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The Japanisation of Europe
Culturally, the Land of the Rising Sun and the Occident are admittedly very different. The laws of physics apply the same way in both the western and eastern hemispheres. The same can be said about the laws of economics, even though a certain local and cultural effect on the economy is always present. Recently, the question of whether the fate of Japan’s ailing economic growth is now striking Europe has begun to be heard increasingly often. The answer is quite likely “yes”, or, if you look at European developments in the past decade, it is most certainly “yes”.
For nearly the past 40 years, Japan has had the oldest population in the world. According to the UN, 27% of the Japanese population is older than 65, and, on average, there are two working people per pensioner. In Estonia, there are currently three working people per pensioner; by 2040, however, we will be in the same situation currently faced by Japan, that is, with two working people per one pensioner. Still, the future of Japan is even more complicated – it is estimated that by 2050, 40 per cent of the Japanese populace will have reached the age of retirement. Japan is a demographic indicator on the path that Europe is also travelling on. A total of 22% of the population of Germany, which is the largest Member State of the European Union, are over 65 years of age, and by 2050, this percentage is estimated to rise to 31.
The Japanese economic miracle was followed by a rapid decline
In the eighties, Japan was a complete economic miracle, similar to China at the beginning of the 21st century. While the GDP per capita in Japan was about USD 9000 in 1980, then a decade later, this indicator had reached US 23,000. At the time, Japan was the second largest economy in the world, behind the United States, an engine of innovation, and such rapid growth did certainly not go unnoticed in Washington, either. Today, it is the trade war between the United States and China that is generating a lot of heat; back then, it was a rapidly growing Japan that was the main economic adversary of the United States. Tensions were relieved with an agreement signed in 1985, at the Plaza Hotel in New York City, where the five leading countries in the world at the time decided to intervene in the management of exchange rates to mainly ensure the weakening of the US dollar against the yen, but also against the Deutsche Mark. Over the next two years, the dollar lost half of its value against the yen, which clearly increased the export capability of US companies. History looks at us with an ironic gaze when we remember the fact that the Plaza Hotel, where the agreement was born, was sold in 1988 to none other than Donald Trump. Mr Trump compared the purchase of the Plaza Hotel with buying the Mona Lisa.
The Japanese economic miracle came to an end in the last days of the 1980s, when the Japanese stock market index, the Nikkei, hit the intraday high of 38,957 points, on 29 December 1989 – at present, the index has fallen to the 22,000 point level. Yet, at the turn of the decade, analysts were still forecasting the rise of the Nikkei to 45,000. Ironic smirks towards analysts, who are able to predict the continuation of trends but rarely their change, were as relevant then as they are now.
At the same time, Sony from Japan purchased Columbia Pictures in the United States for USD 3.45 billion, and the real estate branch of Mitsubishi acquired Rockefeller Center – the Japanese bull market seemed unstoppable. And yet, a major crisis followed, where the Nikkei index fell 38% in 1990 and has since been unable to surpass those peaks. The rapid economic growth was followed by a generation-long stagnation, constant monetary policy trials and errors, let-downs, new trials and further let-downs.
We have now arrived at a situation where the debt level of the Japanese central government is about 2.5 times the size of the state’s GDP. In the Eurozone, the debt level of governments is, on average, 85 per cent of the gross product of the community, despite the fact that the Maastricht criteria, which is the basis of the eurozone, sets out 60% of GDP as the maximum debt level. The Bank of Japan owns approximately 45 per cent of the government’s debt. In addition, the Bank of Japan holds 80 per cent of the ETFs of the Japanese stock exchange; having cultivated the purchase thereof over the entirety of the past decade. A total of 70 per cent of Japanese government debt is financed domestically. The lesson here is that a society consisting of a larger number of older people is frugal, preferring safe domestic government bonds over other overseas financial assets with a higher rate of return. The 10-year Japanese government bond is currently yielding a negative return – investors are paying a premium to lend money to the central government with currently the highest debt level in the world. All of this is very difficult to explain using economic knowledge obtained in school.
If we were to distribute economic growth solely among the working-age population, the situation in Japan would certainly not be as bad as one could expect. During the period of 1988–2018, the average economic growth of Japan per working-age inhabitant (age 20–64) was the second best among G7 countries, being bested only by the same indicator of “Das Export Machine” Germany, but outperforming the United States and the United Kingdom.
All of these modern day events are caused by the interaction of two unfavourable factors – the ageing population and the expanding debt level. Europe, the United States, and Japan were all caught up in the horrors of World War II, albeit fighting on opposite sides. They all experienced a flurry of optimism after the war ended, and birth rates grew rapidly. Countries exited the war with very different baggage – Europe’s infrastructure had essentially been destroyed, the United States, however, ‘escaped’ direct destruction with only the Pearl Harbour attacks, in addition to the human losses suffered in the liberation of Europe and the Pacific region, of course. Post-war optimism was as unifying as the baby boom that followed the singing revolution in Estonia. For example, 4.54 children were expected to born per woman’s life in Japan in 1947. This indicator fell to 2.07 children per woman, i.e. essentially to the population replacement level, in only a decade. While the children of our singing revolution are presently in the labour market, and decades of work-filled years await them, then the corresponding post-war generation of Japan and the United States has retired, encumbering the state budget with pensions and medical expenses.
