The recent decision by the European Central Bank (ECB) to impose negative interest rates on bank reserves has again highlighted the vital role that policymakers must play if the eurozone is to continue on a path to recovery.
Despite some clear differences in economic situation and policy response, comparisons between the current situation in Europe and Japan’s painful experience of low growth and deflation continue to be drawn.
There is no doubt that there are some striking parallels between the eurozone today and Japan in the 1990s. However, a brief look at both experiences reveals that there are also significant differences.
The asset bubble in Japan peaked at the end of 1989, after which the stock market fell by a massive 50 per cent over the next two years, and stayed subdued for the remainder of the decade.
Land prices also fell from 1992 and have not recovered. Nonetheless, the most severe effects of the bubble bursting were not felt in the local economy immediately.
Nominal GDP continued to grow until 1997, and unemployment did not exceed 3 per cent until 1995.
Even CPI (excluding food and energy) stayed above zero until 1998 and at zero until quantitative easing began in 2013.
By contrast, in Europe the economic correction was far more abrupt than in Japan, and the asset price crash was part of an international phenomenon.
It was Europe’s exposure to global trade which caused the steep drop in economic activity, while the onset of the sovereign debt crisis played its part later.
Property bubbles did exist, most notably in Spain and Ireland, but were confined to these regions. And unemployment increased much more quickly.
In Japan, the reason for the slower decline was in part due to cultural factors.
Within the banking sector, for example, bad loans were rolled over and not realised, resulting in a situation where so-called ‘zombie companies’ continued to operate unprofitably.
This had the effect of keeping unemployment down, but it also reduced the probability of new companies being set up, new loans being offered and new jobs being created.
In Europe, efforts have been made to avoid the same situation, via stress tests and forced recapitalisations – with mixed success.
In some crisis countries, so-called ‘bad banks’ have been created to quarantine high risk and bad debts from bank balance sheets, and these measures have been largely successful.
On the downside, policymakers’ focus on shoring up the banking system has come at the cost of lending growth.
Banks have been concerned with getting their own house in order, and headline data shows that private sector lending is continuing to contract across the eurozone.
Private sector lending must be a focus for the ECB going forward if the situation is to differ from that in Japan, where credit growth was non-existent or in contract from 1995 to 2013.
Indeed, the recent decision of the ECB to impose a negative interest rate, shows that private sector lending is now a policy target.
Having highlighted the differences, it’s important to remember that the straw that broke the camel’s back in Japan was in fact an exogenous factor, namely the Asian crisis in the late 1990s combined with the ill-fated increase in the consumption tax.
This was the point that corporate failures began in earnest, and with them an inevitable surge in unemployment.
Despite the fact that there is relative optimism in Europe, a similar exogenous shock could still push the Eurozone into a deflationary abyss.
In fact, the situation is particularly fragile, due to the huge debt burden in Europe, and policymakers should not ignore the potential deflationary pressure that slowing growth in China will exert.
Structural reform in Japan and the eurozone is what will matter
The eurozone is faced with myriad difficulties when implementing monetary policy, largely because a ‘one size fits all’ solution is not possible.
Striking a balance between policy which is accommodative enough for the periphery and not too accommodative for Germany, is a tough proposition.
Fiscal policy also presents challenges. The experience in Japan suggests that fiscal policy designed to boost demand can result in bank balance sheets becoming increasingly devoted to government debt at the expense of the real economy.
In Europe, efforts have been made to limit the build-up of government debt and fiscal consolidation has been a priority.
Ultimately, European policymakers are right to emphasise supply-side reform.
Despite the fact that it is much slower to bear fruit than quantitative easing, and benefits are felt in the longer term, bringing down cost pressures and boosting local productivity will be essential to promote growth.
So do the similarities outweigh the differences?
There are enough parallels between the deflationary experience in Japan and the current situation in Europe to cause concern for policymakers and investors alike.
However, the bottom line is that the eurozone’s fate lies squarely in the hands of policymakers, who must continue to act aggressively if they are to mitigate ongoing risks and confront any exogenous shocks if and when they emerge.
On the upside, recent events show that the ECB is not afraid to use its considerable firepower, which should give comfort to investors who understand that the fight against deflation could prove to be the ECB’s toughest yet.
Louis-Vincent Gave is the chief investment officer of GaveKal Capital Limited, an investment partner of Certitude Global Investments.
