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Why Japan is a warning sign for the Eurozone

Japan’s struggle to drag its economy out of an entrenched deflationary cycle offers a cautionary tale for other economies such as the eurozone, demonstrating the enormity of the policy effort needed

The global economic slowdown has brought ‘Japanification’ risk – longterm low growth and low inflation or deflation – back on to the agenda, with the danger especially apparent in parts of the eurozone such as Italy and Greece. Since it launched a series of policy shifts in 2011, Japan’s relative economic performance has been quite respectable.

GDP per head has risen 1.2% per year since 2010, slightly above the G7 average and better than Australia, Canada or the eurozone. The cycle of deflation and very weak growth seen in Japan in 1997/2011 has eased. Japan’s improved performance since 2011 reflects a mixture of easing deflationary forces and an intensified fight against low growth and deflation on multiple fronts. Progress has been mixed but the broad strategy looks like a decent template for other economies fighting ‘Japanification’ risks.

On the labour force, Japan has managed annual growth of around 1% per year since 2016 despite the working age population dropping 1% per year. This has occurred mostly thanks to rising numbers of women and older workers. That said, with many women and older workers working part time, total hours worked are still falling. The eurozone has also been defying its demographic drag in recent years – labour supply has grown around 0.5% per year since 2016 despite the working-age population falling slightly. Retirement reforms are likely to have helped here.

But there may also be a cyclical element (better growth dragging people outside the labour force into it), which won’t persist. On productivity, the picture is less upbeat for both Japan and the eurozone. In Japan, productivity growth collapsed in the 1990s and while it staged a recovery in 2001/07, it has been very slow again since at 0.3% per year (across a range of estimates).

Eurozone productivity growth was respectable in the 1990s but slumped in the 2000s after the dotcom bust and has deteriorated even more since 2007. Across a range of estimates it averaged just 0.1% from 2008/18. On monetary policy, it is notable that Japan’s aggressive easing since 2011/12 has had only modest success (in 2015-2016) in terms of boosting the broadest monetary aggregates – the dramatic slowdown of which from 1990 clearly foreshadowed the slide into deflation.

In the eurozone, the collapse in broad money growth since 2008 is eerily similar to that in Japan in the 1990s and the situation looked very dangerous in 2013 with broad money shrinking. More expansionary monetary policy by the ECB headed off that risk and money growth since has been reasonable. On the exchange rate, Japan disastrously let the yen real exchange rate – already strong in 1990 – surge in the early 1990s, worsening deflation pressures. The real exchange rate was not decisively lower until the aggressive monetary easing from 2012 and was a key factor in stopping price deflation.

The eurozone also saw a sharp currency appreciation after the financial shock of 2000/2001 – similar in scale to Japan’s in the 1990s. But the starting level for the euro was much less elevated than it had been for the yen and the euro has eased back since. We can see that the eurozone has managed to avoid some of the policy errors Japan made, which exacerbated and perpetuated deflationary pressures.

But the similarities between parts of the eurozone and Japan are uncomfortable, with growth and inflation very low and persistent risks of a slide into deflation. Japan’s experience also shows that the policy actions required may need to be extreme. Rates remain at zero across the curve in Japan, the central bank owns over 40% of the (massive) government debt and the real exchange rate has depreciated by 30% since 2011 and 50% since 1995. Scope to copy Japan’s mix of strong fiscal and monetary expansion and financial repression is very limited in the eurozone.

Yet such policies may well be what is needed if the global downturn worsens and this pushes eurozone states like Italy and Greece towards outright deflation. In such a scenario, it seems likely that the ECB would need to engage in another bout of quantitative easing. This implies bond yields staying very low or compressing further and, perhaps, a very sharp depreciation of the euro given that this would be likely to be the most effective channel for raising inflation. And the latter might be harder to achieve than it was for Japan in 2012/2013, as the yen was more clearly overvalued then than the euro is today

Adam Slater is lead economist at oxfordeconomics.com


Originally published in Economia on 17 July 2019.