Japan's lesson to the world: Don't fiddle while the economy burns – take action now

In an increasingly desperate attempt to lift Japan out of its two-decade long slump, the Bank of Japan yesterday slashed interest rates even closer to zero and announced a programme of "quantitative easing" – a direct injection of cash into the economy – through a programme of purchases of government securities and commercial paper.

The world's second-biggest economy, already in recession, is suffering fresh challenges as a result of an appreciation of the yen. This has been caused over recent days by the decision by the US Federal Reserve to reduce official rates to below Japanese levels.

The Bank of Japan's move to lower its benchmark policy rate from 0.3 to 0.1 per cent follows Tuesday's dramatic cut by the US Federal Reserve, which left their policy rate at 0.25 per cent. Almost all of the world's major central banks seem to be engaged in a race to the bottom on interest rates: most analysts expect the Bank of England and the European Central Bank to follow suit over the next few months.

Japan's exporters, especially in the car industry, have been openly lobbying for help on the yen. Yesterday the chief executive of Honda, Takeo Fukui, warned the strong yen could spur massive lay-offs, and force Honda to rebase more production overseas. "If the government is saying 'We don't care about the export industry', then that's fine – we'll act accordingly."

The Japanese government will buy as much as 20 trillion yen ($223bn) of shares held by banks to boost their capital and support the stock market. The Nikkei 225 index is down 44 per cent this year, one of the worst performances in its history. The move is part of a wider stimulus package totalling 75 trillion yen that also includes 10 trillion yen for capital injections into banks. Investment losses on stocks held by banks and marked to market have severely impaired their ability to lend.

Yesterday's decisions highlight the parlous state of the Japanese economy, more than two decades after its "bubble economy" collapsed. In an uncomfortable echo of recent developments in Britain and other Western economies, Japan witnessed in the 1980s a property and share-prices price boom followed by a banking crisis and a contraction of lending that soon led to falling prices and a stubbornly deflated economy drained of confidence. Having almost doubled in two years to peak at 38,915.87 on 29 December, 1989, the Nikkei 225 index has fallen more or less consistently ever since, with 26-year lows plumbed this autumn. The FTSE 100 peaked on 31 December 1999 at 6,930, and now stands at 4,287.

Having watched helplessly while deflation tightened its grip in the early 1990s, the Japanese government and central bank have tried almost everything to revive their recumbent economy. Interest rates have been left at zero or close to it since 1995, and have stood at 0.1 per cent for most of the Noughties. Yet cheap money, and other measures to strengthen the banks, probably came too late. Lending contracted, both because of the banks' weak balance sheets and because o f the lack of demand from timorous consumers and businesses. As real estate prices plunged, few showed any of their former passion for buying property; businesses were similarly squeezed by falling retail prices.

Japan was affected by the debt deflation phenomenon first identified by the economist Irving Fisher: as prices fall so the real burden of debt increases; yet as businesses and households rush to pay off that debt, they reduce demand in the economy and push prices lower still – so a vicious deflationary spiral builds up.

Many – not all – economists view Japan since 1990 as being caught in a "liquidity trap". This is because when prices are falling it is difficult for the central bank to reduce the real interest rate once the nominal rate hits zero. Thus if prices and wages are rising at say 20 per cent a year and an interest rate is set at 15 per cent, that apparently high rate is actually a very low, negative real rate. Consumers and businesses with their incomes rising at 20 per cent will find a 15 per cent interest burden easy to bear. However, if prices are falling, even a rate of 0.1 per cent or zero will seem high: no mortgage rate is low enough to compensate for constantly falling property prices. This asymmetry – it is pretty much impossible to engineer a negative interest rate – means that relying on monetary policy to stimulate an economy can be like "pushing on a string", to recall John Maynard Keynes' description.

The next step is "quantitative easing" – the idea of "helicopter money" now being pushed by the US Federal Reserve chair, Ben Bernanke (the phrase is Milton Friedman's originally). That too was done by the Japanese in the 1990s and the Noughties, and again with surprisingly little effect.

The third lever is fiscal policy. Here again the results have been disappointing. In 20 years, the Japanese government's debt has risen from about 15 per cent of GDP to around 100 per cent now (way above our 50 to 60 per cent). Some economists, adding in "off-balance sheet" items, put Japan's debt at 200 per cent of GDP – near war-time proportions. Yet growth, employment and spending have remained stubbornly depressed, along with prices – because the Japanese simply saved any extra income they received, for fear of losing their jobs.

All Japan has been left with is a huge national debt and a legacy of massive public sector overinvestment – a network of lightly used motorways and bridges that lead nowhere in particular. After an export-led economic miracle with growth approaching double digits for the first four decades after 1945, Japan's economy struggled to achieve an average growth rate of 1.5 per cent in the 1990s. Since 2005, it has been close to 2 per cent, but even this brief recovery will not be sustained: Japan's economy will contract in 2009, says the IMF, by 0.2 per cent.

So what is the lesson of the Japanese experience? Very simple, and expressed volubly by the Japanese at every international function: "Do it now". Japan's policies failed because they were wrongly timed. Put simply, they reflated and bailed out the banks too slowly. Once Japan had sunk into deflation, there was nothing that could be done.

The lesson, therefore, is to avoid that depression in the first place by immediate, dramatic, rapid action. Hence the coordinated programme of interest rate cuts, fiscal stimulus packages and recapitalisation of banks witnessed this autumn across the G7. We will soon learn whether the rest of the world has repeated Japan's errors and missed the opportunity to avoid a deflationary slump. The US economy likely won't start recovering from the recession for at least another year, making this the longest downturn since the 1930s, according to the Harvard University economist Martin Feldstein, a member of the committee that charts American business cycles: we may have dithered too long.