Editor's Note: This is part of an ongoing series on the global recession and signs indicating how and when the economic recovery will begin. Click here for The Recession in Japan, Part 1.

Since the massive collapse of its housing and equities bubble in 1990, Japan has tried every trick in the book to deal with its economic woes, from lowering interest rates to expanding government spending. With nothing new at its disposal to effectively fight the current global recession on its own, Japan will have to ride the coattails of its chief external markets -- especially the United States and China -- for any kind of recovery. But bleak demographics mean Japan's best days may be behind it.

By the end of the first quarter of 2009, the global financial and economic crisis had exacted a heavy toll on the Japanese economy. In the first quarter of the calendar year, 2009 gross domestic product (GDP) shrank by an annualized 14.2 percent, after shrinking 13.5 percent the previous quarter. The Bank of Japan predicts that the economy will shrink by 3 percent overall in 2009, but others (such as the International Monetary Fund) estimate a contraction of more than 6 percent -- far greater than during Japan's period of economic malaise through the 1990s and early 2000s. Any way you look at it, Japan is among the hardest hit economies amid the current global recession.

Japan's latest recession was not triggered by the U.S.-born global financial crisis but began with the global commodity inflation that raged throughout 2007 and 2008 and caused a major increase in import costs. Lacking natural resources, Japan has always been highly dependent on imports to meet its needs for basic commodities, such as energy and food. Moreover, although Japan's is a consumer-driven economy (private consumption accounts for about 55 percent of GDP), that consumption is languid and has grown no faster than 1.1 percent each year since 1997, often not growing at all. Weak consumption is easily discouraged by high prices. In 2007, global inflation caused Japan's chief imports to rise in price, from mineral fuels such as oil and liquefied natural gas to raw materials like iron ore and foodstuffs like cereals. Private demand shrank for most of the year. This trend worsened dramatically in 2008, when Japan's energy imports rose by nearly 54 percent and food by 16 percent compared to the year before.

Then came small (but foreboding) losses in Japan's all-important export sector. While they make up only about 15 percent of GDP, far less than China's 32 percent and South Korea's 55 percent, exports are an indispensable contributor to Japan's economic growth. In mid-2008, with global commodity inflation raging, key foreign markets were slowing down, especially in the United States and Europe, hurting Japanese exports (most notably cars). The combination of fewer export gains and higher import costs led Japan to teeter on the brink of recession, with GDP shrinking in the second quarter of 2008. A rare monthly trade deficit in August 2008 signaled that the worst was yet to come.

When the financial crisis erupted in the United States in September 2008, it had significant negative effects on Japan's already dysfunctional financial system. Moreover, as the financial contagion spread and froze up global credit channels, it forced international trade to a virtual standstill, sending Japan's exports plummeting by 14.6 percent in the second quarter of 2008 and 28.8 percent in the first quarter of 2009 (seasonally adjusted and compared to the previous quarter). From October through February Japan saw monthly trade deficits, and fiscal year 2008 marked the first yearly deficit since 1980. Repeated trade deficits are grim news for a country whose exports are its last leg to stand on in terms of growth. Export losses accounted for 2.8 percent of the total 3.8 percent contraction in real GDP in the fourth quarter of 2008 and 4.2 percent of the overall 4 percent GDP contraction in the first quarter of 2009 (when imports offset exports losses a bit).

The problem for Japan's exporters was compounded by the rapid appreciation of the yen, which global investors sought as a safe haven. The global carry trade consists of investors who take out low-interest loans in established currencies (such as Japanese yen or Swiss francs) and use the money to invest in high interest-yielding emerging-market assets to make a profit on the exchange rate variation. Throughout 2007 investors scrambled to pay back their debts in yen -- from May 2007 to February 2008, the yen's value appreciated by 18 percent. Between July 2008 and December 2008, when the financial turmoil spiraled out of control, the yen went on another appreciating streak, strengthening by 17 percent to 90 yen per U.S. dollar. The yen's insuppressible rise made Japanese exports even less attractive during a period of rapidly dwindling demand.

Losses in exports quickly translated to pain across the rest of the Japanese economy, stopping output, cutting wages, laying off workers and causing companies to go bankrupt.

