Recovery from the decade of the 1990s followed stringent reform of the financial sector and structural reform programs in many other areas, plus expansionary fiscal and monetary policy. None of these policies was applied consistently, much backtracking and political bickering took place, and external criticism was harsh. But it looked like the medicine had worked. What we now see is that new vulnerabilities have been revealed.

What ails the Japanese economy now is different from what ailed it in the 1990s. Then, lax monetary policy created an asset bubble, lax regulation allowed banks to lend excessively and encouraged (some) investors to borrow unwisely and squander resources on unproductive projects, and eventually resulted in appalling and frightening fragility in the financial system. Very similar to what has happened in the US and Europe today.

But that is not what is happening in Japan now.

What has happened this time is a large external shock, transmitted through collapsing export markets and combined with a rising yen. This has revealed that Japan’s economy has grown more dependent on exports to support growth than it was during the ‘high growth era’. Its industrial and export structures have become more concentrated on a few industries and a few trade partners (though new ones such as China have replaced some of the old ones).

At the same time, the international financial system still does not adjust very quickly to changing trade balances and sudden shifts in domestic consumption and savings. Exchange rate systems are increasingly driven, in the short run at least, by considerations such as domestic liquidity needs and perceptions of risk. They cannot carry the burden of adjusting trade balances alone. So, whereas the yen might be expected to depreciate under the present circumstances, it continued to strengthen until this week.Without some yen depreciation Japan’s exports cannot gain the ground they have lost from collapsing demand abroad. But Japan cannot quickly alter the value of the yen without international support. Depreciation would at least require the tacit agreement of the US and the EU not to complain too loudly before any intervention would be possible.

The world has looked to Japan’s experience in the 1990s for pointers on how to respond to the global financial crisis and has come to admire some of what it once criticized as either insufficient or excessive government involvement in the economy. There is still a lot of misunderstanding of what Japan actually did, but that discussion needs deeper analysis at another time. The urgent question for Japan is what it should do now that it has swallowed its bitter medicine (wiping huge amounts off inflated asset values over the 1990s, writing off trillions in non-performing loans, and living with unemployment levels twice their historic rates for 10 years) and still faces more pain.

This crisis should be amenable to more conventional policy responses than the last one. Replacing lost external demand by temporarily increasing domestic demand through fiscal policy, stimulating government and private consumption while loosening monetary policy to keep interest rates from rising and to avoid upward pressure on the currency, and embracing any slight upward pressure on prices, would all be good responses but these responses become difficult when politics are in disarray so budgets cannot be passed, when the legacy of past fiscal policies has created large government debt, when interest rates are close to zero and when international hostility would greet any softening of the value of the currency.

Japan still needs to enact all these policies but will also have to wait for the rest of the world to recover. It must hope fervently that the world avoids protectionism and in the meantime it will have to go on improving the flexibility of its own economy via (now unpopular) structural reform. It will face continuing high (for it) unemployment and will have to improve safety nets and soften the social and economic impact of it by a variety of means.

These are tall orders and if Japan is not able to manage them it matters to the region and to Australia. Japan is still our largest export market and is at the hub of production networks in the Asian region. Japan’s growth not only depends on the region but impacts on it and we must all hope that it is able to recover sooner rather than later. Thankfully Japan is not, at the moment, withdrawing from the region. Indeed it has recently contributed in significant ways to global and regional efforts to respond to the crisis – supporting an expanded Chiang Mai initiative at the recent ASEAN+3 summit, increasing its contribution to the IMF and supporting capital increases for the ADB. But what the shock over the data shows is that we understand Japan’s economy no better, or even less well, now than we did in the roaring 80s.

In Australia there are no regular macroeconomic analyses of Japan and few, if any, macroeconomic models in use that say anything about the impact of Japan on Australia. So, when asked how big the effect of Japan’s collapse on Australia might be, well-informed observers can do little better than ‘wait and see’. Is this really good enough or is it time we began to pay more attention to the health and functioning of the economy of our largest export partner and most significant regional ally?

Professor Jenny Corbett is Executive Director of the Australia-Japan Research Centre, ANU. This piece first appeared in the Australian Financial Review, February 26, 2009.