The Eurozone: a new Japan?

The slowdown in economic activity in the Eurozone and inflation structurally below the target rate have raised the spectre of “Japanification”. This would mean effective growth running below potential, very low interest rates and negative inflation. In Japan, this combination of factors resulted from the bursting of the financial and real estate bubbles of the early 1990s. There is a range of factors that could cause “Japanification”. Faced with the challenges of an ageing population and slowing productivity gains, the Eurozone will need to focus its efforts on boosting its potential growth and its resilience to shocks. Short- and medium-term economic policy choices will therefore be crucial in limiting, as far as possible, the risk of “Japanification”.

The ‘Japanese Syndrome’ can be defined as a combination of three economic phenomena[1]: a real-terms actual growth rate below the potential growth rate (g<g*); a zero policy interest rate in nominal terms or a real natural interest rate[2] below zero; and negative inflation (deflation).

Is the Eurozone heading for this kind of scenario? Increasingly discussed, the issue of “Japanification” in the Eurozone has now assumed a particular importance given the ongoing economic slowdown – which could deteriorate still further – and the weakness of inflationary pressures, despite significantly accommodative monetary policy. More broadly, the Eurozone has seen stop-start economic trends since its creation, and since the crisis of 2008 appears to have slipped into a regime of lower growth. A similar phenomenon has also been observed in other developed economies. For its part, Japan’s economic history since the financial deregulation of the 1980s has seen a number of major shocks: the bursting of the real estate and financial bubbles in the early 1990s, from which the economy struggled to recover; the Asian crisis a few years later; and the great financial crisis of 2008-2009.

How has the Japanese economy remained over a long period in a position of weak growth, particularly low policy rates and low, or even negative, inflation? Is the Eurozone now suffering from the same macroeconomic weaknesses? This article will examine these questions and will attempt to outline the macroeconomic profile of the Eurozone. We will highlight both similarities and differences between the Eurozone and Japanese economies.

The Japanese economy struggled to recover

The financial deregulation in Japan during the 1980s and the overall relaxation of monetary policy encouraged a fall in bond yields and, more generally, a significant easing of credit conditions. The degree of relaxation of monetary policy drove rapid growth in credit, with outstanding loans[3] in Japan rising to more than 210% of nominal GDP in 1990, from around 140% at the beginning of the 1980s. The country saw particularly high credit growth (15% year-on-year at the end of the 1980s).

Over the course of the 1980s, economic growth clearly assisted these favourable conditions for financing. GDP growth, in real terms, was particularly robust and averaged 4.5% over the period. Japanese per capita GDP also rose strongly, gaining an average of over 4% over the same period.

Unlike other countries that have experienced similar crises but have recovered from the shocks relatively quickly, Japan suffered from poor macroeconomic conditions for a long time. One of the explanations for Japan’s failure to recover was the slow and timid response from the authorities when it came to economic policy and the stabilisation of the banking system. On this point, Sweden is often identified as a counter-example[5]. Following the economic and banking crisis that hit the country in the early 1990s, the Swedish authorities responded immediately in order to address imbalances in the banking sector, through restructuring and the creation of ‘bad banks’. Conversely, in Japan, the high level of non-performing loans on bank balance sheets was not addressed sufficiently quickly, hitting credit growth, domestic demand and, eventually, prices and growth.

The crisis that hit East Asian countries in 1997 represented a further shock for Japan, where macroeconomic imbalances had still not been absorbed. Emerging Asian countries saw their economic growth dip significantly over this period. At the end of 1997, the bankruptcy of Yamaichi, one of the country’s biggest securities firms, increased instability in financial markets and Asian forex markets, triggering a chain reaction of bankruptcies at financial institutions[6].

The experience of protracted deflation

The deterioration of macroeconomic conditions (Japan went into recession in early 1998), against a background of falling domestic demand, hit prices. An increase in the consumer tax (equivalent to value added tax or VAT) in April 1997 also hit consumer spending, with some observers criticising the primary structural adjustment[8] that Japan introduced in that year.

Weak domestic private demand, reflecting the deleveraging of economic agents, partly explains the long period of deflation experienced in Japan. But there were other more structural macroeconomic factors that flesh out the explanation. Growing competition from other Asian countries and emerging economies, together with the increasing duality of the labour market, with rising numbers of workers in insecure jobs, put pressure on wages and prices. In addition, the deflationary climate encouraged risk-averse, wait-and-see behaviours[10]. Lastly, the ageing of the Japanese population (to which we will return later) also put downward pressure on growth and inflation. Demographic trends in Japan have, for instance, driven down land prices (which have not recovered since the bursting of the real estate bubble, Chart 1)[11]. The negative wealth effect that resulted depressed demand and ultimately prices.

