The Fear Economy

SYNOPSIS: We thought that the Great Depression couldn't happen again. But could it?

The American economy is usually quick to shrug off the effects of disaster. When Hurricane Andrew swept through South Florida in 1992, and again when the Northridge earthquake struck Southern California in 1994, the property damage was immense and the lives of millions of people were disrupted for months thereafter. Yet few economists thought of either event as a threat to national prosperity, and if you look at a chart showing the growth of gross domestic product, it's quite hard to see any effects.

Will it be different this time?

Although Sept. 11 was a human tragedy on a scale far greater than any of America's recent natural disasters, in monetary terms the immediate loss was not much more than one might have expected from a severe hurricane or earthquake. Yet many people fear that the terror attack, unlike a hurricane or an earthquake, will have dire consequences for the economy -- indeed, that it may even tip the world into recession. And though they are probably wrong, they could be right.

The reason they might be right has little to do with the nature of the calamity. It's true that there is something especially horrific about a disaster that was an act of man rather than an act of God. And the after-effects were unsettling: airlines losing hundreds of millions of dollars a day; empty airports, hotels and theaters; conventions canceled; Wall Street spiraling downward. It's also true that the story isn't over, that unknown perils -- another attack? a full-scale war in central Asia? -- lie ahead. And of course the terrorists struck right at the nerve center of global capitalism.

But the economic repercussions from the World Trade Center disaster, unnerving as they are, would soon fade out if the economy had been strong to begin with. The main reason to worry about the economic fallout from the attack is not the attack itself, but the timing. Suppose the terrorists had struck five years ago, while the economy was in the midst of a healthy, investment-led expansion and before the rise and fall of the stock market bubble. Would we have been as worried as we are? I doubt it.

The point is that even before the attack, our economic condition was looking unusually precarious. We weren't in a severe recession; technically, we may not have been in a recession at all. But there was an alarming sense that things were out of control, that our economy's ailments weren't responding to the usual medicine. In another time we might mourn the dead and move on; but this economy was already fragile.

To understand the economic risks we may now be facing, in other words, we need to understand why we were in trouble even before terror struck. It's a story that takes us far afield in time and space -- to the Great Depression of the 1930's and to the difficulties of modern Japan. These stories of other times and places give ample reason to be concerned. For they remind us that even highly advanced economies like our own have sometimes stumbled badly. But the stories also give us reason to be optimistic, even if things go badly over the next few months. The terrorists may have taken us into uncharted territory in many ways, but the economic landscape is fairly familiar, and we have some pretty good ideas about how to deal with the risks ahead.

But first things first: although the atrocity was an immense human tragedy, it was limited to a small part of one city. How could destroying a few buildings, however large, even possibly threaten an economy as huge as ours?

The Psychological Impact

A disaster can hurt the economy in one of two ways. It can reduce supply -- that is, it can interfere with the economy's ability to produce. Or it can reduce demand -- that is, it can make people unwilling to buy the economy's products. What are we worried about right now?

The answer is that for all the damage in Lower Manhattan, the impact on supply of the terrorist attack will be minor compared with the awesome scale of the United States economy. Perhaps 15 million square feet of office space was lost. While that may sound like a lot, it's less than half of 1 percent of the office space in the nation. The cost of clearing the rubble and rebuilding will run into the tens of billions of dollars -- less than 0.1 percent of our national wealth. While airlines were grounded for the better part of a week, they are flying again. Yes, the airlines are in financial trouble, and they have cut back flights and laid off tens of thousands of employees, and Boeing is scaling back in anticipation of canceled aircraft orders. But the basic ability of the American economy to move people and products around the country has not been seriously impaired.

This story might change if a military confrontation leads to a disruption of oil supplies from the Middle East. For now, though, the ability of the economy to supply whatever people want to buy seems to be almost completely intact.

But how much will they want to buy? That is the question.

