By the time the bombing stopped and the smoke cleared, Japan's total economic losses from World War II amounted to the equivalent of about one year's national output. That tally included everything that could have a price put upon it--the factories and the flame-throwers, the homes and the howitzers, the silos and the submarines. In modern values, the bill was 19.5 trillion yen or some 140 billion dollars.

The bursting of Japan's "bubble economy" in 1990 started another extraordinary episode of wealth destruction. The war, of course, was incomparably more costly in human terms. But Japan's 1990s peacetime disaster of deflation has been vastly more expensive in an economic reckoning. Within five years--from 1990 to 1995--a period comparable to the length of the Pacific War, the collapse of land values and stock prices had inflicted losses equal to nearly two years' national output. The money value of these losses was 827 trillion yen or about 6 trillion dollars. It takes Uncle Sam four years to collect this much in taxes and it takes the Russian economy fifteen years to generate this much wealth. And Japan's losses are still mounting as land and stock prices continue their long downward trajectory.

The nature of the experiences differs. The wartime damage was chiefly physical, the peacetime losses financial. But the comparison brings into perspective the enormity of Japan's self-inflicted economic disaster, one more costly than losing a major war. And it raises the question: can Japan bounce back this time? A growing body of expert opinion says no.

Japan has been in stagnation now throughout the 1990s, the gloom punctuated only by the false dawn of 1996, when it seemed that recovery was nigh. The short-term outlook is poor enough. One of the more accurate forecasters of Japan's economy over the last decade, Nobuya Nemoto of the Nomura Research Institute, told me in June, "We already have most of the necessary conditions for the recession to become a depression. We have a fragile banking system, a credit crunch, falling corporate earnings, companies are pushing wages down, that is dampening demand, and prices are falling--this is the prototype of a depressionary spiral. A crash on Wall Street now may be enough to cause the recession to become a depression."

Since then, Wall Street has begun to show signs of obliging. "The worst of the adjustment may not be behind us", Nemoto added, "it may be ahead of us."

The customary consolation for short-term misery is the prospect of longer-term prosperity. But the striking element of Japan's mess today is that there is no such guarantee. There is no light at the end of the tunnel, only an unrelenting blackness. Until the bursting of the bubble, Japan's rate of economic growth had fallen significantly below 3 percent only once in thirty years. But now the Ministry for International Trade and Industry (MITI) estimates that even if the country manages to emerge from recession, its maximum potential growth rate until the year 2010 is a pathetic 1.8 percent, and a miserable 0.8 percent thereafter. And that is one of the more optimistic assessments.

One of Japan's foremost economic think tanks foresees at least a quarter century of stagnation--or worse. A nonprofit affiliate of the Nikkei newspaper group in Tokyo, the Japan Center for Economic Research, this year issued its regular outlook for the Japanese economy over the next twenty-five years. It projects near-zero growth for the next few years and then a long period of gradual but unrelenting shrinkage in Japan's economy. Or, as Warburg Dillon Read's chief economist in Tokyo, Brian Rose, puts it, "I don't think there is going to be a happy ending to the Japan story. I think the current stagnation is as good as it gets--these are the golden years. Everything points to Japan sticking with its current line of policy, which is stagnation. And a very long period of stagnation."

History, Karl Marx said, is economics in action. If so, then what would a long Nipponese stasis imply? "Think of it this way", suggests the regional economist for Prudential Bache Securities in Hong Kong, Robert Rountree: "Britain has been in decline since World War II. So what's the big deal about Japan entering the same phase? The UK lost the chemical, motorbike, and steel industries and now it's in the process of losing the finance industry as it's bought up by foreigners. Britain has lived off its savings through the current account surplus.

"People are worried about Japan because it is a paradigm shift. But once the Japanese invest overseas again and start earning nice fat returns on their investments, just as the Brits do, things will settle down again. Unfortunately, the cost of this shift could be a world recession."

In Japan's Foreign Ministry, a senior official explains that the new reality of a no-growth economy will transform Tokyo's global strategy: "We have been trained in a linear track mentality. We have now come to the end of the line and we have to adjust. We have to re-set our national goals in this new climate. We have been aiming in the long term to be a superpower. We now have to learn to live comfortably as a power--not a superpower. We have been aiming to alone represent Asia. Because of China's growth and our stagnation, we have to now recognize that this is unrealistic. We have to learn to be modest about our capacity and the limits of our power."

