Should we worry that the euro zone is in deflation (pdf)? Certainly, deflation is a symptom of a severe problem - that of weak demand which has resulted in almost one-in-four (pdf) young people being out of work. And the very fact that deflation is unfamiliar might create uncertainty which itself is bad for economic activity. Beyond this, however, I suspect that what we have to fear is not so much deflation as bad policy.

For one thing - as Robert Peston points out - the fall in the CPI is entirely due to lower oil prices, which should raise real incomes and activity. (Note, though that even excluding energy inflation is only 0.6 per cent, which is well below the ECB's target of "below, but close to, 2%." In this sense, there has been a failure of economic policy.)

And for another thing, history tells us that deflation needn't lead to weaker growth. My chart plots GDP growth against inflation in the previous year for the UK before WWII - a period when deflation was common. You can see that, if anything, deflation led to faster growth than did inflation. Of course, there are many differences between 19th Century England and the euro zone today (though maybe not so many in Germany), but this historical evidence suffices to tell us that there is no necessary, inherent reason why deflation must lead to worse economic performance.

All this said, there is a danger here. It lies in the dynamics of government debt. Remember the simple equation which tells us what primary budget balance governments must run to stabilize the debt-GDP ratio. It is:

d * [^(r-g)/_(1+g)]

where d is the debt-GDP ratio, r the nominal interest rate and g the nominal growth rate.

This equation tells us that if g falls relative to r, then more fiscal austerity is needed to stablize the debt ratio. And such a fall is quite possible if (for example) permanently lower inflation is accompanied by markets worrying about debt sustainability, which would keep bond yields high.

This poses the danger of a vicious circle in which deflation leads to austerity which leads to further deficient demand and deflation.

What could prevent this? In theory, the mere existence of the inflation target should do so; this should keep inflation steady at just under 2%. What's in doubt, though, is whether the ECB can or will achieve this. In this sense, calls for a higher inflation target, whilst perhaps reasonable in other contexts, aren't (yet) relevant; the ECB's not hitting its current target, let alone a higher one.

Instead, there are two other possibilities. One, of course, is full-blown QE. Sure, it's doubtful how much this will raise activity and inflation. But even so, it has another virtue. It would hold down bond yields and so help prevent the rise in r - g that would worsen debt dynamics. In this sense, QE is a form of fiscal policy.

Ah, yes - fiscal policy. The solution to deflation at the zero bound is simply a looser fiscal policy. And, taking the euro zone as a whole, there is plenty of room for this; the OECD estimates that the region is running a surplus on its underlying primary balance.

It is, however, unlikely that this option will be exercised. Which is why I say that the biggest danger for the region isn't so much deflation as bad policy.