Europe Needs Its Own Koizumi

Angel Ubide

Only a few years ago leaders of the European Union bubbled with confidence about their economic future, and Japan looked like a lost cause. Now, as Japan’s recovery gains momentum, some forecasters expect its economy to grow faster than 3 percent, or faster than Europe and the United States, in 2006. It’s time for Europe to ask what it can learn from Japan. The answer: a lot.

The first lesson is that timing is everything. Japan got reform right by cleaning up its debt-burdened and politically connected banks first. A more independent and vibrant financial sector forced corporations to streamline, and to press reforms on workers, including an end to promises of lifetime employment. Yet there was no popular revolt, because the emerging recovery was bringing Japan back, making reform respectable. In Europe, where leaders first pushed labor and welfare reform, the result has been no improvement in growth, and massive street protests against declining benefits and job security.

The second lesson: it’s the politics, stupid. Prime Minister Junichiro Koizumi has transformed his ruling Liberal Democratic Party from a coalition of powerful factions defending conservative rural interests into a modern party bent on reform. Europe, meanwhile, remains caught in a political trap, as powerful interest groups defend an inefficient system: farmers fight for massive agricultural subsidies; older workers for generous pensions.

The seeds of Japan’s recovery lie in Koizumi’s decisive moves to cut the government-backed ties between banks and their corporate clients. This made it clear to companies that they had to reform or die. Thousands of zombie companies closed down. Excess capacity was eliminated. The result is an increasingly broad-based recovery, with wages rising alongside employment, and the strongest labor income growth since the late 1990s. The improving labor market is anchored by rising corporate profits, with margins at historic highs. Stronger income growth is mirrored in a U-turn for asset prices. Stock prices have doubled from the lows of early 2003. Land prices are rising in large cities. The consumer price index is starting to edge higher, signaling the imminent demise of deflation.

Koizumi capped this revolution by fighting the September 2005 general election on his promise to privatize Japan’s post office—which is also the world’s largest bank, with $3 trillion in Japanese savings. By winning big on this issue, Koizumi proved that economic reform could be popular. Meanwhile, European leaders, by talking grandiosely but failing to deliver, have generated “reform inflation,” devaluing the whole concept of reform. In Japan, reform is good; in Europe, it’s stigmatized.

Ironically, the European approach to reform was designed to work as Japan’s has. The European bureaucracy was supposed to defend reform against national politicians’ catering to special interests. The process of creating a single market was designed to slowly but surely eliminate inefficiencies, and opposition. The European Central Bank and the adoption of the Growth and Stability Pact—a cap on national budget deficits at 3 percent of GDP—were supposed to ensure that nations got the macropolicy right. They have not. Today, the squabbling over the E.U. budget, which focuses on which interests will win and which will lose, shows how deeply Europe remains stuck in old-fashioned politics.

Perhaps the key for Europe now is to change the timing of reform. European nations have tried numerous labor-market and social-security reforms, some liberalization of trade in goods and services, and little financial-market integration. The sequence should have been precisely the opposite. Stronger financial markets could drive national reforms, force liberalization in goods and services markets, and make labor-market reforms unavoidable.

Specifically, European leaders need to move faster on the EU action plan to open up financial markets, and they need to eliminate lingering inefficiencies at the national level. They should allow cross-border mergers of banks in France, Germany and Spain, which would integrate the Continental market, lower prices and increase market pressure on the corporate sector to become more efficient. They should create a Europe-wide market in which fixed-rate mortgages can be refinanced easily and cheaply, allowing consumers to tap their home equity for consumption. An integrated financial market would make monetary policy more effective, by speeding up the impact of interest-rate changes, and lift Europe’s growth rate. As Japan has shown, recovery can make tough reform popular. What Europe lacks most is a Koizumi to make it happen.

Angel Ubide is a fellow at the Center for European Policy Studies in Brussels. This article was published first in the april 3 issue of Newsweek.