Japanisation is shorthand for slouching towards that country's noxious mix of low growth and high debt. Euro zone governments will find it tough to keep the ugly new word out of their lexicon, according to Reuters. Concern is mounting over a deterioration in Europe's long-term growth prospects that, unaddressed, will make it even harder to tackle the banking and debt problems underlying the current life-or-death struggle over the euro. The financial crisis that has been rocking the global economy since 2008 has permanently reduced trend growth across the industrial world. The Organisation for Economic Cooperation and Development in Paris reckons the potential output of its 34 member countries has dropped by about 2.5 percent. "A lot of countries are going to take a permanent hit to their trend rate of growth. This is not a ordinary recession and so we're not going to see countries bouncing back to pre-crisis rates of growth," said Philip Whyte, a senior research fellow at the Centre for European Reform, a London think-tank. As firms have gone bust, capacity has been lost for good. With demand subdued, profitable companies are not replacing old plant. And as high unemployment persists, skills atrophy. This weakens productivity and shuts people out of the job market for longer and longer periods -- a danger stressed by Federal Reserve Chairman Ben Bernanke at the U.S. central bank's Jackson Hole symposium last month. Apart from sapping animal spirits and forcing governments to raise taxes or cut spending, diminished growth closes off one route for lowering the high sovereign debt to gross domestic product ratios that have locked Greece, Ireland and Portugal out of the bond markets and are unnerving investors in Italian and Spanish debt. Against this background, and with the scope for fiscal and monetary stimulus all but exhausted, politicians might be expected to grasp the nettle and push through reforms to improve the supply side of the economy -- policies such as making it easier to hire and fire, promoting greater competition and investing more in training. Far from it. Pier Carlo Padoan, the OECD's chief economist, says he is less optimistic about the prospects for deep-seated change than he was at the start of the year. "I see that measures are being announced. I would like to see them being implemented," Padoan said. With policy ammunition running desperately short, he said it was time for governments to overcome their squeamishness about confronting vested interests opposed to change. "This is a luxury that many countries cannot afford any more. The situation does not allow it." SOUTHERN DISCOMFORT The vicious circle of rising debt and falling growth is made worse by the fact that those countries drowning in debt on the periphery of the euro zone are also the ones that have dragged their feet on freeing up their product and labour markets or modernising their education systems. "They're going through some truly horrible times. I'm very worried about the whole southern European fringe, not just on an 18-month to 2-year view but looking out a decade or longer," said Whyte with the Centre for European Reform. Germany, by contrast, derided a decade ago as the sick man of Europe, is being held up as a model, at least when it comes to jobs. "The remarkable resilience of the German labour market in the last few years, where wage moderation and flexible time accounting shielded the economy from excessive job destruction, illustrates admirably the promise of well-structured reforms," Jean-Claude Trichet, president of the European Central Bank, said approvingly in Jackson Hole. How much are countries missing out by not pressing the reform button? Padoan says Europe's trend growth has fallen in recent years to an average of just 1.5 percent a year, but he says some members of the 17-nation euro zone could almost double that rate with a supply-side jolt. Italy needs to liberalise its service sector, open up professions to new entrants and improve energy efficiency, Padoan said. Greece needs to do all that and overhaul its labour market and competition policy at the same time. POOR ADVERT FOR FREE MARKETS Germany, too, could grow faster still if it liberalised services, which would trigger increased investment. These policy prescriptions are well worn. Leaders of the European Union enshrined them and a host of other reform goals in the 2000 Lisbon Agenda, which they promptly ignored. The pledges have since been repackaged as the Europe 2020 Strategy, but Whyte says the havoc wrought by the near-collapse of the international financial system will make politicians more wary than ever of the social disruption that reforms entail. "The Great Financial Crisis hasn't been a great advert for free-market capitalism," said Whyte. His research outfit publishes a booklet this week exploring how Europe could take off by embracing innovation. But in this area, too, Whyte fears the political climate means policy is likely to be increasingly hijacked by incumbent firms hostile to competition from start-ups. Europe is not doomed to go down Japan's path of economic stagnation. Its potential growth rate is low but stronger than Japan's -- estimated by the Bank of Japan at just 0.5 percent a year because of a fast-shrinking working-age population. But the spectre of a renewed recession is a reminder for governments that, even if they can spirit away the euro zone's currency and debt woes, they have still to find the elixir for growth. "I'm not saying politicians will implement reform, but they should," Padoan said. "Some politicians resist reform because they are captive to interest groups. Well, the price for those governments in terms of sustainable growth will be very high."