The Clinton administration appears to accept the inevitability of Japan's long-term relative decline. Bill Clinton's trip to Beijing this year was the first time in the postwar period that a U.S. president had visited China without also visiting America's key security ally in the region and Asia's economic superpower. Assuming that this was studied rather than inadvertent, one can surmise that the President was acting on expectations of the future status of the big Asian powers rather than current realities, as Japan is not only America's chief security partner in Asia but has an economy five times the size of China's. To borrow the jargon of the market, Japan is trading at a big discount to its face value.

But is this assessment correct? The world has consistently underestimated Japan's powers of transformation. Japan is a dribble of small islands spattered along the eastern coast of the Asian mainland. It has a population the size of Pakistan's and only half that country's land area. It does not have the natural resources to support its population in first-world lifestyles. It produces only 64 percent of its people's food needs and just 20 percent of its energy requirements.

Yet consider a few of its accomplishments in the past 130 years. After the Meiji Restoration of 1868, Japan became the first Asian country to master the techniques of the Industrial Revolution. In the Russo-Japanese War of 1905 it became the first Asian nation to crush a European power by force of arms. In its imperial sweep south in the Pacific War it single-handedly drove the European powers out of their sprawling Asian colonies and briefly occupied a third of the globe.

After World War II it grew rapidly from insignificance to account for one dollar in every six generated by the world economy. When The Economist in 1964 dubbed Japan Asia's first "miracle" economy, it seemed to be no exaggeration. Then, when the United States went on its 1980s debt binge, Japan systematically financed the U.S. federal deficit to help prevent an explosion in American interest rates. From a pauper nation it emerged to become the world's major creditor, with today almost a trillion dollars in net external assets. Japan compressed into thirty years the economic development that the United States accomplished in a hundred.

Japan proved that it was possible to be Asian and rich. It became the inspiration for a continent, the model for all the developing countries of Asia. In this way, it contributed to immense improvement in the lives of half of humanity. The only factor as constant as Japan's powers of transformation has been the world's underestimation of its ability. Even after Japan struck the U.S. Navy at Pearl Harbor with stunning force in 1941, there was a general American incredulity that the Japanese could have had the wit and audacity to pull it off--the Germans were widely thought to have put them up to it.

What could have gone so badly amiss with this extraordinary country that experts at home and abroad are prepared to write it off for a generation or more? And are they right? Are Japan's problems really so intractable? Or are all these experts making a huge and costly miscalculation?

The System Survived

In the West, it is generally assumed that after World War II Japan completely rebuilt from the ground up. It is taken for granted that wartime destruction, Allied occupation, war crimes trials, the purge of 210,000 militarists, and the break-up of the zaibatsu industrial conglomerates dismantled the existing structures, allowing a wholly new economic structure to spring up. This is a fundamental misapprehension. While the end of the war was an important new beginning in many ways, there was solid continuity in two of the mainstays of pre-war Japan. One was the financial system. The other was the people who operated it--the finance bureaucracy. To understand this is central to understanding what is happening to Japan today, and what will happen there tomorrow.

While General Douglas MacArthur's occupation administration purged 210,000 people from public life, it purged only 2,000 from the civil service, and these targets were concentrated in the military bureaucracy and the oppressive Ministry of Home Affairs. The department that operated the economy and the financial system of the nation, the Ministry of Finance, lost just nine officials to the purge. Its pre-war personnel and principles remained essentially untouched.

As for continuity in Japan's financial system since that time, the most astute explanation available was supplied in 1977 by two former Finance Ministry officials in a deeply revealing essay entitled "Dissecting the Finance Ministry-Bank of Japan Dynasty." They wrote, "We believe that the economic system which until now has supported high growth is fundamentally a continuation of the wartime system of total mobilization of economic resources. . . . Financial controls constituted the core of the economic system for all-out war, as is made clear by the Bank of Japan Law. . . .

"Patterned after the Reichsbank law of Nazi Germany, the law was promulgated in 1942 as a consummation of the wartime institutions for the control of financial activities, and today it remains in existence as a fundamental part of the Japanese financial system, thirty-odd years after the end of the war. True, the bank's goal . . . changed from the execution of war to the achievement of economic growth in the postwar period, but the system itself, geared as it was to all-out war, remained intact in spite of Japan's defeat."

The Bank of Japan law was revised ultimately--but only last year, fifty-two years after the war's end. And it wasn't just the central bank law that survived the occupation. The two former finance officials continued, "A similar observation may be made about commercial banks. . . . It is indeed surprising that the banking industry alone retained the wartime structure, in the midst of the all-transforming economic growth of the postwar years."