Policy Tools

With Japan falling deeper into recession, the government, along with those of other G20 countries, pledged to take drastic fiscal and monetary measures to stabilize the financial system, mitigate the painful losses for households and businesses and stimulate the economy so that it could at least jog in place. These policies followed a clear sequence. First and foremost, central banks everywhere set about lowering interest rates to ensure that credit was available to firms caught in the liquidity crisis -- many lowered rates to unprecedented levels to try to stimulate borrowing and new investment. The next step was for governments to expand their own spending. With banks and other businesses hoarding cash to patch up their balance sheets, only governments could fill the demand gap by increasing their own spending, though it drove most of them further into deficit territory. Next, governments directed their spending into stimulus policies that would prop up failing businesses, encourage specific industries and sectors and give funds directly to consumers to induce them to go shopping.

Yet unlike other G-20 members, Japan had been using these same techniques for over a decade. Financial stability measures such as capital injections (of which Japan made 446.2 billion-yen worth in fiscal 2008, ending in March) have not come with firm requirements for subsequent restructuring of the failed institutions, so there is no reason to expect the institutions to make wiser choices that bring better returns. Purchases of stocks off banks' portfolios will likely result in long-term losses for the government, as has happened in past attempts, due to the long-term decline of Japanese share prices. In other words, stabilizing Japan's banking system is a byword for continuing to inject taxpayer money periodically as a form of life support for a system already too sick to be cured.

Interest rates in Japan were already below 1 percent and had been for over a decade when the Bank of Japan set about lowering them in the final months of 2008. Shaving off tens of basis points from the discount rate has not, in the past, succeeded in inspiring new borrowing and spending, though it has enabled firms on the verge of failure to roll over their debt and live another day. Unfortunately for Japan, rates cannot go lower than zero, and the domestic population has long taken for granted the availability of subsidized credit. So cheaper borrowing costs provide no incentive to borrow for the Japanese public, which is still in a savings mode.

The next policy step, deficit spending, has become so consistently practiced in Japan that the Finance Ministry even includes funds generated from bond sales in the "revenues" section of its general accounting budget. Thus, deficits in Japan cannot provide a jolt when it is most needed. Additional government expenditures amounting to 5 percent of GDP will not have nearly as much effect on an economy that is consistently pampered with deficits worth 8 percent of GDP as it will on an economy -- like Germany's -- that normally does not run deficits at all.

The problem with stimulus packages is related. Japan's three fiscal stimulus packages, so far amounting to roughly 25.9 trillion yen (or 27.4 trillion, depending on the value of the third stimulus package), or about 5 percent of GDP, will have some impact in propping up domestic demand, since the public portion of that demand shrank for most of 2008. But in general, stimulus is another tool that will not be as effective for Japan as for other countries because it is not new -- few economic stones can be turned over in Japan that do not reveal subsidies of some form or another. Citizens, municipal and regional governments and major industries have come to rely on government assistance. Though policymakers rightly hope to allot special grants for sectors that will multiply the potential for Japanese growth in the future -- such as in research and development for electronics, robotics, pharmaceuticals, genetics and environmentally friendly cars -- they must also allocate funds with political considerations and the need to preserve employment in mind. This means funds will provide not so much stimulus as stilts for failed (but probably politically connected) businesses and one-off transfers that will not contribute to sustainable growth. At the same time, major infrastructure projects can only be performed so many times, and after decades of building government-mandated bridges and roads, infrastructure projects become liabilities, failing to provide enough economic benefits to pay for themselves.

In other words, Tokyo has already worn down to the nub every standard tool that nations use to fight off recessions. And the economy may take unforeseen twists and turns calling for further action. But there could be some relief in sight. While exports to the United States and Europe continued to decrease as of May, the United States appears poised to begin purchasing anew as shrinking inventories of consumer goods spur new orders. While a revived U.S. market is essential, the Japanese are also looking anxiously to China -- initially for the effects of Beijing's $586 billion stimulus package, which the Japanese hope will translate to higher exports to China, but ultimately for the possibility of tapping into the vast (and partly mythical) consumer market that lies hidden within the masses of China's poor in the interior provinces.

With nothing at its disposal to effectively fight the recession on its own, Tokyo will have to ride the coattails of its chief external markets -- especially the United States and China, since Europe appears to be in for a long correction -- as the sole means of recovery. As foreign demand revives, the demand for Japanese goods will, too.

