When President Bush met Japan’s Prime Minister Mori last week, he know that the Japanese economy is in big trouble and that its problems are likely to get worse before they get better. But although a Japanese downturn would reduce US exports, the impact on the American economy would be very small. There is no reason for the US government to interfere in what is essentially a Japanese problem.

Japan’s economic problems began in the early 1990s. Since then, Japan’s real growth rate averaged only about one percent year, less than one-third of the US rate during the same years. And the key index of Japanese stock prices has fallen from 40,000 in 1990 to only slightly more than 10,000 today while the U.S. Dow Jones average increased nearly four fold. Analysts of the Japanese economy are now predicting that it will soon shift from slow growth to outright recession.

Why did Japan get into this terrible mess? Why haven’t the aggressive policies pursued by the Japanese government succeeded in accelerating growth and avoiding the recession? And what might Japan do now to improve its prospects?

A key source of Japan’s problems was an asset price bubble in the late 1980s. The combination of very low interest rates and self-reinforcing expectations drove prices of stocks and real estate to unrealistic heights. Banks nevertheless gave loans to businesses and individuals secured by this overvalued collateral. Banks also owned substantial amounts of stock themselves and were allowed under international banking rules to count a fraction of the stock market gain as part of the bank’s capital, thereby permitting the banks to increase the total volume of their lending as long as share prices continued to rise.

When the unrealistically high levels of share prices began to fall, the lower capital in the banks forced them to reduce their total lending. Banks also cut back on lending when their borrowers were unable to service their debts and the banks could not collect the outstanding loans because they were based on inadequate collateral. Construction companies were a particular problem for the banks because they had real estate that they could not sell but that was worth less than the amounts that they had borrowed.

These asset price problems were paralleled and exacerbated by falling profits in many manufacturing and retailing businesses. These profit declines were driven by falling prices after Japan opened its markets to foreign products, as required by the GATT and subsequent World Trade Organization rules. Many Japanese companies scrambled to keep their costs down by establishing their own manufacturing base in low wage Asian countries like Thailand. But while this allowed them to produce and import low cost products, the Japanese culture essentially prevented them from laying off their long-term employees in Japan. The burden of continuing to pay these workers turned corporate profits into losses. Because of these losses, many firms were unable to pay the interest on their bank loans, further weakening the condition of the banks.

Japanese households became pessimistic when they saw profits falling, banks in trouble, and the prices of their stocks and real estate plummeting. Although layoffs were uncommon, firms stopped hiring and the unemployment rate rose. Faced with these deteriorating conditions, households reduced their spending and increased their saving. This in turn meant less demand for goods and services, further slowing economic growth. The government’s announcement that the Social Security pensions would eventually have to be cut because of the ageing of the population reinforced the desire of Japanese households to save more.

The Japanese government responded to these problems with traditional but basically inappropriate macroeconomic policies. At first, they drove down interest rates, with the very short term rate set by the Bank of Japan now virtually zero. This was supplemented by large deficit-financed government public works programs. In a relatively few years, the national debt grew to more than 100 percent of GDP. While these programs may have ameliorated the slowdown, they were not sufficient to kindle strong growth.

The low interest rates were largely irrelevant because banks with substantial losses and large amounts of nonperforming loans were unwilling to lend. The government eventually recognized that the banking sector was a key to recovery. It forced the closing and merging of several key banks and injected large amounts of capital into others. But the problems persist because the banks still lack enough capital to make loans, have too many bad loans still on their books, and are basically unwilling to force their clients who cannot repay into bankruptcy.

Most experts agree that a prerequisite for recovery is to force banks to write off their bad loans and remove the life-support systems from those weak companies that cannot ever recover enough to provide growth and employment. Unfortunately, that treatment will deepen the upcoming recession while it paves the way for new growth.

For job losers to get new employment quickly will require changes in the regulatory environment that now places excessive barriers in the way of companies and individuals that might want to establish new businesses, particularly in retailing and services where it should be easiest to create jobs. But a by-product of such new job creation through reduced regulation will be new competitive pressures that force other firms to fail.

It might be useful also for the government to take steps to bolster consumer confidence by creating an explicit deposit insurance system, by improving benefits for the unemployed, and by specifying the extent and timing of the Social Security cuts that will be necessary so that households don’t have to plan for the worst possible outcome. Unfortunately, the short-run gains that such policies produce might hurt the economy in the longer term.

There are no easy solutions for the Japanese. If there were, the Japanese would have found them. The one thing that is clear is that the restructuring of the Japanese economy that is likely to be needed to restart solid growth is going to be painful. That’s reason enough for the U.S. government to leave the process of developing a strategy for reform and restructuring to the Japanese themselves.

Martin Feldstein, the former chairman of the Council of Economic Advisers, and his wife, Kathleen, also an economist, write frequently together on economics.