Is Europe Facing A Lost Decade?

The euro zone economy could go through a lengthy period of painful adjustment similar to Japan’s post-bubble experience.

E quities account for 55% of capital resources in both the U.S. and Europe, but European banks are much more important to the economy, accounting for about 40% of financial resources allocation (versus about 20% for U.S. banks). The key difference is that the U.S. has a deep, liquid and vibrant corporate bond market, which has also allowed companies to bypass the banking system to obtain financing at times of severe banking crises and credit crunches. This is a key reason why the U.S. economy has sprung back much more quickly from the 2008 Great Recession than either Europe or Japan, where economic activity is held hostage by banking retrenchment.

Going forward, the credit crunch in Europe will get worse before it gets better.

European banks are not as well capitalized, but much more leveraged than their U.S. counterparts, and the credit crunch in the euro area has barely begun. To bring capital ratios up to a level equivalent to the U.S. average, the largest European banks will have to either raise €900 billion in new capital or cut back their asset base by €9 trillion. In Japan, credit contraction lasted well over nine years in the aftermath of the asset bubble bust. During that time, deflation prevailed and economic growth averaged a measly 0.5% annual pace.

According to our Global Investment Strategy service, euro zone growth could be even worse than Japan’s during its deleveraging period. Unlike in Japan, the European credit crunch will be compounded by severe public austerity, creating a potential downward spiral in output.

Bottom line: The risk that Europe goes though its own version of a lost decade is not trivial.