The Eurozone may be headed for stagnation: Fidelity.

When pessimists want to express the utmost gloom ahead for the eurozone they often cite Japan’s lost decades as their most-feared outcome for the 18-member area.

The worriers invoke a familiar tale when they talk of Japan’s endless stagnation since an asset-bubble popped from 1989. From the early 1990s, real estate values and stock prices plunged and banks wobbled under bad debts. Even though Japan’s export success persisted, the country’s economy failed to flourish despite massive fiscal stimulus, interest rates being slashed to almost zero and the invention of quantitative easing. A potent symbol of Japan’s malaise is that deflation became entrenched from 1995 to 2013 (with the exception of 1997).[1]

Europe’s economic performance is so lacklustre that the financial crisis that European Central Bank President Mario Draghi doused in mid-2012 with his “whatever it takes” pledge has become an economic and political crisis. The eurozone recorded no growth in the second quarter, when the Germany and Italian economies shrank 0.2%. Deflation is shadowing the region. Eurozone prices only rose 0.3% in the year to September, deflation having already taken hold in eight countries including Spain, Italy and Portugal. Deflation would prove Ebola-like for the eurozone because net government debt now amounts to 87% of output. All but two euro-users have net government debt ratios above the prescribed rate of 60% of output, while the number where net public debt exceeds GDP is six, now that Belgium (102%) has reached the triple figures that make default a possibility for a slow-growth economy. Unemployment for the eurozone is 11.5%, and soars as high as 27% in Greece and 24% in Spain. Eurozone banks reek with bad debts and are reluctant lenders. Needless to say, the economic calamity is poisoning politics. So is Europe heading for Japan’s popularly ascribed fate? You bet. But there are two twists when comparing the eurozone’s fate to the story of Japan’s lost decades. One of them may surprise investors. The other could calm their concerns.

There is always hope that eurozone policymakers will do more to resurrect their economy and puncture the pessimism. The split in France’s ruling Socialist Party over imposing austerity could spark a welcome backlash among euro users against the self-defeating fiscal straightjacket enforced by Berlin, whose resistance may weaken as Germany’s economy stagnates. The ECB, watching the collapse of inflation expectations, is sending signals that it will launch a quantitative-easing, or full-blown asset-buying, program before too long. Perhaps authorities will heed the calls from respected economists that, to boost growth, central-bank-financed fiscal stimulus is justified (real money printing via fiscal policy and a surefire way to generate inflation). The more the economic crisis intensifies, the greater the pressure on politicians to compromise over the political, banking, fiscal and other integration the eurozone needs to surmount its debt crisis and secure the euro’s future. The problem for the eurozone is that politically viable remedies, such as relaxing fiscal targets and quantitative easing, are only half-hearted solutions while true cures appear politically impossible. Thus the lost years since 2008 will turn into a lost decade soon enough.

The despair

Almost incredibly given the woes of the eurozone economy, many media reports and commentators refer to a eurozone recovery because they use the flawed system of judging the business cycle by looking at growth from one quarter to the next. (The flipside of this misleading oversimplification is to define a recession as two consecutive quarters of negative growth.)

The best way to adjudicate economic performance is to look at how an array of indicators such as output, employment, income growth, industrial production and retail sales perform over time. This is the flexible method by which the National Bureau of Economic Research declares recessions and expansions in the US to no dispute, often well after the troughs and peaks in activity have occurred. The same method is applied to the eurozone by the UK-based Euro Area Business Cycle Dating Committee. This body, rightly, won’t declare the eurozone out of recession even though its economy has expanded during four of the past five quarters. In a sense, what the body is saying it that it’s too early to say that activity has troughed.

While such informed judgements of business cycles are the most credible way to call recessions and expansions, they don’t readily allow for comparisons across regions or time. The best way to do that, for all its flaws is firstly to look at how long an economy takes to regain its previous peak in output in gross and per-capita terms and, secondly, to calculate the maximum drop in output over a recession. On this basis, for instance, the US regained its 2007 output peak in 2011 in gross terms and two years later on a per-capita basis. The worst of the downturn was in 2009 when GDP was 0.7% below 2007’s level. The US economy is thus rightly described as being in recovery, for output in 2013 was 5.9% above the level of 2007. (The National Bureau of Economic Research will call the end of a recession before GDP has fully recovered its previous peak when comparing quarterly output. It dates the most recent recession as ending in the June quarter of 2009 when GDP was 1.3% below that of the fourth quarter of 2007. It made this decision 15 months after the trough in activity occurred.)[2]

The eurozone’s GDP peaked in 2008 at 13.6 trillion euros (A$19.3 trillion) and it is yet to regain such heights for 2013’s output was 1.8% below the pinnacle of 2008. The worst of the slump occurred in 2009 when the eurozone’s GDP was 4.4% below the height reached the previous year. The IMF, which does not provide GDP-per-capita figures for the eurozone, predicts that the eurozone’s GDP will only regain its 2008 apex in 2015.[3]

Among the three biggest and most populous eurozone economies, Germany regained its 2008 peak in 2011 and by 2013 its economy was 2.3% above the highs of five years earlier. France reclaimed its 2007 high point in 2011 but by 2013 its economy was only 0.1% above its level of six years earlier. Alas, Italy’s GDP in 2013 was 9% below the record it set in 2007. On a per-capita basis, only Germany is ahead, having clawed back to 2008 levels by 2011. By 2013, Germany was 4.9% ahead on this, the best, measure of prosperity. Last year, France’s GDP per capita was 2.3% below its record of 2007 while Italy’s was 11% under on this basis.[4]

