Keep taking the tablets

Monetary policy - using changes in interest rates to influence economic growth - has been likened to taking aspirin. It is fine for most minor illness but no good when a serious disease comes along.

The question is whether a serious disease - deflation - is looming on the horizon that will require more drastic measures. Interest rates have been remarkably successful for most of the past 10 years in Britain and the United States. But in the US they are now down to 1.25% and some commentators think that short-term rates will fall further. HSBC analysts, for instance, argue that "it is probably time to think about a world in which US rates, for example, fall to zero". As interest rates drop towards zero, monetary policy becomes less effective. There is less "wiggle room".

It is theoretically possible for interest rates to fall below zero. It happened a few months ago in Japan. But it is not an obvious panacea to lend money overnight and get back less than you loaned the following day (unless prices are falling even faster - which brings problems of a different kind). Either way, you would be better off keeping it under your pillow. And what good does that do for the economy?

The Bank of England dismisses any prospect of deflation in the UK and it is probably right, at least in the short term. But then central banks are loath to issue warnings about deflation because their very warnings could make it come true. If your friendly central bank tells you that prices will be much cheaper in a few months time then everyone will have a vested interest in postponing purchases (as has happened in Japan), thereby triggering a self-imposed recession.

The trouble is that deflation is already happening, especially in Asia. In Japan, prices have fallen for four years running and it has started to happen in China as well. The difference is that in Japan it has been accompanied by falling or stagnating output whereas China has been expanding by 8% a year.

Brian Reading, of Lombard Street Research, distinguishes between "benign" deflation China-style, where output is rising, and "malign" deflation of the kind that hit the victors of the first world war when output was falling (most of the losing nations after the war, he says, suffered from hyper-inflation). The extreme case of deflation, he adds, was Denmark after 1816 when prices dropped by three quarters during a period of 12 years.

There is no textbook solution to defeat the spectre of deflation except to remember that prevention is better than cure. Once an economy enters a deflationary context, as Japan knows to its cost, it is extremely difficult to get out not least because rational reactions to it (like saving more and therefore not spending) can make the problem worse.

Europe's best defence is attack - get people spending and industry investing so it can climb back into a virtuous circle of growth in which more people are employed providing more spending power which generates a further stimulus. This in turn leads to yet more people being employed. That needs a combination of reduced taxes (the opposite of what Germany is doing) and lower interest rates. But they had better start doing something quickly. The aspirins are running out.