Tuesday, 22 January 2013

The eurozone: Turning Japanese?

With all things Japanese in vogue today, I was asked whether Japan’s lost decade (or two) of growth foretells the outlook for the eurozone. This is a very natural comparison – indeed it is one which I have used before – because Japan and the eurozone have some stunning similarities. After all both Japan and the eurozone have low growth, both have challenging demographics, both are energy dependent and both suffer from a strong currency.

But when I made the comparison in the past, I tended to describe what the eurozone might become if it were less reliant on the private sector as the lender of last resort for European governments (in the interview I used the rather dubious phrase that a crisis-hit eurozone could aspire to Japan’s slow decline). If that sounds like a dubious aspiration, how about this from an insider?:
“I am sure the Euro will oblige us to introduce a new set of economic policy instruments. It is politically impossible to propose that now. But some day there will be a crisis and new instruments will be created.” Romano Prodi, former Prime Minister of Italy (FT, 2001!)
Amazingly these instruments and institutions have been put in place, in a hurry, and the crisis has been averted. So is it a Japanese style deflation from here on in?

I think the Japanese parallel was fit for purpose when Europe was trying to escape from a state of crisis but, now that road has been travelled, it makes sense to be a little more specific about defining the destination. Remember there are those who suggest that Japan is blazing a trail not just for Europe but for most of the Anglo Saxon economies too – in the case of the US I think that now starts to look really quite far-fetched – notwithstanding the obvious similarity in terms of monetary conditions. The reality is that countries don’t follow the same path. There are, to my mind, too many differences for these kind of comparisons to have meaning.
Source: Bloomberg

The most obvious ones, in the case of Japan and the eurozone, are scale and breadth. Scale because the Japanese asset bubble was like nothing the world has experienced in any other period; and breadth because, in the case of the eurozone, rather than starting solely as an asset bubble, a series of imbalances arose – asset bubbles, balance of payments crises, collapsing productivity, deteriorating public finances – all of which stem from the same, fundamentally rigid economy.

Beyond the differential diagnosis, the prescription is also different. The response from the Bank of Japan was inadequate due to that Japanese trend of fundamental conservatism and, lets be fair, as the first economy to reach the zero-rate bound it was always going to be more difficult to embrace unconventional monetary policy as much as those who came after did. The government’s response suffered from the more standard influence of populist measures, so banks were propped up, loans were rolled over, the working week was cut, new bank holidays were introduced and hiring and firing practises remain challenging.

That is the stark difference between Japan and the eurozone. The eurozone has identified its path to salvation – the Prodi quote above suggests it always had – that wages would adjust while inflation and exchange rates remained fixed. The question has always been how to enforce it, because historically and culturally the eurozone social model is one which is inflexible in labour terms. But there is a tremendous will to achieve this transition – and there is a structure. Politically, there is probably not another economy in the world that could achieve the wage devaluation which Europe will attempt (with the possible, but debatable, exception of China) because the government would fall. But when European governments falter, the markets will expose them through higher borrowing costs, and when that happens they will have very little choice but to take the unpalatable medicine on offer from the ECB. That may depress growth for a decade, as it has in the case of Japan, but the difference is that, if the European economy survives the process, it will be a fundamentally stronger economy at the end of it.

Guy Foster
Head of Portfolio Strategy

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