Ailing Japanese Economy Runs Out of Options

International credit rating agencies are about to downgrade Japan's rating to below Botswana's despite howls of protests from the world's second largest economy.

It will be the latest humiliation for a country that not so long ago was seen as poised to overtake the US as the world's leading economic power. The idea seems laughable now but in the late 1980s and early 1990s, pseudo experts churned out books predicting how Japan was about to buy up America, from its film studios in Hollywood to its prestige skyscrapers in Manhattan.

Instead America reigns supreme, its economic problems notwithstanding, while Japan remains mired in an economic morass. Japan has entered its third recession in 10 years, locked in the most serious debt and deflationary spiral to hit an industrialised country since the global slump of the 1930s. Successive Japanese governments have tried to resuscitate the economy through vast spending public programmes and low interest rates - now at zero. But the measures have proved futile.

Japanese consumers have little incentive to spend as they know that tomorrow, prices will sink. Demographic pressures are also at work. Japan has an ageing population due to a low birth rate, compounded by low immigration. As people approach retirement age, they want to save rather than spend, feeding the deflationary spiral.

Meanwhile, the banking system threatens to implode. Japanese banks sit on the world's largest debt pile, about Y43 trillion (£227bn). The Japanese government has set up a special state agency, the Resolution and Collection Corporation, to buy up bad loans, but the RCC is making snail-like progress having bought just Y63bn since January.

In setting up the RCC, Japan is following in the footsteps of the US, which set up a similar organisation to deal with the savings and loan crisis in the 1980s, when hundreds of financial institutions went bust after recklessly expanding from mortgage lending. That episode cost about $300bn in taxpayer money.

Any number of suggestions have been made to extricate Japan from its current plight. The most extreme would be to push many of Japan's troubled banks into bankruptcy, a sort of shock therapy that would "cleanse" the country of all those dud banks. Shock therapy always sounds great in practice, but you never know what unsavoury politicians lurk in the undergrowth to capitalise on social and political turmoil. As history teaches us, economic upheaval can easily pave the way for demagogues to exploit people's fears and insecurities.

With shock therapy not on the cards, what's left? The Japanese prime minister, Junichiro Koizumi, is trying desperately to push through reforms that includes privatising previous state institutions such as the post office and the speedier disposal of non-performing loans weighing on the banking sector. In the process he is getting flak from the US for not acting fast enough, while vested interests in Japan resist reforms that would curb their powers.

While Mr Koizumi is right to press on with structural reforms and with efforts to clean up Japan's banking system, that promises to be a long drawn-out process. Japan needs some medicine that will work sooner than that. One ingenious idea comes from Paul Krugman, the American economist, who argues that the Bank of Japan should be given an inflation target and be encouraged to print money to reach it.

"What Japan needs to do is promise borrowers that there will be inflation in the future," he argues. "If it can do that, then the effective 'real' interest rate on borrowing will be negative: borrowers will expect to repay less in real terms than the amount they borrow. As a result they will be willing to spend more, which is what Japan needs."

What Mr Krugman advocates flies in the face of conventional economics, which argues that inflation is bad - eating away at our savings. But his argument may not be as crazy as it sounds. Remember that the Bank of England is set an inflation target of 2.5% by the Treasury with Gordon Brown's insistence that an undershoot of the target be treated as seriously as an overshoot. It means that the Treasury considers too low an inflation rate just as dangerous as too high a rate.

Mr Krugman admits that his prescription for more inflation could be wrong. But having tried so many other options to little avail, it might be time for Mr Koizumi to try something different, in addition to the other tactics he is currently using.