Deflation or an environment of falling prices has not only hit Ireland but threatens to morph into runaway deflation following the latest report on consumer prices.

Ireland’s consumer price index fell 4.7% in May from a year ago – the sharpest contraction across Europe and the worst in Ireland since 1933. Though not as chronic as Ireland, consumer prices have indeed turned negative in other Euro-zone countries since March.

In the United States, consumer prices turned negative in March for the first time since 1955. In May, CPI actually gained but remains down 1.3% over the last twelve months.

Deflation is now attacking a handful of industrialized economies in the West as a combination of soaring job losses and declining wages put pressure on consumer price data. Since late 2007, a blitzkrieg has walloped consumer balance sheets, including plunging stocks and real estate – the largest assets defining personal wealth.

Ireland has been a model for low corporate taxes, high productivity and a booming financial services hub for years until the property bull market collapsed about eighteen months ago. There’s no doubt that Irish real estate prices went overboard over the last decade and were long overdue for a correction or worse. In May, Irish mortgage-interest costs fell 42.4% on the year.

Economists expect unemployment to reach 17% by the end of 2010 while the country’s budget deficit is skyrocketing – a consequence of financing a bailout of the Irish banking sector last fall. On a per capita GDP basis, no other country has greater bank liabilities than Ireland.

Along with the Italian, Greek and Portuguese economies, Ireland is now a drag on the euro. Credit spreads for weaker euro-zone members have indeed compressed since March but remain historically elevated since the creation of the euro in 1999.

Though it’s highly unlikely Ireland will exit the euro-zone, that strategy might be the quickest avenue to recovery because of its inflationary consequences. That’s what the United Kingdom and Italy did back in September 1992 when they quit the ERM or the European Exchange Rate Mechanism – the euro’s predecessor. Yet the cost of financing Ireland’s enormous fiscal spending packages would also surge and that would not help the country.

Deflation, not inflation, remains a primary threat to global markets. It’s still premature to be concerned with inflation. The destruction of credit lingers in the West as most banks continue to hoard cash. Deflation still rules the landscape.