The Japanification Of Europe

by: Shareholders Unite


The eurozone is resembling Japan's lost decades ever closer on a host of metrics, including demographics, growth, inflation, yields and debts. In some respects, the eurozone crisis actually resembles the Great Depression of the 1930s.

If policy makers do not respond to this crisis, things are likely to get worse rather than better.

Japan responded with new policy initiatives, getting it out of deflation; its stocks remain a better bet until the ECB wakes up.

While the US economy seems to have achieved just about enough momentum to reach escape velocity, the eurozone isn't so lucky, quite the contrary. Now even the German economy, for long the well performing exception in a pool of economic malaise, is also stuttering and the problems with Russia over Ukraine aren't making things easy.

The situation is remarkably similar to that of Japan, with deflationary forces gaining strength.

Japan's population is one of the oldest in the world and its share of retired people keeps on increasing. Famously, the sales of diapers for old people are exceeding those for babies.

Just like Japan, many eurozone countries are plagued by stagnant or even shrinking populations, with France the main exception. The US has a main advantage here. Shrinking population complicates economic performance in several ways:

  • Slow or even negative population growth reduces investment, as there is less need for additional production capacity.
  • A rising ratio of retirees per working population raises the financial burden on working people, as their pensions are (mostly) paid from taxes.
  • A growing proportion of old people increases demand for medical expenditures, which, due to ever newer and more expensive treatments and limited scope for productivity increases, are already increasing disproportionately to income.

Low growth
While the Japanese decades post 1990 are known as 'the lost decades', on mildly closer inspection this turns out to be rather relative. As it happens, GDP per capita growth was comparable to that in the US and Europe, and Japan never really experienced any major decline in production or anywhere near double digit unemployment.

Compared to that, the plight of much of the eurozone since the 2008 financial crisis is actually worse, much worse; only in Germany has production returned to pre-crisis levels and only just.

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Many economies are stagnant or even contracting, sometimes sharply, and there have been a few false downs already. One recently, and one in 2011, when the ECB was so optimistic it actually raised interest rates.

In fact, the eurozone slump is taking on distinct characteristics of the Great Depression of the 1930s, at least in terms of duration and lost production:

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So, while Japan might have had lost decades (growth was indeed markedly lower than in the previous decades), much of the eurozone is suffering a substantially worse situation.

The low or negative growth is, not surprisingly, accompanied by low or, in some eurozone countries, even negative inflation. This isn't yet in Japanese territory, as Japan suffered from actual deflation for a substantial part of these lost decades.

The eurozone slump is in the early innings yet (at least compared to Japan) and there is considerable evidence that it is difficult for economies to produce deflation (due to nominal rigidities). Japan's slump is much older, so it had more time to break through these nominal rigidities.

However, if the eurozone slump lasts (and at present there is little to suggest it won't), the risk of deflation setting in becomes larger.

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The combination of low growth and low inflation (let alone negative growth and deflation) produce a so-called denominator effect that really complicates debt trajectories. Since we have already written about this (here), we can be brief.

The denominator effect is simple, debt expressed as a percentage of GDP keeps rising even with mild deficits (like Italy's) because the denominator (nominal GDP) is stagnant or even falling. And this despite heroic efforts to contain the deficit through austerity measures.

Look what's happening to Italy's debt trajectory:

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Other eurozone countries like Greece, Ireland, Spain and Portugal have suffered similar fates. Japan's fate is worse in the sense that the same denominator effect (nominal GDP today isn't much different from that in 1990!) has had much longer to wreck havoc, and therefore the debt/GDP ratio has spiraled upwards to dizzying heights well above 200% of GDP:

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There are two differences between the Japanese and the eurozone situation here:

  • Japan never embraced austerity, bar the episode in 1997 (which didn't end well) and the tax hike in April this year.
  • Japan is more master of its own debt, in the sense that there are fewer political obstacles for its central bank (the BoJ) to exercise fully its role as lender of last resort. The ECB has pledged to do so, but this pledge was conditional on the country whose bonds it would buy to implement its policy prescriptions, and even then it remains to be seen whether the ECB can fully deliver on its pledge when the rubber meets the road.

