Worst Case Scenario

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As Japan takes some radical steps, though, it continues to support unprofitable enterprises with ties to the entrenched Liberal Democratic Party. These sectors--agriculture, transportation, construction and thousands of small businesses around the country--have escaped attempts to weed out the weak. If the banks start calling in their bad loans, companies from these sectors would be first in line, so it has been in the interest of the L.D.P. to stave off such a day of reckoning. "Say there are five companies in one industry," says Yasuhisa Shiozaki, a reform-minded L.D.P. lawmaker. "Government interference makes them all as unproductive as the weakest one of the five." It does that with direct subsidies, by shielding them from imports and by not forcing lenders to call in bad loans.

Following up on initial steps toward reform would help Japan's fundamentals over the long term. But the really scary part is that dramatic attempts to rev the economic engine right away have had minimal effect. The government, originally acting on the advice of Washington, tried to stop the initial slide by slashing interest rates and funding huge public-works projects. But the government spending has been directed toward things the country really doesn't need: expressways in rural areas and bridges to nowhere. The Bank of Japan has dropped interest rates to near zero, but that hasn't worked to stimulate the economy either.

The central bank and the Ministry of Finance have openly feuded over what course of action to take. Last summer the bank defied the finance ministry by raising short-term rates from zero to 0.25%. But after the GDP declined, the bank lowered interest rates again, to 0.15%. And when officials meet next week, they are expected to discuss dropping rates to zero again by April.

Last week government officials finally admitted what everyone else has known for a long time: Japan is in a deflationary spiral. This is where it gets dangerous. Companies aren't investing, so they don't expand, so unemployment rises, so people put off spending, so prices decline, so people save their money because they figure things will cost less in three months or a year than they do now.

Is there any way out? "The younger members of the party recognize this is a crisis," says Shiozaki, a member of the lower house of parliament. "I think some of the old ones even understand that now." Shiozaki and a gang of younger Liberal Democratic pols are attempting a coup, trying to grab control of the party. This kind of thing is breaking out all over, even at MITI. After 17 years at the ministry, Yoshiaki Murakami, 41, quit in 1999 to start an investment fund. His plan: to shake up boardrooms by challenging the cross-shareholding system that protects troubled banks and companies. He attempted a hostile takeover, the first in Japan, of a small electronics company last year. It failed, but Murakami is not deterred. "Look at Yahoo," he says. "It lost money, so suddenly the CEO leaves. Of course! In Japan? Never happens! Now is the time for shareholder power."

If Murakami learned this kind of thinking at MITI, the symbol of Old Japan, it was by observing what not to do. The rest of Japan has had plenty of lessons in that in the past decade. Now it's time to see what it has learned.