Macro Weekly – Europe is not Japan

by: Han de Jong

Weekly macro - Europe is not Japan - 4 Sept 14 ()

Pessimism about the eurozone economy is widespread. Many commentators argue, usually casually, that the eurozone economy is sliding into a ‘Japan scenario’. Unfortunately, what that is exactly is not well defined. Presumably, what is meant by the Japan scenario is a long period of deflation and no growth, due to the bursting of asset bubbles against the background of high debt . There is no denying that potential growth in the eurozone is low and that the economy’s growth performance is likely to be very modest at best in the period ahead, but I still think that the situation in the eurozone is very different from what happened in Japan after the bursting of the asset bubbles over twenty years ago. In fact, looking at the data, perhaps Japan’s economic performance hasn’t been as bad as many make it out to be. So in a sense, even Japan may not be the Japan as some see it.

Japan is not ‘Japan’

It is not entirely clear what people mean when they say that Europe is falling into a Japan scenario. But one must assume they mean a sustained period of stagnation, or worse, combined with deflation. However, the fact is often overlooked that the Japanese economy has grown modestly since the bursting of its bubbles in the late 1980s. The standard of living in Japan is high and unemployment is low. In fact, the country is looking at ways to increase its labour input by trying to raise the participation of women and by considering allowing more immigration. When one travels to Japan, one does not get a sense of being in a country that has been in crisis for 20 years.

Differences with Japan

Recessions are a normal part of the business cycle in any economy. The causes of recessions can vary. Sometimes, mature upswings lead to bottlenecks and rising inflation. When central banks try to fight inflation with tight monetary policy, they regularly push the economy into a downturn. A recession can also be caused by a shock, such as a sudden sharp rise in energy prices. Another form of recession is often described as a ‘balance-sheet recession’, a term coined by the economist Richard Koo. Such a downturn is caused by the loss of wealth following declining asset prices against a background of high debt. The necessity to repair balance sheets forces households, companies and banks to reduce spending and save. As economic activity drops, asset prices are undermined further, making it hard to achieve economic recovery. The process of balance-sheet repair is slow and painful, as we have been experiencing for some time.

140907 - JPY

The deflationary effect of the bursting of bubbles in Japan was massive. Japanese policymakers had kept the value of the yen artificially low after the second world war, but pressure to allow the yen to appreciate started building in the mid 1980s. The yen then, indeed, doubled in value, appreciating from some 250 yen per dollar in 1985 to 120 two years later. The appreciation continued albeit at a slower pace. The euro has been more expensive than its ‘fair value’ for some time, but it has not doubled in value.

The Japanese stock market reached a high near the end of 1989 when the Nikkei traded at nearly 39,000 points. Almost 25 years later, the index stands at some 15,600. The Eurostoxx50 index peaked at around 4500 in 2007, then fell to below 2000 in 2009, but has now recovered to some 3250. This is no comparison with Japan.

140907 - Nikkei

Another difference is property prices. Japan’s real estate became unbelievably overvalued in the 1980s and then fell for a period of more than 15 years. A number of European countries have also seen property prices come down, but, again, what happened in Japan does not bear comparison.

140907 - Landprices

Japanese policymakers allowed the budget deficit to rise to 10% GDP in 1998, and while the deficit has been lowered since, it has averaged some 7% GDP over the last 15 years or so. Combined with very sluggish growth of nominal GDP, this has led to government debt currently above 200% GDP. Here, too, there is no comparison with Europe.

A last major difference is the response of the monetary authorities. After the equity and property bubbles burst in Japan, the BoJ initially tightened monetary policy. Stimulus came much later. Bank supervisors were also slow in responding to the problems in the banks. The ECB’s efforts to create transparency about the banks’ positions cannot really be called ‘decisive’ either, but they have been quicker and more assertive than their Japanese colleagues.

Very sluggish growth, but positives are appearing

It can be argued, of course, that regardless of the causes, Europe is facing a period of stagnation and deflation similar to what people believe Japan has gone through. Recent disappointing data strengthen such fears. There is no doubt that the eurozone’s trend growth rate is relatively low and that inflation is currently too low for comfort. We have recently seen a couple of positive developments, however.

First, as mentioned a few weeks ago, the ECB’s bank lending survey is indicating a modest loosening of credit standards by eurozone banks. That survey also suggests that credit demand is strengthening. Last week saw some hopeful signs in Germany. Having been sluggish for some months, industrial orders and industrial production were strong in July. Orders jumped no less than 4.6% mom, while output was up 1.9%. Another helpful development is the weakening of the euro. The single currency has lost some 10 dollar cents since March with most of the decline occurring since July. This should provide some useful strengthening of competitiveness over time.

Last, but not least, there was Mario Draghi. The potential for the ECB boss to disappoint markets last week was high. But Draghi did not disappoint. In fact, he exceeded expectations by cutting interest rates and suggesting that sizeable action in terms of asset purchases will be forthcoming soon. It is starting to look like the ECB is in the process of launching a multi-stage rocket. The first tranche of the TLTRO is due on 18 September. By cutting interest rates last week, the ECB has provided further encouragement for banks not to be shy and to go for a high take-up. The ECB will also announce an asset purchasing programme next month and start buying asset-backed securities and covered bonds straight away. The remarks Draghi made about the desire to increase the size of the ECB’s balance sheet back in the direction of the levels seen in 2012 suggest that the asset purchases will be sizeable. We continue to have a nagging feeling that European markets for these securities are too small to achieve the size of purchases Draghi is hinting at. The icing on the cake will be the release of the outcome of the asset quality review among banks and the results of the stress tests. There is, clearly, a potential for disappointments. But if the ECB plays its cards the way Draghi has been doing recently, we could be looking at a period of positive news.

US going from strength to strength, but labour market takes a breather
Last week saw the publication of the various ISM measures in the US. According to this gauge, business confidence in the manufacturing sector strengthened from an already high 57.1 to 59.0. Even more impressive was the rise in business confidence in the non-manufacturing sector: 59.6, up from 58.7. This series goes back to 1997 (in Bloomberg) and its August level has been exceeded only three times since then. Interestingly, business confidence in services also strengthened in China last month.

The employment report for August fell short of expectations. For the first time in six months, the US economy added fewer than 200,000 jobs in one month. The August total amounted to a modest 142,000 while the data for the previous two months was revised down by a total of 28,000. A stronger number would have been better, but this is not bad either. It implies that the recovery is continuing. The trend increase in the labour force is most likely somewhat below 100,000, so even the August number reduces unemployment, albeit not by much. At the same time, the relatively weak number provides support to the doves on the FOMC who prefer to start tightening monetary policy later rather than sooner.