The Japanese model - an example that should serve as a warning

'Japanese politicians were pretty cocky 10 years ago: one suggested that Japan should buy California'

The gyrations on the world's stock markets that continued yesterday raise many questions, but perhaps the most disturbing one is: could the world catch the Japanese disease?

The gyrations on the world's stock markets that continued yesterday raise many questions, but perhaps the most disturbing one is: could the world catch the Japanese disease?

It might seem strange that our financial markets should be in disarray on the day that Britain reports that unemployment is below one million for the first time for a quarter century. After all, companies do not take on more people unless they are confident that they face sustained profitable demand for their products and services. You don't employ more people if you think there is going to be a recession. But this juxtaposition of boom in the real economy and slump in the financial one is familiar. The real economy is about what happens now; the financial one about what might happen at some stage in the future.

Japan is a good place to start for anyone seeking to understand what might happen to the rest of the world - or at least the dangers that lie ahead. For it had its great boom 10 years ahead of the rest of us and, uniquely, it has failed to recover from the subsequent slump.

Remember that 10 years ago Japan was the most admired economy on earth. Its companies seemed to have found the magic mix of vigorous product innovation, secure employment prospects and rapid expansion overseas. Its apparently egalitarian society might seem a little stifling to outsiders, but visitors to Tokyo noted that there was very little crime and that, unlike in any of the othermega-cities in the world, there were no beggars. Liberal British writers told us Britain had to adopt the Japanese system of close links between banks and companies so that our firms, like Japan's, could drop the short-term policies they had to follow to please the stock market.

We now know that was rubbish. Japan has been the worst performing large economy through the 1990s by a large margin. To be sure, the visitor to Tokyo does not see much of a change. The city centre shines as ever. The bars may be emptier and the taxis more plentiful, but the young still throng the clubs of Roppongi, the senior citizens still take their holidays abroad and the trains still run on time. But I'm told that this is a facade: leave the centre of town and you see the tented cities of the homeless, while the unemployed salarymen conceal their status from their neighbours by pretending still to go to work. And yes, both the UK and the US, where jobs are supposedly so insecure, now have a smaller proportion of their workforces on the jobless roll than Japan, where supposedly many people have jobs for life.

But before we congratulate ourselves, we should look at the performance of the Japanese stock market and compare it with the US, for there is an almost uncanny fit. Take the performance of the Japanese market in the 1980s and superimpose the US one in the 1990s on top. The peak of Japan's in 1990 was within a few weeks of the US in 2000. The rise in the previous decade was almost identical, and the fall so far almost exactly on track. Much the same fit can be shown in industrial production and overall growth.

In the case of the UK the boom of the 1990s was less dramatic than that of the US, both in terms of financial markets and the real economy. In Continental Europe, the main markets have been closer to UK experience than US. Nevertheless, the experience of the world's second-largest and once most-admired economy should be chilling to us all. No reasonable person expects a boom to go on forever. But no reasonable person expects a country with great companies, a diligent and well-educated workforce and products demanded by the rest of the world to remain in a state of stagnation. Is Japan's experience a one-off, or might it be a fate that in some measure awaits us all?

The trouble is that no one fully understands what has gone wrong. We can see specific bits of the problem - a banking system that was too closely tied to industry and now suffers from having made excessive loans to companies, an inefficient tax system that penalises individual enterprise, over-investment in loss-making projects, rigid planning and other regulations and so on. All those apply mainly to Japan.

But we can also see more general problems that apply to all of us - world deflation, ageing populations and hence soon declining workforces. Some European countries, such as Italy and Spain, are set to age even faster than Japan. And of course, we have seen some of the financial market excesses too, excesses that are now being unwound.

The sensible, non-alarmist response is that say that we have to learn from Japan's failure. There can be little doubt that the next four or five years are going to be tougher for the whole world economy than the past five. Insofar as financial markets are any predictor, the next couple of years may be particularly rough. But the trick will be to ride with the punches that the financial markets inflict, rather than trying to pretend that it is business as usual. If there has been one single mistake that the Japanese authorities have made (and they have made many) is has been to deny that there is a problem.

If you listen to our politicians - and those of the both parties in US and their counterparts on the Continent - they are pretty cocky. Gordon Brown comes out phrases like "we have created a million jobs". In reality, the Government has not created any jobs as such. It happens to have been in office during a period when the private sector created a million jobs, and has managed things sufficiently well not to have inhibited that job creation.

Well, Japanese politicians were pretty cocky 10 years ago: one suggested only half-jokingly that Japan should buy California off the US. I recall being told by a powerful fund manager in Tokyo during the 1987 stock market crash that his own and other funds were going to shore up the American market. "Japan will save America," he said.

But now the game for all of us will be adjusting to more difficult times. In practice this will mean accepting that loss-making companies have to restructure, even if that means some rise in unemployment. It will mean using government resources wisely, rather than over-investing in infrastructure projects, as Japan has done. Crucially, it will mean avoiding over-regulation - another of Japan's mistakes.

So we are right to celebrate our own progress. Getting unemployment roll down is a real success. But we should be aware of the warning from the world's financial markets - and the stagnation of Japan.