The Allied occupation had decided to smash up the five biggest banks. But it withdrew the plan when the Cold War arrived in Asia in 1948 and U.S. Secretary of the Army Kenneth Royal stressed the importance of Japan's swift economic revitalization as a bulwark against Chinese communism. This decision to preserve the big pre-war banks intact, the essay continues, "proved to be an event of decisive importance to the subsequent evolution of the Japanese economy."

Another vital part of the system was made up of Japan's special-purpose policy banks: "Playing a central role in the wartime financial regime were so-called special banks, such as the Industrial Bank of Japan. Some of them, like the Bank of Taiwan and the Bank of Korea, were shut down after the war, while others, like the Nippon Kangyo Bank and the Hokkaido Takushoku Bank, were reorganized as ordinary commercial banks.

"But established in their place were the Long-Term Credit Bank of Japan, the Japan Development Bank and the Japan Export-Import Bank. These newly created special banks controlled the bulk of fund flows until the mid-1950s in much the same way as did the old special banks during the war. The role of the Industrial Bank of Japan was to serve as the mainstay vehicle of financing Japan's wartime industry. In the postwar 'total-war' economy, this role was amplified rather than diminished."

The authors nominate two more instruments of economic control--the bureaucracy's close supervision of foreign exchange, and its power to police interest rates offered by the banks--to fill out the armory of available mechanisms that allow officialdom to conduct "total mobilization" of the postwar economy. In sum, they write, "postwar occupation reforms thus did not bring a complete liquidation of the old economic order. What the occupation forces achieved was a reorientation."

The identity of these two insightful officials? They had both left promising careers at the Finance Ministry to take university posts. One, Dr. Yukio Noguchi, flourished in academia. He is now one of Japan's leading academic economists, a professor at the University of Tokyo. He went on to write a bestselling 1995 book, The 1940 System, based on the 1977 essay. The other returned to the Finance Ministry. He is now one of the Ministry's two or three topmost officials. As the vice-minister for international affairs, Dr. Eisuke Sakakibara is Japan's chief international economic negotiator. The markets have nicknamed him Mr. Yen because of the power of his pronouncements on exchange rates. In his current job, he is obliged to defend the system he so incisively analyzed in 1977. This would not necessarily be a problem, except that he and Noguchi foresaw in their joint essay twenty-one years ago that the system would fail--indeed, that for the sake of Japan's future it needed to fail.

Out of Control

The so-called 1940 financial system was a vital asset in Japan's postwar catch-up. But the moment Japan caught up, it became a liability. It was an asset because it marshaled the savings of the Japanese people into a closed system. It kept the rate of interest artificially low. It channeled these savings into selected industries. This was a competitive boon because it gave those industries--steel, machine tools, autos, shipbuilding, electronics--access to a big pool of low-cost money. These industries invested the money in bigger and newer factories and hired more workers to run them. A virtuous cycle took hold. The workers continued to bank their money at low interest rates; the system continued to funnel their money into the priority industries; and the priority industries continued to add more and more productive capacity.

One might wonder why the workers saved so much, and why they kept putting those savings into bank accounts if they got such lousy returns on them. The answer to both questions is that they had little choice. Because the entire financial system was a giant cartel operated by the authorities, the banks did not compete aggressively to lend money to households. Restricted in their ability to borrow, families were obliged to save strenuously for the big-ticket items of housing and education. At the same time, they were forced to accept poor returns on those savings because the interest rates offered on savings accounts were virtually identical across the banking system; there were few safe investment alternatives in Japan for ordinary people; and it was very difficult to move money out of the country. In addition, obligatory pension schemes sequestered a chunk of workers' wages, increasing the level of savings. The workers were prisoners of the controlled financial system. This has been dubbed the era of the Bankers' Kingdom. The Japanese savings rate became one of the highest in the world.

This phenomenon of massive saving and investment in the private sector had a parallel in the public sector. The postal savings system channeled vast volumes of low-cost capital into the so-called zaito system, the Fiscal Investment and Loans Program. This program, administered by the Finance Ministry, plowed these savings into public sector investment. The program became so big that it was nicknamed the "second budget" and by the mid-1990s its annual investments were two-thirds the size of the national budget.

The companies that were on the receiving end of all this cheap capital started to do very nicely. They pushed out into the world marketplace and drew attention to Japan as an exporting power. But instead of handing profits back to their stockholders, they reinvested most of their earnings in adding yet more production lines and hiring yet more workers. In this way, savings generated investment, and the investment generated more savings. The system was absolutely essential to Japan's postwar catch-up. It was a crucial national asset.

