On Europe As Japan 2.0
With Greece and Spain (and arguably Portugal and a few others) stuck in dramatic debt-deflation spirals, the political need for maintaining these nations in the euro far outweigh the economic 'benefits'. As UBS notes, looking at the euro area today, one cannot help but notice the parallels to Japan of the early 1990s. Europe today, as with Japan a generation ago, is an aging society with structural rigidities, pockets of corporate excellence, but wide swathes of inefficiency; but the two most striking similarities (and not in a good way) lie in the banking system (bloated from over-leveraging, under-capitalization, and bad loans); and fiscal policy (which is inherently pro-cyclical - as the politics of monetary union preclude national level stimulus - leaving ineffective monetary transmission channels unable to help fiscal failure). As UBS concludes, the current euro's similarities to Japan are key impediments to growth - and as such we should expect sclerotic economic activity for a five-year period.
Via UBS: The euro as Japan 2.0
Looking at the euro area today, one cannot help but notice the parallels to Japan in the early 1990s. We expect mediocre growth in the euro zone for several years, and it is hard to see a return to trend growth within five years. Europe today, as with Japan a generation ago, represents an ageing society with structural rigidities in its markets. There are pockets of corporate excellence, of course, just as there were in Japan. There are also areas of inefficiency. The two most striking similarities with Japan lie in the banking system and fiscal policy.
- Japan’s banking system problems in the 1990s stemmed from bad loans. For much of the euro area the problem is more undercapitalised banks (though there are bad loans too). From an economic perspective, it is not the cause as the effect that matters. The euro is likely to experience low bank credit growth in the coming years. This constrains economic growth.
- The second parallel is fiscal policy. In Japan’s case, fiscal policy failed to provide much economic stimulus because the political structures of the time directed stimulus into ultimately inefficient projects. In the euro area, the bias of fiscal policy is pro-cyclical not counter cyclical, as the politics of the monetary union preclude national level stimulus. Thus, monetary policy is unable to stimulate as the monetary transmission mechanism is failing to operate effectively, and fiscal policy that is failing to compensate for monetary failures.
However, as with any software upgrade, the euro as Japan 2.0 is not the same as Japan 1.0. One of the more significant differences is the position of the small and medium-sized enterprise sector. In Japan’s case, many SMEs were weak, not just in a cyclical sense, but in a structural sense. The “hollowing out” of Japanese industry (endaka) left the SME sector without key customers. Generally speaking, the euro area Mittelstand is not in the same situation. Of course, the problems of the cyclical downturn are felt by the euro area’s SMEs, but they are better positioned to participate in an economic recovery when it comes. This is important, as small businesses are labor intensive and can contribute to employment growth in a cyclical upswing.
A second key difference is particularly important in analyzing the debt implications of the economic position. The euro area has not, as yet, experienced the same degree of difficulty in achieving nominal GDP growth that Japan faced in the 1990s. Euro nominal GDP growth (outside of Germany) has risen significantly in the past decade. Even in a low real world environment, it is possible that inflation in at least parts of the euro area will contribute to a higher nominal GDP growth rate, which will in turn make the process of deleveraging more manageable.
Some care is required here – it is not yet clear if this is an area of difference or similarity with the Japanese experience. Certainly the pattern of euro CPI has shown more resilience than in Japan so far. The output gap is perhaps narrower in the euro area than was the case (initially at least) in Japan. Parts of the euro area are discovering the political expediency of raising VAT rates, which of course supports inflation (Japan did not raise its consumption tax rate until 1995). Finally, of course, the ECB has acted earlier and more aggressively than did the Bank of Japan in the 1990s.
This has so far prevented a deflation mentality taking hold in the euro area. The risk is that the persistent low growth environment may encourage a deflation mindset in parts of the euro area. However, it is unlikely to take hold across the euro as a whole, and to that end should limit the risks of a structurally low nominal growth environment.
What this goes to suggest is that the euro is similar to Japan as to some of the key impediments to growth, and as such we should expect sclerotic economic activity for a five-year period. However, the differences in the euro as an upgraded version of the Japanese economic crisis mean that the weak growth episode is unlikely to be as enduring as that of Japan. Japan 2.0 is a five-year risk, not a two-decade risk.