Eurozone monetary weakness, in the view of the author of these notes, has been the key driver of the recent deterioration in global economic and financial conditions. Various posts over the last year drew attention to a contraction of the real narrow money supply, M1, initially in the periphery but spreading to the core in early 2011.

By February 2011, Eurozone-wide real M1 was 2.1% lower than six months before (not annualised). The six-month change has turned negative on seven previous occasions over the last 40 years, in five cases signalling an oncoming full-scale recession and the other two instances a significant contraction in industrial output – see first chart below.

Against this backdrop, it was astonishing that the European Central Bank, which trumpets its adherence to monetary analysis as a distinguishing feature of its modus operandi, chose to rein back its longer-term repo lending in late 2010 and raise official interest rates in two quarter-point moves in April and July. This was a repeat of its error of 2008, when it hiked by a quarter-point in July despite a fall in real M1 – the economy, in fact, had already entered a recession in the second quarter.

Real M1 contraction, predictably, has fed through to economic weakness and heightened risk aversion, reflected in ongoing sovereign debt woes and increased banking system stress. Conventional economic leading indicators are now confirming the recessionary signal from monetary trends. Our proprietary transformation of the OECD’s leading index for the Eurozone, for example, is at a level only previously reached before major downturns – second chart.

The hope was that Euroland’s economic relapse would be tempered and offset globally by favourable monetary trends elsewhere – particularly the US and Japan, where real M1 rose by 4.5% and 3.4% respectively in the six months to June. As previously noted, G7 real money expansion has revived since early 2011. The global loss of confidence stemming from the Eurozone’s unravelling, however, threatens to “freeze” these cash balances – the monetary pick-up, in other words, could be neutralised or outweighed by a fall in the velocity of circulation.

On this diagnosis, a reversal of current negative drift requires the ECB to admit its mistake and embark on a major loosening of policy, cutting the repo rate and stepping up government bond purchases to inject cash directly into the economy. These purchases should be spread across national bond markets rather than focused on Italy / Spain – it is not the ECB’s role to engage in quasi-fiscal transfers. The aim, in other words, should be to reduce peripheral yields by driving core rates towards zero rather than targeting spreads.

ECB “QE” would be much more effective than Fed easing, partly because it addresses the fundamental cause of current global difficulties and partly because a further injection of US cash would risk tanking the dollar and renewing upward pressure on commodity prices, thereby reversing the recent welcome relief to G7 real incomes from slowing inflation. Unilateral ECB loosening would allow the overvalued euro to depreciate – another necessary escape-route for struggling peripheral economies.

The consensus is that any such action would be vetoed by the Bundesbankers and their allies, although recession looms even for Germany. Incoming ECB President Draghi, however, has every incentive to be bold. A majority of the Governing Council would probably support large-scale policy easing. If EMU is to break up, let it be through the voluntary withdrawal of Germany rather than the forced exit of peripheral economies pushed into a depression by hardliners masquerading as monetarists.