With panel on Japanese deflation and graph showing falling eurozone and UK inflation

Inflation slowed to 0.5% last month, its joint lowest rate in 26 years, prompting fears that the UK economy could soon follow the example of the eurozone and go into reverse. Consumers are enjoying the lower prices but will deflation be good for Scottish businesses and the economy?

Deflation is the opposite of inflation: when prices for goods and services decrease. But, unless you happen to work in the oil industry, what is there not to like about lower food and fuels costs at a time when wages are growing at their fastest rate for two years - finally outstripping inflation for the first time since 2009 - and unemployment is at a six-year low?

With real average weekly wages still below their pre-recession levels most consumers will welcome a period of falling prices as it will boost their spending power.

Economists have drawn a distinction between "good" deflation - where falling prices drive consumer spending, company investment and accelerating economic growth - and the "bad" sort, where weak demand leads to a vicious deflationary circle of falling prices and rising unemployment knows as the debt-deflation spiral, which politicians have been desperately trying to avoid since the financial crisis hit in 2008.

"Good" deflation - dubbed "joyflation" by analysts at Oxford Economics - can be good in short bursts to give a boost to a flagging economy, but if it goes on for too long there is a risk that what was initially welcomed as a hefty tax cut morphs into the pernicious sort.

This happens when people hold off from making purchases in the knowledge or expectation that prices are falling. Businesses are then forced to lower their prices still further to compete and are likely to make job cuts and the newly redundant employees are less likely to buy goods and services. This then makes prices fall still further, and so on.

Deflation has the opposite effect to moderate or gentle inflation, which encourages spending and investment because it makes sense to buy something today if prices are likely to rise tomorrow.

The consensus view among economists is that inflation of between 1% and 3% is the ideal target as a small amount of inflation helps oil the wheels of the economy. With inflation now far below the Bank of England's 2% target, John McLaren of Fiscal Affairs Scotland says that a revision of the target is now overdue.

But, while the consumer price index (CPI) is hovering around 0.5%, the retail price index (RPI) - the traditional measure of inflation which includes housing costs but is now thought to be less accurate - shows 1.6%. Meanwhile "core" inflation, which strips out volatile food and energy prices, stands at 1.3%.

Whichever measure you take, though, the Bank of England's interest rate of 0.5% is now so low that, if the UK were to enter a period of protracted deflation, interest rates could no longer be used as a tool to restore flagging demand. Analysts are now expecting that rates will not rise until 2016.

With inflation now more than one percentage point below the Bank's target, governor Mark Carney will have to write a letter of explanation to the government. Carney recently admitted for the first time that deflation is now a possibility for the UK economy, but insisted that the tools are available to deal with it if it comes.

The positive effects of short-term deflation on the economy were highlighted last week in a report from the economic forecasting Ernst & Young ITEM club, which raised its UK domestic growth rate forecast for 2015 from 2.5% to 2.9%, saying that the 4% of extra household disposable it expects to come from falling energy and food costs (a 10.5% drop in motor fuels and a 1.9% fall in food prices over the last year) will lead to consumer spending driven growth and a rebound to the UK housing market.

Last week, though, the economist David Blanchflower, a former member of the Bank of England's interest rate-setting Monetary Policy Committee (MPC), warned that there is "deflationary contagion in the air" after the Swiss National Bank abandoned its long-held policy of pegging the Swiss franc to the euro. The shock move caused a 30% jump in the value of the franc, which is expected to further exacerbate deflation in the alpine nation's economy.

This forced Denmark to cut its key interest - already in negative territory - to prevent the krone from strengthening. Both Denmark and Switzerland now have negative interest rates, which means that depositors pay to keep money with their central banks.

It is thought that both country's decisions were taken in the knowledge of Thursday's announcement by the European Central Bank that, after years of dithering in the face of German opposition, it would embark on the life-support mechanism of large-scale quantitative easing (essentially creating electronic money to increase liquidity), after the European Court of Justice said that the policy - which was widely used during the financial crisis in the US and UK and continues to be used in Japan - was legal.

The long-trailed decision was welcomed by markets, with European stocks last week rising to a seven-year high.

The main aims of the ECB's €60 billion (£46bn) a month QE programme are to shore up confidence and to combat poor growth and the threat of a deflationary cycle which would cripple those parts of the eurozone with high levels of government, corporate and household debt. It is expected that the bond-buying programme will drive down the value of the euro which in turn will help to boost exports and kick-start growth.

But some question whether the larger than expected €1.1 trillion cash injection promised by the ECB will be enough to stave off a lengthy period of Japanese-style deflation (see panel). Even if it is successful, it may - if the UK's £375bn QE programme is anything to go by - take at least two years before its effects are felt as its impact on raising demand, for example, is unlikely to be as immediate as using the tried and trusted tool of cutting interest rates.

