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Saturday, September 20, 2014

The Japanisation Of Europe

By now it should be clear that the monetary experiment currently being carried out in Japan (known as “Abenomics”) is fundamentally different from the kind of quantitative easing which was implemented  in the United States and the United Kingdom during the global financial crisis. In the US and the UK QE was implemented in order to stabilize the financial system, while in Japan, and now the Euro Area (EA) the objective is to end deflationary pressures and reflate economies which are arguably caught in some form of liquidity trap.

In particular it is hard not to draw the conclusion that something structural and more long-term is taking place in Japan, and that that something is only tangentially related to the recent global financial crisis. One plausible explanation is that Japan’s long-lasting malaise is not simply a debt deflationary hangover from the bursting of a property bubble in 1992 but rather with the rapid population ageing the country has experienced. If this is the case then the ongoing economic stagnation in Europe may have a lot more to do with the Japan experience than it does with  the recent economic dynamics seen in the UK and the US. The reason for this is simple:  Europe’s population is the second oldest on the planet after Japan’s. Certainly at first sight the similarity is striking, especially when it comes to working age population dynamics.


So is the Euro Area the New "Japan"?

"Europe is becoming Japanese" is an expression that is being used more and more. People saying this normally point to the fact that German 10 year bund yields recently went under 1% (and hence have started to look like 10 year Japan Government Bonds).


But behind this argument lies some kind of "reverse causality". In Japan JGB yields have been driven to very low levels by central bank intervention, with the BoJ now buying a very large share of all new issue bonds. In Europe, on the other hand, the ECB isn't buying Euro Area sovereigns, the markets are in anticipation of QE. So to talk about the Japanisation of Euro Area yields is a little misleading. Bond purchasers and their models are provoking this downward lurch, not the central bank response to weak growth or creeping deflation. To really push Mario Draghi into Japan-style QE in the short term markets would need to move back into risk-off mode on periphery assets, yet there is little appetite to go for what might potentially become another "widowmaker" trade by taking on a powerful central bank. Yet as long as the bond markets remain relatively well behaved Draghi will try to do as little as possible.

Another argument used to justify the "Japanisation" of the Euro Area idea carries much more clout, and that is the one being used by Paul Krugman based on working age population dynamics. "If you’re worried that secular stagnation might be depressing the natural real rate of interest (the rate consistent with full employment)”, he told blog readers “and you think that demography is a big factor, Europe looks really terrible, indeed full-on Japanese."

Inflation dynamics in Europe also look strikingly similar to those seen in Japan (but with a 20 year lag, see chart below).




The basic idea is that working age population dynamics play a big part in determining movements in aggregate demand and hence inflation. This idea received support from a research paper published at the start of August by a group of IMF economists - "Is Japan’s Population Aging Deflationary?" The first part of the paper abstract runs as follows:
"Japan has the most rapidly aging population in the world. This affects growth and fiscal sustainability, but the potential impact on inflation has been studied less. We use the IMF’s Global Integrated Fiscal and Monetary Model (GIMF) and find substantial deflationary pressures from aging, mainly from declining growth and falling land prices. Dissaving by the elderly makes matters worse as it leads to real exchange rate appreciation from the repatriation of foreign assets. The deflationary effects from aging are magnified by the large fiscal consolidation need."
Strikingly Japan entered deflation not in 1992, but in 1997/8 at exactly the point the working age population peaked and in the EA it is happening in 2012/13 - just when EA working age population dynamics turned negative. The correlation may be just an odd coincidence, but it is striking.

Not according to the ECB

Naturally Mario Draghi will have none of this. "I think that the situation in the euro area is quite different from what it was in Japan in the 1990s and early 2000s", he told an ECB press conference in December 2013. He then went on to offer five reasons.

Reason No 1: "we have taken decisive monetary policy measures of great significance at a very early stage, even when, as a matter of fact, inflation was not at the levels at which it is today. It was way higher and way closer to 2% and this did not happen in Japan".

This is the case, but the vast majority of the ECB's non conventional policy measures were intended to avoid financial instability, not to  provoke inflation. The measures were largely liquidity oriented not outright "money printing" ones, so they were mainly addressing the monetary policy transmission mechanism - which was broken - not the fact that the refinancing rate was stuck up against the zero bound. There still hasn't been sufficient analysis of why outright deflation didn't hit the Euro Area sooner, but a big part of the story is probably associated with the presence of excessive rigidity in wages and prices and the constant consumption tax and administrative charge increases put in place as part of the deficit containment exercises.