In the long upward march of American prosperity, there have been occasional setbacks. In the worst of these, from 1929 to 1932, G.D.P. fell by a third. Yet America was no less productive, no less technologically advanced in 1932 than it had been three years before. What happened was that people stopped spending, and the factories that could have been producing found no buyers for their products. It was, in short, a failure of demand rather than supply.

And the thing about demand is that, to a far greater extent than supply, it's a matter of psychology. If you ask how much the United States economy is capable of producing over the next few months, the answer is mainly determined by the physical realities -- the capacity of the factories, the bandwidth of the fiber-optic cables, the size of the work force. If you ask how much consumers will consume and investors invest over the next few months, the answer is determined largely by feelings -- what John Maynard Keynes called ''animal spirits.'' If frightened people decide not to spend, their nervousness can translate into a depressed economy.

So could the terror attack -- a very small thing in terms of its physical impact on the economy -- have a disproportionately large psychological impact? Could a small cause have large effects? Yes, it could. After all, the Great Depression had no obvious cause at all.

So the reason to be concerned about the economic effects of terrorism is not the actual damage but the possibility that nervous consumers and investors will stop spending. Truly, the only thing we have to fear is fear itself.

But isn't that always true? Why should we be any more vulnerable to fear now than we would have been five years ago? To answer that question we need to ask why in normal times it would be easy for economic policy to offset the psychological impact of tragedy on overall demand -- and why right now that may not be so easy.

When economists discuss the great depression, their general sentiment is ''never again.'' This is partly a matter of resolve, but it is also a boast. We think, or we thought until recently, that we have learned enough about fighting economic slumps to prevent a recurrence on that scale. Modern economies, after all, have powerful defenses against economic slowdown and both the will and the knowledge to use them.

The first line of defense against an economic slump is monetary policy: the ability of the central bank -- the Federal Reserve, the European Central Bank, the Bank of Japan -- to cut interest rates. Lower interest rates are supposed to persuade businesses and consumers to borrow and spend, which creates new jobs, which encourages people to spend even more, and so on. And since the 1930's, this strategy has consistently worked. Specifically, interest-rate cuts have pulled the United States out of each of its big recessions over the past 30 years -- in 1975, 1982 and 1991.

In fact, for most of the past 40 years the only serious problem with interest-rate cuts as a policy has been that they work too well, tempting countries to pursue overly ambitious targets for growth and employment. When they do that, the result is inflation. That is, when an expansion goes too far, companies take advantage of the good times to raise prices, workers demand higher wages, and a wage-price spiral threatens to develop.

As a result, one preoccupation of economic and political thinkers these past few decades has been how to ensure that governments not cut interest rates too readily -- to rein in the temptation to seek short-term political gain by revving up the economy at the longer-term expense of price stability. That concern is one of the main reasons that all advanced countries now have independent central banks that are largely insulated from the influence of other branches of government.

Behind the first line of defense is a second line, fiscal policy. If cutting interest rates isn't enough to support the economy, the government can pump up demand by cutting taxes or increasing its own spending. The conventional wisdom among economic analysts is that fiscal policy is not necessary to deal with most recessions, that interest-rate policy is enough. In other words, they believe that stabilizing the economy is properly the job of the Fed, not the Treasury Department. But the possibility of fiscal action always stands in reserve.

Does the existence of these two lines of defense mean that the economy is no longer at risk of recessions? Obviously not: the United States has experienced three major downturns in the last three decades. But in a way there was less to those downturns than met the eye.

For one, they were partly intentional. In each case, the recession started when the Fed deliberately tried to slow the economy in order to cool off inflation. Each went further than the Fed intended, because monetary policy is a blunt instrument. But each recession did end after the Fed reversed policy and cut interest rates. So the overall track record has actually been reassuring. Recent history seems to suggest that recessions may happen, but also that we can deal with them.

So should we be relaxed about the economic picture in the aftermath of the terror attack? Maybe not.