Note: Both total inflation and underlying inflation have been adjusted for changes in indirect taxes. The real interest rate is deflated by the total inflation rate (adjusted)

The major economic crisis of 2008-09 caused a third significant shock to the Japanese economy. Growth in Japan was hit particularly hard, with contraction of 1.1% in 2008 and then 5.5% in 2009, before rebounding in response and then getting carried forward by the introduction of ‘Abenomics’[12]. This brought about economic improvements, most notably the end of deflation, one of the programme’s priorities, and a recovery in economic activity. Inflation and growth have nevertheless remained at low levels, despite the extremely high levels of public debt (gross public debt is close to 240% of nominal GDP) and monetary accommodation, specifically through the launch of a Quantitative Easing programme (the Bank of Japan’s balance sheet is now 100% of the country’s GDP and continues to expand).

In total, Japan’s nominal GDP was more or less stable from the early 1990s until the introduction of Abenomics (Chart 5). This reflected both limited growth in volume terms and the weak, or negative, growth in prices. Volume growth fell very sharply after the 1980s, to an average of less than 1% in the 2000s, whilst the GDP deflator averaged -1.2% over this period. Since 2012, the recovery has been noticeable but timid. On average, growth in real terms has been barely above 1%. In addition, prices have risen on average, but again this has been a slow process (Chart 5b).

Japan’s experience of deflation is unique in recent economic history. The bursting of the financial and real estate bubbles, and the only partial response of economic policy, still weigh heavily on the economy.

The Eurozone is suffering but showing resistance

An environment of low inflation, feeble economic growth, negative interest rates across a fairly wide range of maturities, non-conventional monetary policy, decreasing but still high government debt, and structural weaknesses (ageing population, slowing growth in total factor productivity,…) provide a combination of factors for the Eurozone economy that might, at first sight, tempt one to draw parallels with the macroeconomic situation in Japan.

The narrow M1 measure of money supply[13], provides a good indicator of the slowing of economic growth or recession in the Eurozone[14], given that its growth also fell during the two crises and then recovered rapidly.

A prolonged period of low or negative interest rates

The ageing of the population, the high and rising savings rate, the slowdown in productivity gains, inequality and an increase in risk aversion are all deep-seated changes that can affect interest rate movements. On certain estimates, the real natural short-term rate in the Eurozone is now zero or even in negative territory[16].

Despite political tension, Italy has also seen a narrowing of its spread, albeit without moving into negative territory. Having stabilised overall between late-2016 and late-2018, rates have started falling again. Against the background of the marked slowdown in the Eurozone since Q3 2018, investors have, indeed, been taking an increasingly cautious stance.

Choices need to be made in the Eurozone

Synthetic index of “Japanification”

In line with the method adopted by Ito (2016)[21], we have constructed a simple index of “Japanification” for the Eurozone (Charts 14a and 14b). To calculate this we have taken the unweighted aggregate of the three characteristic features of the Japanese Syndrome: (i) the gap between actual real growth and potential growth (g-g*); (ii) total inflation (p, year-on-year); and (iii) main policy rate[22], indicated as i.

Japanification index = Growth gap (g-g*) + Total inflation (n) + Policy rate (i)

The “Japanification” index for the Eurozone has been on a downward trend. Having contributed to its high pre-crisis level, inflation and interest rates have tended to contribute to its drop since the crisis. The index remains above that for Japan. In Japan, inflation, or deflation, has often worked to drag down the overall index since the end of the 1990s.

If we include real estate prices in the index (Charts 14c and 14d), the gap between the Eurozone and Japanese economies widens. As discussed above, growth in real estate prices resumed relatively rapidly in the euro area, against a background of monetary easing, whilst in Japan they remained relatively inert following the bursting of the bubble in the early 1990s.

Although the Eurozone seems to be resisting the “Japanification” for the time being, its future is less clear. The ageing population, the slowdown in productivity gains and the absence of any further deepening in the construction of the Eurozone could all have a lasting effect on the zone’s economy and increase the risk of “Japanification”.

Significant challenges and obstacles

The challenge of long-term growth

Alongside the loss of demographic vitality, the slowdown in productivity gains could act as a brake on long-term growth.

Although certain analyses predict only a temporary slowdown in productivity gains, other more pessimistic work suggests a structural weakening of productivity growth[24].

Lastly, on a demand-based approach, the Eurozone could be lastingly affected by a structural slowdown in global trade (Chart 18). Weaker trade growth since the end of 2018 lies in a longer-term pattern of slowing trade under the effect of a number of factors such as the ending of the fragmentation of value chains, a pause in the integration of global trade, lower trade intensity in economic growth which is now turned more towards services and consumption, and so on.

Given a level of economic openness (ratio of exports to GDP by value) of nearly 50%, the Eurozone is directly affected by these trends.

The challenge of deepening the institutional framework of the Eurozone

The growth profile of the Eurozone over the medium term will depend on its ability to meet the next shock it faces. Its authorities will have to avoid the economic policy errors of the past. On the monetary front, for example, an excessively rapid or abrupt tightening, such as that carried out in 2011, could weaken the Eurozone still further. Fiscal policy, meanwhile, will have to play a greater counter-cyclical role than it did during the 2012 crisis for example. At that time, the Eurozone (on an aggregated level) carried out a structural primary adjustment even though it had not yet seen a return to growth.

