A European Lost Decade?

Michael Heise

AUG 22, 2014
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ECB euro crisis



MUNICH Europe is in a difficult predicament. Inflation has fallen to 0.4%, and economic growth has been anemic for years. Though the European Central Bank has kept interest rates close to zero, private credit growth is stalling and public debt continues to rise. 

This sounds a lot like Japan’s situation in the 1990s, which culminated in a “lost decade” of economic stagnation and deflation from which the country is still working to recover. Is Europe bound for a similar fate?

The parallels between the European and Japanese economies’ trajectories are undeniable. Both experienced a prolonged debt-fueled real-estate and asset-price boom, followed by a deep balance-sheet recession. As wealth was wiped out and wages contracted, consumption growth collapsed. More damaging, prices for real estate and financial assets plummeted, but the liabilities remained – a major shock for businesses and the financial sector.

Indeed, the combination of declining collateral and rising bad debt squeezed Japanese banks, which were too weakly capitalized to bear large losses. To avoid a surge of insolvencies, they rolled over corporate debt, bringing about a long and painful period of financial consolidation, low investment, and slow economic growth. To compensate for weak private demand, the government increased spending, more than doubling the stock of public debt, to more than 230% of GDP, in just 15 years.

Fortunately, such an outcome is not inevitable for the eurozone. Though some eurozone countries had real-estate bubbles, they were less extreme than Japan’s in the 1980s, and the ensuing losses were smaller.

Moreover, while mortgage debt rose sharply in some eurozone countries, the increase was moderate in others and completely absent in Germany. Likewise, the excess borrowing by companies in Spain, Portugal, and Ireland was largely offset by relatively sustainable borrowing in the eurozone’s three economic heavyweightsGermany, France, and Italy – where the need to deleverage is thus limited.

Finally, the correction in European asset prices was smaller. In fact, eurozone stock-market indices have already made up many of their losses since 2007; by contrast, Japan’s Nikkei 225 Stock Average Index remains around 15,000, compared with a peak of nearly 40,000 in 1989.

Europe has another important advantage: it can learn from Japan’s mistakes. Perhaps the most grievous of these was the Japanese government’s failure to pursue growth-enhancing structural reforms – a result of the country’s difficult political environment. Even Prime Minister Shinzo Abe’s government, with its huge popular mandate, has struggled to make headway in contentious areas like agriculture and labor markets.

The eurozone, despite facing significant political constraints of its own, seems to be more inclined to pursue such reforms. Indeed, the debt crisis has already forced Spain, Portugal, Greece, and Ireland to implement wide-ranging reforms, and Italy may soon follow suit.

Another lesson from Japan concerns monetary policy. But, contrary to popular belief, that lesson is not that the central bank should shift swiftly to expansionary monetary policy, as the ECB did at the beginning of the eurozone crisis. Though the Bank of Japan (BOJ) hesitated before initiating such a shift in 1991, it then cut interest rates aggressively and began injecting large amounts of liquidity into the economy.

Japan’s real monetary-policy lesson is that prolonged monetary accommodation with near-zero rates enables banks to delay any serious effort to clean up their balance sheets. For about eight years after the crisis began, banks simply used their massive stocks of government bonds as collateral to obtain liquidity from the BOJ, which they then used to finance loans to weak companies. The result was widespread financial forbearance, often described as “zombie lending.”

The good news is that the ECB, recognizing this danger, has been calling for a rigorous cleanup of European banks’ balance sheets and is submitting the banks under its supervision to an asset quality review and stress tests. The bad news is that extreme monetary accommodation continues to undermine these efforts.

Europe cannot avoid a Japanese-style lost decade just by upping the dose of monetary medicine. No amount of extra liquidity will entice overleveraged companies and households to borrow more. This was the case for Japan in the 1990s, and it is true for the eurozone (and the United States) today.

Nonetheless, though monetary policy has not helped to kick-start growth in the eurozone, many observers continue to argue that, in order to help governments address their fiscal challenges, the ECB must launch quantitative easing (large-scale purchases of long-term assets). That is what Japan did, with the result that the BOJ is now the largest holder of Japanese sovereign debt, with around ¥200 trillion ($1.96 trillion) in government bonds.