Japan's Slow-Motion Depression

The history of the United States economy since World War II inspires at least a mild sense of complacency about the risks of economic downturn. The defenses in place against any repeat of the Great Depression have held very well. And if our own history were the only evidence at hand, I and many others would probably feel quite at ease about the current situation.

But we are not the only advanced economy that has had to face economic stress, and others have not fared so well. Three years ago I wrote a paper for the Brookings Institution titled ''It's Baaack: Japan's Slump and the Return of the Liquidity Trap.'' The rather flip title was meant to convey the message that events in Japan -- a faraway country of which many Americans know little -- should trouble us, because they suggested that Japan's economic woes may not be unique. In fact, they seemed to show that we might not be as well defended against depression-style problems as we imagined.

In the 1980's Japan had the most dynamic economy in the advanced world; indeed, many Americans viewed it as a dangerous competitor. But then came a recession in the early 1990's, and Japan has never really recovered. There have been ups and downs over the decade, but each slump has been deeper than the last, each recovery more anemic. The period as a whole amounts to a sort of slow-motion depression.

Still, why should that dismal record trouble us here? Because Japan's troubles show that the usual defenses against economic slowdown can fail. In Japan the first line of defense, interest-rate cuts, has in effect been overrun by the enemy: short-term interest rates have been reduced all the way to zero, yet the economy remains depressed. Fiscal policy has fared somewhat better: huge deficit spending has kept the economy from experiencing a full replay of the 1930's, at least so far. But the results look more like a holding action than a truly effective defense. And now, with debt piling up alarmingly, there is reason to worry whether even that holding action can long continue.

But let's look a bit more deeply at Japan's experience and why it should worry us.

Over the past decade Japan's economy has come to look more and more like a 1930's model. However, the Japanese haven't suffered a year like 1931 in the United States, when everything collapsed at once. Instead, depression has crept up gradually.

Averaging the ups and downs, an economy that grew almost 4 percent per year in the 1980's has grown only about 1 percent annually since 1991. Unemployment has risen almost without a break, from 2.1 percent in 1991 to 5 percent today. That still doesn't sound that bad, but Japanese statistics seriously understate the truth: nearly a million Japanese workers have lost their jobs in the last few months, yet only 120,000 of those displaced workers are registered as unemployed. You should probably think of Japan's labor market as being comparable to what ours looks like at the bottom of a deep recession, with unemployment approaching 10 percent.

The psychological impact of these job losses -- and the closely associated surge in bankruptcies, which were rare in the 1980's but have reached epidemic proportions -- is particularly severe in a society that usually tries to avoid such stark outcomes. Japan is, after all, the land of lifetime employment and the ''convoy system,'' in which strong companies help weaker companies to stay in business. So perhaps it isn't too surprising that the grimmest indicator of Japan's troubles is a sharp rise in suicides, especially among those who have lost their jobs or their businesses.

So why hasn't Japan tried to get its sluggish economy moving again? The worrying answer is that it has tried, over and over -- and failed.

Remember that the first line of defense against recession is monetary policy, the ability of the central bank to cut interest rates. Well, in Japan monetary policy has hit the wall. Interest rates came down and down, falling below 1 percent in 1996. In early 1999 the Bank of Japan, the counterpart of the Federal Reserve, reduced the overnight rate to zero. Yet, there has been no sign of inflation -- or of recovery. And you can't push interest rates below zero.

Economists refer to Japan's situation, in which a zero interest rate just isn't low enough to restart growth, as a ''liquidity trap.'' The point is that, other things being equal, ''liquid'' assets -- cash -- are better than bonds: you can't use a bond in a vending machine. The only reason people are willing to invest in bonds is that unlike cash, they offer interest. When the interest rate gets very low, this incentive disappears, and people just hoard cash instead. So if even a zero interest rate isn't low enough to get consumers and businesses to spend, there's nothing more you can do with interest-rate policy; you're trapped.