Deflation

But even if Japan's economy starts to grow, it will not likely be strong growth. Deflation -- Japan's ever-returning bane -- could be poised for a comeback that would weigh down recovery. In April 2009, the consumer price index stood at -0.1 percent compared to the previous year, and the IMF predicts prices will fall by an average of 1 percent overall in 2009. By Japanese standards, that degree of deflation is not unfamiliar, but deflation is self-reinforcing and can lead to a quicksand situation that prolongs a recession, similar to what occurred from 1998 to 2003. Consumer prices were weak before the crisis, since Japan did not overcome its latest bout of deflation until 2007. And price decreases were expected as part of the disinflation of prices on food and fuel that were irregularly high prior to the recession.

But lower food and fuel prices are beneficial for importers of those goods, like the Japanese. The real potential problem is that price drops are now occurring in areas like household furniture, medical care, communications, recreation and services, revealing that consumers are shying away from these goods and services, which will drive prices further downward. While recent statistics show improvements in consumer confidence, job offers are drying up, unemployment is up to 5 percent (which is high for Japan) and wages are down by 3 percent, which means that there are more people jobless or short on cash, making consumer spending unlikely to revive any time soon.

Not to mention that all of the aforementioned fiscal actions will fatten Japan's gargantuan public debt, imposing a still greater burden on the private sector. The 2009 budget deficit, including budget supplements, is likely to approach 11 percent of GDP -- assuming an optimistic GDP performance and no additional extra-budgetary spending (which is not a safe assumption). This will be paid for by bond issues. In terms of the percentage of GDP, Japan is the most debt-laden country in modern history, with total government debt amounting to roughly 173 percent of GDP in 2008. By the time the recent supplementary budgets and 2009 deficit have been accounted for, something like 85.6 trillion yen in new debt will have increased total debt to an estimated 916.1 trillion, which could amount to 183 percent of GDP or higher.

The 2009 Elections

With public finances on the rack, Prime Minister Taro Aso recently postponed the country's deadline for a balanced budget from 2011 to 2019. But to balance the budget, Japan will need to eliminate about 42.4 trillion yen from its 2009 budget, which is about 80 percent of the year's general expenditures and would be tantamount to scrapping allotments for social security, education, national defense, public works, military pensions and economic assistance combined. To put it another way, balancing the budget by 2019 would require hacking off the equivalent of 2009's total projected national defense expenditures each year (assuming revenues stay the same). Of course, trying to fix the country's finances would likely include raising taxes, and it is realistic to think Japan would opt to increase its consumption tax (perhaps to as high as 15-16 percent) to lighten the enormous burden of debt.

Japanese bureaucrats and politicians are aware that austerity measures eventually will have to be put in place to rein in the debt if the country is to avoid a catastrophic situation in which capital markets become unable to purchase bonds. But no Japanese politician wants to risk losing power by spearheading these painful changes in such a conservative society. Attempts by the Hashimoto administration in 1997 to rein in spending notoriously caused the economy to slow down, resulting in reduced tax revenues and increased deficits (and some have argued that Junichiro Koizumi's reforms had a similar effect). Even if a leader emerged who was capable of doing so, the Japanese system cannot be easily changed. Reform initiated at the upper echelons rarely translates to faithful implementation by the government ministries, and businesses expect their share of lucrative government contracts if they are to use their levers to deliver voter support for politicians.

As it happens, 2009 is an election year, and elections for the lower house of Parliament, which must be called by September, when members' terms expire, will not change any of the towering difficulties Japan faces. Surprisingly, the elections have become hotly contested for a country that has had a single party dominate its politics for the vast majority of the past 50 years, and some are anticipating a historic change to the status quo. The gloomy economy has sped up the process by which the Liberal Democratic Party (LDP), which has been in power almost without interruption since 1955, loses ground to opposition parties. In particular, the Democratic Party of Japan (DPJ) looks set to make sweeping gains, despite a damaging campaign finance scandal that brought its leader down.

The LDP government is hoping that a sudden upturn in export markets and the trickling down of stimulus funds will be enough not only to help the economy but also to generate enough public approval to keep it in power. More important, the Japanese public may not be willing to hand a full majority to a party like the DPJ, which it sees as relatively lacking in leadership experience and personnel. But even if the DPJ succeeds in taking over, it will likely only be able to tinker with details on taxes and social programs, and it will not be anxious to jeopardize its hard-won authority by pushing through harsh fiscal reforms. Thus, the 2009 election is far more likely to reinforce a stalemate in the legislature than to pave the way for sweeping change, regardless of whether the LDP's domination is broken.