We're all in the same boat, Alan

The bluffer's guide to economics is a slim volume. For the last 15 years, if you've wanted to impress, three pieces of wisdom have normally done the trick. Macro-economic policy is about ensuring low inflation rather than managing demand. Independent central banks are the best if not the only way to achieve this. Alan Greenspan rules OK.

Be warned. Last week, the fashionable word in the markets was "deflation".You were out of touch unless you had an opinion on whether Germany would follow Japan down Deflation Alley. What's more, pressure was mounting on central banks to show that they were equipped - temperamentally as well as technically - to cope with the problem. As for Greenspan, a reassessment of his culpability for America's rollercoaster ride through boom and bust is long overdue.

Let me explain. Globalisation, exacerbated by the aftermath of the bubble, has led to a situation of too much supply and too little demand. As any economist knows, this means downward pressure on prices. That's not a problem when inflation is 10% plus, as in the 1970s and 1980s, but it can be a real headache when inflation is 1-2%, as it is now. The penny has finally dropped inside central banks that the world has moved on from the days of loon pants, stack heels and 20-minute drum solos, and there is a risk that further economic weakness could lead to falling prices in the west.

There are some who scratch their heads at this point and say, what's wrong with deflation? Doesn't a period of falling prices mean that money is appreciating in value rather than being progressively eaten into by inflation?

In theory, that's true. In reality, deflation spells disaster and central banks know it. The global economy is run on tick, with consumers and corporations sitting on mountains of debt cheerfully proffered by the banks. Just as inflation erodes the value of a debt, so deflation increases it. Borrowers retrench, savers hold on to their money knowing it is increasing in value, and the economy goes into recession. Policymakers respond by cutting rates, but they can't fall below zero, so borrowers go bust. If the banks are in poor shape, they threaten to bring the financial system down with them.

So much for theory. How close are we to deflation? Policymakers acknowledge there is a risk but say it is rather remote. As Mandy Rice-Davis remarked: "They would say that, wouldn't they." Core inflation - excluding food and energy - in the US is 1.5%, its lowest for three and a half decades. The International Monetary Fund says there is a high probability of mild deflation in Germany and is moderately anxious about three other eurozone economies - Belgium, Finland and Portugal. Japan, of course, has known all about the perils of deflation for some time.

Misreading the signals

The reason we have arrived at this position is that the expert technocrats in our glorious independent central banks misread the signals. As far back as 1996, the Bank for International Settlements was warning that inflation was licked and that attention should be paid to deflationary risk. This was a good call, since two decades of anti-inflationary policies, the globalisation of supply, the end of the cold war, freer trade, the break-up of state monopolies and the weakening of trade unions had all changed the zeitgeist. In Japan, the authorities knew there was a problem but ignored it until it was too late. In Europe, central banks refused to accept there was a problem, and still do.

Yet while the criticism of Europe and Japan is merited, the US has avoided its share of the blame. Greenspan responded in a different way. He stoked up a colossal asset-price boom which encouraged a spending spree based on notional stock market gains and the accumulation of ever higher levels of debt. Greenspan's big idea in the late 1990s was to keep share prices high. Inevitably the bubble burst, adding to the deflationary pressures on the global economy. As Albert Edwards of Dresdner Kleinwort Wasserstein put it: "To a lesser or greater extent, central bankers are wriggling on a hook of their own incompetence. The BIS warned seven years ago that deflation was going to become a more serious threat than higher inflation. While the ECB and the BoJ take all the brickbats, the Greenspan-led Fed has been as incompetent as any."

Opinions differ on whether having mishandled the bubble, Greenspan is now making a pig's ear of the bust. Some believe that the interest rate cuts over the past couple of years together with the biggest easing of fiscal policy in the US for 50 years will lead to a rapid recovery during the second half of 2003 now the war in Iraq has been won.

James Glassman, writing elsewhere on this page, is one of the optimists. Others are less sanguine and believe the weakness of the labour market and the inability of the corporate sector to boost profitability will force the Fed to cut rates to 0.75%, and take what are known as "unconventional measures" to boost the economy. Ben Bernanke, a governor at the Fed, said in a speech last November that these might include buying bonds in order to bring down long-term interest rates or offering fixed-term loans to banks at low or zero interest rates.

Moves of this sort, while indicating that the Fed had fallen behind the curve in its fight against deflation, would be sensible. For now, however, these weapons are being kept in reserve while the US tries another way of boosting both demand and inflation - allowing the dollar to sink on the foreign exchanges. All this does, of course, is export deflation to other countries, because the flipside to a falling dollar is a rising yen and a higher euro, making it more difficult for Japan and the eurozone to sell their goods overseas. Places such as China and Hong Kong have their currencies linked to the dollar, the pound tends to fall in tandem the greenback, so any weakness in dollar tends to affect only a few currencies. Economists at HSBC say that Japanese intervention holding back appreciation of the yen against the dollar means the euro has become the release valve for dollar weakness.

Bush's revenge

US policymakers might argue that solution for the eurozone is for the to compensate for a higher exchange rate by cutting rates, and they are. It would be an act of gross negligence for the ECB to do nothing, and fortunately the signs are that rates will by half a point next month. This is unlikely to be enough for Germany, however, where inflation is already below 1% and falling. The eurozone exports more of its output than America, the policy of dollar neglect is Bush's revenge for Iraq, it is both ill-advised counterproductive. The upshot will fall in global demand, which will prevent US exporters from taking advantage of the cheaper dollar.

What does all this mean? In the term it means that interest rates are coming down and will stay low for long time. There will be an onus on policymakers to tackle a dearth of demand through coordinated, rather than beggar my neighbour policies. Mr Edwards doubts whether they are up to the job. Some funny things were done in the quest for the economic nirvana that would come through killing off inflation and eliminating budget deficits. "Perhaps the most ludicrous was giving central banks their independence," he says. "Having the unelected strive for the ridiculous was always likely to end disaster, and so it is proving."

For the time being, that remains minority view. One thing is pretty certain, however. The next book on Greenspan is unlikely to be titled "Maestro".