The Eurozone has recently moved into deflationary territory (story here). But is deflation such a bad thing? Deflation has two major consequences. First, it means that debtors have to pay back more in real terms than they borrowed (inflation, on the other hand, helps debtors by reducing the real amount they have to repay on their loan). This, as was the case in the Great Depression of the 1930s, can have detrimental consequences for financial stability. Second, nominal wage rigidity makes it very hard for employers to reduce nominal wages in line with deflation. What does the historical experience with deflation have to say? Click here to read a BIS working paper by Michael Bordo and Andrew Filardo which looks at deflation in a historical perspective. They find that some deflation experiences have been good, other have been bad, and some have even been ugly.
As an undergraduate, I was taught about the failure of Herstatt Bank in 1974 and Herstatt risk. This bank was only the 35th largest bank in Germany at the time so why would anyone be interested in studying its failure? Herstatt failed because of its involvement in risky foreign exchange business. When it closed its doors on 26 June 1974, counterparty banks (mainly in New York) had not received dollars due to them because of time-zone differences - this is known as settlement risk. The cross-jurisdictional implications of its failure resulted in the Bank for International Settlements setting up the Basel Committee on Banking Supervision and Herstatt's failure was a key reason for the establishment of real-time gross settlements systems, which ensures that payments between two banks are executed in real time. The Bank of England's Ben Norman has an interesting post on Herstatt over at the Bank's new blog ( Bank Underground ). As well as giving an excellent overview of