Unlike today, deflation -- in which prices fall each year rather than rise -- was not always seen as a threat. For a couple of hundred years up until the beginning of the 20th century, vibrant economies often experienced sustained bouts of the phenomenon. Indeed, Milton Friedman maintained that, in theory, governments should aim to sustain a moderate amount of deflation.

When prices of items on the high street and beyond are gently falling, it means that every dollar you have in your pocket becomes worth more. Even if your income does not increase each year, its purchasing power does indeed go up. You need not worry, therefore, that your cash may become next to worthless in a few years' time, as could be the case in an economy with high inflation.

Deflation and Depression

Benign deflation, however, was eclipsed in the 20th century by more painful experiences of falling prices -- none more so than during the Great Depression of the 1930s. The Depression followed a major increase in share prices throughout the 1920s, with much of the stock bought not with savings but with borrowed cash. When in 1929 investors realized that the spectacular gains made (the Dow Jones Industrial Average had increased by a factor of five over the previous six years) were based not on reality but on hope and speculation, the market crashed.

What followed was the darkest period yet experienced by the US economy -- and many other nations around the world -- as banks collapsed under the weight of their debts, house prices fell, companies shut down and millions of people lost their jobs. One of the problems at the very core of the crisis was deflation.

Prices started to fall as people realized they had been artificially inflated by the greed and mania that had dominated the economy in the 'Roaring Twenties'. But although shares and house prices fell, the value of the debts people had taken on to secure them remained unchanged. So, with prices falling by 10 per cent a year, the cost of $100 of debt -- in terms of what such a sum could now effectively purchase -- rose to $110. Of those households that had not instantly succumbed to the crash, millions fell victim to deflation as the value of their debts arbitrarily increased.

A tougher Spiral Deflation affects not only those with debts but the whole economy. As prices start to plummet, people tend to hoard cash, knowing that things will be cheaper in a few months. Their reluctance to spend causes prices to slide further. Furthermore, because people's salaries are usually set out in legally binding contracts, businesses suddenly find their wage bill effectively rising, as what was previously a $1,000 bill now costs the equivalent of $1,100. It is a disaster for the employer, who is selling goods and services for lower prices but still facing the same wage costs. And while it might initially seem good news for the employee, in practice it will mean companies having to fire more workers to keep themselves afloat. Similarly, although banks will receive increased mortgage payments from some borrowers -- in relation to other prices in the economy, which are falling -- other borrowers will not be able to pay them at all.

Many of these symptoms are very similar to those experienced in a period of high inflation. Both effectively involve the price of certain items rising, in real terms, at an uncontrollable rate. However, while inflation has the effect of making goods on the street more expensive, deflation inflates the cost of debt and other commitments.

The biggest risk with deflation is that prices fall at an ever-increasing rate as companies cut back and see their losses mount, which in turn will push prices lower still. This is arguably even more difficult to escape from than an inflationary spiral -- largely because modern economies have evolved certain mechanisms to deal more effectively with the latter.

Diagnosis and Solutions

The economic explanation for deflation is that the amount of money in the system falls or the supply of goods and services increases. So, whereas inflation involves too much money chasing too few goods, the opposite is true in deflation. In the case of the Great Depression and Japan's experience in the 1990s and 2000s, a contraction of money (associated with the debt bubble -- when people saved more and spent less after years of excesses and living beyond their means) was the cause; the benign deflation of the 19th century was, in contrast, more a function of an increase in the supply of goods due to greater productivity.

Typically, the main tool central banks use to control inflation is interest rates. However, they cannot reduce these below zero, so when prices fall there is little more they can do except resort to more unconventional tools, most of which amount, in the words of Ben Bernanke, then a Federal Reserve Governor, to activating the 'printing presses'. In other words, contrary to episodes of inflation when they attempt to keep the amount of cash in the economy constant, central banks start injecting more cash into the economy. They can do this a number of ways -- for instance, by directly buying assets such as bonds or shares, or by increasing the amount of cash commercial banks have in their vaults -- but all of them are known collectively as quantitative easing.

Such schemes were used by both the Japanese at the turn of the millennium, and the Federal Reserve and Bank of England after the 2008 financial crisis, as they attempted to reverse debt-fueled financial crises. It remains to be seen whether their efforts will prove successful.