Yields in the eurozone sovereign debt markets have fallen to such low levels that they are, in effect, predicting recession and the incipient Japanification of the eurozone. At the same time yields on eurozone corporate bonds have slavishly followed sovereign bond yields downwards this year despite the fact that recession would normally imply increased credit risk, more corporate defaults, falling corporate bond prices and rising yields. How can this apparent contradiction be rationalised?

One explanation might be that because many market observers expect the European Central Bank to expand its asset buying to include corporate bonds, or even sovereign bonds, investors consider that the central bank is about to turn into a buyer of last resort for overpriced IOUs. In that case credit risk in the corporate sector becomes irrelevant. We would be moving into a Japanese-style world of zombie companies that are insolvent but on permanent life support from the ECB, and where banks unlearn the discipline of credit risk. On that scenario the sovereign and corporate debt markets are marching in tune.

It is possible, though, to assume too much sophistication in market behaviour. A more likely story is that investors have simply been chasing yield regardless of risk, and the possibility of ECB corporate bond purchases comes as a serendipitous bonus. Either way it would be unwise to assume that the proposed expansion of the ECB’s balance sheet necessarily implies a move to full US-style quantitative easing, or that the governing council’s statement that it is ‘unanimous in its commitment to using additional unconventional instruments within its mandate’ automatically implies corporate bond buying.

The key to addressing deficient eurozone demand lies in fiscal policy. Of course the ECB can do something. Asset purchases are quasi-fiscal to the extent that they expose European taxpayers to

the risk of capital loss and default

In reality the extent of the central bank’s future asset purchasing programmes remains uncertain. While Mario Draghi, ECB president, has indicated that he would like to expand the balance sheet by 1tn euros, no one yet knows how that number will be attained. And there remain legal questions about whether the purchase of corporate and sovereign bonds is within the mandate. The ECB is, after all, modelled on the Bundesbank. If Jens Weidmann, Bundesbank president, felt able to sign up to the statement on additional unconventional buying, it must be because he does not want or expect purchases to include anything that would have potentially big fiscal implications — of which more in a moment.

Equally important, QE would work differently in the eurozone. In the US growth was fostered through a wealth effect resulting from the rise in both bonds and equities. In the eurozone bond markets play a much smaller role in financial intermediation. While the rise in US equity markets was closely correlated with the expansion of the Federal Reserve’s balance sheet under QE, no such correlation is apparent in Europe. The Institute of International Finance, a club of leading global banks, points out that the Euro Stoxx index lost nearly 20pc as the ECB balance sheet grew 60pc between July 2011 and mid-2012. Since then the stock market index has risen 35pc while the ECB balance sheet shrank more than 1tn euros.

In fact the eurozone has already had a wealth effect, on the basis of a spillover from the US: there is a much closer correlation between the Euro Stoxx and the S&P 500 index than with the ECB. The question then is how on earth QE would impart stimulus when bond yields are so low and equities have boomed in the face of a stagnant eurozone economy, and how precisely would further inflating the ECB’s targeted securities markets boost lending?

The likelihood is, as many on the ECB’s governing council believe, that QE will have limited potency and that there is not much left in the monetary locker. The key to addressing deficient eurozone demand lies in fiscal policy. Of course the ECB can do something. Asset purchases are quasi-fiscal to the extent that they expose European taxpayers to the risk of capital loss and default. At today’s historically low yield levels, capital losses look a near certainty.

That is a central plank in the case for scepticism about full-blown QE. In the end the eurozone’s problem is political. Until Germany is driven to consider a more expansionary fiscal policy, stagnation is inevitable. It may take a slump, with even higher levels of eurozone unemployment, to bring that about.

Published in Dawn, Economic & Business, November 17th, 2014