Yesterday’s Japan is Today’s Europe

Chen Zao, who has been an influential economic and financial advisor of policy makers for years, paints an almost hopeless picture of Europe and its economic perspectives.
The former senior advisor of the Chinese government and university professor currently works as Chief Strategist at BCA Research, a think tank involved in practical application of financial sciences and research.

Mr. Zao says in his interview to that the European Central Bank is basically anti-business. He also criticizes the decision makers of ECB for not facilitating the rise of asset prices in the deflationary period as this would be the only stimulus for demand and economic growth. According to him, Europe is heading toward deflation, while Japan is moving out of it. The United States has “won the battle”, has overcome the crisis because both the Japanese and American central bank understood the sign of the times. We talked to Chen Zao at the yearly portfolio management conference of the Uhlenbruch Verlag in Frankfurt.

Zentai Péter: As a financial researcher, you give investment advice to portfolio managers. At this conference, you recommended that professionals managing millions of dollars invest in yen instead of euro. I would not bet on the strengthening of the yen…

Chen Zao: There are a couple of reasons why people should long the yen and short the euro. Firstly, the market has already very shorted the yen; a huge amount of money has been driven away from the Japanese currency worldwide.
Secondly, by looking at the PPP (Purchasing Power Parity), the yen is about 40 percent undervalued against the euro. I do not think that is not going to change any time soon.
Thirdly, from an aspect of economic performance, Japan is moving out of price deflation, whereas the Eurozone is entering a deflationary era. As a result, the Bank of Japan will probably put an end to quantitative easing, while the ECB (European Central Bank), on the contrary, will have to purposely drive down the euro to avert deflation.

Are you sure that Europe is sliding into deflation?

You only have to look at what is happening on the peripherals of the Eurozone, especially, in the Southern European countries. Due to the high exchange rate of the euro, these countries have to deflate their economies. By the level of their productivity, by their pricing behavior, and by their competitiveness, the euro remains too expensive for the French, the Spanish, the Italian, or the Portuguese economy – but not for the German economy.

From your words I may conclude that all problems would be solved in Europe, if the euro was devalued? This would be the cure for stagnation?

The overvaluation of the euro is indeed a major problem of the Eurozone. Another one is that they save way too much and invest way too little. There is a huge amount of excessive savings reflected as a large current account surplus. This and the price decline are characteristics of deflation – and both of them can be found in Europe. Last but not least, the poor demographics also strengthen or deepen deflation. The population decline around Europe may preserve it for a long time.

If you are right, Europe’s situation is hopeless. But I cannot believe this…

Why would it be hopeless? Just look at Japan’s experience! They have launched QE (quantitative easing) and devaluated their currency.

Almost everybody is doing the same: the United States, Great Britain – starting earlier –, Japan, and a whole host of other central banks and governments inspired by them have driven down their currencies. If everyone takes similar actions, everyone depreciates, what will change?

The problem is that not everybody does this. Basically, they are accommodating. A major concern of the world’s leading economies is that they have a production capacity larger than needed. They have to eliminate this oversupply problem.
As the examples of the United States and Japan show, this is entirely possible. The quantitative easing launched by the FED did not necessarily drive down the American dollar but prevented deflation. And now, Japan is getting out of deflation the same way.

Due to the central banks’ actions, stocks are getting more and more expensive. What do you think of these pricings?

If the economy gets into a liquidity trap – meaning that demand falls and interest rates go to zero –, the central bank loses its typical transmission mechanism by which it stimulates the economy – that is interest rate adjustment. In a monetary policy, there are only two additional channels that can have an impact on the real economy: the exchange rate and the wealth effect. Wealth effect is basically driving up the asset prices (stocks, other securities, real estate, gold etc.) in order to increase the spending power of the people.

Again, the United States and Japan have shown the way and have done it rather successfully: by making assets more expensive, consumption increases, and the economies start to grow.

What works in America does not necessarily work in Europe. Although stock prices go up, there are hardly any investments. Companies and individuals are afraid of taking out cheap loans and invest it in the real economy.

This is because the European Central Bank is completely anti-business – unlike the United States or Japan. The American and Japanese central banks created an environment that allowed the economy to grow. The FED drove down the dollar at the right time and in the meantime, manufacturing picked up. Japan did the same thing.
However, Europe was staying out of this. If ECB is really trying to help the free market operate, why doesn’t it weaken the euro? Why does it let the Spanish, Portuguese, Italian, and Greek economies suffer? Why does it allow the nominal GDP to fall by 30 percent and youth unemployment rates rise up to 30 to 40 percent?
No other central bank around the world would allow that happen to its own economy.