Europe and Japan have little in common other than their levels of economic development. On opposite sides of the globe, one is a continent, the other a string of densely populated islands. They are rich countries, but for extended periods of time, starting with Japan in the 1990s, and Europe more recently, they have faced low inflation and weak economic growth.
Is Europe turning Japanese? The European Central Bank signaled yesterday that it’s concerned enough about that prospect that it surprised markets with a plan for massive new purchases of bonds, upping spending from 60 billion euros to 80 billion euros per month. It also cut its main interest rate to zero, and pushed its deposit rate further into negative territory, meaning banks now pay the ECB to hold excess cash.
The move is bound to intensify a debate over whether Europe faces the same difficulties as Japan, which is in the thrall of over two decades of stagnation, and whether its program of quantitative easing — forcing cash into the economy — is helping Europe to grow, or planting the seeds of future disaster.
“Nobody knows how the experiment with negative interest rates will unfold,” Michael Collins, an investment commentator at Fidelity International in Australia wrote in a research note. “Investors can be comforted with the thought that sub-zero rates have persisted for three years in the eurozone and for longer elsewhere in Europe without too much drama.”
Because Europe and Japan have enough differences — with certain advantages accruing to one but not the other — that make the question of “turning Japanese” a tough call. Declining working-age populations complicate matters in both places, but Europe has more of a history with immigration. Government spending to help ease the pain has been easier in Japan than in Europe, where the existence of the euro constrains options. And Europe, unlike Japan, has a vigorous chorus of naysayers who rail against activist central banks.
At its core, the problem of Japan-style stagnation in Europe is an issue of deflation.
Falling prices, however appealing they sound at an intuitive level, are poison for a functioning capitalist economy. For starters, they signal stagnant or falling demand, because purchasers aren’t buying enough to tempt profit-hungry producers to bid up prices. Absent possibilities for profit, companies won’t invest in new plant and machinery or hire new workers; those absent purchases then feed the doom loop of deflation.
Inflation in the eurozone is extremely low. The ECB has missed its target for inflation — which is close to, but below, 2 percent — for 3 years running. Prices actually dropped in February after weak readings in previous months, suggesting the specter of deflation — a general decline in prices — is approaching.
After Europe’s sovereign debt crisis in 2012, economists began pondering the way out of the mess for the 19 countries that use the euro, the common European currency. As inflation remained low, the comparisons to Japan started to pop up, and economists started to wonder aloud if Europe was in for a long period of stagnation.
In 2014, Credit Suisse draped charts of European performance over graphics of Japan’s recent history, and found a disturbing alignment. The period around the financial crisis in 2008 was looking like the period after 1993 in Japan, when a real estate bubble burst and led to a recession. Government fiscal stimulus that cushioned the blow, as did aggressive action by the Bank of Japan. Although the economy hasn’t bounced back to healthy growth, neither has it fallen into the abyss.
The backdrop to deflation is a problem that can’t be solved quickly: demography.
In Europe and Japan, the working-age population is declining, with Japan’s falling since the late 1990s, and Europe’s more seriously since about 2008, depending on the country. When workers exit the labor force, they draw on savings or government pensions and tend to spend less than in their earning days.
“Maybe the next few decades will be different. We doubt it — not with the population shrinking,” Carl Weinberg, chief economist with High Frequency Economics, wrote in a research note. “Depopulation ensures a secular contraction of demand and GDP as well as falling prices.”
Europe doesn’t have the same acute demographic problem that Japan has, and it has more immigration than Japan — more than Europe wants. The refugee crisis that’s seen millions of people from in and around war-torn Syria and Iraq head to Europe in the past few years is a potential bonanza for countries that need fit, working-age adults, if they can be integrated into the labor force.
An obvious solution — government spending — is hard for Europe.
The aftermath of the financial and debt crises drained treasuries from Madrid to Dublin to Athens, giving governments far less leeway than they might otherwise have to spend money that would add demand to the economy. Governments that are in a position to borrow — notably Germany — are refusing to do so. Finance Minister Wolfgang Schaeuble rebuffed attempts to boost demand at the latest G-20 meeting, in Shanghai.
Japan’s government, at least, has been in the position to borrow about 150 percent of GDP for spending on infrastructure and other projects. European countries that faced the toughest economic conditions — mainly Greece, Spain and others on the periphery of Europe — can borrow, but don’t control their own currency issuance, having given it up to the ECB. So, as was the case with Greece, they will hit limits imposed by international investors, but won’t be able to devalue their currency.
The harder question — and perhaps the sharper debate Europe — will be whether the ECB policy against stagnation simply runs around before it has the chance to stop Japan-style stagnation.
Mario Draghi, the ECB’s president, already angered officials in the eurozone’s largest country, Germany, when he promised to do “whatever it takes” to ensure the survival of the common currency in 2012. It was taken as an implicit promise to ensure no government defaults, and that the ECB would become the lender of last resort, a role not foreseen in the treaties that created it.
Now, with negative interest rates and bond purchases, Draghi is pushing further into unchartered territory. Some German officials have left the ECB in protest already, and some are expanding their critique of the Italian Draghi’s policies.
Joerg Kraemer, chief economist at Germany’s Commerzbank, channeled their frustration in a research note after Draghi’s latest announcement. He argued that the ECB’s billions will ease pressure on European governments to undertake vital structural reforms. The policy will also dampen business confidence, Kraemer argues, though this is a tough point to prove because companies also fear the weak demand the ECB is trying to combat.
Still, Kraemer believes Draghi will push ahead, confident that he can avoid the Japanese outcome that Europe dreads.
“If the medicine doesn't work, it could be abandoned,” Kraemer wrote in a research note. “It is more likely, however, that the ECB will give us more of the same in some shape later in the year.”