Economist (Jul 20, 06) has a special report describing how Japan's stagnation from 1990 has resulted in wealth destruction, persistent poor growth, deflation and financial distress. Between 1990 and 2005, [Japan's] real growth averaged just 1.3% a year. Without the malaise, Japan's GDP would have been about 25% higher in real terms than it is now. Over the period from 1997 to 2005, the nominal GDP of neighbouring South Korea, which bore the full brunt of the Asian financial crisis, has risen by 65%; America's is up by 50%.

To understand why this happened and assess Japan's prospects as normality returns, you need to go all the way back to the end of the second world war. At first, Japan's American overlords wanted to rip up the bank-dominated system that had done so much to finance the rise of Japanese militarism—free capital markets and democracy seemed to American idealists, then as now, to go hand-in-hand. Yet by the early 1950s, with a cold war with the Soviet Union and a hot one in Korea, harder noses prevailed. What Americans wanted from Japan was a predictable flow of industrial goods. The Japanese, for their part, argued that banks were the best way to channel scarce resources towards industries that could help rebuild the economy swiftly. So banks, not capital markets, became the chief source of finance.

As Gillian Tett points out in her book, “Saving the Sun”, capital markets were not abolished completely; the Tokyo Stock Exchange reopened. Yet the point of shares was not to raise capital, but cement ties with other business groups in an interlocking set of cross-shareholdings. These groups, with a principal bank at their core, became known as the keiretsu. In this system, the strong carried the weak.

For a while it worked spectacularly. Banks, cosseted by protected markets, regulated interest rates and a maternal finance ministry took in households' cheap savings and channelled them towards chosen industries. Savers did not get much in interest, but back then the Japanese were nothing like the consumers they have become. Japan was making things chiefly for export. And the virtue of the system was that everyone had a job. Between 1960 and 1973 the economy grew by 9.6% a year, twice the OECD average. Unemployment, averaging just 1.3% over the same period, was well under half that of the rest of the OECD.

Even after the 1973 oil shock, growth averaging 3.8% a year, as it did up to 1989, was better than most. But by then Japan was bumping up against the constraints of a maturing economy. Creeping deregulation was eating into banks' protected markets at a time when demand for credit was no longer so great.

By the 1980s, Japan was the world's biggest creditor. But its current-account surplus had become a political thorn in relations with America. The Plaza Accord of 1985 was meant to pull the thorn by blessing a rise in Japan's exchange rate. In 1985-86, the yen rose from ¥260 to ¥150 against the dollar. Fearing that exports and the economy would slump, the BoJ repeatedly cut interest rates.

Instead of weakening, the economy took off. The government plugged its budget deficit and the stockmarket shook off the Wall Street crash of 1987. Property markets blossomed, giving the banks a wonderful new source of lending. By the end of 1989, Japanese shares accounted for half the world's stockmarket capitalisation. Land prices soared. A value was famously put on the grounds of Tokyo's Imperial Palace equal to that of California. Then, on December 25th 1989, the BoJ decided to cool the party and raised interest rates.

The effect was bracing, as share prices fell and land dealings dried up. Japanese banks were unusually sensitive to the value of those assets. Four-fifths of bank loans were reckoned to be related to land, which was often used as collateral. Banks also counted as capital a good part of their equity holdings in other firms. As share values fell, so banks' capital levels were threatened. The system of cross-shareholdings began to work against them.

Yet for some four years an eerie calm prevailed. Optimism was still high that asset values would pick up again. Counting on a recovery, banks often lent more to distressed borrowers or tucked problem loans out of sight in subsidiaries. Bank regulators wanted to see no evil.

Only late in 1994 did a sense take hold that something was going badly wrong. Two poorly run Tokyo credit co-operatives had to be bailed out. More credit co-operatives failed and there was trouble at the seven Jusen, housing-loan corporations founded by the big banks. Their losses, reckoned to be ¥6.4 trillion ($68 billion), were more than the founder banks could muster. For the first time taxpayers contributed to a bail-out, to prevent contagion.

Yet the spreading crisis had already touched the country's big banks. Daiwa Bank, one of the biggest, lost $1.1 billion through a fraudulent employee in New York and was ordered by American regulators to close all its United States operations. A domestic problem, as Hiroshi Nakaso of the BoJ, recounts in a paper* on the crisis, now had an international dimension.

In the spring of 1997 the smallest of three long-term credit banks, Nippon Credit Bank, had to be injected with private and public capital. In the autumn a default by a middle-sized stockbroker, Sanyo Securities, paralysed the interbank market. Soon after came the failure of Hokkaido Takushoku Bank, the dominant bank in the northernmost island of Hokkaido, where it had lent billions against resort developments. Shortly after, Yamaichi Securities, one of the biggest brokers, abruptly collapsed. The BoJ supplied liquidity and what remained was later taken over by Merrill Lynch.

Japan's financial system appeared to be on the edge of a meltdown, like much of Asia's at the time. Reassurances were hurriedly made by the finance minister and the BoJ's governor, and by the following spring ¥30 trillion in public funds was made available as capital for troubled banks. Bad loans in the system were admitted to be at least ¥60 trillion.

The public injections may have been politically unpopular, but they seemed to calm things down—until the collapse of Long Term Credit Bank (LTCB) in the autumn of 1998. With assets of about $240 billion, this was among the world's biggest banks. As Ms Tett recounts, everything was done to prevent the problems coming to light, including dropping boxes of papers down manholes in the basement when inspectors called—not that the regulators wanted to find too much.

By the time of the collapse of LTCB, the scale of Japan's banking crisis had finally sunk in. Japan strengthened the system for deposit insurance. Public funds boosted the capital of the biggest banks and a newly created independent regulator, since renamed the Financial Services Agency, set out to break the cosy ties between banks and their former regulator, the finance ministry. In 1999 another injection of public money encouraged nine of the country's biggest banks to merge into four “megabanks”, which have since consolidated further into three.

This fresh start for the banking system should have been a fresh start for the economy, too. But the recovery never happened. In 2001, with recession again threatening, Junichiro Koizumi became prime minister on a reformist ticket. The following year fears of another crisis grew. As share prices fell, the BoJ announced plans to buy equities from banks.

In 2003 the government finally created a vehicle to clean up bad loans, although doubts about the motives behind this were widespread. And it was not until early 2005 that the banks could claim to have put their bad-debt problems behind them; they are now paying back the public money. After falling for a decade, net lending by banks started to rise again this year. And inflation, measured by “core” consumer prices, which exclude fresh food but include energy, has at long last turned consistently positive.

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