Last month deflation returned to the eurozone for the first time since 2009 - when an oil price slump contributed to falling consumer prices. But this time round, Inverness-based economist Tony Mackay believes, the cause of eurozone deflation is primarily low economic growth - even recession in countries such as Greece, Italy and Portugal - and has nothing to do with falling oil and other commodity prices.

The danger, according to McLaren, is that "bad" eurozone deflation - caused by lack of demand - could "seep into" the UK economy through the back door.

In the year to December last year, consumer prices in the eurozone fell by 0.2%: well below the ECB's inflation target of 2%.

In a keenly anticipated announcement at the ECB's headquarters in Frankfurt on Thursday, the bank's president Mario Draghi said that QE would continue, "until we see a sustained adjustment in the path of inflation".

The main drivers of deflation in the 19-country common currency area have been weak demand, austerity, debt and poor or negative growth. If you add to the mix the downward trajectory of the price of oil - down almost 60% since June - there are now real fears that the much of continental Europe could be in for a prolonged period of the wrong sort of deflation which could plunge the region, and with it the UK, into economic depression.

Thankfully so far at least, according to Krugman, none of the price declines in world markets are as bad as the massive deflation that preceded the Great Depression of the 1930s. But the situation in some EU states is far from stable, and the outcome of today's general election in Greece could be critical.

A win by the radical left-wing party Syriza, which has been leading the polls for the last few weeks, could lead to Greece leaving the euro: a result that the International Monetary Fund's head Christine Lagarde warned last week would be "devastating" for the country.

Blanchflower claims that the UK's economy is lagging roughly six months behind that of the eurozone (see table) which means deflation could become established in the UK in time for May's general election. The prime minister and his chancellor have been extolling the benefits of low inflation for the last two weeks, but will politicians say the same if low inflation turns to deflation?

And Blanchflower is not a lone voice: the minutes of this month's MPC meeting revealed that the Bank of England now believes there is "a roughly even chance" that inflation will dip below zero in the first half of 2015. Even if deflation does not become entrenched in the UK economy, a period of prolonged stagnation is a real possibility.

If either scenario comes true, how would Scotland fare? When Carney earlier this month sought to reassure the world that tumbling UK inflation and the risk of deflation were not a cause for concern he said that falling oil prices are a "negative shock to the Scottish economy but it is a negative shock substantially mitigated by the fiscal arrangements in the UK".

CBI Scotland's new director Hugh Aitken, meanwhile, told the Sunday Herald that he expected the continuing fall in oil prices to continue to "weigh on already low inflation" for the foreseeable future.

"Broadly, this is good news for consumers and businesses," he said. "It will give a welcome boost to household incomes, contribute to reducing input costs for firms and is likely to underpin an already solid UK economic recovery. However, its impact on North Sea oil producers could undermine investment and jobs there."

Given that Scotland's main export, oil, will be the one to suffer the most from continued low oil prices would the overall effect of "good" deflation have as positive effect on the Scottish economy as the UK's? Perhaps, as the UK as a whole imports much more oil than it produces, so cheaper oil might be expected to be a net benefit to Scotland as well as the rest of the UK.

In the short-term, at least, McLaren believes that Scotland will benefit from the fall in fuel and food prices more than consumers south of the border, as Scottish consumers typically spend a higher proportion of their incomes on essentials such as heating, food and petrol. But if deflation became entrenched in the UK, the implications for the Scottish and UK economies could potentially be disastrous.

It now looks quite possible that the UK's economic recovery could be reversed or at any rate stalled if deflation becomes established for longer than a few months. And if that were to happen the big question then becomes whether productivity, innovation, education levels and population growth can rise fast enough to stimulate growth in the future or whether the capitalist system, which relies on growth, has run out of gas.

SIDE PANEL ON JAPANESE EXPERIENCE OF DEFLATION

The country with the most prolonged experience of deflation in modern history is Japan which suffered negative inflation in eight of the 15 years between 1999 and 2013.

During that time prices fell by an average of 0.23% each year and the world's third largest economy suffered anaemic growth, falling prices, mass bankruptcies, defaults and unemployment.

Japan only recently dragged itself out of deflation after Prime Minister Shinz� Abe launched a three-pronged strategy - dubbed Abenomics - of quantitative easing, short-term fiscal stimulus and debt consolidation.

But can the UK learn anything from the Japanese experience? According to Charles Edmond of the Japan Society of Scotland, not that much. The former investment analyst - who worked in Asia for much of his career, including spells with Barings Bank, HSBC and Bank of Tokyo Mitsubishi - said that there are a number of significant differences between the EU and Japan, which mean that the "parallels to be drawn will be limited".

Japan's two "lost decades" of deflation were sparked by the bursting of a property bubble, which led to real estate crashing 80% in value in the early 1990s. This followed two decades of massive growth when it was assumed that the economy would continue to grow forever. The seeds of deflation in Europe, by contrast, have been falling demand and rising unemployment.