To find another case of a liquidity trap, you have to go back to the United States in the 1930's. In 1939 the interest rate on Treasury bills was effectively zero (strictly speaking, it was 0.02 percent), yet the economy was still stuck in a depression. But that was a long time ago. By the 1990's, hardly anybody even thought about the possibility of a liquidity trap, and those who did usually dismissed it as something that probably couldn't happen in real life.

But Japan's example showed, ominously, that it could. The liquidity trap is back.

What about the second line of defense, fiscal policy? Japan has tried that, and it has worked -- sort of. Let me explain.

If you have visited Japan recently you know that it does not look like a country in the midst of a depression. There are strong similarities between Japan in the 1990's and the United States in the 1930's, but there is also a big difference. America descended rapidly into depression. Japan's crisis has unfolded far more gradually. Why has Japan's depression, if that's what it is, been so low key?

One important answer -- which is, by the way, a reason not to panic in the current situation -- is that, being a modern country, Japan has not allowed its banks to fail. Economic historians will tell you that the Great Depression didn't begin with the stock market crash of 1929. Although there was a recession following the crash, it was nothing out of the ordinary. Things didn't really fall apart until late in 1930, when a wave of bank runs swept across America, driving a third of the nation's banks out of business.

Today, no government would allow anything similar to happen. In Japan, furthermore, the government has stepped in repeatedly to prop up the banks, merging weak banks with stronger ones and occasionally putting in big infusions of cash to cover the banks' losses. There is much to criticize about this process, which has kept the banks alive but not restored them to health. But by averting a banking crisis, Japan has helped protect the economy from any sudden collapse.

The other reason that Japan does not look like a country in the midst of a depression is that the government has found a concrete solution to the problem of mass unemployment. By ''concrete,'' I don't mean serious, hardheaded, substantial. I mean concrete, as in roads, dams and bridges.

Think of it as the W.P.A. on steroids. Over the past decade Japan has used enormous public works projects as a way to create jobs and pump money into the economy. The statistics are awesome. In 1996 Japan's public works spending, as a share of G.D.P., was more than four times that of the United States. Japan poured as much concrete as we did, though it has a little less than half our population and 4 percent of our land area. One Japanese worker in 10 was employed in the construction industry, far more than in other advanced countries.

Without those public works programs, things might have been much worse. For there is no question that enormous public spending has helped keep the economy from sliding into a true, unambiguous depression. As one Japan expert, Adam Posen of the Institute for International Economics, points out, the record of the 1990's is unmistakable. Every time the government tries to scale back its spending, as it did under Prime Minster Ryutaro Hashimoto back in 1997, the economy goes into a recession. Every time the government goes back to its free-spending ways, as it did after Hashimoto resigned in disgrace, the economy perks up a bit.

Now for the bad news: deficit spending has slowed the Japanese economy's slide, but it has not reversed it. That is, the public works programs provide only temporary, symptomatic economic relief. The favorable effects last only as long as the spending itself. They don't seem to lay the basis for a permanent turnaround.

And meanwhile, though Japan has thus far avoided mass unemployment, its policy of massive public works spending has produced many nasty side effects. One is the vast environmental damage that has been inflicted in the name of job creation. Another is pervasive corruption, as rakeoffs and kickbacks have become a way of life, distorting the whole economic and political system.

Furthermore, a decade of huge deficit spending has left Japan with an enormous public debt. Japan last ran a budget surplus in 1992. In that year, the nation's public debt was about 60 percent of G.D.P., about the average for advanced countries and slightly less than the figure for the United States. The years of deficit spending since then have pushed Japan's debt above 130 percent of G.D.P. That's the highest ratio among advanced nations, considerably worse than either Belgium or Italy, the traditional champions. It's almost twice the advanced-country average and 2.5 times the figure for the United States.