But then, in the second half of the 1970s, it started to become a national liability. As in the tale of the Magician's Apprentice, the mechanism, once in full swing, kept generating tremendous liquidity long after Japan needed it. The place started to flood and the Finance Ministry apprentices tending the machine did not have the wit or the power to stop it. Japan had caught up with the world's richest economies and the total war mobilization could now be called off--but it was not. The system continued to pile up far more savings than the economy could usefully invest. For example, in the five years from 1986 to 1990, net saving in Japan was the equivalent of 19.2 percent of total economic output as defined by GNP. But it took the equivalent of only 16.4 percent of GNP to satisfy the economy's investment needs. The rest--2.8 percent of GNP--was excess. This amounted to a cumulative $345 billion over those five years, which is, for perspective, roughly the size of the annual output of an economy like Switzerland's or India's.

So what happened to that excess $345 billion? Japan exported it as capital. The world noticed; the capital outflow found its dual expression as Japan's big wave of overseas investment and as its hugely disruptive trade surplus. Remember the tsunami of Japanese investment in the United States in the 1980s? An investment banker later told how Mitsui Real Estate deliberately overpaid by $235 million to buy the Exxon Building in Manhattan just so that it could claim the record for the world's most expensive building. Japan's trade surpluses became so jarringly big that it became a poisonous issue with many of the country's trading partners, including the United States.

Inside Japan itself, these chronic excess savings fueled the mad boom known as the Bubble Economy. The big companies that had borrowed so much for so long eventually outgrew the need for their traditional bankers in Japan. The best of them could now tap directly into the world's capital markets and no longer bothered dealing through the middleman banker. In 1985 corporate Japan raised 5 trillion yen on the capital markets, or around 36 billion dollars at current exchange rates. In 1989 they raised four times as much in this way. When they found they could raise money on the stock market at near-zero interest rates, many Japanese companies were completely carried away, raising the money not because they needed it, but because it was so cheap. Who needed to borrow from the banks at 5 percent when money was on tap virtually for free in the stock market?

Japanese companies became so flush with cash that they did not know what to do with it. It became common practice for big firms to raise cash from the stock market at a cost of around half a percentage point, and then put it on deposit at the bank where it earned 6 percent. In 1988, for instance, corporate Japan put 23 trillion yen or about 165 billion dollars on deposit at the bank. The banks were in a terrible dilemma. Their biggest borrowers had not only stopped borrowing money, they had suddenly become their biggest depositors. Desperate for new borrowers, the banks found people like Harunori Takahashi. A small-time businessman working from a Ginza backstreet, he found establishment banks pleading with him to borrow their money. In just four years, his tiny company with its staff of fifty, EIE International, borrowed 1 trillion yen or about 7 billion dollars. Takahashi claimed that there was no limit to the credit at his disposal. He snapped up hotels and resorts around the world and accumulated three corporate jets. The walls of his poky office with its peeling wallpaper were soon groaning under the strain of multimillion dollar French Impressionist masterpieces.

Takahashi's main financier? It was one of the special policy banks set up to finance Japan's postwar re-industrialization--the Long-Term Credit Bank. His top assistant and chief dealmaker, Dr. Bungo Ishizaki, later explained, "It got to the point where it was an embarrassment even for us. We did these bullshit feasibility studies with flowery words and some glorified numbers." The arriviste entrepreneur would then pass them to the ultra-respectable Long-Term Credit Bank. "They wouldn't even scrutinize it but would rip the cover off, put their own cover on it, and syndicate the damned thing", bringing other banks in on the deal, and backing yet another triumphal Takahashi acquisition. His lieutenant later admitted that the firm had never drawn up a plan for servicing its vast debts.

The company, EIE, is, of course, now finished and Takahashi is on trial for fraud. Now effectively insolvent, the once-mighty Long-Term Credit Bank has become a test case for Japan's bank crisis policy. It is now in the process of being nationalized as the only alternative to total collapse. The bank, Dr. Ishizaki explained to me, was "just looking for an excuse to shovel their money out the door and we provided that excuse." This experience was replicated manifold across Japan and throughout its banking system. Thousands of Takahashis borrowed trillions of dollars from banks as desperate as the Long-Term Credit Bank. An official study of the period, commissioned by the Finance Ministry, concluded in 1993 that Japan's Bubble Economy of the late 1980s could be classed with the Dutch Tulip craze, the South Sea Bubble, and the Roaring Twenties boom in the United States as one of history's great episodes of speculative madness.

