Why You Should Keep an Eye on Japan...

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Economy in tatters: Japan's premier, Yoshiro Mori, is under pressure to resign

TIME.com: What's wrong with the Japanese economy now?

Bernard Baumohl: What we're witnessing here is a slow-motion implosion of the economic and financial system. It's been 10 years in a slump, and growth is now right around zero. Interest rates are too low for the central bank to cut, and the government has run up huge deficits trying to stimulate the economy with spending, which hasn't worked. The banks would be bankrupt if they ever tried to write off all their bad loans, and the government is too tied in to the special interests to do anything bold or creative.

Consumers aren't spending, not only because unemployment is a near-record 4.9 percent, but because they have no faith in the government to construct some sort of solution. Besides that, deflation has set in — and when prices are dropping, there's a disincentive to buy now. Purchases get postponed even further. Right now, nothing seems to be going Japan's way.

Sounds familiar. What's the new ingredient?

BB:In two sessions, the Nikkei index has returned to lows last seen in 1985. And the U.S. slowdown is hurting too, because it's threatening the only source of strength in the Japanese economy — exports.

Why is that such a big deal?

BB: When you have a bank in the U.S., you have to keep a certain amount of cash to back up your loans. In Japan, they let the financial institutions — banks, insurance companies, pension funds — use stocks as their capital, and these banks are heavily invested in Japanese stocks. The stock markets' decline is threatening to tip these institutions over into total insolvency.

That would require the biggest government bailout in history. Japan's national debt, at $5.4 trillion, is 130 percent of their GDP, whereas the U.S.' $3.4 trillion is only 35 percent of its GDP — the Japanese government just can't afford it.

What can they do to avert that?

BB: In the short term, a lot of economists say what they've been saying for a while — that Japan has to cause some inflation in its economy. That's the only thing that can create an incentive to spend, and borrow, which is what you need to spark a recovery — you've got to finance a recovery. And the only way to create inflation is to print more money.

Longer-term, there's got to be structural reform in the banking system, beginning with some sort of clearing out of this $600 billion in bad debt that the banks are saddled with. Because as it is, they're unable to do any risk lending, any entrepreneurial lending, and that's what gets an economy going.

The Japanese government is not known for its agility in times like this. What happens if they don't act quickly?

BB: Well, the doomsday scenario is one that we've been worrying about for a while, and it's tied to those falling Japanese stocks. The Japanese banks, desperate to stay afloat, start selling their other big asset — U.S. treasuries. When those treasuries go back on the market, interest rates in the U.S. will go up — and that could really choke off the economy here. This still isn't inevitable — I'd put it at 40 percent probability — but it's looming larger than it has in a while.

And if that starts to happen, Japan may have no other choice but to throw open the doors and let American and European banks start coming in and doing this bailout themselves, privately. Despite their financial woes, a foothold in Asia would still be an attractive option for a lot of foreign banks.

Would that qualify as a happy ending?

BB: It might be the only way, if the government doesn't start taking the appropriate steps. But with the U.S. and Europe in a slowdown already, an implosion of the Japanese banking system would certainly be a very painful experience for everyone.

Did someone say IMF bailout?

BB: Don't laugh. It happened to the U.S. in the early postwar period; it could happen today. Japan is still the world's second largest economy. A financial crisis that started there would not be pretty.