Here's a surefire way to start a scrap at a party: Proclaim that America's economy is no different from Japan's a decade ago when its stock market bubble was bursting.

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The accusation is unfair. America today does differ from Japan a decade ago in ways that will be explored. But with the wrong government policies and problems in the banking sector, America too could become the land of the setting sun.

The fact is, Japan's sluggish economic record through the '90s to the present -- and therefore its stock market's abysmal performance -- has largely been caused by two things the West has demanded that Japan do: boost government spending and flood the system with yen. And because assorted American politicians and experts have urged these measures, it follows that the Federal Reserve and any U.S. administration would likely repeat those mistakes.

A casual examination of Japan in the second half of the '80s and the U.S. in the latter half of the '90s reveals striking similarities. Heady economic growth occurred without a big uptick in inflation. Stock indices rocketed. Margin debt went through the roof. Money supply grew at rampant rates. Investment in capital goods soared as a percentage of gross domestic product. And, of course, many talked about Japan's economy being a beacon to others, as they do of America's today.

Good Old Daze Japanese money supply, 1985-1991*

*As measured by M2 Source: Federal Reserve, Detox

Look Familiar? U.S. money supply growth, 1995-2000*

*As measured by M2 Source: Bank of Japan, Detox

Seeing inflationary pressures in 1989, the Bank of Japan raised interest rates -- just as the Fed did in the middle of 1999. Eerily, in both cases, it took seven months for monetary policy tightening to cause stocks to tank. The higher rates and slowing in money supply growth revealed much investment to have been wrongheaded. Demand for capital goods slackened and the economy started to slow. In response, both central banks started cutting interest rates.

Contrast

Here's some good news. It appears that Japan's boom was even crazier than America's. Monetary policy was considerably looser in Japan in the second half of the '80s. Money supply, as measured by M2, grew on average at 9.7% a year in Japan, almost double the 5.3% in the U.S. in the second part of the '90s. Only a small portion of that can be explained through high economic growth: In the relevant periods, Japan's economy grew only 25% faster. There are other signs that Japan was more lenient: In 1989, with its discount rate at 2.5% and its inflation rate at 2.5%, Japan's real interest rate was zero, encouraging reckless borrowing. At the start of 1999, the fed funds rate was 4.75% while inflation was 1.7%.

In addition, capital expenditure appears to have been more excessive in Japan. Capital investment as a percentage of GDP peaked at 22% in 1991 in Japan. Worryingly, that ratio has soared in the U.S. from just under 10% five years ago to 14% in 2000, but that level is still far lower than in Japan. Likewise, capital investment accounted for a massive two-thirds of economic growth in Japan in the second half of the '80s; it accounted for 25% of U.S. growth in the second part of the '90s, according to Dick Berner, economist with Morgan Stanley.

Bubble Checklist
Japan	Category	America
4.50% (1985-89)	Annual Average GDP Growth	3.90% (1995-99)
2.26% (1989)	Inflation	2.20% (1999)
4.25% (end 1989)	Key Interest Rate	5.50% (end 1999)
9.70% (1985-89)	Annual Average M2 Growth	5.30% (1995-99)
39% (Nikkei 225)	One-Year Market Decline	62% (Nasdaq)
Source: IMF, Bank of Japan, Federal Reserve, Yahoo! Finance, Economagic, Detox

Berner also notes that a good share of Japan's capital expenditures went into industries like steel and automakers. These are harder to downsize and in Japan the government was keen to protect them from tough times. At this point, it's hard to see President Bush jumping in to shield the likes of Cisco (CSCO:Nasdaq - news - boards) or Microsoft (MSFT:Nasdaq - news - boards) from the consequences of their dumb investments.

Japan had a runaway real estate boom in addition to a soaring stock market. The country's banks were heavily exposed to both bubbles. So far, real estate has reached crazy levels only in concentrated parts of the U.S.

Banking on a Recovery

The U.S. banking system is generally believed to be much better positioned for an economic slowdown. That remains to be seen. Bizarrely, American banks have let loan loss reserves drop and, like in Japan, they have recently shown an unhealthy willingness to lend to troubled clients simply because they are in trouble, perpetuating past mistakes.

In fact, the health of the banking sector could well turn out to be the decisive factor. Japan's experience shows that no matter how much a central bank cuts interest rates, money supply won't grow if banks won't lend because they are loaded with doubtful loans or can't find enough viable borrowers.