Money off everything! In a country that has made shopping its national pastime, the idea of persistent falls in the prices of all or most products and services sounds like the ultimate bargain bonanza.

Yet in an economy already beset by dangers and difficulties on all sides, the emergence of just this trend – deflation – is rapidly emerging as the latest peril to Britain’s prospects.

With the “R” word, recession, already a grim reality, now it is the less familiar “D” word that is provoking fear and loathing among economists and officials. Behind this alarm lies the knowledge that, although sustained falls in prices across the economy might seem like a dream for shopaholics, in practice this can swiftly become an economic nightmare.

As relentless price cuts lead consumers to curb spending, constantly waiting for ever cheaper deals, deflation can suck the oxygen of demand out of the economy, sending it into a vicious downward spiral.

What sounds like a blessing quickly mutates into a pernicious economic blight.

We know this because this was exactly the fate endured by the United States during the Great Depression of the Thirties and by Japan during its “lost decade” of the Nineties, when it became trapped in the economic quicksand of deflation.

Now, after inflation in Britain plummeted last month, with the sharpest plunge in consumer prices in any October for 14 years, and with further steep falls expected, the anxiety is that it could be set to suffer a similar curse.

Anxieties that Britain might soon succumb to the same deflationary plight as Japan are inflamed by the stark similarities between the UK’s predicament now and Japan’s a decade and a half ago. As Michael Saunders, of Citigroup, observes, in both countries, the stage for recession was set by a runaway credit boom, a headlong surge in asset prices and a turbocharged property boom.

Then, in both economies, as an excessive boom gave way to destructive bust, property values collapsed, banks left reeling by the fallout screwed down the flow of credit and, ineluctably, prices dived.

The scary similarities should not be dismissed and, as Mr Saunders also argues, in some ways Britain’s position now is worse than that of Japan in the Nineties. With UK households weighed down by a huge burden of personal debt and their savings rate already close to zero, there is less of a cushion for the economy than in Japan, where high-saving consumers could tap large nest eggs to shore up their spending as recession hit.

Fortunately, however, there are also some good reasons to believe that Britain is not simply doomed to mirror Japan’s recent, tragic economic history.

To begin with, deflation comes in various guises – and it is vital to distinguish between the good form, the bad and the ugly.

Britain has already had a minor entanglement with a limited form of “good” deflation in the first half of this decade, when prices for many kinds of goods fell consistently.

Only steep increases in the costs of services kept overall inflation decisively positive. During this period, falling prices boosted consumers’ spending power and household incomes rose in real terms, fuelling faster growth.

The driving force behind those trends was an excess of supply of cheap imports rather than a recessionary collapse in demand. And crucially, now as then, the immediate prospect of falling prices this time also flows substantially from cheaper imports – this time for oil and commodities. At least to some extent, these savings should act in the same way as before, giving a useful boost to spending power and real incomes as recession takes hold.

Yet there remains a clear threat that these developments could morph into “bad deflation”. While a dose of falling living costs might be benign, this could turn ugly if the sort of downward deflationary spiral first explained by Irving Fisher, the great Thirties economist, emerges.

Under this worst-case scenario, a “negative feedback loop” builds up as falling prices drain away the economic lifeblood of demand. As consumers wait for cheaper goods and businesses sell less and less, profits plunge, wages fall and staff are laid off.

A rising wave of bankruptcies and unemployment then further erodes demand, as well as business and consumer confidence, leading to a still sharper retrenchment.

Things turn really nasty if wage cuts and rising joblessness then trigger falling incomes, sparking a rise in the real value of debts, relative to incomes. In Britain, the already heavy burden of personal debt would become unbearable for many households – triggering another wave of bankruptcies and economic pain.

Again, however, there is good cause to hope that Britain will escape such a brutal outcome.

Critically, aggressive action has been taken quickly by the Treasury and the Bank of England to prevent the present crisis escalating – unlike what happened in Nineties Japan.

The Bank has cut interest rates radically, to their lowest in more than half a century, and is set to cut them still further next month.

Rates have fallen twice as fast since house prices peaked last autumn as they did after Japan’s property crash in the second half of 1990.

Secondly, the Treasury has already acted decisively to underpin the British banking system, while today the Chancellor will reinforce the Bank’s measures with a fiscal stimulus of tax cuts and increased public spending. Tellingly, these measures are just the action urged on Western economies by fretful Japanese officials who learnt the lessons of their searing Nineties experience.

Finally, although Japan’s pains were aggravated by a sharp rise in the yen as its crisis deepened, the steep drop in the pound, by almost a fifth over the past 12 months, is giving an added spur to the UK economy, increasing the competitiveness of British exports.

None of this means that Britain will escape what is likely to be a deep recession, but it does mean that the calamity of “bad deflation” can be averted.

gary.duncan@thetimes.co.uk

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