Europe seems determined to replicate Japanese slump

Both the US and UK central banks are edging carefully towards an interest rate rise. That’s always big news in financial markets but probably never more so than today. Indeed, there are probably some senior traders and investors in New York and London who have never lived through a rate rise – it is nearly seven years since the Bank of England, for example, last pushed interest rates up (and that was probably a mistake). The London property market is going to be worth observing through a UK rate rise.

The contrast with the European Central Bank couldn't be starker: policymakers in the US and UK now have the happy problem of economies that just might be normalising, leading, ultimately, to more familiar levels of interest rates. In Europe, we are still wondering whether the ECB will ever have to face a similar problem.

Europe seems determined to replicate the Japanese experience of the last 25 years. There, a series of policy errors led to what is often referred to as Japan's lost decade. Things have gone on for so long that it is now a lost quarter of a century. The latest indicator that Europe is in danger of turning Japanese is the news that inflation registered a meagre 0.7 per cent in the euro area in February. It's not yet deflation but it is getting close – and that statistic conceals wide variation between countries. Some are already in deflation. It could be that Europe becomes Japan one country at a time.

Another telling indicator of Japan-style problems is the exchange rate. Notwithstanding residual existential concerns, near-deflation, low growth and high unemployment, the euro has been rising. This is, perhaps, the biggest single clue that points to where things are likely to head. Analysts and commentators were puzzled for years by the strength of the Japanese yen. One of the lessons of Japan is that great structural economic problems can be accompanied and reinforced by seemingly perverse exchange rate rises.

Draghi's rhetoric
ECB president Mario Draghi recently tried to talk the euro down. Unlike some of his other rhetoric, his words didn't seem to have much effect, at least on foreign exchanges. Like his Japanese counterparts he will have to find deeds to match his verbal interventions.

A rising exchange complicates the ECB’s tasks in a number of ways. Most notably, it puts downward pressure on import prices, making deflationary forces worse. A strong euro dents competitiveness and, ultimately exports.

There are a number of ways we can capture all of this. We can look at simple bilateral exchange rates such as the all- important dollar and sterling rates. But, while important, these sorts of comparisons paint only a partial picture. The “trade weighted” exchange rate tries to encapsulate the breadth of the export/ import relationships involving euro-area countries. Importantly, we also need to take into account different inflation rates between countries when considering the ultimate effects of changing exchange rates.

China's trade weight
Looked at in these broad terms, one new feature of the global financial landscape and its effect on Europe leaps out. Twenty years ago, China's trade with the then nascent euro area meant the weight of the renminbi was about 6 per cent or 7 per cent of the euro's effective index. Today that weight is heading towards 20 per cent. By contrast, the importance of the UK, US and Japan – while still significant – has steadily declined.

The rise of China and the growing importance of its exchange rate means the most recent decision by the Chinese government to devalue its currency has extra significance for Europe. Again, I suspect that not enough attention is being paid to this.

Overall, despite a rollercoaster ride, the euro is roughly back to where it was, in real terms, when it came into existence. The problem is, first, is that it should probably be lower than this. Second, for much of the past year it has been steadily rising.

This, as much as any other indicator, tells us that Europe is making serial policy errors. It is going to be a very long time before Draghi is able to think about emulating his counterparts at the Fed or the BoE.