Japanification: the economic spectre haunting Europe

The eurozone is showing the perturbing symptoms first diagnosed in Japan, but ever-looser monetary policy is not the answer

August 16, 2019
A view of Frankfurt including the European Central Bank. Clouds are gathering over the currency union. Photo:  Boris Roessler/DPA/PA Images
A view of Frankfurt including the European Central Bank. Clouds are gathering over the currency union. Photo: Boris Roessler/DPA/PA Images

Two decades ago as Europe was preparing to launch the euro, something rather odd was starting to happen on the other side of the world. In the late 1990s, Japan began to experience deflation, a condition thought to be banished in the buoyant post-war era of global expansion. Both short-and long-term interest rates fell to historic lows, even turning negative in some parts of the money market. At the time the phenomenon appeared to be specific to Japan, reflecting a wrenching economic slowdown and a prolonged banking crisis. But now the exception is fast becoming the rule as “Japanification” spreads around the world, above all in the euro area.

Along with Donald Trump’s trade wars, Japanification explains much of what is happening in the global economy at the moment. Take the Federal Reserve’s decision to cut interest rates at the end of July, even though that month marked the longest ever economic expansion in America on records going back to the 1850s. One reason was that the US central bank felt compelled to protect American businesses from the backwash arising from Trump’s tariff follies. More fundamentally, however, the Fed was responding to the fact that its preferred measure of headline inflation is, at 1.4 per cent, uncomfortably below its 2 per cent target even though unemployment (currently just 3.7 per cent of the work force) is at its lowest in almost 50 years.

Even more so than America, the euro area is feeling the pain from Trump’s wrecking ball and a slowing Chinese economy. The 19-strong monetary bloc is much more exposed to trade headwinds than the US. The eurozone’s hub economy, Germany, is in trouble as its export-reliant manufacturing sector has gone into reverse. German GDP contracted by 0.1 per cent in the second quarter, curbing growth in the euro area to just 0.2 per cent, well below potential.

The setback is all the more worrying because Europe has a much more serious case of Japanification than America. The currency union, set up with such high hopes 20 years ago, is showing many of the gloomy symptoms once thought to apply only to Japan. Headline consumer-price inflation in July was a low 1.1 per cent according to Eurostat’s initial estimate. Core inflation, which strips out volatile components including food and energy prices, was just 0.9 per cent. Both were well short of the European Central Bank’s longstanding goal of a little below 2 per cent.

That will prompt the ECB to follow the Fed and ease monetary policy when its governing council meets on 12th September. But whereas the Fed has cut rates after a period of increasing them (between late 2015 and the end of 2018), the ECB has not raised rates since 2011 and now looks set to cut them further. And whereas the Fed has run down some of the assets purchased through earlier quantitative easing, the ECB has not and now appears poised to crank up its QE machine again, only nine months after turning it off.

The biggest contrast of all between the world’s two main central banks is in the starting point for their interest rates. The Fed cut by a quarter of a point, from a (not very) high of between 2.25 and 2.5 per cent. That peak might have been modest but at least it was positive. By contrast if the ECB cuts rates again, it will push them deeper into negative territory, lowering the deposit rate from a once unthinkable minus 0.4 per cent (reached in March 2016). That will put pressure on neighbouring central banks to cut rates that are already lower (in Sweden the deposit rate is minus 1 per cent).

Low and even negative interest rates have become a defining characteristic of Japanification. Central banks have crashed rates through the “zero bound” once thought to hold because depositors can switch into cash, which at least does not bear a penalty. In practice it turns out that large depositors can be made to pay because of the inconvenience and security concerns of hoarding large holdings in banknotes, though the zero bound does still generally hold for retail deposit accounts.

Even more remarkably, negative interest rates have spread out well beyond the short-term to embrace long-term bond yields. Negative yields on German government bonds now stretch out to 30 years. Around the world there are negative yields on $15 trillion of debt issued mainly by governments but also by companies. Lenders are paying rather than being paid on a quite extraordinary scale.

Central banks have undoubtedly played their part in upending the financial order, through negative rates and QE. But deeper forces are at work in turning finance upside-down. It is no accident that Japan led the way two decades ago. The Japanese are also at the vanguard of population ageing. As the post-war generation of baby-boomers has grown older not just in Japan but in other advanced economies, this has created a structural shift towards higher saving and lower investment, which bears down on both inflation and long-term interest rates.

The demographic impulse behind low inflation and interest rates calls into question received wisdom in monetary policy. Inflation targeting came into fashion when inflation was typically higher than the 2 per cent target that rapidly became the new norm. But when inflation is being held at bay by structural forces such as demography (and benign forces such as technology), does it make sense to bend every sinew to try to yank price increases up to 2 per cent?

Not just the recent experience in Europe but the much longer test run in Japan suggests that central bankers, for all their willingness to embrace unconventional remedies such as negative rates and QE, are still stuck in the orthodoxy of inflation targeting. The Bank of Japan was after all the first to introduce quantitative easing, between 2001 and 2006, but core inflation remained stubbornly negative during this period. Critics said it did not go far enough then. The central bank has pulled out all the stops with further QE since 2013, yet in June headline inflation was just 0.7 per cent while core inflation languished at 0.5 per cent. Patently, the policy has failed to deliver.

The strongest rationale for trying to raise inflation to the target has to do with debt. If inflation switches to deflation the real value of debt, which is mainly issued in nominal rather than index-linked terms, rises. At worst, economies can slide into a vicious circle of debt and deflation in which falling prices increase the burden of debt which in turn pushes down demand, exacerbating deflationary pressures. Yet that debt-deflation spiral into great depressions identified by the American economist Irving Fisher in the middle of one—“the big bad actors are debt disturbances and price-level disturbances,” he wrote in 1933—is the exception. “Periods of falling prices have often coincided with sustained output growth,” the Bank for International Settlements has pointed out.

Given the ineffectiveness of monetary policy to meet inflation targets, it is surely time to think again. If debt is the problem then write it down directly. And if slack demand is the problem then accept that monetary policy is now out of ammunition and that only fiscal stimulus can help; or, in the case of America, that the answer lies in ending the damaging trade wars. If central banks really want to show they retain genuine independence, they could do worse than saying they can do no more. Japanification calls for a rethink of the orthodoxy of rigid inflation targeting that treats 1 per cent inflation as poison and 2 per cent as nectar.