Today, the issue is one of the limited room for manoeuvre in both monetary and fiscal policy. Now constrained, it would seem difficult for the ECB to make another massive intervention on the scale of that conducted by the BoJ, whose balance sheet, we should remember, is now equivalent to nearly 100% of the country’s GDP. On the fiscal front, European rules inhibit a sufficiently flexible approach in the event of a contraction in economic activity. Although total debt in the Eurozone has trended downwards since late 2014, it remains high in several member states. Completing the architecture of the Eurozone thus looks like the best way of avoiding a prolonged impact from any fresh economic downturn in the currency area. In particular, greater fiscal integration across the Eurozone, through the creation of a macroeconomic stabilisation mechanism, looks necessary[25]. Combined with continued fiscal consolidation during expansionary periods, such a tool would allow a better balance in the policy-mix and increase the impact of monetary policy. To avoid slipping into “Japanification”, Eurozone member states will need a coordinated, committed and disciplined approach.

The debate about “Japanification” spreading to the Eurozone is not over. This article has attempted to provide an overall macroeconomic profile of the Eurozone, highlighting both similarities and differences between it and Japan. Whether it is unavoidable or not, the “Japanification” of the Eurozone would clearly have significant economic consequences. If actual growth is below potential for a long period, for example, this could trigger a deflationary spiral which in turn would have damaging consequences for growth. Elsewhere, the current climate of low interest rates could persist and already some are highlighting their negative side effects. From a macroeconomic viewpoint, low interest rates might skew the perception of risk, destabilise the balance between savings and investment or encourage the financing of less productive activities. This situation could persist given the limited inflationary pressure, which itself is raising questions about the appropriate central bank response. All of these mechanisms are worthy of in-depth examination and we will be paying them particularly close attention.

[1] T. Ito, Japanization: Is it endemic or epidemic ?, NBER, February 2016

[2] The natural interest rate is the real interest rate at which inflation remains stable whilst actual GDP growth is at its potential level (the output gap is zero) in the absence of any temporary shocks.

[3] We are considering here total credit to the non-financial private sector.

[4] E. Dourille-Feer et al., La crise japonaise, ou comment un pays riche s’enlise dans la déflation, CEPII, 2002

[5] La crise nordique des années 1990, Séminaire scandinave, DG Trésor April 2012

[6] Statement by the Governor concerning the Yamaichi Securities Co., Bank of Japan, 2 June 1999

[7] See footnote, page 4

[8] The primary structural adjustment represents the change in the primary structural budget balance, that is to say corrected for cyclical effects.

[9] The measure of underlying inflation excludes products with volatile prices, such as oil products and food. The underlying inflation index thus helps identify underlying trends in price movements.

[10] E. Dourille-Feer, La difficile sortie de la déflation au Japon, Billet du CEPII, 2014

[11] D. Anderson et al, Is Japan’s population aging deflationary ?, IMF working Paper, August 2014

[12] Introduced in Japan in 2012, the ‘Abenomics’ stimulus programme has three pillars: an expansionist fiscal policy, a non-conventional monetary policy (including purchasing of long-term sovereign debt) and structural reforms, in particular to address the ageing of the population.

[13] M1 money supply includes notes and coins in circulation and sight deposits.

[14] R. Fendel et al, Predicting recessions using term spread at the zero lower bound: The case of the euro area, VOX CEPR, January 2019

[15] M. Del Negro et al, Global trends in interest rates, VoxEU, November 2018

[16] C. Brand et al, The natural rate of interest: estimates, drivers, and challenges to monetary policy, ECB Occasional Paper Series, December 2018

[17] T. Adrian and F. Natalucci, Lower for longer: Rising vulnerabilities may put growth at risk, IMF Blog, October 2019

[18] T. Ito & F. Mishkin, Two decades of Japanese monetary policy and the deflation problem, NBER, 2004

[19] L’arrêt des achats nets d’actifs ne met pas fin au quantitative easing, Jean Dalbard, et al., Banque de France, December 2018

[20] Monetary policy and below-target inflation, speech by Philip R. Lane, Bank of Finland, July 2019

[21] See footnote, page 1

[22] For this rate in the Eurozone we have used the Deposit Facility Rate (currently at -0.5%). For Japan, the rate used is the Overnight Call Rate, currently at -0.1%.

[23] IMF estimates

[24] Relating to the US economy: R.J. Gordon, Is US economic growth over? Faltering innovation confronts the six headwinds, NBER, August 2012

[25] N. Arnold, A central fiscal stabilization capacity for the Euro area, IMF, March 2018 or, for a simplified version, Eurozone convergence: Where do things stand today?, Louis Boisset, Conjoncture, BNP Paribas, April 2019