Unless the nettle of debt write-offs is grasped, we are entering a second, more serious round of the European crisis argues James Meadway

As oil prices continue to fall, a strange phenomenon is making itself known across Europe: deflation, the opposite of inflation in which prices of the goods we buy fall and fall again. Familiar in Japan since the 1990s, consistently falling prices are unheard of Europe – and across the world – since the grim years of the 1930s. On December’s figures, prices inside the eurozone are falling by 0.2% a year.

This can initially sound like good news. After all, with money wages and salaries barely increasing, both here in the UK and across Europe, declining prices means an increase in people’s real purchasing power. Each euro in your pocket stretches, on average, just a little bit further than before. And in the short term, the decline in the price of oil does seem to have fed into some improvements in real living standards – or, at the very least, set a floor to their decline. If the price falls were confined to just falling costs of energy and transport, this argument could hold. A sharp fall in the price of oil lead to briefly falling prices in Germany and other European countries in the mid-1980s, without serious further consequences.

But it’s the second-round effects that cause such concern, should declining prices spread and take hold. These second-round effects fall in two parts. First, if you know that the price of anything you buy will be less in the future – why not wait until the future to buy it? Once people expect falling, rather than rising prices, they have a major incentive not to buy. Demand falls, less is sold, the recession worsens.

Second, and more ominous, is something that economist Irving Fisher first highlighted, back in the 1930s. Falling prices means producers earn less money from anything they sell. They look to cut costs. That means cutting someone else’s income – either reducing payments to suppliers, or cutting the wages paid. Incomes start to fall, alongside prices. People in general have less money in their hands, even if each pound or euro of that money can buy slightly more.

But if they have debts, these debts still have to be paid in money – precisely the thing everyone has less of. The real burden of debt, in other words, starts to increase. Of their declining incomes, more and more, proportionately, will have to go towards servicing debt. This means less and less will be spent on goods and services. Demand falls, less is sold, the recession worsens. As the recession worsens, incomes fall still further, increasing the real burden of debt. And so on.

This spiral downwards is debt deflation. It’s a huge issue if there’s a lot of debt around. And if there’s one thing that Europe has a lot of, it’s debt – both public (government) debt, as in Greece, and private debt, as in Spain or the UK. It’s the risk of debt deflation that is leading the European Central Bank towards supporting more unconventional measures, most likely announced at its next Governing Council meeting on 22 January, and probably including some form of quantitative easing (QE). The intention will be, one way or another, to get more money back into the Eurozone economies, and so (hopefully) pull the single currency out of what threatens, otherwise, to become a vicious deflationary circle.

It’s not clear QE will work, at least over the long term. It’s had some impact in the UK because, in effect, the £375bn QE money fed into the housing market, via mortgages. The Bank of England used to QE to give cheap money to UK banks and they expanded lending for mortgages (although not, pointedly, to small businesses). That may not happen across the eurozone, where housing and mortgage markets can work in quite different ways to here. (For instance, Spain has close to 80% home ownership; Germany, just over 50%.)

If QE doesn’t work, they may well have little choice but to move towards breaking the other side of the debt deflation mechanism – cutting debt, as demanded by Greece’s Syriza , the radical left party currently topping opinion polls there. That’s not popular in elite circles, to say the least, since it implies losses for Europe’s creditors – for Greece, the ECB itself; for most of Europe, its major banks, who have successfully, thus far, passed the costs of the crisis away from themselves and onto wider European society.

The election battle in Greece is, to a large extent, about whether that process can continue. The ECB has, over the last three years, inched away from its hardline position at the start of the crisis in which it demanded exceptional austerity measures, alongside tight monetary policy. There may be some wriggle room for a possible Syriza government. The spectre of the 1930s may help spook Frankfurt into remedial action. But unless the nettle of debt write-offs is grasped, we are entering a second, more serious round of the European crisis.