The threat of deflation in the world's major economies is a frightening prospect. It would deepen the recession and be difficult to arrest.

Deflation is a persistent decrease in the general price level – a negative inflation rate. Because nominal interest rates in the US are at zero, and heading that way in the rest of the developed world, deflation - by leading to a rise in real interest rates – would increase debt in real terms.

Given the huge rise in borrowing by households before the recession, the onset of deflation would be disastrous. It would swell the real burden of these debts, forcing consumers to cut spending even more – the opposite of what is needed to get out of recession.

Under these conditions a deflationary spiral could develop, as in the Great Depression. This occurs when decreases in the prices of goods and services lead to lower production and business profits, which in turn lead to lower wages, job losses and lower demand – which in turn leads to further decreases in prices.

Over the past six months, US headline inflation has retreated by the largest (six-month) amount since 1949, dropping to zero in January. Consumer prices have been falling nearly as fast in most other advanced countries. In Japan, wages have fallen four percent over the past year.

Reserve Bank's failure to call an emergency meeting

SA is not likely to experience deflation as long as electricity prices continue to rise at 30 percent/year, as they did when measured in January. Overall, the CPI rose by 8.1 percent in January year on year, against expectations of 7.5 percent. The disappointing figure appears to be behind the Reserve Bank's failure to call an emergency meeting to cut rates, as was widely expected.

MIT economics professor Paul Krugman fears that deflation could become a global scourge. "Two years ago, I would have said (it) couldn't happen," he said in a recent radio interview. "Now I look at Japan, I look at Germany, where they're pretty close to it. A deflationary spiral is something that could happen any month now in Japan, despite everything they're doing. And, yes, it's turned out that deflation, once it gets started, is much harder to stop, which is another reason not to be complacent."

Until the 1930s, it was believed that deflation would cure itself. As prices decreased, demand would naturally increase and the system would correct itself. This was challenged during the Great Depression by Keynesian economists. They argued that governments had to boost demand through tax cuts or increases in government spending. With the rise of monetarist ideas, the focus in fighting deflation was put on expanding demand by lowering interest rates.

The global consensus now is to use both these fiscal and monetary tools simultaneously, and to maximum extent.

Consumers want to save rather than borrow

There is just one problem, notes Sanlam Investment Management economist Arthur Kamp. Expanding the monetary base (through central banks buying commercial and government paper from the banks for cash) achieves nothing when banks prefer to hoard money rather than lend, and consumers want to save rather than borrow. The same applies to tax cuts and lower interest rates.

"Even at the exceptionally low interest rates prevailing at the moment, there is little borrowing, and even though base money is exploding in the US, the money isn't finding its way into the economy," says Kamp.

Does this mean a deflationary spiral is inevitable and that the world is on the brink of another great depression? "Only the most depressed think that fiscal policy, of the scale being proposed around the world, will have no impact," says Kamp. "The policy reaction has not only been swift and large, it has been aimed in the right direction - unlike the early experience of the Great Depression."

The key is to prevent gradual deflation from being built into inflation expectations, because this could create a self reinforcing downward spiral. Japan is in a tight spot, given a collapse in inflation expectations, but the Fed has acted early. US inflation expectations, though still low, recently bounced back.

Short-lived decline in prices

Kamp expects policy makers to limit the outcome to a short-lived decline in prices, even if it means government creating money and spending it itself.

The UK is heading rapidly in this direction. The Bank of England last month agreed to ask the government for authority to create money after cutting the benchmark interest rate to one percent, amid warnings that the UK could experience deflation if the recession intensified.

One way to bid up inflation expectations is if governments can credibly promise that future price levels will rise. Perhaps this was the rationale behind the Fed publishing a long-term inflation forecast of 1.7 percent to two percent last week.

The strategy may work in an environment where most have figured out that government's fiscal response will leave it with a huge debt hangover – historically, large budget deficits have been associated with higher inflation.

But higher inflation is tomorrow's problem. Right now, deflation is the new evil.

Financial Mail