As each day goes by the similarities between the eurozone and Japan seem to grow. Problems with an ageing population? Check. Struggles with high levels of public debt? Check. And now the looming threat of deflation makes it even more likely that the eurozone is about to tread the same path as Japan in the 1990s.
Last week Japanese policy makers shocked markets by expanding its already aggressive quantitative easing programme in a move to fend off the threat of deflation.
As Japan’s problems have existed for much longer, experts agree that its plight provides valuable lessons for eurozone policy makers, especially if they want the euro to remain a competitive currency.
Some of Europe’s similarities to Japan have been evident for many years.
The ageing-population crisis has taken decades to develop. According to Record Currency Management, the currency investor, the eurozone has the second-highest proportion of the population who are over the age of 65, after Japan.
Recent trends have increased the economic parallels. Javier Corominas, head of economic research at Record Currency Management, says: “Disturbingly the eurozone’s debt burden is approaching similar levels to that of Japan in terms of sustainability.”
From a currency perspective, one of the most significant similarities is the persistent low-inflation environment in the eurozone. Mr Corominas says: “Not only is inflation low in Europe, but the European Central Bank’s preferred gauge for inflation expectations suggests inflation will remain low.”
The combination of persistent disinflation with a current account surplus caused the Japanese yen to remain strong for decades. Mr Corominas says: “These economic characteristics result in a persistent demand for the currency because of the trade surplus in that region’s goods and services.”
Like Japan, a substantial current account surplus emerged in the eurozone three years ago. Azad Zangana, European economist at UK fund house Schroders, says: “Europe has improved its economic outlook by boosting its trade balance, which has resulted in its current account surplus running at a historically high level.”
Just as in Japan, the combination of the current account surplus and low inflation was a significant driver of the strength of the euro over the past few years.
A strong currency is not ideal for an economy trying to deleverage. “A strengthening currency makes the low-inflation environment more acute as the import prices fall at the same time as the domestic economy is also cutting its prices,” says Mr Zangana. Falling profits and low or negative wage inflation make it harder for both businesses and consumers to pay down debts.
One of the easiest ways for a central bank to weaken its currency is to cut interest rates. But the European Central Bank is close to its limits in terms of interest rate policy. Mr Zangana says: “Despite the historically low interest rates, this still does not seem to be enough to generate an economic recovery. That is exactly the same position that Japan was in.”
The ECB’s policy stance has not helped to dislodge low inflation. Matt Cobon, head of currency investment at Threadneedle Investments, says: “The ECB is a much more conservative institution than either the US Federal Reserve or the Bank of England, which meant they approached their mandates differently.”
However, the ECB has taken proactive steps – and much more quickly than the Bank of Japan. “The ECB recently introduced a form of quantitative easing by buying asset-backed securities and covered bonds,” says Mr Cobon.
Nor has the president of the ECB, Mario Draghi, ruled out further quantitative easing. Mr Cobon says: “If inflation continues to be lower than they have anticipated, then the next step would be full-blown QE where the ECB starts to buy back government bonds.”
Putri Pascualy, partner at Paamco, a $9bn investor in hedge funds, agrees: “The ECB is aware of the problem and is willing to take more drastic measures to avoid becoming another Japan. The key is to act quickly to avoid a deflationary spiral.”
Japan made a series of mistakes. “Japan made deflationary pressures worse by raising tax rates in 1997 and then the Bank of Japan increased rates in 2000. In contrast, Europe and the ECB look unlikely to make these mistakes,” says Mrs Pascualy.
It is not only that the ECB appears to be willing to act more rapidly than the Bank of Japan, it is also that the crisis in the eurozone is not as severe as it was in Japan. Mrs Pascualy says: “The extent of bad loans in the eurozone financial system is much less than that it was in Japan.”
The sense is there are good reasons to be hopeful that European policy makers have learnt from the mistakes made by Japan and will ensure the euro remains competitive.