ECB headquarters in Frankfurt, Germany. (Photo: AP)

The European Central Bank flooded the sickly European banking system with its second tranche of cheap money Wednesday, making 530 billion ($705 million) euros available to 800 banks two months after a 489 billion euro liquidity injection sent European markets soaring.

Indeed, while U.S. investors just pushed up the Dow above 13,000, giddily watching the market rise nearly 10% in the first two months of the year, European markets have actually outperformed the U.S. year to date. The Euro Stoxx 50 index has climbed over 13% since the start of the year, while European banking stocks have risen 21%.

The European Central Bank’s Long-Term Refinancing Operations program that has now injected over a trillion euros into the European banking system deserves much of the credit for this. The banks can borrow at a super-low 1% rate and use the funds to retire maturing debt, make new loans or, like their U.S. counterparts in the years after the financial crisis, make “carry trade” purchases of government bonds—ensuring an immediate profit: By borrowing at 1% and using the funds to buy, say, Italian 10-year bonds at 4.5%, banks immediately strengthen their balance sheets while governments see their financing costs go down as investors scoop up their debt instruments.

The obvious problem with this policy is its quite transparent circularity. The ECB’s balance-sheet expansion has the same effect of printing money. ECB President Mario Draghi is gambling—as has Fed Chairman Ben Bernanke before him-that economic growth will restart before bond vigilantes once again notice how leveraged the Continent’s banks and governments are. It does not help either that the ECB got into the “quantitative easing” business years after the U.S. did, and with an economy that is structurally weaker than the U.S. as well.

It is not yet known how European banks will make use of the money. Central bankers hope that much of it will be channeled into lending to businesses in order to fuel growth, though lending in the U.S. never fully recovered despite the Fed’s easy money. Credit remains hard to obtain for people seeking to buy homes or start small businesses.

What’s more, dovish monetary policy has had perverse effects of “repressing” ordinary savers in the U.S. and Europe who face negative net returns (after inflation) on their savings deposits and who, despite these losses, remain wary of risky equity markets. Tight credit, high consumer losses and a widespread negative perception of financial institutions likely have a depressing effect on economic confidence.

The ECB’s liquidity lifeline to banks—like America’s quantitative easing policy—offers a chance to avoid a deeper economic depression, but only if that window of opportunity is used to make sustained structural reforms that policymakers on both sides of the Atlantic have so far avoided.

That means reforming entitlements and state and municipal government pensions—the Pac-men that are eating through government budgets. And it means instituting policies that treat wealth creators with respect.

To cite an extreme example, Mark Perry’s Carpe Diem blog recounts a visit to Greece in which Perry met a friend at a bookstore/café, where ironically regulations prevented the store from selling books or making coffee. That pretty much explains why Greece is now essentially bankrupt. No monetary chicanery will prevent the U.S. and Europe from experiencing Greek levels of pain if governments fail to mend their ways while there is still some time left.