So far, thanks to the extraordinarily low interest rates on its debt, the Japanese government has been able to continue borrowing despite this burden. But how much longer can it go on? And what will happen to the economy when creditors begin to balk? (That may already have started. Just before the terror attack, Moody's, the bond-rating agency, reported that it was considering a downgrade of Japanese debt, which would have the effect of raising interest rates.)

Japan's experience, in other words, should puncture our complacency. It shows that an advanced country with all the advantages that status brings can still fail to cope effectively with economic slowdown.

But does any of this have any relevance to us? Does America look anything like Japan?

It Could Happen Here

I wish I could say with confidence that Japan's dismal experience is of no relevance to the United States. And certainly our nations are very different in many ways. But there is a distinct resemblance between what happened to Japan a decade ago and what was happening to the United States economy just a few weeks ago. Indeed, Japan's story reads all too much like a morality play designed for our edification.

At the most general level, Japan offers an object lesson of pride going before a fall. It has only been a few years since every other cover in the business section of the airport bookstore showed a samurai warrior or a rising sun, when Japanese businessmen and bureaucrats were both admired and feared. Now, to the extent that Americans think at all about Japanese managers and government planners, it is with contempt. These days we're the ones who think we have all the answers.

More specifically, the rise and fall of Japan's financial bubble sounds all too recognizable to post-millennial Americans. An already advanced nation pulls ahead of its first-world peers, taking the lead in all the hot new technologies. Stock prices soar to levels that look insane using conventional criteria, but everyone agrees that in such a dynamic economy old rules no longer apply. And then the bubble bursts, leaving behind a mountain of bad debts and an economic engine that refuses to turn over. Name two countries whose experiences in the last 20 years fit that description.

That similarity between Japan and the United States was causing sleepless nights for many economic analysts, myself included, even before the world revealed itself to be a more dangerous place than any of us imagined.

What did I think when tossing and turning? That we keep saying that we are nothing like Japan, but more and more it looks as if the language may be different but the song remains the same.

When Wall Street first began to show signs of irrational exuberance back in the middle of the 1990's, a few lonely voices warned that we might be about to develop a Japanese-style bubble. But conventional wisdom said that this was nonsense, that our mature financial markets would never get that out of touch with reality. When stock prices reached multiples of earnings that were way above historical norms, some warned that it was indeed a Japanese-style bubble. But conventional wisdom said that this was nonsense, that the New Economy justified those higher multiples.

When our bubble finally burst, some warned that we might have a Japanese-style recession. But conventional wisdom said that this was nonsense, that the economy was more resilient than that. And when the slowdown came, some warned that we might find it as hard as the Japanese did to turn it around. But conventional wisdom said that this was nonsense, that the great Greenspan would soon set things right.

By Sept. 10, however, the Fed had already cut rates seven times, and it was still hard to see where a recovery would come from. Indeed, some business economists had started referring privately to the Fed chairman as ''Greenspan-san.'' Business investment was still falling, because corporations clearly invested way too much back when optimism was the rage. Housing was doing better, thanks to low interest rates, but some analysts were warning about a housing bubble -- and even if they were wrong, how solid a recovery could we have from housing alone?

So things were already looking fairly dicey before the terrorists struck. In fact, if we do have a recession now we will never be quite sure whether it was the result of the attack or something that was going to happen anyway.

Still, as they say, everything is different now. What does the economic picture look like after the horror?

The Fear Economy

As I've pointed out, the terrorist attack inflicted only minor damage on the American economy's supply side. Its initial effects on demand were much more pronounced. Vacations were canceled, at first because there were no planes and later because people were afraid to fly. Consumers quickly returned to purchasing necessities, but many were in no mood to indulge themselves in luxuries. And businesses, worried about the economic effects of the crisis, scaled back their investment plans, introducing the risk that their concerns could become a self-fulfilling prophecy.

