Markets are grappling with the issue of whether the bursting of the credit bubble will usher in sustained deflation, as occurred in the US in the 1930s and Japan in the 1990s. The answer will depend on monetary trends.

The onset of deflation in Japan was presaged by the annual rate of change of M2 turning negative in September 1992 – see first chart. M2 growth subsequently recovered but never rose above 5%.

When an economy enters deflation the demand for money rises, reflecting its appreciating purchasing power. To create “excess” money balances and reverse the falling trend in prices the authorities need to engineer a major acceleration in monetary growth. The Bank of Japan never achieved a boost on the required scale and the economy arguably never exited deflation.

In the interwar US, the annual rate of change of M2 was negative for almost five years between 1929 and 1934 – second chart. However, a major recovery ensued in 1935-36, with annual growth reaching a peak of nearly 13%. This succeeded in pulling the economy out of deflation temporarily before money trends slumped again in 1937-38.

US annual M2 growth was stable at about 6% between mid 2007 and mid 2008 and has recently moved above 7% – third chart. A broader liquidity aggregate including institutional money funds, large time deposits, commercial paper and Treasury bills is rising at a faster pace, of about 10%. The financial crisis has resulted in a rise in the precautionary demand for money but these growth rates appear incompatible with sustained deflation. (The latter should be distinguished from a temporary fall in consumer prices due to commodity price declines.)

Some commentators portray deflation as an inevitable consequence of the bursting of the bubble and monetary policy-makers as powerless bystanders. This is wrong. The Fed and other central banks are capable of expanding the money supply on whatever scale is necessary to prevent falling prices. The Fed has recently announced measures that will directly boost M2; the UK authorities must quickly embrace similar initiatives.