It is noteworthy that in Greece, for example, wage costs came down sharply a long time before the CPI began to fall.



Reason No 2: "We are in the process of doing the asset quality review.......the situation in Japan lasted much longer than it should have because the balance sheets of the banking system and the private sector were burdened, and had to be deleveraged and the action to induce this deleveraging lacked for many years."

Well, maybe, just maybe, the ECB President has his timing a little bit out here. Japan's bubble burst in 1992, and the banks started getting seriously recapitalized in 1998. The global financial crisis hit the Euro Area in 2008, and the AQR - which is supposed to be the prerequisite for realistic recapitalization - is taking place in 2014. The time difference in fact seems to match. So we could also say the necessary action on the part of the ECB also "lacked for many years".  Of course, banks in some of the most troubled countries have already been recapitalized once, most notably in Ireland and then in Spain in 2012. But still problems remain, which is why the AQR is taking place. Earlier stress tests have just not been realistic or rigorous enough.

In a process not too dissimilar to the one taking place at the present time in the EA Japanese banks were recapitalized to the tune of 0.4% of GDP in March 2009, and by another 1.5% of GDP in March 1999. The order of magnitude of these recapitalization is not in any meaningful sense larger than that which is taking place in the Euro Area. Following an AQR type process conducted by the recently formed Japanese Financial Reconstruction Commission non performing loans were systematically identified and banks required to recapitalize accordingly. 14.8% of GDP's worth of NPLs were finally identified, a figure not notably different from the current Euro Area one, and well below the levels prevailing in the worst affected countries like Spain and Italy.



Reason No 3: "the situation of the private sector balance sheets is not at all comparable in the euro area. It is not at all comparable with what it was in Japan at that time."

I just think Draghi is wrong about this. The level of credit exposure of Japanese banks to the private sector was not *that* different from the EA one in 2008 (see chart below) and as we have seen the level of distressed lending was pretty comparable.


In effect this whole comparison with Japan in the late 1990s is a bit flawed, since as will be recalled Abenomics was only introduced in April 2013. The point being that Japan was still stuck in deflation up to that point (and may still be so when the effects of the devaluation and the tax hike wear off), and so it is a bit hard to pin all this on a couple of bad decisions in 1997 and 1998. Underlying structural factors are at work (liquidity trap, possibly driven by ultra low fertility) and these may be similar in both the European and the Japanese cases.

It is true that the bank of Japan underestimated the scale of the problem between 1992 and 1997, but the same sort of accusation can be brought to the door of the ECB. In both Japan and the EA measures were (and are being) implemented to help banks avoid liquidity crunches in the hope that this will encourage lending, but in neither case has (or is) this had/having any evident success. The poor initial demand for TLTROs being just one example of this problem.


 Reason No 4: "countries in the euro area have made significant progress in addressing their structural weaknesses....that’s the fourth difference between Japan in the 1990s and 2000s and us today."

Well, as Draghi himself admitted, the structural reform process in Europe is far from complete (France, Italy) and I think he also underestimates the kinds of reforms which were carried out in Japan at the time. The "lifelong employment" tradition, for example, was ended in the late 1990s.


Reason No 5:  "if you look at the inflation expectations in the euro area and the corresponding inflation rates you would see that in Japan the inflation expectations were dis-anchored quite significantly, and for a long period of time, which is not something we are seeing here."

This isn't exactly as straight forward as Draghi makes out either. He himself has accepted in his Jackson Hole speech that EA inflation expectations are not as well anchored as he thought they were, while on the other hand inflation expectations were better anchored in Japan than he seems willing to acknowledge (see chart below showing how 10yr inflation expectations evolved in Japan). That is to say in neither case did the central bank see the problem coming. (Click on image for better viewing)


Bottom line, despite all the denials from Mario Draghi that the Eurozone is not another Japan there are plenty of grounds for thinking that it is steadily becoming one.

 Postscript

The above arguments are developed in detail and at far greater length in my new book "Is The Euro Crisis Really 0ver? - will doing whatever it takes be enough" - on sale in various formats - including Kindle - at Amazon.