Moreover, ten-year bond yields for Spain and Italy are already close to US levels, and are much lower for France. Reducing borrowing costs further would diminish the incentive for governments to put their fiscal houses in order

Meanwhile, the ECB would be acting as a fiscal agent, redistributing risk and administering sizeable financial transfers among eurozone countries. As a result, the entire eurozone could fall into a trap of rising public debt and weak economic growth – just like Japan.

Of course, governments need to spend more to smooth the deleveraging process – but only temporarily. As Japan’s experience shows, prolonged fiscal and monetary stimulus is not a recipe for faster growth. Europe’s leaders should heed that experience. Unfortunately, it is far from certain that they will.


Michael Heise is Chief Economist at Allianz SE and the author of Emerging From the Euro Debt Crisis: Making the Single Currency Work.


Nobel economists say policy blunders pushing Europe into depression

German Chancellor Angela Merkel defends eurozone and says it is hard to manage a currency for 18 states

By Ambrose Evans-Pritchard, in Lindau, Germany

7:31PM BST 20 Aug 2014
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Activists of the Occupy Frankfurt movement have set up a fire place near the Euro sculpture in front of the European Central Bank in Frankfurt, Germany
Professor Joseph Stiglitz said austerity policies had been a 'disastrous failure' and are directly responsible for the failed recovery Photo: AP

An array of Nobel economists have launched a blistering attack on the eurozone's economic strategy, warning that contractionary policies risk years of depression and a fresh eruption of the debt crisis.

"Historians are going to tar and feather Europe's central bankers," said Professor Peter Diamond, the world's leading expert on unemployment.

"Young people in Spain and Italy who hit the job market in this recession are going to be affected for decades. It is a terrible outcome, and it is surprising how little uproar there has been over policies that are so stunningly destructive," he told The Telegraph at a gathering of Nobel laureates at Lake Constance.

"It could be avoided with better use of stimulus, and spending on infrastructure. That would boost growth and helped the debt to GDP ratio," Mr Diamond said, echoing a widely-heard critique among the Nobel elites that Europe's policies have been self-defeating.

Professor Joseph Stiglitz said austerity policies had been a "disastrous failure" and are directly responsible for the failed recovery over the first half of this year, with Italy falling into a triple-dip recession, France registering zero growth and even Germany contracting in the second quarter.

"There is a risk of a depression lasting years, leaving even Japan's Lost Decade in the shade. The eurozone economy is 20pc below its trend growth rate," he said.

Mr Stiglitz said the eurozone authorities had massively underestimated the contractionary effects of austerity and continue to persist in error despite claims that the crisis is over. "I am very concerned about the future of monetary union, and they haven't yet felt the impact of geopolitical tensions."

He said the eurozone needs joint debt issuance to repair the structural flaws of EMU, but almost no progress has been made. "Europe suffers from fatal politics," he said.

German Chancellor Angela Merkel told the forum that it was hard to manage a currency for 18 states, when sovereign parliaments refuse to follow polices agreed by the EU institutions. Yet she insisted that the crisis countries had slashed current account deficits and the "first fruits" of durable recovery are in sight.

Professor Christopher Sims, a US expert on monetary policy, said EMU policy makers had not sorted out the basic design flaws in monetary union, and are driving Club Med nations into deeper trouble by imposing pro-cyclical austerity.

"If I were advising Greece, Portugal or even Spain, I would tell them to prepare contingency plans to leave the euro. There is no point being in EMU if all that happens when you are hit with a shock is that the shock gets worse," he said.

"It would be very costly to leave the euro, a form of default, but staying in the euro is also very costly for these countries. The Europeans have created a system that is worse than the Gold Standard. Countries are in the same position as Latin American states that borrowed in dollars," he said.

Mr Sims warned that the European Central Bank may not be able to carry out a mass of purchase of bonds unless the eurozone grasps the nettle on fiscal union, and might itself be engulfed by crisis. "A speculative attack could put the ECB balance sheet at risk," he said.

In the end, ECB president Mario Draghi may be forced to intervene and present Europe's political leaders with a fait accompli.

"The Germans don't want the euro to collapse, so if they really need a fiscal back-up in a crisis, they'll come up with it somehow," Mr Sims said.