After a year in which we saw a combination of trade and tariff uncertainty and a general slowdown in global manufacturing, it is perhaps little surprise that Germany narrowly avoided a technical recession. Germany is widely recognised both as a manufacturing and industrial powerhouse, and also as the driving force behind the eurozone economy. Weakness in Germany contributed to a general dip in confidence across Europe and a slew of soft manufacturing data for much of the year. In parallel, it also revived comparisons between the eurozone and Japan, raising the question of whether the eurozone is inevitably on track to repeat the “lost decades” that Japan suffered in the 1990s and 2000s. 
There are some clear commonalities between the two regions: both have ageing populations, both have experienced a period of deleveraging, have an inefficient banking sector, and exceptionally low policy rates. However, there are also important differences: demographics on aggregate are less extreme, deleveraging occurred in the eurozone government, not in the private sector, and both banking sector derating and the move to quantitative easing happened far quicker in Europe than in Japan.
On balance, while we see ongoing disinflationary forces at play in Europe and recognise the need for further restructuring of the banking system, we do not believe that the eurozone is on a monotonic path to Japanification. Exploring the case for and against, we can better understand how Europe can avoid following that path.
Those who worry that Europe could repeat Japan’s lost decades of deflation and secular asset market declines focus first on demographics. Any suggestion that a shrinking labour force might drive up wage inflation was largely disproven in Japan. Instead, lower potential growth resulting from a shrinking workforce, together with the deflationary forces of private sector deleveraging and lower spending patterns by older cohorts, weighed on nominal growth.
In some countries – Italy and Germany notably – demographic trends are concerning, but on aggregate the demographic drag is less severe than in Japan. According to Eurostat, the age dependency ratio across the eurozone will rise from just over 30 per cent today to just under 50 per cent in the next 20 years. But there is a wide spread across countries, with Ireland’s ratio projected at around 35 per cent while Italy’s approaches 60 per cent; by contrast, Japan’s dependency ratio is expected to top 80 per cent by the end of the 2030s. The propensity of European citizens to save via fixed income markets may lead to some tolerance of disinflation. Increasingly, though, eurozone policymakers recognise the importance of preventing consumers’ expectations of lower prices from becoming entrenched.
In the 1990s Japan faced the aftermath of an asset and property market bubble. The corollary of this bubble bursting was a prolonged period of private sector deleveraging that weighed on aggregate demand and price inflation. Certainly, parts of the eurozone enjoyed a debt-fuelled boom in the early 2000s, following the convergence of rates towards lower, German levels in the 1990s. But Europe’s asset boom was far less extreme, and much less pervasive than that in Japan. The eurozone sovereign debt crisis of 2010-2012 followed pockets of sharp deleveraging and reductions in government expenditure; swift and decisive action from policymakers avoided an existential threat to the euro itself.
The banking sector is central to the economies of both the eurozone and Japan. Prolonged deleveraging, writing down non-performing loans, and rebuilding capital buffers acted as a drag on the monetary plumbing in both economic blocs. As a result, both eurozone and Japanese banks now trade at around 0.5x price-to-book, but while the derating took almost 20 years in Japan, it unfolded much more quickly for eurozone banks. Visibility on eurozone bank balance sheets is much higher as a result of the stress tests, and the rebuilding of capital, which is now essentially complete, was largely funded by private sector sources.
Central banks in both the eurozone and Japan have adopted ongoing policies of negative rates and quantitative easing. In the absence of tiering (only recently implemented in Europe) negative rates are a major headwind to bank earnings. Nevertheless, the policy response to the eurozone crisis – while rather slow by US standards – was much quicker than the policy response in Japan in the 1990s. It can be argued that Europe’s negative rates environment is creating a liquidity trap and introducing a ‘paradox of thrift’ – the idea that individuals save more during recessions – to the economy. But even then, the speed of policy easing relative to Japan in the 1990s is noteworthy. In addition, credit is expanding in the eurozone, providing a welcome stream of lending income, whereas in Japan credit growth was negative for long periods in the 1990s and 2000s.
In sum, while we acknowledge passing similarities between the economies of the eurozone and Japan, Europe is not necessarily condemned to relive Japan’s lost decades. Certainly there are risks, but we believe that it would require a series of meaningful policy errors to consign the eurozone to this fate. We are encouraged further by the debate that the new European Central Bank president, Christine Lagarde, has initiated over more expansionary fiscal policy in the eurozone. Given ultra-low rates, the eurozone has the fiscal space which – if appropriately deployed – could further distance Europe from Japan.
There is also another, less frequently discussed example of a low inflation, low rate, highly advanced economy to which Europe might also be compared: Switzerland. The Swiss economy, while considerably smaller than that of the eurozone, has adapted well to the challenges of low inflation and a strong currency. As a result, Swiss equities have outperformed Japanese equities by around 60 per cent in euro terms since the global financial crisis. Perhaps those nervous about how the eurozone plots its future course through low inflation and population ageing might start by looking close to home for a more optimistic comparison.
John Bilton is head of global multi-asset strategy and Stephen Macklow-Smith is an International equity group market strategist at JP Morgan Asset Management. The views expressed above are their own and should not be taken as investment advice.