Japan: Lessons from Europe

26.03.14 Publication:

Can countries or regions learn from each other? They certainly should, since international data and experiences are a big potential resource for policy-makers. Currently, between Europe and Japan there are several big and important lessons to be shared, from which both regions could benefit.

What is not clear is whether political leaders are willing to pay attention.

They do use each other’s histories when it is politically convenient to do so. Thus at the Davos World Economic Forum meeting in January, Shinzo Abe used Europe’s tragic history of 1914 as a warning to the world about the danger being posed by China’s assertiveness in the East China Sea. And European policy makers now often talk about Japan’s recent history of deflation and the need to avoid repeating it themselves.

Yet the problem is that the lessons from history and from other countries often involve politically awkward or painful features that governments in democracies prefer to ignore.

The main lesson that European governments should be learning from Japan is that deflation can produce long-term economic weakness, in the form of a persistently low growth rate, if the main drivers of overall demand in the economy – which are household incomes and government borrowing – are both allowed to remain weak.

After 1997, Japan followed a policy of fiscal consolidation in order to try to limit the rise in its public debt, and at the same time introduced reforms to its labour market that encouraged companies to employ part-time and irregular workers rather than full-time, permanent employees.

The result was declining wages, flat or declining overall household consumption and a continued rise in the public debt, even though fiscal policy was mainly contractionary. The other potential driver of demand, business investment, remained always disappointing. Companies accumulated cash and reduced their debts rather than making big new investments.

Europe is risking the same outcome. Led by Germany, all the members of the euro zone are pursuing fiscal consolidation. Reforms in labour markets in the indebted southern European countries are leading to falling incomes. The hope is that business investment will save the day. But there is no obvious reason why businesses should increase their investments.

A reasonable forecast is that the euro-zone countries will now endure several years of deflation and disappointing economic growth, at the end of which someone will promise to rescue Europe by introducing something similar to Abenomics.

Yet there is a problem with this forecast. It is that Abenomics itself looks likely to fail. Why? Because Mr Abe and his government are ignoring a lesson from Europe.

That European lesson is that without structural, liberalizing reforms, there will be no real incentive to create new jobs, rising incomes and fresh business investment. Adjusting fiscal and monetary policy amid an unchanged economic structure cannot transform long-term economic prospects.

The best European examples of this can be found in the contrast between Italy and Sweden. Both of those countries faced a huge financial crisis in the early 1990s. In Italy’s case, that crisis led to a big programme of fiscal consolidation from the mid-1990s onwards, and by replacing its lira currency with the euro in 1999, Italy experienced a big fall in interest rates, which should have provided a big “Abenomics” style expansionary force for the economy. But that expansion never happened. Economic stagnation continued.

In Sweden, by contrast, the government responded by introducing a big programme of liberalizing reforms, assisted by the fact that Sweden joined the European Union in 1995. So it joined the EU’s single market, which reduced barriers to trade and investment in the same way as the Trans-Pacific Partnership talks between America, Japan and other Asian countries are supposed to do during the next decade. Now, Sweden has low public debts and one of the best track records of economic growth over the past decade.

So the European lesson for Japan should by now be obvious. The third arrow of Abenomics, which consists of liberalizing reforms, is politically painful, as it involves confronting and defeating the interest groups that have supported the Liberal Democratic Party for many decades. It is also politically awkward, because such reforms take many years before they produce their full benefits.

So far, in its attitude to farmers, pharmaceutical companies, doctors and other interest groups, and in its approach to the TPP talks, the Abe government has indicated that it would prefer Japan to be like Italy than to be like Sweden. At a moment when the country is about to experience a rise in the consumption tax, a move likely to bring to an end the recent growth in household demand, that is not a very happy prospect. But, by failing to fire his third arrow, it is the choice Mr Abe seems to have made.