This risks creating a deflationary spiral from which the ECB cannot escape, Darda writes: market-based indicators of inflation risk in the eurozone have collapsed. This is a problem because of the real exchange rate misalignment in the eurozone (i.e., peripheral costs are high relative to core costs): The lower the rate of inflation in the core, the higher the rate of deflation in the periphery. We can see this starkly now in the behavior of German and Italian breakeven inflation spreads: As the German five-year breakeven spread has collapsed to below 1%, Italian breakeven spreads have plunged into negative territory. The ECB's monetary errors are now creating the real risk of a deflationary collapse in the periphery, meaning that no amount of austerity would be able to balance budgets or reduce deficits.

The surge in corporate bond spreads in the eurozone now suggests that nominal GDP could plunge by 3%-6%, which would be a disaster for both peripheral and core budgets. In short, credit markets have tightened massively in the eurozone; if the ECB does not act in a resolute enough manner to offset this tightening (and, so far, it has not), then it will have to shoulder the blame for presiding over perhaps the largest monetarycatastrophe since the 1930s.

Mark Gongloff