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Monday, August 25, 2003

Europe on the Japenese Road Map

Strong article from Anatole Kaletsky this. I wouldn't go along with his tongue in cheek optimism about the UK and the US, but on the danger of what he calls the media cliché of Germany being the prinicipal deflation candidate (I think you will find I was saying this here and on Bonobo Land long before it became fashionable to do so) I think he is bang on target. Also exceptional is his recognition that: "Cutting unemployment pay, reducing job protection and scaling back pensions can accelerate economic growth in an economy where demand is growing. But in an economy suffering from long-term demand stagnation, even the talk of such harsh supply-side reforms is likely to damage consumer confidence and further undermine demand." This is a point - like voices in the wilderness - Eddie Lee and I have been trying to hit home for some time. The srtuctural reforms are necessary, but everything is timing and mix, and if you don't get these right you're more likely to sink Germany further than to do anything constructive. Germany is an ageing and apprehensive society:

Last week's figures confirmed that the German, Italian and Dutch economies have all entered their second or third quarters of economic decline, and that the eurozone as a whole was stagnant for the ninth consecutive month, with most industrial indicators pointing to further weakness ahead. Despite all this grim news, investors are bidding up share prices across Europe, Germany has been the best performing major stock market in the world this year and the euro remains cripplingly expensive against the pound, yen and dollar, not to mention the Chinese renminbi - as anyone who has been on holiday in Europe this year can attest.

This divergence between market behaviour and economic reality can have one of two consequences. Either the eurozone economy will soon start to perform much better than the present statistics are suggesting; or investors in euro assets will soon realise that they are caught up in another asset bubble in some ways even more irrational than the dot-com speculation of the 1990s or the bond bubble that imploded so spectacularly two months ago. There are several reasons why the outlook for Europe today looks considerably worse than it did for Japan in the mid-1990s, when its economy lurched from cyclical recession to structural depression. The first is the paralysis of monetary and fiscal policy as a result of the single currency project. The monetary response to economic stagnation in Europe is proving even more timid than it was in Japan.

The European Central Bank has consistently dragged its feet and aggravated the recession, to the point where investors actually expect an increase in European interest rate next year. Compare this to what happened in Japan after the yen shock of 1995. Japan had already reduced its interest rates to 2 per cent a year before the yen shock hit in early 1995. From that point on the Bank of Japan became much more aggressive, slashing three-month rates to zero in six months (see bottom chart). Does anyone seriously expect the ECB to act so decisively in the next six months? Fiscal policy will provide even less support for the euroland economy. European budgets are already in deficit, and fiscal policy is prevented by the Stability Pact from playing an active stabilising role. Japan managed to avoid a deep depression in the late 1990s because government spending kept the economy afloat, providing a net stimulus of almost 1 per cent of GDP each year between 1995 and 1999.

In euroland, the fiscal stimulus will be nil in the next few years - even on the optimistic assumption that Germany and France continue to ignore the Maastricht treaty's insane strictures to reduce budget deficits when they ought to be expanding. Meanwhile, the euro has become almost as overvalued as the yen was in 1995. In fact export prospects for Europe are now even bleaker than they were for Japan in the 1990s. Japan's net exports grew rapidly from 1996 until 2000, providing the economy with its main source of growth. But Japan was able to increase its trade surplus only because America was allowing its trade deficit to expand. Combining the influences of fiscal policy and trade, we can see that Japan was saved from depression in the late 1990s by a widening of budget deficits and export surpluses, which added more than 1 per cent to GDP growth each year.

Europe now faces exactly the opposite macroeconomic outlook. The budget deficit will be stable at best and may even narrow, if governments are mad enough to follow the instructions of the European Commission and the ECB. At the same time, euroland's current account will shift towards deficit by 1 to 2 per cent of GDP. Thus Europe is carrying a much heavier handicap in the global deflation stakes than Japan did in the 1990s. But what about economic reforms? Surely the Europeans are finally getting the message about deregulating labour markets, cutting taxes, strengthening competition and trimming their welfare states?

There are some grounds for greater optimism in this area, especially in Germany, where Gerhard Schroeder's Agenda 2010 programme is proving surprisingly successful in introducing some modest labour market reforms. But structural reforms, in the absence of a positive monetary and fiscal policy, can be worse than useless. Cutting unemployment pay, reducing job protection and scaling back pensions can accelerate economic growth in an economy where demand is growing. But in an economy suffering from long-term demand stagnation, even the talk of such harsh supply-side reforms is likely to damage consumer confidence and further undermine demand.

This is another of the key lessons from Japan. With an aggressively growth-oriented monetary and fiscal policy (of the kind seen in the US and Britain since the early 1990s) labour market reforms can create new jobs and win public support, but in the absence of a clear commitment from the central bank and the government to keep demand growing, supply-side reforms simply put people on the dole. Yet in Europe, the institutions that created the euro have made the co-ordinated changes in monetary, fiscal and structural policies almost impossible, even if the reform movement starts to command strong political support. This is at the heart of the long-term economic problems faced by the eurozone.

Japan became a laughing stock in the last decade because of the inability of its politicians, bureaucrats and central bankers to agree on the economic reforms that were clearly required. But Japan's challenge in creating consensus is nothing compared with the nightmare of creating co-operation among the warring institutions of the eurozone. The ECB is a far more independent central bank than the BoJ ever could be. The European Commission, even more than the Japanese bureaucracy, is a self-serving institution that pursues its own agenda, regardless of what elected politicians may say.

The eurozone has 12 governments, which between them include roughly 50 coalition parties, as against the single government (more or less) in Japan. This means that Japanese-style problems of fiscal, monetary and political co-ordination must be multiplied by 12 in Europe, or maybe raised to the twelfth power. Investors around the world are betting that Europe is suffering nothing worse a standard cyclical downturn and will soon recover to become the healthiest economy in the world. They could turn out to be right. But remember: that is what everybody thought about Japan in 1995.
Source: The Times

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