How does this compare with Japan? This may well be the surprise. Japan’s economy expanded in 16 of the 18 years from 1990 to 2007 – it contracted 2% in 1998 and shrank another 0.2% the following year – so there was never post-crisis drop in output. In the decade after the asset bubble peaked in 1989, Japan’s economy swelled 15.5% in gross terms. On a per-capita basis, Japan’s expansion was 12% over these 10 years, while the jobless rate only ever got as high 4.7% over that time, in 1999.[5]

Admittedly other economies outshone Japan over this period – Australia recorded 24% per-capita growth from 1989 to 1999, the US 22% and Germany 17%. But the figures for Japan show that talk of a lost decade in the 1990s is an exaggeration to say the least.

The same goes for the following 10 years. After the slight dip in 1999, Japan’s economy grew every year from 2000 to 2007, even though, it’s worth pointing out, the country was in mild deflation from 1999 to 2005 – the annual decline in consumer prices averaged 0.5%.[6] (The GDP deflator would show deflation stretched from 1998 to 2013 but it’s real economic growth that counts.) All up, from 1989 to 2008, Japan’s GDP jumped by 29%. The country’s output swelled 24% over these two decades on a per-capita basis. The highest the jobless rate ever climbed over these two decades was to 5.4%, in 2002.

Nobel-Prize-winning Paul Krugman is among those who call talk of Japan’s two lost decades a “myth”. He found that using GDP per working-age population – an adjustment that takes account of Japan’s shrinking and aging population – Japan recorded “not bad” growth of 1.2% a year from 1990 to 2007.[7]

If anything, Japan’s worst economic patch since 1989 has been the past six years because its economy contracted in 2008, 2009 and 2011. But since 2007, Japan has still performed better than the eurozone for by 2013 Japan’s GDP had regained its 2007 peak.

The consolation

Europe’s economy is thus already worse than Japan’s in just about every way, even if Tokyo’s net government debt stands at 144% of GDP.[8] So too is its political and social situation. Japan has its own currency and monetary policy (including its own central bank) and can make its own decisions on fiscal policy rather than operate within constraints set by Brussels. Asia’s second biggest economy is still a strong exporter. Government debt in the country is largely owned by locals, which helps insulate the country against foreign speculators. Japan has beaten deflation, for now at least, as consumer inflation excluding food reached 3.1% in the 12 months to August. Japan is a homogenous country, even if an aging one. It is politically stable and its low unemployment has never allowed extremists to flourish.

Sadly, the best comparison for the eurozone’s stagnation is the 1930s. As Nobel-Prize-winning economist Joseph Stiglitz says: “The only way to describe what is going on in in some European countries is depression.”[9] Even more startling perhaps, in terms of time taken to regain the previous peak, the eurozone is on track to surpass the worst-performing group of countries of that era; those that stayed on the gold standard, the closest thing to a fixed-currency regime as damaging as the euro. (The euro is worse because it’s proving impossible to quit.) The eurozone has already overtaken the time taken for the gold quitters of that era to recover.

Work by UK economic professor Nicholas Crafts shows that the group of European countries that stayed on the gold standard – Belgium, France, Italy, the Netherlands and Switzerland – while admittedly suffering a steeper contraction of 10%, took 7½ years to recover their previous group peak. In comparison, the so-called sterling bloc, namely Denmark, Norway, Sweden and the UK that quit the gold standard, only took 4 ½ years to recover. The eurozone’s downturn is five years old as of 2013.

But that doesn’t mean that stock investors should despair (though Europe’s unemployed can be forgiven for being despondent). There is something to the Japan story to calm investors. This comfort is how well the global economy and global share markets coped with the troubles of the world’s then-second-largest economy and the collapse of its stock market.

At the end of 1989, Japanese stocks accounted for 41% of the MSCI World Index.[10] After the Nikkei 225 Stock Average fell 80% from its peak on 29 December 1989 to its post-bubble low on 31 March 2003, Japan’s weighting in the MSCI World fell as low as 7.8% in May of that year.[11] How did global stocks fare over that time? They rose. The US S&P 500 Index surged 140% over those 14 ½ years, helping the MSCI World Index in US dollar to climb 32% over the period.

However you assess Japan’s economic performance over the decades after its bubble popped, these returns show that the global economy and a portfolio of global stocks can survive the stagnation of a big economy if the US economy is doing well enough, other parts of the world are expanding and no shocks emerge. As long as the woes of Europe don’t lead to jolts and no other shudders emerge, a US recovery and decent performance elsewhere – including in Japan! – should be enough to propel global stocks in coming years. By then, the most pessimistic outcome you could paint for a modern developed economy would be that it’s facing lost decades like the eurozone.

by Michael Collins, Investment Commentator at Fidelity

All GDP figures are real. As footnoted, GDP and GDP-per-capita figures come for the IMF World Economic Outlook Database. April 2014. http://www.imf.org/external/pubs/ft/weo/2014/01/weodata/index.aspx.

Figures on eurozone consumer inflation, unemployment and government debt come from Eurostat (http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home). Other financial information comes from Bloomberg unless stated otherwise.

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