Euro zone may struggle with its own Lost Decade

May 24, 2012

Additional Reporting by Andy Bruce and polling by Rahul Karunakar and Sumanta Dey.

As Europe’s crisis drags on, the prospect of a Japanese-style lost decade of economic malaise is becoming increasingly real, according to a new poll. Half of the bond strategists and economists surveyed by Reuters are now expecting just such an outcome.

Many market participants have dismissed the fall of two-year German bond yields below their Japanese counterparts as being merely a result of a crisis-fueled flight to quality bid. Two-year German yields are now close to zero, offering returns of only 0.02 percent. By contrast, equivalent Japanese bonds are yielding 0.11 percent.

But a significant portion of analysts in a Reuters poll see something more sinister in the rapid narrowing of the premium investors require to hold German debt over Japanese bonds. One half of those polled – 12 out of 24 – said it is likely the euro zone is close to entering a period of prolonged low or no growth and inflation and low interest rates, with the other half saying it was unlikely.

According to Stephen Lewis, chief economist at Monument Securities:

I don’t really see an early end to the financial crisis in the euro zone. I think it’s very unlikely that Germany and the other countries will see eye to eye in the course of this year. That’s going to keep the euro zone economy looking very weak for the next several quarters.

Europe’s economy stagnated in the first quarter of 2012 and is expected to shrink 0.4 percent this year, according to another recent Reuters poll. Data on Thursday certainly pointed in that direction, suggesting even wealthier countries like France and Germany are also starting to feel the pinch.

And things could get much worse. There is increasing speculation Greece may eventually leave the euro with unforeseen consequences for the rest of debt markets and the euro zone as a whole. Indeed, 15 out of 27 analysts polled by Reuters are now forecasting it will exit the currency bloc by the end of next year, a similar proportion to the 35 out of 64 economists polled earlier this month.

To be sure, there are differences between the circumstances that plagued Japan a decade ago and the euro zone now. Japan’s “Lost Decade” was triggered by a bubble in the real estate and equity markets, while the euro zone’s woes have been fueled by fiscal problems resulting from the near-collapse of the banking system after the U.S. subprime mortgage crisis. But some point to the eerie similarities between Japan’s banking sector problems then and the Europe’s today.

Benjamin Reitzes, senior economist at BMO Capital Markets explains:

Failure to recognise losses and then raise capital in a timely manner – that has probably been one of the key issues in Europe. In Japan you had a similar type of situation, banks just didn’t realise the losses they should have.

Over-optimism has also blinded policymakers somewhat, according to some analysts. Colin Asher, senior economist at Mizuho Corporate Bank says:

To date there has been an assumption that growth will return to pre-crisis levels. Consequently the assets on the banks’ balance sheet are seen as less stressed and there is less (of a) requirement to deal with the problem aggressively. That was very much the case in Japan as well, where policymakers also continued to expect a return to normal.

He adds:

Unfortunately what they got was a lost decade.

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