Market stimuli in the ‘too little, too late’ style does not work
Japan’s financial experiments have always been an indicator; borne out of necessity, not merely the desire to experiment. Europe has a lot to learn from this. One must always consider that Japan is a sovereign state and therefore the master of its own currency. The Eurozone is a community of countries. For the past twenty years, the Bank of Japan has been forced to keep the interest rate near zero, without being able to lead inflation anywhere near the expected rate of two per cent. They have also started purchasing central government bonds for the first time; however, doing so in a very limited extent. If we were to generalise the experiments carried out in Japan, it could be summarised as ‘too little, too late’. The Bank of Japan has taken a number of correct steps, but they have been too careful and modest in doing so, and they have immediately ceased any stimulation at the sight of any positive market signals. This has turned out to be a mistake. Every new notification about another economic stimulus package feels like news of another Barbra Streisand farewell tour of the past.
The United States demonstrated exemplary skill in slowing down the economic recession following the 2008 financial crisis. The banking sector was quickly capitalised, the automotive industry was also saved. This was all done even in a situation where some bank managers claimed they did not need additional capital. The government made them an offer that they could not refuse. In addition, Ben Bernanke, then Chair of the Federal Reserve System, initiated a massive government bond purchase programme. By the way, Ben Bernanke defended his Doctoral Thesis in 1979, at the Massachusetts Institute of Technology (MIT), specifically on the topic of the Great Depression. To many, the Fed’s unconventional activities at the time felt like sacrilege, which would give life to a thousand-headed dragon named inflation who would no longer be tamed. However, this did not happen in the United States or Europe, and definitely not in Japan. While the United States was effective in its actions, Japan’s actions were ineffective.
Interest policy is always the primary tool of central banks. What should one do in a situation where interest rates are already at zero, or even negative? A zero interest rate is like a communist utopia in a capitalist society – free money for everybody, which means that saving money is punished and lending is facilitated. Interest should act like a yardstick, used to assess the profitability of business projects. Of course, the loan margin is also added to the interbank floating interest rate – no one gets a loan with zero interest from a bank. This policy brings about the sustainability of zombie companies that do not live or die, and reduces the need to be innovative; it also inhibits inflation, and reduces economic growth in the long run. It is also said about Japan that one of the reasons behind its poor economic growth are zombie companies that are only able to survive in a very low-interest environment, hindering economic development.
According to the OECD, the creation of new companies, and the number of bankruptcies on the other hand, as a ratio of the total number of companies, is about three times as low as in other developed countries, meaning that the normal blood circulation of entrepreneurship is not functioning. In Japan, the number of company bankruptcies has decreased for the past seven consecutive years. Zombie entrepreneurship prevents working-age people from moving to companies with higher added value. Will Europe meet the same fate? Based on the example of Europe, it is too early to talk about zombie entrepreneurship yet; emphasis on the word yet, since the European Central Bank’s zero, or rather negative, basic interest rate policy is still in its infancy. In this category, the Italian banking sector stands out; non-performing loans constitute 9 per cent of all issued loans there. What would happen to the proportion of Italian non-performing loans if Euribor were not negative? The total value of all listed companies in Germany today is as large as Microsoft’s and Apple’s market value together across the pond. Culturally, a successful German Mittelstand entrepreneur prefers to be the owner of their incognito family business, instead of a well-known major shareholder in a financially X-rayed listed company. It may be presumed that as the low-interest environment continues, zombie entrepreneurship will also take root in Europe, especially in uncompetitive Southern Europe.
Italy is the problem child of the euro area
If we were to draw conclusions based on the different examples from the United States and Japan, we could say that excessively modest behaviour by central banks is not the solution. If the wish is for a change in monetary policy to have an immediate effect on the course of a crisis, one must fire the entire salvo of financial artillery at the same time. Since the European Central Bank may currently own up to a third of bonds issued by Member States, it can certainly be said that this limit is starting to become outdated. All eyes are now on Italy – the country which is said to be too important a member of the Eurozone to ignore their problems, and, at the same time, too big to save. The primary domestic financial indicator of Italy which, due to extensive media coverage, is familiar even to every Italian housewife, is la spread, i.e. the difference between interest rates of the 10-year government bonds of Germany and Italy. This provides a real-time evaluation of financial markets which shows how much poorer the Italian economy is considered to be compared to the German economy. If Brussels were to punish Italy with a financial penalty in response to a budget deficit that is too high, they would likely be shooting themselves in the foot – the populists in power would domestically gain more verbal ammunition to rail at Brussels and paint Brussels to be the root cause of all their troubles. Based on past experience, it only seems reasonable for the European Central Bank to raise the bond purchasing limit from 33 per cent to, for example, 50 per cent. The purchasing of bonds would only be continued if the Member State were to implement difficult structural reforms. These would primarily involve significant relaxation of rigid employment relationships almost everywhere in Europe, and simplifying the business environment by reducing the regulatory burden. Perhaps Europe would offer the Member State temporary monetary relief and turn a blind eye to the budget deficit, if the Member State were to implement reforms improving long-time competitiveness – this way, the carrot and the stick would be in one package. This is not a cure for the worsening demographic situation, but it will help to restore economic competitiveness in the world arena. At least temporarily.
It is precisely with this ‘whole salvo’ mandate that Shinzo Abe became Prime Minister of Japan in December 2012, and he is still in office today. Prime Minister Abe’s solution to ailing economic growth was based on three arrows, as he himself referred to them – massive monetary easing, structural reforms and fiscal stimulus by the state. The average return on equity of businesses before Abenomics was initiated was four per cent; at present, it has reached ten per cent, which is still lower than the corresponding indicator for European and US companies. It is clearly too early to draw final conclusions regarding Abenomics; however, the growth of nominal GDP, the weakening of the yen – which the Obama administration endured much better than the Trump administration – and the continuous decrease of unemployment, are clear facts. It is likely that Europe has, yet again, something to learn from Japan – ‘too little, too late’ is not a great solution.
Viljar Arakas
CEO of EfTEN Capital
September, 2019