If you only have to look at one chart this week, let it be the one on this page (chart one).

Chart 1_sbp june

It shows how Europe and Ireland have become cash economies because bank lending has collapsed. This slump in bank lending is why the European Central Bank (ECB) introduced revolutionary measures last Thursday. These new moves by the ECB may have a significant positive impact on our economy in the years ahead, because they will now reward banks that lend and penalise banks that don’t. Significantly, the ECB will not reward banks that lend to property. This is a crucial positive for Ireland.

Since the crash in 2007-2008, bank lending has fallen progressively everywhere. This is what always happens after an asset bubble. The people have too much debt and they don’t want to borrow and the banks have too much bad debt and they don’t want to lend.

In such an environment, even good projects can’t get financed and therefore this type of recession – one where there’s too much legacy debt – goes on for much longer than other recessions. Globally, since 1945 the average recession lasted 10 months, this one feels like it’s been going on for years.

One of the traditional roles a bank must play in an economy is that it must recycle money from savers to borrowers. There will always be people who want to save and there will always be people who want to invest. The bank should match these people together offering savers a place to put their money and offering investors that same money to invest.

But if banks are not lending, the savings, when they are put in the bank, stay in the bank and don’t get recycled out into the rest of the economy.

This bottleneck chokes off recovery and allows deflation to take hold. Deflation is when prices are falling. This process can become ingrained if after a few years of falling prices, people expect prices to fall, not rise in the future. (See chart two.) This is what happened in Japan from 1990-2010.

Chart 2 sbp June

Deflation is precisely what the ECB has now moved to fight. But it won’t be easy, because nobody is sure that the latest initiative will work. If it doesn’t work quickly, the ideological sceptics in Germany will force the ECB to abandon the experiment.

To see why the Germans are not behind ECB president Mario Draghi all you need to do is examine recent history. In fact, the D-Day celebrations this week are a good place to frame this history.

One of the interesting aspects of the defeat of the Nazis was the unbelievable success of the country that emerged from the ashes, namely West Germany. At the core of the Federal Republic was a constitution which protected the citizen’s liberty against the state and a powerful constitutional court in Karlsruhe to police the state on behalf of the citizen. The other institution was one that protected the citizen’s money against the State: the central bank – the Bundesbank in Frankfurt.

From day one, the aim of the Bundesbank was to protect the citizen’s savings from inflation, which had destroyed the German economy in the early 1920s.

When the problem is inflation, the solution is deflation.

Heresy

However, what the Bundesbank never contemplated was what happens if there is deflation. By logical extension, if the problem is deflation, the solution is inflation. But it is heresy for central bankers to embrace inflation – however, that’s what Draghi knows they have to do.

Writing as a former central banker, schooled in the traditional way to be always on the look out for inflation, I know how difficult it is for these guys in Frankfurt to accept that they have to turn policy on its head and generate inflation now.

To execute this new strategy, Draghi has presided over a very un-Germanic coup at the ECB, where the Germans have been out-gunned, out-thought and out-voted. To put it bluntly, last Thursday Draghi wrote the obituary for the Bundesbank. The ECB is deeply Latin now. And it is doing what all Latins do in a crisis: print money.

The ECB has pushed rates down towards zero and says rates will stay there for four years..

It has also unveiled a new LTRO scheme which is, in effect, a giant cash for trash scheme encouraging banks to lend to the real economy, all financed by a money printing central bank. The new scheme will allow banks to exchange dodgy assets on their balance sheets for real cash and the bank can then lend this real cash to companies. Crucially, the new scheme can only be availed of by banks that prove they are lending to the real economy. This is a new and significant development because it means that banks will be rewarded for lending to the private sector firms that need financing.

This plan gives banks time to plan how they want to offer the money to the economy. It puts the ball firmly in their court. Let’s hope they do something this time. This is an intriguing development and it shows that Draghi is prepared to tear up the rulebook scripted by the German Bundesbank and replace it with his own new version to fit the new deflationary reality.

The impact could be most significant on the periphery where the credit crunch is most damaging. Tellingly for Ireland, he has stipulated that bank lending need to rise, but this rise can’t include property lending. This doesn’t mean that Irish bank will not lend against property (which is the risk), but that it will be more profitable for them to lend against other stuff.

If this re-balances Irish bank lending away from property into start-ups and companies which produce things, it could be a huge positive for an economy like ours that has a weakness for destroying itself with its property obsession.

At this stage, it’s a big if. But we have to give it the benefit of the doubt. At least after seven years of fighting deflation pressures with more deflationary pressures, the ECB has admitted that it was wrong all along. The solution to deflation is inflation and, God knows, Europe could do with a bit of that right now.

David McWilliams hosts the Dalkey Book Festival June 19-22nd. dalkeybookfestival.org