As oil prices continue to fall, a strange phenomenon is making its presence felt across Europe: deflation. Familiar in Japan since the 1990s, consistently falling prices for the goods we buy are almost unheard of in Europe, not seen since the grim years of the 1930s. But according to figures released in December, prices inside the eurozone are now falling by 0.2% a year.

You might think this is good news. After all, as wages and salaries stagnate, declining prices means an increase in people’s real purchasing power. Each euro in your pocket stretches, on average, just a little bit further than before. And in the short term, the decline in the price of oil alone has fed into some improvements in real living standards – or, at the very least, set a floor to their decline.

If the price falls were confined to just falling costs of energy and transport, this positive argument could hold. In the mid-1980s, a sharp fall in the price of oil led to briefly falling prices in Germany and other European countries without further consequences.

The reality of falling prices

But should declining prices spread and persist, there are two serious causes for concern. First – if you know that the price of anything you buy will be less in the future, why not wait until the future to buy it? A general expectation that prices will fall rather than rise creates a major disincentive to buy. Demand falls, less is sold, the recession worsens.

Second, and more ominous:  falling prices mean producers earn less money from anything they sell and so must look to cut costs. That means cutting someone else’s income – either payments to suppliers, or wages to employees. Incomes start to fall, alongside prices. People have less money in their hands, even if each pound or euro of that money can buy slightly more.

But if they have debts, these debts still have to be paid in money – precisely the thing everyone has less of. The real burden of debt, in other words, starts to increase. As incomes decline, more and more proportionately will have to go towards servicing debt, further reducing what can be spent on goods and services. Demand falls, less is sold, the recession worsens. As the recession worsens, incomes fall still further, increasing the real burden of debt. And so on.

This spiral downwards is debt deflation

It’s a huge issue if there’s a lot of debt around. And if there’s one thing that Europe has a lot of, it’s debt – both public (government) debt, as in Greece, and private debt, as in Spain or the UK.

It’s the risk of debt deflation that is leading the European Central Bank towards supporting more unconventional measures, most likely announced at its next Governing Council meeting on 22 January, and probably including some form of quantitative easing (QE). Their aim will be to get more money back into the Eurozone economies, and in doing so pull the single currency out of what otherwise threatens to become a vicious deflationary circle.

Does QE offer the solution?

It’s not clear QE will work, at least over the long term. It’s had some impact in the UK because, in effect, the £375bn QE money fed into the housing market via mortgages. The Bank of England used QE to give cheap money to UK banks and they expanded lending for mortgages (although not, pointedly, to small businesses). That may not happen across the eurozone, where housing and mortgage markets can work in quite different ways to here. (For instance, Spain has close to 80% home ownership; Germany, just over 50%.)

If QE doesn’t work, the ECB may well have little choice but to move towards breaking the other side of the debt deflation mechanism – cutting debt, as demanded by the Syriza party currently topping opinion polls in Greece.  That’s not popular in elite circles, to say the least, since it implies losses for Europe’s creditors – for Greece, the ECB itself; for most of Europe, its major banks, who have successfully, thus far, passed the costs of the crisis away from themselves and onto wider European society.

The election battle in Greece is, to a large extent, about whether that process can continue. The ECB has, over the last three years, inched away from its hardline position at the start of the crisis in which it demanded exceptional austerity measures alongside tight monetary policy. The spectre of the 1930s may help spook Frankfurt into remedial action and give a possible Syriza government wiggle-room. But unless there is serious reconsideration around debt write-offs, we are entering a second, more serious round of the European crisis.