I recently argued that the Fed and the ECB were passively tightening monetary policy and thus responsible, in part, for the increasing economic stress in their regions. Michael T. Darda makes the same argument today for the Eurozone in his note titled "Anatomy of a Deflationary Debt Collapse":
Indeed.As the ECB fiddles with its forecast, European inflation-indexed bond spreads have plunged to record lows, while eurozone corporate bond spreads continue to hit new highs for the year. Inflation breakeven spreads in the indexed swap market in Europe have tumbled to the lowest level on record (i.e., below both the 2008 and 2010 lows). With corporate bond spreads at new 2011 highs this morning, the European Central Bank can now be blamed for a passive tightening of monetary policy. Why? Central banks are responsible for responding to velocity shocks by adjusting the supply of money to offset changes in the demand for money. If there is a spike in the demand for money and a central bank does nothing, a “passive tightening” of monetary policy will ensue. The message from plunging inflation breakeven rates and surging corporate bond spreads is that the eurozone could now be headed for a negative velocity shock and thus a deflationary debt collapse. There will simply be no way for governments in the periphery (including Spain and Italy) to pay debts with credit markets shutting down, economic activity collapsing and policymakers either not responding or responding in a way that is likely to make matters worse.