Money supply data appears to indicate that too-big-to bail Italy appears to be heading into recession. The news broke in Ambrose Evans-Pritchard’s column in the Telegraph:

“Real M1 deposits in Italy have fallen at an annual rate of 7pc over the last six months, faster than during the build-up to the great recession in 2008,” said Simon Ward from Henderson Global Investors. Such a dramatic contraction of M1 cash and overnight deposits typically heralds a slump six to 12 months later…

…”What is disturbing is that the numbers in the core eurozone have started to deteriorate sharply as well. Central banks normally back-pedal or reverse policy when M1 starts to fall, so it is amazing that the European Central Bank went ahead with a rate rise this month,” Mr Ward said.

We have been here before. The One Size Fits Germany policy had led the European Central Bank to tighten rates just as Europe was tipping over into recession in 2008. The penalty the first time round was deflation and riots for the periphery of Europe. This second mistake could now plunge the Euro project itself into chaos with an unknown future:

Italy is not a high-debt nation. Italian households are frugal by Spanish and UK standards. However, Italy has a toxic trifecta of problems that affect long-term debt dynamics: a public debt stock of €1.8 trillion or 120pc of GDP; rising interest rates; and economic stagnation. It is the interplay of these elements that has set off flight from Italian bonds. Italy has to roll over or raise €1 trillion over the next five years, with a big spike as soon as August.

Italy is too big to bail, which adds to the nervousness and skittishness of its bondholders. Mixing recession and rising interest rates with Italy’s high debt stock creates an explosive cocktail. Just the whiff of vapours from such a cocktail is enough to send many investors to the emergency exits. If Italian bond yields decisively cross the 6% line, there will only be two outcomes possible: either a disorderly debt default for many Eurozone nations, including possibly departures from the Eurozone, or a hasty marriage at gunpoint with the creation of a single European Treasury, with veto power over government spending decisions.

Default is the common sense solution for the current state of affairs. However, it could have been handled in an orderly manner, much earlier, and without paying the price of deflation in the European periphery. Now, as a result of the futile efforts to ensure that “no bondholder is left behind”, Europe is carreening towards the defaults it so desperately wanted to avoid, with the deflation machine in full swing. The disorderly defaults will likely trigger a new phase of the credit crunch, exacerbating the deflation of asset values.