What is deflation?

The dreaded D-word, one of the most feared of economic blights, refers to sustained falls in prices across the economy for goods and services.

Don’t we already have falling prices for some products?

Yes. For goods such as many types of clothing, Britain has got used to steadily cheaper prices as a result of intense high street competition, and cheap imports from Asia. But deflation is different, meaning falls in prices more or less across the board.

Sounds good. What’s the problem?

For individuals, this trend can sound like a money-saving bonanza. A short-lived burst of deflation for just a few months need not be a disaster. The problems start when consumers curb their spending, constantly waiting for cheaper prices to come. In turn, this sucks the lifeblood of demand out of the economy. With spending falling sharply, businesses sell less, are forced to cut wages and lay off staff, leading to less spending and lower demand, and sharper falls in prices. A vicious downward spiral takes hold that can spell deep and prolonged recession.

Are there any other effects?

Unfortunately, yes. A bigger headache still comes from debts. Where prices and incomes are falling in a bout of deflation this means that the real value of people’s debts, relative to falling incomes, rises. People’s debts become an ever bigger burden, stretching the time needed to pay them off. This is known as “debt deflation”. In an economy like Britain’s, where households have the highest debt of any leading economy, it poses a severe danger.

Are we likely to suffer deflation?

There is a significant risk that, as Mervyn King, the Governor of the Bank of England, has admitted, inflation could turn negative for several months. However, a protracted bout of “full-blown” deflation remains a relatively limited threat, given the aggressive action being taken by the Bank and the Chancellor to stave off the danger. It is still a threat that should be taken seriously, however.

How do economies escape deflation?

With great difficulty. Deflation is like quicksand. Once in it, it is very hard to escape the mire, as Japan found after enduring years in such a bogged-down economy. Potential solutions to “reflate” the economy are found in flooding the financial system with ultra-cheap money.

Money Central: the 10 items that are falling in price quickest

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