Looking out a bit further, the picture may be better. Life will go on, and people will eventually want their consumer goods -- and even their vacations. This return to normalcy will, of course, be delayed if there is another terrorist incident or a large-scale shooting war. At the time of writing, though, military analysts seemed to expect a prolonged but low-intensity campaign -- bombs and commandos, not tanks and heavy infantry divisions. If they're right, it will look like the sort of campaign Israel has waged more or less continuously for decades -- and Israelis have not lost their taste for life's small luxuries.

Meanwhile, the crisis has led to changes in policy that will offset some of the slump in private demand. In fact, I'd say that the odds are at least even that a year from now it will be clear that the terrorists indirectly gave the economy a boost. That's because the events of Sept. 11 have led to more expansionary policies, on both the monetary and the fiscal side.

First, the Federal Reserve cut interest rates by half a percentage point on the first day the markets opened, just six days after the attack. The case for another rate cut had been building in any event, but the Fed was reluctant to move before its next meeting, which wasn't until October -- among other reasons because Greenspan and company didn't want to look as if they were panicking. Distasteful as it is to say this, the atrocity gave the Fed an opportunity to move earlier and more forcefully than it might otherwise have dared.

Second, the attack opened the door to a large but temporary increase in government spending -- precisely the kind of fiscal policy some economists had wanted but which had seemed politically impossible before. In early September, discussions of fiscal policy had been mired in bitter partisan politics. Democrats were reluctant to endorse fiscal stimulus because it might let Republicans off the hook on the consequences of their earlier tax cuts. Republicans wanted to use the economy's weak state as justification for further tax cuts. Those debates are still out there, but Congress, meanwhile, quickly agreed on a large spending package for the military and another large package for rebuilding New York. This spending package could quickly get much larger -- and provide an even bigger stimulus -- if, contrary to expectations, this does turn into a full-scale conventional war.

Finally, the terror attack also seems to have led to some favorable policy changes elsewhere in the world. Until this September, many economists had been gnashing their teeth over the obduracy of the European Central Bank, which refused to cut interest rates in the face of gathering storm clouds over the world economy. And we had begun to suspect that the E.C.B.'s refusal to act was increasingly based on pride and stubbornness -- it wouldn't cut precisely because everyone was so critical of its actions. The terrorists changed all that. Just hours after the Fed's action, the E.C.B. matched it.

It's worth remembering that wars usually stimulate rather than depress economies; the main economic danger from war is inflation, not deflation. True, we are not at war in the traditional sense; the analogy with Pearl Harbor is a very bad one in many ways. Still, it wouldn't be that strange if the terror attack turns out to be a short-run plus for the economy.

Yet one can't dismiss the possibility that this time will be different, that the terror attack will have a persistent negative effect. Or, alternatively, that the positive effects will be too weak to offset the bad things that were already in train. How bad could it get?

Stopping a Slump

Before the terrorist attack, my great concern was that Alan Greenspan would run out of ammunition. Having seen him reduce the overnight interest rate from 6.5 percent to 3.5 percent since January without stopping the economy's slide, I envisioned him completing the process by reducing the rate all the way to zero without doing any better.

After the attack my great concern is exactly the same. The overnight rate is now down to 3 percent, which leaves only another 3 percent to go. Will it be enough? How much are we like Japan, anyway?

Here one can offer some slightly reassuring comparisons. Both Japan and the United States had stock market bubbles, and they were of roughly equal size: between 1985 and 1989 the Nikkei, Japan's main stock index, tripled; between 1995 and 2000 the S.&P. 500 did the same. But Japan also had an equally large bubble in real estate and land prices. I've never known whether to believe the famous factoid that the land under the Imperial Palace in Tokyo was worth more than all of California, but Japanese land prices certainly reached ridiculous levels. And much of the bad debt that still troubles Japan was run up to support real estate speculation. We had nothing comparable in this country.

