30/05/2019 - What if the Japan is the good scenario?

The impressive expansion, that saw Japan become one of world’s richest nations, came to an abrupt end almost three decades ago with bursting of the bubble. Subsequent domestic policy errors combined with negative external shocks, and not least the 1997 Asia Crisis, sent the Japanese economy into the icy grip of deflation. Exiting this state was not made any easier by a rapidly ageing population and the 2007/08 Great Financial Crisis.

Man on a Japanese trading floor

When Shinzo Abe returned to the office of Prime Minister in December 2012, Japan has suffered years of weak growth and the GDP deflator had spent almost 20 years trapped in negative territory. Despite the significant efforts of Abenomics, combining the “three arrows” of aggressive monetary policy easing, a more flexible fiscal policy and structural reform, consensus is that Japan’s trend potential growth remains subdued at around 0.7%. Moreover, with interest rates at near zero across the yield curve, a central bank balance sheet that now just exceeds nominal GDP in size and public debt close to 240% of GDP, concern is that Japan is running out of policy ammunition to tackle a new significant downturn.

Looking over to present day Europe, several of the warning lights observed in Japan’s lost decades are flashing orange or even red, leading to fears of so-called “Japanification” with the economy trapped into permanent low growth. The parallels are indeed not hard to spot; the euro area has ultra-low interest rates, large debt stocks, still significant amounts of nonperforming loans in the periphery, a lacklustre banking system and a rapidly ageing population. At present, consensus sets euro area trend potential growth at 1.3%, still well above that of Japan, but down from 2.0% just before the Great Financial Crisis struck.

Important differences nonetheless exist. On a positive note, recent immigration to the euro area should offset some of the demographics headwinds longer term. Structurally high unemployment and pressure on jobs from new technologies, have, however, seen a significant political backlash emerge, and not least against immigration.

Turning to policy room, we note that the Bank of Japan today owns ¥476tn of Japanese Government Bonds, equivalent to around 85% of GDP or just under half the outstanding stock. It’s hard to imagine the European Central Bank purchasing a similar volume of euro area government bonds without being accused of overstepping its mandate and running into significant political opposition. Japan’s more flexible approach to fiscal policy, moreover, does not seem compatible with the current goals of the European Semester.

The most important difference between Japan and the euro area, however, is fragmentation, be it along the lines of interest rates, the banking system, capital markets, imbalances or economic performance. Economic Union, Financial Union, Fiscal Union and Political Union are structures that Japan already full enjoys, but these are far from complete in the euro area, leaving the region more vulnerable to shocks. Moreover, Japan has so far been largely spared the type of populism that is currently observed in several euro area member states and, for that matter, the United States.

This leads us to the rather depressing conclusion that it seems unlikely that the euro area would have the possibility to follow in the footsteps of Japan, with public debt heading significant higher and without triggering a severe new crisis, and not least in the euro area periphery. The newly elected European Parliament and the soon to come new Commission, will, together with the Council, have the daunting task of quickly completing the euro area architecture, not least finalising Banking Union and Capital Markets Union, and doing so whilst lifting social mobility and addressing climate change. Failure to act could well make “Japanification” look like a highly desirable outcome for the euro area rather than the downside risk scenario that it should be.

Michala Marcussen, Societe Generale’s Group Chief Economist