When one of the world’s best economists warns that the global economy is sinking into a quagmire of depression and deflation, we should listen. Paul Krugman, professor of economics at Princeton, has in fact been warning of this since 1998-long before the boom turned to bust. So far, he is looking prescient. Now many economists and central bank officials have joined him in seeing deflation-a sustained decline in price levels-as a serious danger.

Growth has slowed to a standstill in most regions, and inflation rates are below 2 per cent in the US and the euro area (but not Britain). Prices fell in Japan, China and Hong Kong last year. In the countries that have experienced property booms, like the US and Britain, house prices might be starting to falter, and the fear is they will soon follow share prices in a crash. The recent depreciation of the dollar will help the US economy but will reduce import prices elsewhere and therefore fuel the deflation affecting Japan and perhaps spreading to Germany. The uncertainties added by the war in Iraq, terrorism, and Sars are also hindering any global economic recovery.

Deflation anxiety is compelling because the phenomenon is outside our experience. For all of our lifetimes, up to now, we’ve seen inflation rather than deflation, even during recessions. Inflation on a massive scale. The years from 1947 to 2000 saw a 23-fold increase in the level of prices in Britain and similar rises in other developed economies. A pound tucked under the mattress in 1947 was worth about 4p by 2000.

Inflation above, say, 5 per cent a year, is economically and socially corrosive. It discourages investment, redistributes wealth from savers to borrowers, causes instability and reduces growth. And it is hard to eliminate. It was only after 1990 that all the main central banks brought inflation down to an acceptable 2-3 per cent annual rate. (So in this country, prices have risen by “only” 50 per cent since 1990.)

Deflation at anything other than a very moderate rate is just as damaging. Perhaps more so. The last time we experienced it, the great depression, rightly scarred our collective memory as a time of misery and turmoil.

But the late 1920s and 1930s stand out as uniquely deflationary in just the same way that the remainder of the 20th century stands out as uniquely inflationary. In earlier periods, including much of the late 19th century, it was common to see moderate deflation combined with real economic growth. Even during the 1960s and 1980s the level of prices fell in some countries from time to time-deflation indicators for Germany were clearer in the mid-1980s than they are today. So the question is: what degree of deflation, if any, are we heading for?

The first thing to point out is that prices paid by consumers in almost every country are rising, not falling-at an accelerating rate in most cases. We still have inflation (a useful economic lubricant in small doses). Consistently large declines in price have characterised certain categories of goods, linked either to rapid progress in technology or to rapid industrial development in China. Most of our economies consist of services, though, and their prices are increasing.

Nor is there any sign that the price falls, where they are occurring, are prompting consumers and businesses to postpone their spending and wait for even cheaper prices in future-one way that deflation can turn into depression. Where investment and consumer spending growth has slowed, it has been by no more than you would expect in a business cycle downturn. Indeed, the downturn has been mild given all the shocks buffeting the world economy since the late 1990s.

Secondly, there’s no evidence outside Japan that wages are falling, which would be a genuinely alarming sign. Lower prices are good for consumers because they boost spending power, but not if they feed via lower profits to falling wages. Unemployment has risen in the US but earnings are growing. Unemployment in much of Europe is far too high, but has been so for over a decade for reasons that have nothing to do with the global economy.

A third area for concern is the effect of falling prices on debt. Deflation increases the real value of debts, which have to be serviced from falling profits and cashflow, with knock-on effects for investment and employment. Households realising their net worth is lower than it was in real terms will save more and cut back on spending. Massive indebtedness is certainly keeping the Japanese economy stuck in recession. But the greatest accumulation of debt during the boom years was in Britain and the US, the two major countries least at risk of a deflationary spiral now.

None of these effects is too troubling if deflation is mild, and so far it is mild to nonexistent. But the fear is that the rest of the world could become, like Japan, immune to reflationary policies. The Bank of Japan has set interest rates at zero, the government has piled up budget deficits year after year such that the national debt is three times GDP, and still the economy won’t start. Japan is in the “liquidity trap” that Keynes diagnosed in the 1930s. When prices are falling at a rate faster than the nominal level of interest rates, the real rate of interest at which borrowers repay loans is positive. The faster the deflation, the higher the real interest rate. Cutting the nominal interest rate in an attempt to stimulate the economy will be ineffective-like pushing on a piece of string, as it’s usually put. It’s this quicksand of slow growth combined with deflation, from which even the most active monetary policy can’t pull the economy, which worries economists, rather than the mere fact that some prices are falling a bit. And, like the real thing, it is easy to wander into this quagmire without noticing-and then realising it is too late.

It is many decades since we experienced an economic downturn starting from a low rate of inflation, so this is unknown territory. Deflation is a reality in three important economies, although a problem-for now-only in one, Japan. Most other developed economies are not in recession but are growing at rates below their potential.

So most economists welcomed the European Central Bank’s recent, belated cut in interest rates. And many would argue that the world’s three big central banks, the ECB, US Federal Reserve and Bank of Japan, should follow the Bank of England’s practice of adopting an inflation target. The Fed has gone almost that far. An inflation target is a precaution against erring on the side of deflation, mindful of the fact today’s central bankers have all been trained to fight inflation not deflation.

The professional disagreement about deflationary dangers is a matter of degree. And the degree will depend on why prices are falling. Is it, as in the late 19th century, due to new technologies and improved productivity-favourable shocks to the economy? Or is it, like the 1930s, because of a bursting asset price bubble, falling demand and policy failure-adverse shocks to the economy?

The answer is bound to be a bit of both. However, three substantial recent pieces of research-from the IMF, the Federal Reserve and the Centre for Economic Policy Research-suggest the risk of generalised deflation is extremely small, and there is anyway plenty of scope for conventional macroeconomic policies to head it off. Only a handful of countries are at high or medium-high risk, with Japan in the former group and Germany in the latter. For most of the rest, deflation is no more than a distant possibility, and not necessarily the harbinger of depression if it does occur.