Moreover, the United States has a marked advantage when it comes to demography. Japan's persistent economic problem is that consumers want to save more than businesses want to invest. One important reason for that, many analysts agree, is the combination of a low birth rate and a refusal to allow large-scale immigration. An aging population tends to save a lot in preparation for retirement, and it's hard to get businesses to invest all those savings when they know that the working-age population will be shrinking for decades to come. We have problems with an aging population here, too. But they are nowhere near as severe, and our working-age population is still growing steadily.

In one way, however, our situation is actually worse than Japan's. For the past decade, Japan has been an island of depression in a sea of prosperity, its economy stagnating even as other major economies -- ours in particular -- boomed. That was, you might say, quite an achievement. Our current problems, on the other hand, are shared by much of the world -- not least by Japan itself.

In fact, Japan, which remains, despite all its problems, the world's second-largest economy and one of our biggest trading partners, has lately seemed to be on the verge of even deeper trouble: its slow-motion depression seems to be going into fast forward.

In the second quarter of 2001, Japan's economy shrank at an annual rate of more than 3 percent. Indeed, almost all observers believe that Japan was in a severe recession even before the terrorists struck. Aggravating the problem is accelerating deflation: the best measure of Japanese prices, the G.D.P. deflator, has been falling at an annual rate of 2 percent. Deflation adds to the economy's problems, because it gives people an incentive to hoard cash instead of spending.

If you think about this a bit, the story gets even worse. After all, prices are falling because the economy is depressed; now we've just learned that the economy is depressed because prices are falling. That sets the stage for the return of another monster we haven't seen since the 1930's, a ''deflationary spiral,'' in which falling prices and a slumping economy feed on each other, plunging the economy into the abyss. It's pretty scary stuff, not just for Japan but for the rest of us. If Japan slides into the abyss, that will have a direct adverse effect on our economy dwarfing anything the terrorists did.

Yet lately we seem to be living in a world full of dark clouds with potential silver linings -- and this one is no exception. The upside to Japan's troubles is that they leave us forewarned and to some extent forearmed. Think of it this way: without Japan's dismal example, economic officials in the United States might blithely dismiss the risks in our current situation, cheerfully proclaiming that prosperity is just around the corner. That, after all, is what Japanese officials did in the early stages of their slump. They didn't know that what did happen, could happen. We do.

And Japan's woes have not only made us aware that depression-type economic problems can occur in the modern world, they have also led to a much better understanding about how to fight them. Without the example of Japan, economic thinking in the 1990's might have been entirely focused on the problems of prosperity. Questions like the causes of slumps and the options for dealing with them would have been a musty field, attracting the attention of only a few economic historians. Instead these questions have been a subject of intense debate, attracting the attention of some of the world's leading economists. (Full disclosure: I've been working on the Japan problem for several years. But the economists I actually have in mind are people like Lars E.O. Svensson, the Swedish macroeconomist, who has produced the most fully worked-out proposal for Japanese recovery.) And this debate has offered some fresh approaches to the problem.

Not long ago, the two lines of defense against slump that I described earlier -- interest-rate cuts and deficit spending -- were pretty much it as far as economists were concerned. They seemed to be enough: interest cuts had ended every postwar recession, and deficit spending on a grand scale -- that is, World War II -- had ended the Great Depression. On the other hand, if they should turn out not to be enough, economists had few ideas about what might come next.

Now, however, it is widely understood that even if both conventional lines of defense fail, there is still a lot that you can do -- as long as you are willing to abandon conventional notions of prudence. For example, normal practice forbids central banks to invest in anything other than short-term government debt, for fear that decisions about what to invest in will become politicized. And since the short-term interest rate in Japan is already zero, there is nothing more that the Bank of Japan can do within the limits of normal practice. But given the economy's grave state, why not go beyond those limits?

For example, why not buy long-term government debt, which does not yet have a zero interest rate and therefore offers some additional traction? Or the Bank of Japan could print yen and use them to buy dollars; this would push the yen down, making Japanese exports more competitive on world markets.

