By Allan Conway
For 25 years Japan has seen low growth, low or negative inflation and low bond yields. We find that China and Europe seem most likely to suffer from this “Japanese disease”. The US appears to have enough differences compared to Japan to suggest that deflation is not going to become the default state.
Japan enjoyed massive investment after World War 2 as the economy re-industrialised, but investment and spending became over extended. An investment boom led to a debt boom as companies over estimated their rates of growth and over invested, which were mostly financed by debt. An asset bubble burst in 1990 weighing on the economy and growth slowed to near zero by the end of 1992. As the 1990s progressed, Japan became a zero percent economy with inflation and real interest rates joining growth at around or below zero, where levels have since approximately stayed.
So, why are its effects still being felt? The answer is probably a combination of effects, which are:
- Poor policy response. The authorities responded with expansionary monetary and fiscal policy but it was slow to be implemented and was ineffective.
- The response to increasing non-performing loans was also slow and the ‘’extend and pretend’’ strategy of rolling bad debts resulted in zombie companies reliant on bank forbearance.
- Political conservatism weighed on structural reform and little was done to boost productivity and economic growth.
- The situation was exacerbated by ageing demographics which entrenched spending and investment behaviours.
Is the world falling into a Japanese malaise?
When comparing some Japanese features during its crisis to Eurozone, US and China, it is China and Europe that seem most likely to suffer Japan sickness. The US appears to have enough differences to suggest that deflation is not going to become the default state. In Europe, the combination of tight fiscal policy and a central bank that may be reaching the limit of its ability to loosen is putting pressure on the European economy. The fact that Europe has negative real rates without deflation highlights the risks. Also, part of Japan’s problem was shocks to the system becoming entrenched in behaviour. All of the three big economies are potentially big enough to provide that shock to the other two.
More generally, it seems that deflation is not inevitable. But it is more likely if you don’t allow capital to recirculate. When policy does not allow for bad debts to be recognised and banks restructured, more pressure is put on monetary and fiscal policy in the longer term. Add in demographic pressures and banking problems become a trap you don’t escape from.
What needs to happen?
If deflation is a threat, not yet a promise, what needs to happen to avoid it?
China: China is in a different phase of development from other economies. In some ways, China looks like Japan in the 1970s – coming off its investment boom, but a long way from a bubble and crisis. In other ways it looks as though it is succumbing to Japanese disease in terms of its declining growth and inflation. China has overcapacity in some industries which is driving deflationary pressure. It needs to address this overcapacity. Given the deflationary pressure it probably also needs looser monetary policy. That is difficult to do without also leading to a weaker currency, which is politically difficult.
Eurozone: Germany has a solid fiscal position and is underinvested in public infrastructure. Fiscal constraints are hampering Italian efforts to clean up and recapitalise their banks. If fiscal policy is crimping demand and stopping structural reform then it is too tight. The question for Europe is whether the politics and institutional framework of the eurozone can allow for a reversal and accept an expansionary fiscal policy.
US: US needs less structural reform than other countries, as the labour market is flexible and banks are functional. Should the threat grow, government can consider using fiscal measures such as debt forgiveness (e.g. student loans).
The overarching conclusion is that there are certainly things that can be done to alleviate deflationary pressure. But many of them would be considered quite radical and necessitate some considerable political movement in both China and Germany.
Allan Conway is the Head of Emerging Market Equities at Schroders
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