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Japan Should Scare the Eurozone

Author: Sebastian Mallaby, Paul A. Volcker Senior Fellow for International Economics
December 12, 2012
Financial Times


Almost exactly 20 years ago I packed my stuff in London and moved to Japan. The Tokyo stock market had crashed some two years previously; the property market was in free fall; lenders that had relied on buildings as collateral were gasping for air. Yet the country was in denial about its problems. Nobody imagined that Japan would today be suffering its fifth recession in two decades.

The question is whether Europe is walking the same path. As in Tokyo in the early 1990s, eurozone policy makers believe they are doing as much as politics allows. As in Tokyo, financial markets lull them with periods of calm. And yet, also as in Tokyo, fiscal and monetary policy preclude escape-velocity growth in the short term; structural reform is insufficient to deliver reasonable growth in the medium term; and the authorities underestimate the twin challenges of debt and demography in the long run.

The initial shock that Europeans have experienced is more severe than Japan's. In the four years after the crash in early 1990 Japan's economy actually grew by a total of 5 per cent. In the four years since the Lehman Brothers bankruptcy the eurozone has shrunk 1.5 per cent. Four years into the crisis, Japan's equity implosion looked similar to what has befallen peripheral Europe, but its house prices had fallen less than Spain's or Ireland's.

In the early phase of the crisis, Europe's policy response was superior. Starting in October 2008, the European Central Bank cut short-term interest rates by 3.25 percentage points in seven months; the Bank of Japan took 20 months to cut by that amount. Europe's fiscal policy was also more aggressive: the total eurozone government deficit grew 4.3 percentage points in the first year of the crisis, whereas it shrank slightly in Japan.

But four years after the shock, Europe does not emerge as well from these comparisons. Where Japan's policy makers retained some ammunition, Europe's can no longer cut short-term interest rates significantly, and seem unwilling to contemplate full-blown quantitative easing. Austerity measures, meanwhile, coupled with a refusal to issue eurozone bonds, have saddled the region with a fiscal policy that is less supportive than Japan's was at the same point.

What of structural reform? In the real economy Japan's painfully slow progress on deregulating the retail sector resembles Europe's mixed record. Italy has half-modernised its labour law, half-reformed its energy market, and half-deregulated its cosseted professions.

In the financial sector, Japan's enormous error was to wait eight years before recapitalising banks with public money, allowing an extended period in which promising companies were starved of loans. The eurozone is getting to this problem after four years, thereby limiting itself to a medium-sized error. But Europe's banks will not be truly healthy until they are clear about their regulatory future, which means resolving arguments over banking union. This week's EU summit is unlikely to do that.

A huge initial shock; macroeconomic policy nearing exhaustion; and messy progress on structural reform: could things be worse? Yes, is the answer. Whereas Japan went into its crisis with a low public debt ratio, peripheral Europe started out slightly worse (in the case of Ireland and Spain) or far worse (Portugal, Italy, Greece). And although Japan's demographic bust is rightly notorious – sales of nappies for adults now exceed those for infants – the outlook in peripheral Europe is bad enough to be frightening. In a 2010 study, Richard Jackson of the Center for Strategic and International Studies combined demographics and welfare promises into a "fiscal sustainability index". Italy, Spain, France and even the Netherlands fared worse than Japan.

Some observers draw comfort from the fact that Japan's public debt has grown Godzilla-sized without causing disruption. Perhaps the eurozone can allow itself a debt Obelix without paying a high price? It is true, as Martin Wolf argues, that balance-sheet recessions are followed by extended periods in which companies and households pay down debt rather than borrow, with the result that governments can borrow cheaply and huge public debts appear affordable.

But this is not altogether comforting. Once balance sheets are rebuilt, rising private credit demand will push up interest rates for the government – a punishment that peripheral Europe would feel quickly, given that the average public debt maturity is in the region of only six years. The alternative is that the balance-sheet slump endures indefinitely. Japan's two consecutive lost decades are precisely what Europe should not want to emulate.

But the scariest lessons from a Japan-eurozone comparison are social and political. For better or worse Japan has a homogenous society and placid politics; the Liberal Democratic party, architect of the bubble that laid waste to the economy, heads into next Sunday's election as clear favourite.

Japan's cohesion is both reflected in and protected by surprisingly low official unemployment, which has never risen above 5.4 per cent in the past 30 years. Contrast that with Spain or Greece, where unemployment stands at about 25 per cent, or France or Italy, where it stands at 11 per cent. Add in riots and demonstrations across Europe, and you begin to wonder how the centre can hold.

The writer is a senior fellow at the Council on Foreign Relations and an FT contributing editor

This article appears in full on CFR.org by permission of its original publisher. It was originally available here (Subscription required).

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