Why Europe is turning Japanese - not good!

Outside of central bank action, the economics (and demographics) point towards a future Eurozone that looks very much like modern day Japan. We’ve seen from the US experience that market worries can be allayed by strong central bank action but Europe might be a harder nut to crack.

The start of Japan’s problems
A lot has been written of Japan’s fall as an economic powerhouse after the ‘80s. Rapid expansion in exports and strong capital investment drove incredible growth in the Japanese economy. But these years of strong growth bred overconfidence and complacency which led to asset price bubbles, incredible volumes of lending against bad investments and a culture which supported the rolling of these loans. When their bubble burst, problematic lending was never resolved in a quick enough time to restore the banks to health and get them lending again. Eventually credit was squeezed in all parts of the economy. While this was happening, the Bank of Japan took nearly 10 years to cut the official interest rate to zero and didn’t even consider quantitative easing until a long time after that. Nothing else was done to resolve the issue with the banking system either. During the first ‘lost decade’ (which ended up spanning a much longer time period), the Japanese government ran up the biggest government debt load in the world. Now they are left with the lowest government bond yields from the persistence of almost permanent zero interest rates.

A very similar European story

In Europe, a run up of debt in the good years led to a pop that disabled the oversized banking system – and an inactive European Central Bank (ECB) has only exacerbated the situation. The types of debt are different: household debt for some countries (Spain, Ireland) and government debt for others (Greece, Italy, France). While the banking system has had trouble with solvency and liquidity it perhaps wasn’t as bad as the Japanese episode; however, the inability (and unwillingness) to conduct cross-border fiscal transfers to the indebted nations means that instead of banks we have governments that can’t conduct any fiscal help for their economies. Then there is the ineffective central bank that was hiking rates into the GFC because of inflation, and then took too long to cut after that. Now we are left with promises of a poor version of proper quantitative easing (QE) because there are still disagreements between the member nations about adopting full-blown sovereign QE.

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