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If you are looking for a worst-case scenario after Wall Street's big meltdown, just look east to the land of the rising sun. After Japan's asset bubble burst in the early 1990s, its economy drifted in the doldrums for more than 10 years, recording average annual growth of just 1 per cent. Will the United States (and by extension Canada) suffer the same fate? Not if it learns the lessons of Japan's "lost decade."

Japan's collapse was one of the most remarkable of the 20th century. Like China today, Japan was once considered the economic marvel of the world. Its economy grew by 10 per cent in the 1960s, 5 per cent in the 1970s and 4 per cent in the 1980s. Property and stock values rose to stratospheric levels. Then came the reckoning. Beginning on Jan. 2, 1990, asset values began to tumble. Eventually, real estate would fall 70 per cent and stock values 75 per cent.

The government of Japan responded to the economic downturn with the usual battery of Keynesian measures. It cut interest rates to stimulate growth. It increased spending for the same reason, recording budget deficits that added up to 6 per cent of gross domestic product in 1992-93.

But the spending was poorly directed. Rather than cut taxes to encourage consumers to spend more, it wasted hundreds of billion of dollars on public works, building bridges to nowhere and superhighways that no one really needed. In 1997, it committed its worst fiscal blunder when it actually increased the consumption tax (Japan's GST) to 5 per cent from 3 per cent. The intention was to help fix the rising deficits and debt that flowed from so much public spending. The result was to make the Japanese close their wallets at the very time that the economy needed them to start spending again.

Far worse than all this was Japan's failure to grapple with the troubles in its financial and broader corporate sector. There was no big house cleaning à la Wall Street after the Japanese economy tanked in the early 1990s. Hoping to avoid the nightmare of mass unemployment, the government helped essentially bankrupt companies to stagger on with the help of loans from allied banks.

"That meant, however, that prices and profits in many sectors were depressed by the continued presence of 'zombie' companies being kept alive by the banks," Bill Emmott, former editor of the Economist, writes in his new book Rivals. "The result, from 1998 onwards, was deflation, a spiral of falling prices and wages that deterred consumption (because things would get cheaper if you waited) and kept the economy weak and vulnerable to further shocks."

What are the lessons for the United States and the world at large? One is to avoid creating zombies. Washington was wise to let Lehman Brothers expire and Merrill Lynch fall into the arms of Bank of America, rather than use government funds to keep them going.

John Makin of the American Enterprise Institute argued in a paper earlier this year that a crisis such as this demands maximum transparency. What other firms are in trouble? How deep are their problems? Where else do they spread? Covering up the extent of the crisis by helping mortally wounded firms to carry on, as Japan did with its zombies, is a mistake. (A forgivable exception is the federal bail out of mortgage giants Freddie Mac and Fannie Mae, whose impending collapse would arguably have caused more harm than propping them up.) As Mr. Makin puts it, "the worst approach to dealing with the unusual set of problems we currently face would be to deny that they exist."

Another lesson is to beware of deflation. With oil and food prices so high over the past year, inflation has been the main worry of central bankers. It will take nimble action to keep the opposite, equally dangerous, phenomenon from taking hold.

Yet another is to keep taxes in check. It has been fashionable to bash Republican presidential aspirant John McCain for promising further tax cuts after the Bush administration irresponsibly ran up such huge deficits. He may in fact be promising the right thing, if for the wrong (blatantly political) reasons.

With luck, the United States will avoid the dismal fate of Japan and bounce back much faster from the Wall Street crisis. The American system is inherently much more resilient than the Japanese (and indeed most others), because Americans accept that it is part of the game of capitalism to see injured companies die from time to time, making way for others to take their place. It is how the system rights itself.

The current mess on Wall Street is painful and scary, no doubt. But if Japan's experience is any guide, it is far better to take the pain and get it over quickly than to buffer and ultimately prolong it.

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