21st June 2013
The Eurozone needs to learn three lessons from Japan including avoiding chronic deflation argues Didier St. Georges a member of the investment committee of Carmignac Gestion. He begins with a quote from Friedrich Nietzsche – “Slowly and with some hesitation, we are paving the way for a united Europe.”
In a note issued this week, he says: “Since the summer of 2012, stock markets have been buoyed up by the abundance of liquidities, the systemic risk has been averted and the perception of a slight economic improvement in the USA, which has benefited the rest of the world.
“Although the risk of decline in ultra-accommodating monetary policies may be cited on a regular basis, market apprehensions can be rapidly appeased by the sole fact that the inflationary menace is now on the retreat.
“However, in considering this downward trend in inflation, the experience of Japan in the wake of its own recession in the early 1990s should be borne in mind. In Europe in particular, the slow-down in price rises is now accompanied by a persistent economic recession, spiralling unemployment and an inability to reduce the level of public debt. Europe would do well to avoid the quagmire of chronic deflation by drawing three lessons from the Japanese experience: deflationary trends should not be allowed to take root, we must have the courage to pursue ambitious policies and, above all, our efforts must be coordinated.”
He then sets out the following three lessons –
No more waiting
The Abe Government now finds itself constrained to pursue a radical, and consequently hazardous policy of recovery, given that Japan has allowed its economy to stagnate, and its public debt to rise inexorably, over the last fifteen years. The bursting of the property bubble in 1990 ushered in ten years of enforced debt reduction in the private sector, as a corollary to the under-capitalization of the banking sector. As a result, the massive rise in public debt has done nothing more than generate a flaccid and deflationary economy, which persists to this day. Worse still, Japan has twice fallen into the trap (in 1997 and 2001) of increasing fiscal pressure, which has twice resulted in the further weakening of the economy and an increase in the budget deficit.
Europe is now facing a similar pitfall. Substantial efforts undertaken over the last four years by the most vulnerable countries have had the merit of achieving a significant reduction in the overall budget deficit of the euro zone, from 6.4% in 2009 to 3.7% in 2012. This success has nevertheless been accompanied by an exacerbation of public indebtedness, which has risen from 80% to 90.6% of GDP. Any increase in fiscal pressure on economies which are reeling from spiralling unemployment, or on vulnerable entrepreneurs, is manifestly counter-productive: the revenue base from which taxes are to be sourced must be secured first. Moreover, as in Japan in the early 1990s, and for the same reasons, the reduction in base rates of interest has had no impact upon the provision of credit, which continues to decline in the euro zone (down by 8% in Spain on an annual basis! And down by 2% in Italy). At present, according to our estimates, there is a shortfall of at least one hundred billion euros in European bank sector equity required to ensure the transmission of the monetary policy of the ECB to the economy itself. Here we can also see two simple reasons for the superior performance of the US economy at present, in comparison with Europe: recapitalization of the banking sector was pursued at a very early stage, while substantial and essential fiscal adjustments are only being introduced now, four years after the start of the economic crisis, in an economy which is now capable of sustaining their impact.
A further lesson from the Japanese experience is the traumatic impact upon economic operators of a crisis associated with over-indebtedness. Under these circumstances, it is extremely difficult for public authorities to induce any change to the prudent behaviour of consumers or companies in favour of a more daring approach, with increased consumption and increased investment. In other words, at the risk of a potential platitude, a confidence boost is absolutely essential to recover from a balance sheet recession. This is where Japan failed during its lost decade, during which fifteen successive governments failed to come up with any policy which was capable of garnering widespread support. And this is where European governments are faltering today, through lack of ambition. Take the case of Italy, where the reformist initiatives of Mario Monti have been baulked in midstream by the return of political instability. Or France, where the government’s vague and belated essays at reform have secured the support of only a small minority and the enthusiasm of none. Shinzo Abe and the governor of the Bank of Japan, Haruhiko Kuroda, have understood this lesson perfectly, and are proposing an exceptionally bold programme. This includes the reversal of the annual rate of inflation from -0.5 to +2% within two years, the tripling of infrastructure exports within seven years, the doubling of agricultural revenues, tripling the value of exports of transport equipment and electric power plants, etc. These objectives may be unrealistic – this remains to be seen. But they at least have the merit of providing targets upon which energies can be focused. The approval rating for Shinzo Abe, which has now reached 67% of the population, is itself a factor of success, and will be of critical value to him when the roll-out of the necessary and, by definition, difficult structural reforms begins after the July elections.
Adopting a coordinated approach
Quite clearly, given the independence of the ECB – an irrefutable dogma for Germany, and the diversity of budgetary situations within the euro zone, the coordination task facing Europe is substantially more difficult than in Japan. In terms of monetary policy, however, there is already some cause for hope: the 40% rise in the value of the yen against the euro between 2009 and 2012 significantly absorb the impact of the recession in Germany, by favouring its exports at the expense of Japanese exports. Now that Japanese monetary policy is aimed at reducing the value of the yen, and with it many emergent currencies, the strength of the euro will become a substantially better shared problem for the zone as a whole. In any event, Europe will need to focus its efforts on increased coordination (and ultimately greater “integration”) in its economic policies.
The third “arrow” of the Japanese project, whereby budgetary and monetary support measures are to be accompanied by a major programme of structural reforms (details of which have yet to be specified), is absolutely critical, and should inspire European leaders. Reforms of the employment market, the deregulation of protected sectors, pensions reform and the coordination of industrial policies are all essential requirements for Europe. Will Italy, Spain or France be able to prove their commitment to reform, thereby encouraging Germany to support a coordinated European policy for virtuous economic growth?
It is too soon to tell whether “Abenomics” will be a success. Breaking the fifteen-year deflationary habits of an ageing Japan represents a formidable challenge. And to do this without any brutal correction of the bonds market, even more so. However, the draconian policy upon which the Japanese government has now embarked should make Europe think. Between March and April, the rate of inflation fell from 2.6% to 1.5% in Spain, and from 1.8% to 1.1% in Germany. Europe needs to bring its deflationary pressures to a swift end, and enhance its potential for long-term nominal growth. In this endeavour, the experience of Japan should provide a spur, and Nietzsche’s hope be fulfilled.