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.

By InvestSMART · 21 Oct 2014

By InvestSMART ·
21 Oct 2014

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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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Frequently Asked Questions about this Article…

What led to Japan's economic decline after the 1980s?

Japan's economic decline was primarily due to overconfidence and complacency during its rapid growth phase, which led to asset price bubbles and excessive lending against bad investments. When the bubble burst, the slow response in addressing problematic lending and the delayed implementation of measures like cutting interest rates and quantitative easing contributed to prolonged economic stagnation.

How did the Japanese government's response to the economic crisis affect its debt levels?

During Japan's economic crisis, the government accumulated the largest government debt load in the world. This was partly due to the lack of timely and effective measures to restore the banking system and stimulate the economy, leading to persistent low interest rates and minimal economic growth.

What similarities exist between Japan's economic issues and Europe's current situation?

Both Japan and Europe experienced economic challenges due to high debt levels and ineffective responses from their central banks. In Europe, the debt issues were compounded by an oversized banking system and the European Central Bank's slow reaction to economic downturns, similar to Japan's delayed policy actions.

How has Europe's banking system been affected by its debt crisis?

Europe's banking system has faced solvency and liquidity challenges due to the debt crisis. Although not as severe as Japan's situation, the lack of cross-border fiscal transfers and an inactive central bank have hindered effective economic recovery and support for indebted nations.

What role did the European Central Bank play in Europe's economic difficulties?

The European Central Bank contributed to Europe's economic difficulties by initially hiking interest rates during the global financial crisis due to inflation concerns and then taking too long to cut rates afterward. This delayed response exacerbated the economic challenges faced by European countries.

Why is Europe's version of quantitative easing considered ineffective?

Europe's version of quantitative easing is seen as ineffective because it lacks the full support of all member nations, leading to a diluted approach. Disagreements over adopting full-blown sovereign QE have resulted in a less impactful economic stimulus compared to what might be achieved with a unified strategy.

How does household and government debt differ among European countries?

In Europe, the types of debt vary by country. Some countries, like Spain and Ireland, primarily face household debt issues, while others, such as Greece, Italy, and France, struggle with high levels of government debt. These differences complicate the region's overall economic recovery efforts.

What lessons can investors learn from Japan's and Europe's economic challenges?

Investors can learn the importance of timely and decisive policy actions in addressing economic crises. Both Japan's and Europe's experiences highlight the risks of delayed responses and the need for effective central bank interventions to prevent prolonged economic stagnation and support recovery.