Low yields
With stagnant economies and no inflation (or even some mild deflation), and no prospects on the horizon that this will come to an end anytime soon, it's no wonder why yields hit new lows almost daily. In fact, eurozone yields are really approaching Japanese territory.

What has led to these severe economic problems? In Japan, there was a more or less single cause in the form of the bursting of asset bubbles (stocks, land, real estate) of rather epic proportions (three times the size of the bubble that burst in 1929 in the US).

Policy was rather slow to react and banks swept their rising bad debts under the carpet for years, which is especially harmful as banks are much more central for credit provision to the private sector compared to the US, for instance.

The situation lingered, mild fiscal stimulus kept the economy on life support (Japan never really experienced a severe crisis in these years), but deflation crept in.

The eurozone crash is more complicated. We have written a more detailed version of its causes (here), but in essence, what happened can be summarized:

  • The creation of the euro itself led to a fall in interest rates in the periphery (result of the disappearance of the exchange rate risk and more credible monetary policy) leading to large capital inflows
  • These produced asset bubbles (Ireland, Spain), bloated public finances (Greece), brisk economic growth combined with higher inflation, which accumulated and led to a significant loss of competitiveness which couldn't be revived through devaluation.
  • Then came the financial crisis, the capital inflows stopped and reversed, asset bubbles burst, economies crashed.
  • This left an awkward catch-22 situation for the peripheral countries: reflate to boost their economies but lose further competitiveness, deflate to recoup competitiveness (through 'internal devaluation') but further sink their economies.
  • In the end, the peculiarities of the eurozone forced the deflate route upon these countries, as members of the eurozone they could not devalue nor embark on monetary or fiscal stimulus so their economies drifted lower, not even recouping a lot of lost competitiveness as inflation in the core countries is also very low.

Policy response
Japan's economy has been kept floating on large public sector deficits, at least partly compensating large private sector surpluses. Only in the last couple of years has it embarked on a shock-and-awe policy reminiscent of Japan in the 1930s to detract itself from the deflationary rut. The jury is still out on that, although we're mildly encouraged by the early results.

The eurozone has wrestled with the institutional limitations of the eurozone and the proper role of its central bank, the ECB. The latter only embarked on its role as lender of last resort (at least in words) after peripheral bond markets were at the point of no return.

Fiscal policy has generally been a big drag on growth and while the ECB has embarked on some useful monetary policy initiatives, it's the only major central bank not to embark on large scale asset purchases (at least not yet). In fact, the balance sheet of the ECB has shrunk by about a trillion euro in the last couple of years.

Investment implications
We think that at present, Japanese stocks are the better buy. Japan at least is trying shock-and-awe to dislodge itself from deflation with the help of Abeconomics. There is some early success on that front, and compared to Japan, the eurozone seems to be a rabbit caught by the headlights of the oncoming deflation train.

Japanese shares can be best bought through ETFs, unless you are willing and able to do the due diligence on individual companies. One could go with:

  • iShares MSCI Japan ETF (NYSEARCA:EWJ)
  • Deutsche X-trackers MSCI Japan Hedged Equity ETF (NYSEARCA:DBJP)
  • WisdomTree Japan Hedged Equity Fund (NYSEARCA:DXJ)

There actually is an eurozone stock ETF in the form of iShares MSCI EMU ETF (BATS:EZU), but one could also go with individual eurozone member country ETFs, like:

  • iShares MSCI Germany ETF (NYSEARCA:EWG)
  • iShares MSCI France ETF (NYSEARCA:EWQ)
  • iShares MSCI Italy Capped ETF (NYSEARCA:EWI)

The graphs of these look remarkably similar, which testifies to the fact that they're subject to much the same economic forces. Our assessment of eurozone assets would change if the ECB would become much more aggressive, and this is something we expect. We're not the only one, here is Citigroup's chief economist Willem Buiter:

We believe that early easing by both the BoJ and ECB is more likely than the consensus view. We look for both central banks to downgrade their economic forecasts and to launch major QE programs in (the fourth quarter of 2014) or perhaps (the first quarter of 2015).

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.