Spinning Wheels in the Ditch

So it was that Japan's magnificent liquidity machine for the financing of its "total war" economic mobilization achieved its aim, and then, unchecked, went on to drown Japan and the world in excess savings. The system is now being destroyed by its own processes. All the elements of the 1940 structure are, by design or by default, now coming undone. The revisions to the Bank of Japan Law, while thoroughly inadequate, will give the central bank more independence to run monetary policy in the best interests of balanced economic growth rather than a frenetic economic mobilization. Most of Japan's commercial banks are under extreme duress and many will fail. The dismantling of the banks that the Allied occupation had planned is now underway, not according to the fiat of Douglas MacArthur but by the laws of Charles Darwin. Already, one of the top twenty-one banks and a former policy bank, the Hokkaido Takushoku Bank, is gone. The special policy banks, too, will never recover fully. The Long-Term Credit Bank is worst hit and effectively finished, but none has escaped serious damage.

The controls that sustained the system are also in tatters. The closed nature of the structure is already a thing of the past. The so-called Big Bang deregulation of the financial system has flushed away the final vestiges of the old foreign exchange control law. This means that the Japanese saver, once a prisoner, is now at liberty to move his or her money in and out of the country at will--and the Japanese are making the most of this newfound freedom. In the three months following the removal of the last remnants of the old controls on April 1 of this year, there was a net outflow of 7.8 trillion yen or 56 billion dollars--a record for a three-month period. Official control of interest rates, long since abandoned, has, however, been continued by an informal cartel agreement between the banks. This cannot last. Indeed, under the Big Bang, the closed club of Japan's banking sector will be opened to new players. Toyota, for instance, might decide it wants a banking license, and under the new law it would doubtless qualify.

As for the finance bureaucrats who tended the machine even as it worked itself into a destructive frenzy, they are showing signs of paralysis. "The bureaucrats have been criticized so bitterly for the failure of the economy and for their scandals that it made them passive--they have become very pessimistic and very passive", says Dr. Yoshio Suzuki, formerly a senior central banker and chairman of the Nomura Research Institute, now a politician in the opposition Liberal Party. "It's true", says a member of the ruling Liberal Democratic Party and himself a former Finance Ministry official, Kozo Yamamoto, "that the bureaucracy has stopped producing policies. They are not functioning normally. We had to push them to draw up the plan to the banking crisis, we had to insist. They came up with no ideas." A senior official in the Foreign Ministry concurs: "We in the bureaucracy were the greatest think tank in Japan. But today we are brain-dead--we exist like vegetables."

The collapse of the system should not, of course, come as a surprise to the finance bureaucracy. It was after all Dr. Sakakibara who saw in 1977 that the financial system had "at last begun to disintegrate", and understood that "monetary and fiscal controls cannot work where a strong demand for investment does not exist." Or, in other words, where there is too much saving and not enough investment. And it was Sakakibara, with Noguchi, who likened the postwar economy of Japan to a bicycle: "Unless one pedals fast enough, there is a danger the bicycle will fall over." The high-growth postwar economy, the "1940 system" catch-up model, was, they wrote, "a contradictory and unstable structure that could only be sustained by continued growth."

They were right. The growth faltered, the bicycle is now in the ditch, its wheels still spinning. But these astute analysts did not see this as a tragedy for Japan, or as the end of the country as a great power. Instead, they saw it as a necessary precondition to a new beginning: "The transition to stable growth will be impossible without fundamental alteration to the economic structure." The tragedy is that, rather than managed change, Japan has ended up with a savage Darwinian episode of selection through uncontrolled destruction and protracted recession. It has also exported its homegrown crisis to the rest of the world, and will go down in history as the point of origin for the international crisis now recognized as the riskiest period for the world economy since the Great Depression.

Japan remains the same resource-poor country that cannot feed or fuel itself. But it also retains its vast reservoir of human talent and financial resources and the resilience that has, time and again, astonished the world with its regenerative power. The forecasters who have appraised its prospects so dismally all premise their pessimism on the assumption that there will not be significant reform of Japan's economy. All recognize that it has enormous potential. Japan will outlive its obsolete financial system and its catch-up economic model. And when it does, it will rise again. Anyone tempted into the fallacy of extrapolation, seeing Japan's future as nothing more than an unaltered continuation of its present trends, might remind himself of the recent history of the United States. In the mid to late 1980s, it was fashionable in Tokyo to write off the United States as a spent force.

Japan can and will rise again. The real questions are when it will do so, and how much more damage it will sustain in the meantime. The swing factor is policy choice. Prime Minister Keizo Obuchi has promised to "launch major reforms with the hand of the devil and the heart of Buddha." He will need more--the cunning of Machiavelli, the persistence of Sisyphus, and the wisdom of Confucius. And he needs them all right now.