The Breakeven Point (Wonkish But Terrifying)

This from Dr. Krugman - follow link to original
--------------------------------------------------------

The Breakeven Point (Wonkish But Terrifying)

A number of us have been saying for some time that the euro crisis is, at its root, a balance of payments problem. During the careless years, capital flooded from the core to the periphery, leading to big trade deficits and overvalued real exchange rates; now, all that needs to be reversed. Yet “internal devaluation” via deflation in southern Europe is basically impossible; if this is going to have any chance of working, we need a real devaluation in Spain mainly via German inflation rather than Spanish deflation. 4 percent German inflation plus zero in Spain might work; 2 and minus 2 can’t.
And this in turn means that overall eurozone inflation must be sufficiently high. That’s a necessary but not sufficient condition for salvation; not sufficient because a banking crisis can still blow the thing apart, but necessary because you can’t resolve the banking crisis unless there’s some plausible path back to sustainable economies.
One indicator I like to look at is the German “breakeven” — the difference between the interest rate on ordinary German bonds and on bonds indexed to inflation (which it turns out means overall eurozone inflation). This is an implicit market forecast of the inflation rates, and I’ve been arguing for a long time that it really needs to be above 2 for there to be real hope.
So what’s happening? Oh, boy:

I’m not sure this really means that investors expect only 0.7 percent inflation over the next 5 years; it’s probably also reflecting a collapse of liquidity, which drives down prices in the relatively thin markets for index bonds (which happened after Lehman too). But that’s just another kind of disaster.
This chart shows a euro on the verge of imploding. If the ECB can’t change this perception very, very soon — and I think it really is up to them — this goose is cooked.