The transmission mechanism linking the financial and real economic sectors of the U.S. economy remains dysfunctional.

The situation in Canada is not as dire, but our economic fortunes are inextricably linked to those of the U.S. Even the governor of the Bank of Canada, following an Organization for Economic Co-operation and Development (OECD) report published on the eve of the recent G20 summit, has revised downward estimates of Canada's future economic performance.

Forecasts of inflation are now turning negative in many parts of the world. The Economist, for one, continues to insist the real worry is deflation largely because output growth has turned sharply negative, a sure sign of downward pressure on prices. Back in 2003, policy-makers around the world also expressed deep concerns that deflation might take hold. Then, the United States Federal Reserve reduced its policy rate to one per cent insisting that interest rates would not rise until the threat of deflation vanished. A mere six years later we are once again debating the same questions, this time with interest rates near zero and a severe recession taking hold.

Are the fears of deflation justified? Economists believe there are three kinds of deflation. A "good" deflation is one where prices fall because output and productivity growth create an excess of goods and services that puts downward pressure on prices. Federal Reserve chairman Ben Bernanke once suggested that China's deflation in the 1990s might have been of the good variety.

We are likely more familiar with the 1990s Japanese deflation, which began following a collapse of the real estate bubble and was assisted by seemingly interminable delays in fixing their largely insolvent banking system. The Japanese experience is usually labelled a deflation of the "bad" variety.

Finally, there is the "ugly" kind of deflation that most famously characterizes the Great Depression of 1929-33. Here, too, a bursting asset price bubble, together with disastrous policy mistakes, combined to produce economic outcomes no one wants to see repeated.

In all economically costly deflations interest rates are near zero so that future price declines, if they are allowed to persist, actually have the effect of increasing the real cost of borrowing money, further exacerbating the existing downward movement in prices.

There are some fundamental differences between past threats of a spiralling deflation and the ongoing crisis. First, policy-makers are taking aggressive and prompt corrective action to forestall the possibility of a downward persistent decline in prices. Second, governments play a far more important role in the overall economy than in 1929, and they have deployed a large number of instruments to stimulate the economy.

However, there is still cause for concern on a number of fronts. First, the ongoing global financial crisis has spilled into the real economy leading to a rare but potentially devastating synchronized worldwide economic downturn. The collapse of world trade is a serious concern. Yet, to date, essentially only words have been used to fight against its pernicious economic consequences.

One should also not underestimate the ability of some policy-makers to make mistakes that could undo all that has been achieved so far. The U.S. Congress, reluctant to spend more money, may be an obstacle to good policies until it becomes too late. And in Europe, understandable concerns over regulatory failures may push governments to propose changes before the post-mortem required to devise sensible regulatory reforms is undertaken. This can only happen once the financial crisis has passed.

Necessary steps must include policy responses that are credible, together with a joint commitment by governments and central banks that any reforms will be successfully concluded, leading to the creation of a better financial infrastructure. In addition, there is a danger of central banks overstepping their mandate and intervening in ways difficult to undo. Some policy-makers are now preaching an easy exit strategy from the current policies. The reality might well be different.

Fears of a debilitating deflation taking hold are overblown. Nevertheless, an "ugly"deflation may well be the "black swan" in our midst. For example, a sharp appreciation of the Canadian dollar, if it feeds through the price system, could well exert strong deflationary pressures.

Concerted actions by central bankers to inject large amounts of liquidity into the economy ought to forestall an "ugly" deflation.

The flip-side, however, is that in future we may well have to deal with the next Great Inflation if and when the economy eventually overheats, and prices begin to rise too quickly. We will then discover a lesson that has been lost, but is deeply grounded in fact -- namely, that the amount of credit in an economy does matter.

Perhaps then we will also revisit the question of whether it is advisable to ask central banks to aim for a form of price level stability instead of targeting inflation.

Pierre L. Siklos is a senior fellow at The Centre for International Governance Innovation (CIGI) in Waterloo.


The opinions expressed in this article/multimedia are those of the author(s) and do not necessarily reflect the views of CIGI or its Board of Directors.