As many euro area countries edge closer to deflation, many analysts are pondering the likelihood of Japanese-style lost decades. The Japanese economy went missing for more than twenty years: recent signs of life in response to Abenomics (old-fashioned monetary stimulus on a grand scale) are hopeful but sustainable growth is still far from assured.The lesson from Japan is that this is one chronic problem best avoided at all costs.
The similarities are obvious: lousy growth, poor demographics, serial policy mistakes and little appetite for necessary reforms - unless forced by crisis. Deflation is most often mentioned: falling prices are insidious for a number of reasons. If prices are expected to fall further, businesses and consumers will, quite rationally, delay spending decisions - thereby making any economic downturn worse, in turn pushing prices down further. It is a spiral that is very difficult to get out of. Policy is not impotent: the traditional response is to cut interest rates.
The problem the Japanese got into was essentially monetary: they (eventually) cut interest rates to zero far too late. Deflation had taken hold and the correct level of interest rates had become seriously negative. Central banks have been known to cut rates below zero but it doesn’t happen very often: the practical barriers are serious.
But one of the other possible lessons of Japan is that the problems all of this causes are manageable. If something lasts decades without causing too many broader issues we have to ask just how big a problem do we really have. Properly measured, per capita real GDP growth in Japan has been much better than the headline growth numbers would suggest. Delation and falling population can have surprising effects on the numbers. Arguably, Japan was so wealthy twenty years ago, low growth has not been that much of a hardship.
Usually, when we say that something is unsustainable we are absolutely correct but we often don’t have a clue about how long it will take for the necessary forces to build to cause either a crisis and/or the required change in policies. Over the last year it seems that the Japanese themselves have decided that enough is enough and have embarked a remarkable and radical policy experiment. There was no crisis, just a growing realisation, perhaps, that one was waiting down the road.
Comparisons are often odious and I think it extremely unlikely that Europe is going to mimic Japan with decades of low growth. Europe will break far sooner than that. Unlike Japan, it is very fragmented: Japan works as a monetary union, Europe remains, at best, a work in progress.
If we do slide into deflation, our debt levels will come back to haunt us. Some individual households already have a kind of debt deflation problem: not enough income to service the real debt burden. This occurs when income falls: tax hikes, unemployment and/or wage cuts all act to cut the ability to repay debt. Interest rate cuts on the debt can help but, again, rates, at least official ones can’t be cut any further.
This is not yet happening on a wide enough scale throughout the euro area to labeled as classic debt deflation. But it serves as more than a hint of what is to come should current very low levels of inflation fall further. Unlike Japan, where regional differences are completely masked by the proper workings of a single currency area, we know exactly where the pressure points lie in the euro area. If one region of Japan gets into difficulties relative to any other, the natural functioning of fiscal and monetary policy heads off trouble before it is even noticed. By contrast, Europe’s regional - country - differences are the stuff of daily headlines.
Deflation transfers wealth from debtors to creditors. That means Germany and other Northern European economies will benefit at the expense of the periphery, should we fall into deflation. I can’t imagine that lasting very long, or ending well.
Mario Draghi is convinced that we are not Japan. He would say that, of course, but he appears to be sincere, perhaps with good reason. But with each release of inflation data he must be getting more worried. The most recent numbers show more of the euro area heading towards the danger zone, for example. But there is little that Mr Draghi can do now. He is hamstrung by German Constitutional Court rulings and by the peculiar desire by many in power to run Europe as a collection of countries, some of which count for more than others. If, by contrast, progress isn't made towards the creation of a proper functioning single currency area then the end is inevitable, even if its timing is wholly uncertain.
