Calling the eurozone’s bluff?

Headline inflation turned negative for the first time since 2009, inflation expectations have dropped sharply and the economy is struggling to leave stagnation.

Moreover, the amount of official ECB statements hinting at QE have put the ECB into a corner from which it cannot escape without strongly disappointing financial markets. Whether QE is currently justified or not, hardly matters any more. It is all about central bank credibility and fulfilling market expectations.

The ECB simply has to deliver.

The impact of QE in the eurozone is highly controversial. If there is at least one single inflationary tendency in the eurozone right now, it is the amount of articles and opinions on the sense and nonsense of QE. Only time will tell which arguments were right or wrong.

Obviously, with almost all eurozone bond yields currently trading lower than US yields, a further rate reduction will not make a huge difference for the economy.

Unless QE manages to significantly lift inflation expectations.

Moreover, whether ECB purchases of government bonds will really free new lending space at banks or through higher equity prices room for corporate investment is far from certain. Therefore, the safest bet for a positive QE impact seems to be through a weaker euro exchange rate (though one could still hope for a positive confidence effect as well).

Given the track record of earlier acclaimed ECB rescue measures, chances are high that QE will join the boulevard of broken dreams.

Just remember that expiration dates of past bold ECB measures have become shorter and shorter. Whatever happened to negative deposit rates, conditional liquidity or even ABS and covered bond purchases? QE could meet the same fate.

If it does, the entire eurozone would have a problem.

The last magic trick

Up to now, QE has been the ECB’s and the eurozone’s last magic trick, no one dared to perform. If it fails, the ECB and the eurozone are empty-handed and Mario Draghi would no longer be the magician of all central bankers.

Instead, he would turn out to be a simple illusionist who could not solve the eurozone’s structural problems and has now run out of options.

The second seed for new chaos will be planted by the Greek elections. No matter what the results are, the Greek elections will have a significant impact on the eurozone. At least in the medium term.

The worst of all options is Grexit. Greece’s export sector is simply too small to reinvigorate an entire economy on the back of a new, devaluating, currency.

Instead, with a government default, a collapse of the banking sector and increasing poverty, the consequence of a Grexit would be disastrous.

Why should the rest of the eurozone care?

The European Stability Mechanism (ESB) and the ECB should be sufficient to avoid contagion similar to the one in 2012. However, they cannot prevent new, political, contagion. Successful or not, a Grexit would mark the end of the euro’s irreversibility as it would make an exit a viable future option for all other countries in any negotiation.

While a Grexit is clearly not the most likely option after the elections, renegotiations are.

Greece’s European partners will have to make some concessions, either after tough negotiations with Syriza or as a reward for the continuation of the Samaras-government.

In both cases, other eurozone countries may be prompted to ask for equal treatment. With upcoming elections in Spain and Portugal and struggling governments in Paris and Rome, the eurozone’s current crisis management will again be put to a severe test.

The relative calm on markets, first signs of economic improvement in crisis-battered countries and the strong belief in the ECB’s magic power to fix everything has clearly led to an unjustified abundance of enthusiasm last year.

And complacency.

As a result, the monetary union is still a provisional arrangement and actually more fragile than some might think. Public and private debt is still – at least in some parts – unsustainably high, structural reforms still lack ambition, the economy is flirting with deflation and stagnation and the power struggle between national and European levels goes on forever.

This is a clearly unsustainable construction, which at some point in time will either dissolve or move into more economic and political integration. For a long while, the ECB’s magical power has made politicians believe that this crossroad would never come.

Next week’s QE and the Greek elections could eventually call the eurozone’s bluff. It is time for the eurozone leaders to show their magic.

Carsten Brzeski is senior economist at ING Bank Germany