positive territory in 2006 and flat in 2007.

Initially the deflation was brought about by the bursting of an asset price bubble, but it is generally accepted that the policy measures which were subsequently taken were insufficient. The result was a decade of low growth. In the 2000s the economy has grown by little more than 1% a year on average.

The Japanese economy clearly struggled with deflation for a number of years but the downturn in the global economy which started in early 2000 also raised the spectre of deflation elsewhere. Particular worries were expressed about Germany where inflation had been consistently and significantly below the eurozone average.

In the case of Germany, the need for monetary and/or fiscal stimuli to boost domestic demand has been constrained by the European Central Bank’s need to conduct monetary policy for the eurozone as a whole (with monetary policy decisions being based on the average inflation rate) and the stability and growth pact (which inhibits the use of fiscal measures).

What is deflation, and why can it cause so much harm?

Deflation occurs when the overall level of prices falls. It is, therefore, the reverse of inflation. Deflation is quite different from disinflation, a term which is sometimes used to describe a decline in the rate of inflation.

Benign or malignant?

Although the experience of the 1930s and even of present-day Japan might lead to the conclusion that deflation is an unmitigated evil, this is far from the truth. Deflation can be either benign or malignant, depending on its underlying causes.

Prices fell throughout the 19th century, as a result of the huge productivity gains made possible by the industrial revolution.

In much the same way, some of today’s downward pressure on prices is due to technological advances, especially in the areas of IT and communications, with a part also being played by the continuing trend towards deregulation and also through the impact of countries such as India and, especially, China providing cheap manufactured goods to the rest of the world.

The difficulty comes in trying to disentangle the good deflation from the bad.

For at the same time as new technologies are delivering improved productivity and lower prices, the world markets for many commodities and industrial products (including oil, steel, cars, chemicals and microchips) can become massively over-supplied.

The classic deflationary spiral, as experienced in the 1930s, occurs when excess capacity and weak demand force producers to cut their prices.

Consumers delay making purchases in the firm belief that prices will fall. In turn, this delay in spending leads to suppliers attempting to cut costs including reducing the size of their work force in order to stay in business.

Increased unemployment leads to even weaker demand causing companies to retrench even further.

In a deflationary environment the real value of outstanding debt increases, just as it falls during times of inflation. Companies with borrowings are therefore at greater risk of bankruptcy, while mortgages become more onerous for individuals.

To make matters worse, since interest rates cannot be negative, one of the main levers of economic policy is rendered impotent.

In the UK, the inflation target is now framed in such a way as to make too low a rate of inflation and, by implication, too low a growth rate as unacceptable as too high a rate of inflation and too strong an increase in activity.

The Chancellor of the Exchequer in 1997 announced that there would be a point target for RPIX of 2.5% which was revised in late 2003 to a 2% point target for CPI inflation.

There is, however, a proviso that the Governor of the Bank of England would have to write an open letter of explanation to the Chancellor should the inflation rate go more than 1% above the target or 1% below it.