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MERLE HAZARD, an unusually satirical country and western crooner, has captured monetary confusion better than anyone else. “Inflation or deflation,” he warbles, “tell me if you can: will we become Zimbabwe or will we be Japan?”

How do you guard against both the deflationary forces of America’s worst recession since the 1930s and the vigorous response of the Federal Reserve, which has in effect cut interest rates to zero and rapidly expanded its balance-sheet? On May 4th Paul Krugman, a Nobel laureate in economics, gave warning that Japan-style deflation loomed, even as Allan Meltzer, an eminent Fed historian, foresaw a repeat of 1970s inflation—both on the same page of the New York Times.

There is something to both fears. But inflation is distant and containable, while deflation is at hand and pernicious.

JAPAN developed rapidly after American gunboats opened it to trade in the late 19th century. Within 40 years, Emperor Meiji led his once-feudal country into the modern world economically (and, alas, militarily). To do so, the state bought Western technology such as factory machines, railroads and telegraph lines. But until the turn of the 20th century it did so by eschewing foreign loans, which were equated with a loss of sovereignty.

How did a poor country like Japan obtain the foreign currency to pay for such products? The answer was exports: first, of light industrial goods such as raw silk and pottery; later, of heavier materials, including steel and chemicals. It was a huge success. In the 1860s Japan’s small-scale cotton-textile industry was nearly decimated by European imports. By 1914, however, after buying automated cotton spinners, the country sold half of its yarn production abroad, which accounted for one-quarter of the world’s cotton yarn exports.

Thus the “Asian model” of export-led growth was born. The region was inspired by Japan’s lead before the second world war and its economic resurrection afterward. In the 1960s Asia’s four “tiger economies” (Singapore, Hong Kong, Taiwan and South Korea) imitated Japan and flourished. South Korea’s bureaucrats, for example, protected domestic firms and funneled them cheap loans under the condition that they exported their wares.

China also boomed after opening its economy in 1978. Its “special economic zones” were designed to attract foreign capital—initially from Chinese businessmen in Hong Kong and Taiwan—to build factories for export production. Malaysia, Thailand, Indonesia and later Vietnam all forged similar export-led paths to growth.

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TO LOSE one decade may be regarded as a misfortune; to lose two looks like carelessness. Japan’s economy stagnated in the 1990s after its stockmarket and property bubbles burst, but its more recent economic performance looks even more troubling. Industrial production plunged by 38% in the year to February, to its lowest level since 1983. Real GDP fell at an annualised rate of 12% in the fourth quarter of 2008, and may have declined even faster in the first three months of this year. The OECD forecasts that Japan’s GDP will shrink by 6.6% in 2009 as a whole, wiping out all the gains from the previous five years of recovery.

If that turns out to be true, Japan’s economy will have grown at an average of 0.6% a year since it first stumbled in 1991. Thanks to deflation as well, the value of GDP in nominal terms in the first quarter of this year probably fell back to where it was in 1993. For 16 years the economy has, in effect, gone nowhere.

Was Japan’s seemingly strong recovery of 2003-07 an illusion? And why has the global crisis hit Japan much harder than other rich economies? Popular wisdom has it that Japan is overly dependent on exports, but the truth is a little more complicated. The share of exports in Japan’s GDP is much smaller than in Germany or China and until recently was on a par with that in America. During the ten years to 2001, net exports contributed nothing to Japan’s GDP growth. Then exports did surge, from 11% of GDP to 17% last year. If exporters’ capital spending is included, net exports accounted for almost half of Japan’s total GDP growth in the five years to 2007.






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