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LONDON (Reuters) - Monetary policy that cannot get traction; weak banks that cannot or will not lend; an economy trapped in a twilight world of low growth, haunted by the specter of deflation.
If this combination sounds familiar, that's because it is.
The euro zone, still drowning in debt bequeathed by the great financial crisis, increasingly resembles Japan in the 1990s as it struggled with its own balance sheet recession brought on by the bursting of an almighty asset bubble.
Japan was long viewed with pity for its failure to shake off its torpor. Its central bank was criticized for policy timidity.
Now, though, the tables are turned. While new Bank of Japan Governor Haruhiko Kuroda has embarked on quantitative easing on an unprecedented scale, the European Central Bank is shrinking its balance sheet and contenting itself with ‘forward guidance' to talk interest rates down.
In light of the euro zone's wide output gap, reflected in record high unemployment, and the mountain of debt that governments and the private sector still need to pay down, some economists say inflation risks falling uncomfortably short of the ECB's target of just below 2 percent.
In a new report, JP Morgan said it expects core inflation, excluding taxes, to drop below 1 percent, from 1.1 percent in the 12 months to May, and remain below that level at least until the end of 2015.
The downward pressure on prices is especially great in struggling countries on the euro zone periphery.
With the option of exchange rate depreciation closed off, their only way to regain competitiveness is to hold down wages and other costs. Greece, for example, is mired in deflation for the first time in 45 years, adding to the real burden of its debt. Others might join it, JP Morgan reckons.
ECB policymakers acknowledge that the threat to price stability lies to the downside and say they are ready to relax policy further if necessary. For some economists, additional easing is a question of when, not if.
"We're not there yet, and QE is not our base case. But the lesson from the Japan of the 1990s is that the longer Europe waits to clean up bank balance sheets, the larger deflation looms," said Joachim Fels with Morgan Stanley in London.
Warnings about the dangers of delay are coming thick and fast, especially as the failure of Europe's banks to transmit low ECB interest rates to companies and households in southern Europe is splintering the 17-country bloc.
"To reverse these dynamics, bank losses need to be fully recognized, frail but viable banks recapitalized, and non-viable banks closed or restructured," the International Monetary Fund said on Monday.
Japan took the best part of a decade to deal with ‘zombie' banks hit by crashing property prices, while euro zone arrangements to share the cost of future bank failures might not come into effect until 2019.
ECB policymaker Joerg Asmussen says that is too late.
What's more, the proposed agency to shut bust banks will not have an immediate backstop fund to do its job while it builds up a war chest funded by an industry levy.
Demographics are another disturbing parallel.
Japan's working-age population peaked as a percentage of its total population in 1990, marking the end of a golden era of growth. Japan now has more people over 60 - 32 percent of its population - than any other country, according to the UN.
Yet Japan is not alone. Many countries in the European Union will also need to cope with rapidly ageing populations, including Portugal, Ireland and Latvia.
Andrew Milligan, an economist with Standard Life in Edinburgh, is particularly concerned about Italy.
Not only does Italy rank joint second with Germany in the over-60s league, but its weak economic and political institutions will make it harder to push through the structural reforms needed to reverse very low trend productivity growth.
Unless those barriers to change are removed, a lost decade or longer could be in store.
"While overall the West does not suffer from the scale of the difficulties that have plagued Japan, certain European countries, such as Italy, are much more vulnerable to going down the Japanese path than others," Milligan said.
The tricky balancing act for the ECB is to let bond markets apply sufficient pressure on governments to reform while providing enough monetary support to aggregate demand. Hence ECB President Mario Draghi's reassurance that interest rates will stay at current or lower levels for an extended period.
"On the one hand it is helpful that the ECB is adopting some form of forward guidance. It helps offset the view that the rest of the world will follow the path of U.S. policy and clearly has fed into a somewhat lower euro. However, major questions still remain about the ability of the ECB to support individual economies in difficulty," Milligan added.
Of course, there are limits to what any central bank can do. Easier monetary policy can, with time and persistence, raise nominal GDP and so lighten the burden of servicing debt. But central banks cannot make people live longer or work smarter.
The task of wringing more growth and productivity from a shrinking population rests squarely with the government.
In the case of Japan, for all the impetus delivered so far through a fiscal boost and Kuroda's bold monetary policy, that means Prime Minister Shinzo Abe's aim needs to be true when he fires his ‘third arrow' of structural reform after Upper House elections on July 21.
"If PM Abe decides after all to adopt ambitious growth-enhancing measures and ‘Abenomics' proves successful, the most important implication for Europe will be that reviving the economy requires a combination of bold macroeconomic and structural policies, with the right sequencing between the two," said Andre Sapir with Bruegel, a think tank in Brussels.
Editing by Hugh Lawson