Is Europe heading for Japanese-style deflation? by Martin Harvey, Comlumbia Management
- Although there are many differences that should ensure that the eurozone does not follow Japan‘s fate, policymakers will need to act forcefully if the risk of deflation intensifies.
- While the euro area appears to be on track to avert deflation in the short term, many euro countries are “one crisis away from deflation.”
- The European Central Bank (ECB) claims to be ahead of the game, but policy needs to be more pro-active.
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The recent decline of inflation measures across the eurozone has heightened fears of a spiral into deflation akin to that which has blighted the Japanese economy for the past 20 years. In this article, we will assess these differences as well as the parallels in order to gauge the extent of the risk and potential implications for markets.
The Japanese experience
In order to find the ultimate source of the Japanese deflation spiral, one must go back to the asset bubble of the 1980s, which peaked at the end of 1989. Following a fall of more than 50% in the stock market over the next two years, stock prices and land prices remained subdued for the remainder of the decade.
This process was something of a slow death for the Japanese economy, and many of these reasons have been highlighted as differences with the current situation in the eurozone. The key question for the ECB to answer is whether the differences are sufficient to dismiss the possibility of deflation, as the Japanese experience proves that once the process is underway, it is difficult to reverse.
Progress report for Europe
In contrast to Japan, Europe’s asset price crash was part of an international phenomenon. Although there were property bubbles in some euro area countries, such as Spain and Ireland, this was not the root cause of the problem. Initially, it was Europe’s exposure to global trade that caused a steep drop in economic activity in the wake of the Lehman collapse, while the onset of the sovereign debt crisis later played a part.
The scale of the initial drop in the Eurostoxx index was similar to that seen in Japan in the early 1990s (Exhibit 1). On the surface, it appears that the Europeans are adopting correct policies as the Eurostoxx index has surged over the past year, and broken above the levels reached prior to the debt crisis. Europe’s economic correction was far more abrupt than Japan’s. The level of nominal gross domestic product (GDP) has moved slowly higher since 2009 (see Exhibit 2), while the Japanese economy continued to expand at the beginning of the nineties.
Exhibit 1: Relative experience of equity prices from the peak of the bubble
Source: Bloomberg, March 2014. Note: t represents months before and after peak.
Exhibit 2: Relative experience of nominal GDP from the peak of the cycle
Source: Bloomberg, December 2013. Note t represents years before and after peak
The international nature of the 2008 crisis and subsequent slow global recovery goes some way to explaining the abruptness of Europe’s decline. Cultural factors also contributed to the gradual pace of Japan’s economic demise. Specifically, within the banking system, bad loans were not realized in a timely fashion in Japan and were simply rolled over, leading to the build-up of so-called “zombie companies.” Consequently, as banks were not realizing losses in a timely fashion, the subsequent recapitalization of banks that should have occurred was absent, slowing the recovery process.
In Europe, there have been repeated attempts to avoid the same situation. In the crisis countries, “bad banks” have been created to remove bad loans from bank balance sheets, and in the most part this has proved successful. However, it is fair to note that there is probably more work to do on this front and European banks have not been through a recapitalization process nearly as dramatic as that of the U.S. banks.
Monetary policy: When he is quizzed about the similarities between the current eurozone situation and Japan’s lost decade, Mario Draghi is quick to point out that the ECB reacted much more quickly than the Bank of Japan in the early 1990s. QE was eventually introduced in Japan in 2001 and was judged in hindsight as half-hearted due to its limited impact. In contrast, the ECB has emphatically stated that it stands ready to ramp up policy initiatives aggressively if inflation undershoots expectations from here. However, the ECB faces many institutional impediments that could hinder the process and has some way to go if it plans to rival the aggressive policies of other nations since 2008.
Fiscal policy: Although monetary policy was arguably too tight in Japan, fiscal policy was being utilized to boost demand throughout the 1990s. Over many years of nominal GDP stagnation, this drove the government debt stock to unsustainable levels eventually becoming a negative influence on growth. In Europe, by contrast, a strong effort has been made to limit the build-up of government debt following the early years of the crisis. However, this determination has ebbed of late, and debt ratios have risen sharply in some countries. This will continue to be a key trend to monitor.
Structural reform: European policymakers are right to emphasize supply-side reforms. Indeed, some of the disinflationary pressure already evident in countries such as Spain is a direct result of these policy efforts to boost productivity. A key component that will define the success of Japan’s new push to leave deflation is structural reform, the so-called third pillar of Abenomics. Although progress on this front is much slower than monetary expansion, the determination is there to move forward. For both Europe and Japan, once the added benefit of monetary stimulus ceases, this is what will matter.
The demographic consideration: The lack of population growth contributed in no small way to the demise of Japan’s growth potential and consequent stagnation. Europe faces some of the same problems as Japan, in particular in Germany where the working age population peaked in 1998. As populations subside, spare capacity naturally rises as aggregate demand is reduced, leaving a heavy deflationary influence. The headwind that this trend produces in the medium term should not be ignored.
What the market is saying
The recent surge in equity prices suggests that investors are confident that the euro area economy, with a bit of help from the ECB, can avert deflation as the debt crisis of 2011/2012 becomes a distant memory (Exhibit 3). However, with inflation at low levels, equity investors will remain sensitive to any exogenous shocks that could put further pressure on the outlook for inflation and growth.
German bond yields have remained low despite aggressive sell-offs in the other major developed bond markets over the past year (Exhibit 4). Partly this is justified by the divergence in policy stance, with the U.S. and UK moving towards rate hikes and the ECB still threatening rate cuts. However, the extreme suppression of the term premium suggests that some expectation of persistent low inflation is embedded.
Exhibit 3: European equity markets, regional indices rebased to 2007