Is the Eurozone becoming the

9th July 2012

Japan has become a by-word for economic stagnation and political intransigence. Yet, with repeated rounds of quantitative easing, support for failing banks, the propping up of weak companies and little labour reform, many developed market policymakers appear to be sleepwalking into the same traps as the Japanese government has done.

Zombie Banks

Keith Wade, chief economist at Schroders, says that while the US and UK governments moved swiftly to recapitalise their banks, Eurozone policymakers were slow to act. He adds: "By contrast the Eurozone banking system has been following in the footsteps of Japan, where delayed action led to the creation of "zombie" banks, which kept rolling over bad debts. There are strong similarities across Europe with the failure to acknowledge non-performing loans in Japan. For all the benefits of the term LTRO's, one of the adverse consequences of the unlimited liquidity being provided by the ECB might be that the banks no longer feel under pressure to sort out their balance sheets."

But although, they may have got it right on banking reform, the US and UK are still getting it wrong on monetary easing, if Richard Koo of Nomura is to be believed. Business Insider links to one of Koo's key presentations and says: "Koo's main viewpoint is that the world today is much like Japan has been since the late 80s: In the throws of a balance sheet recession, a period where the private sector's main objective is debt minimization. This calls for aggressive fiscal policy, as monetary policy doesn't work at these levels. There's no point in lowering rates when people can't or don't want to borrow more."

Crisis-Economics: How'd we get here in the first place?

So what can policymakers do to prevent it falling into similar policy mistakes to Japan? In examining the causes of the crisis, Raghu Rajan Eric J. Gleacher, distinguished service professor of Finance at the University of Chicago Booth School of Business, points to a number of explanations of the crisis: "Progressive economists argue that the weakening of unions in the US, together with tax policies favoring the rich, slowed middle-class income growth, while traditional transfer programs were cut back. With incomes stagnant, households were encouraged to borrow, especially against home equity, to maintain consumption."

In this case the key to recovery would be to tax the rich, increase wealth transfers, and restore worker incomes by enhancing union bargaining power and raising minimum wages. But he says that the situation in Europe – where Germany has fared better than France or Spain – does not support this version of events: "Income inequality emerged, not primarily because of policies favoring the rich, but because the liberalized economy favored those equipped to take advantage of it.

"The short-sighted political response to the anxieties of those falling behind was to ease their access to credit. Faced with little regulatory restraint, banks overdosed on risky loans."

Lessons we need to learn from Japan

He concludes that in order not to lapse into ‘egalitarian and genteel decline' like Japan, the US should focus on helping tailor the education and skills of the people being left behind to the available jobs, while the uncompetitive parts of the Eurozone need significant structural reform. This will not be easy, but ‘determined governments, like those of Brazil and India, have negotiated programs in the past that set them on the path to sustained growth'.

Stephanie Flanders in her blog points out that there are other lessons the West has yet to learn from the experience of Japan, notably that it takes a long time to recover from a major financial crisis, "even if you smugly believe you have learned all the right lessons from watching what happened here (as many in Washington and London did, back in 2008)."

She also suggests that the other lesson is to confront problems sooner, rather than later – whether it's the bad debts in the banking sector or the structural problems in the economy, or a massive government deficit.

As signs emerge that Japan's economy is weakening once again after a brief period of strength policymakers need to remind themselves of what went wrong there and be vigilant that they do not follow the same path.

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