Eurozone likely to follow Japan's lost decade as worries increase

The stagnant growth of Europe and political dysfunction have inspired frequent comparisons with the lost decade of Japan since the mid-1990s. We are not there yet.

The misery of the region this year: the industrial crisis in Germany and the struggle to repair its banks; Italy's inability to reform itself; the apparent defeat of central bankers seeking to deflect the revival of the euro zone – may seem to give the inevitable impression of a perpetual malaise.

The economy of the euro area is similar to that of its Asian counterpart two decades ago: interest rates lower or equal to zero, mountains of indebtedness and unproductive loans, populations moving from an aging society to a society aging.

Economists insist that there are limits to the comparison, although, while recognizing a protracted period of stasis in Europe, deflation and the powerlessness of central banks remain a threat.

"I am very worried about this," said Adam Posen, president of the Peterson Institute of International Economics, whose areas of expertise include Japan and Germany. "The japanification of Europe is a real risk."

The so-called lost decade of Japan, triggered by the bursting of the stock and real estate bubble, has pushed the economy towards sluggish or even zero growth, with rising unemployment and a decline in interest rates.

Here are some of the ways that Europe has taken in this direction – and others do not.

Decrease in the workforce

The working-age population in the euro area has declined as people live longer and have fewer children. According to Eurostat, overall population growth is expected to peak in 2045. The region is therefore on track to match Japan. There, the population has been declining for seven years. one in three is now 60 or older.

Aging populations are often thought to reduce inflationary pressures as they save for retirement and spend less.

The demographic contraction in Japan has led to more women and older people working and pushed the overall unemployment rate to 2.3%, the lowest level in more than two decades. However, wage growth is lukewarm and insufficient to stimulate inflation.

On the other hand, in the euro area, the unemployment rate remains above its pre-crisis level, but workers' wages have started to improve, frequently signaling ECB officials as proof of the resumption of price growth.

Monetary Policy

The Bank of Japan (BOJ) has fought deflation over the past two decades. The ECB got a glimpse of this fight in 2009 amid a recession and following the sovereign debt crisis in the eurozone. While Japan's difficulties began abruptly in the early 1990s, the eurozone slid more slowly into the weakness of inflation and growth.

The Bank of Japan was the first major central bank to adopt a radical monetary policy, but it remains tied to negative interest rates and badet purchases, which weighs more on detente.

The ECB is far from raising rates. Although the slowdown is worsening more and more, the bank may not be able to adopt more BoJ-like measures, but it may be stuck in its current position for some time.

"By refusing to soften the policy appropriately, the Bank of Japan created a situation in which the country had to keep interest rates close to zero for 20 years," said Athanasios Orphanides, a former responsible for the ECB. "If you look like this, 2020 or 2021 could become completely impossible for the ECB to walk."

Inflation forecasts

Although inflation in the euro area has recovered, it remains below the ECB target of just under 2%, and the key rate is around 1%.

The ECB says the risk that the markets are anticipating, even with a slowdown in inflation, is "very weak". Investors are less optimistic: a gauge based on derivatives prices dipped to 1.3%, its lowest level since 2016 – when the ECB bought bonds at a rate of 80 billion euros per month.

Debt and returns

Japan's debt-to-GDP ratio is now above 230% and rising as deficits accumulate. European Union rules impose tax limits that will limit such accumulation. The euro area ratio is 89% and is expected to decline slowly, but a weaker economy and the need for fiscal stimulus could hinder progress. Nevertheless, bond yields tell a troubling story: German borrowing costs converge with those of Japan.

"Japan and the eurozone are not that different from each other," said Andrew Bosomworth, a fund manager at Pacific Investment Management Co. "We are just following in their footsteps."

Migration

The more dynamic labor market in the euro area, characterized by internal and external migrations, is a major obstacle to comparison with Japan.

Net inflows of migrants peaked in 2015, as the recovery of the European economy coincided with instability in North Africa and the Middle East. This helped to mitigate the decline in the working-age population.

More recently, however, Europeans have developed resistance to large-scale immigration. Annual net inflows into the euro area will decline over the next few decades, according to Eurostat.

Japan, with 126 million inhabitants, has only about 1.3 million foreign workers and remains opposed to a formal immigration policy. The government will probably issue five-year residence permits to some 345,000 low-skilled workers over the next five years. This would fill about a quarter of the anticipated labor shortage.

Bloomberg

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