Some economists have also suggested that an economy in Japan's situation can bootstrap itself back to prosperity through ''inflation targeting.'' This means announcing publicly that you intend to push the economy into a state of persistent mild inflation, say at 2.5 percent per year, and that you will do whatever is necessary to achieve that end. If the announcement is credible, potential borrowers will be more likely to take a chance, believing that they will be able to repay their loans more easily, and consumers will have second thoughts about hoarding cash.

Such radical ideas were branded as irresponsible when they first came out but have since become respectable, almost mainstream. And that means that if the worst comes to pass, if the United States economy starts to show signs of the Japan syndrome, we won't be at a loss for ideas about what to do. Admittedly, it would be nice if Japan had actually tried any of these proposals and reassuring if they had been tried and worked. Alas, despite growing support within Japan, they have not been tried. The reason, I think, is fear -- fear of the unknown, fear of trying anything that might fail.

Fear of the unknown was presumably behind a bizarre recent outburst from Japan's finance minister. Earlier this year Junichiro Koizumi, a maverick and reformer who is intensely disliked by political insiders, was nonetheless chosen as prime minister by the ruling party in response to public pressure. Koizumi has promised that he will fix the economy. Koizumi is pushing ''structural reform'' -- measures like forcing banks to own up to their bad loans -- that will be good for Japan in the long run but will actually depress the economy in the near future.

But there was hope that he would also press for unconventional monetary actions -- and some of his advisers have expressed support for such policies. They have been undercut, however, by the finance minister, Masajuro Shiokawa, who declared that this would ''cause runaway inflation and send the economy spinning out of control.'' This at a time when the economy is already spinning out of control and is threatened with runaway deflation. Perhaps Shiokawa is still traumatized by the wartime inflation of his youth.

Meanwhile, the Bank of Japan, which directly controls monetary policy, has refused to do anything unconventional; incredibly, it refused to make any major changes in policy even after the terrorist attacks. This refusal, I believe, is rooted in a pettier kind of fear. After all, if the Bank of Japan were to engage in unconventional monetary policy, it might fail. It would be very embarrassing. It's far safer to declare that your institution has done all it can and that it's up to somebody else to find a way to make the economy recover.

Let's hope that in a similar situation, our policy makers would be bolder and more responsible.

The Nightmare Scenario

Let me be clear: I don't think that the United States is at any imminent risk of following Japan into deep slump. What I do fear is that a combination of factors -- the legacy of our bubble economy, the trouble in Japan and maybe the psychological impact of the terrorist action -- will drag us into a prolonged period of stagnation.

Here's my nightmare: America's recovery from its current slump, whenever it comes, is tentative and short-lived, because the business investment that drove our boom in the 1990's remains stagnant. Eventually the housing bubble bursts and we have another slump; then we have another weak recovery, this time driven by deficit spending, but that, too, fades out. Eventually we look around and realize that it's 2009, and the economy still hasn't fully recovered from the slowdown that began at the end of the previous decade.

And we also realize that while the government's subsequent attempts to sustain the economy, mainly through tax cuts and subsidies to energy companies, have arguably staved off depression -- the unemployment rate has risen, but only to 8 percent -- they have also devastated the environment and left a huge government debt. The fiscal 2010 budget deficit is projected at $800 billion, and nobody has any idea how we will manage in a couple of years, when millions of baby boomers start collecting their Social Security checks.

Is this outlined situation an actual forecast? No, it's only a possibility. And the terrorist attack doesn't make it any more likely -- if anything, the fiscal response to terror should help give the economy a boost now, when there is a good chance of heading off the chance that we will slip into a Japanese-style trap.

And even if this possible outcome starts to look a more likely one, we should not give up hope. For although Japan may have failed to come to grips with its long stagnation, that failure was not preordained. Many of us think that if Tokyo would show a bit more courage and imagination it could still turn its economy around. And if the worst happens and we find ourselves in a similar situation, so can we.

A truly worst-case scenario would be if the United States not only fell into a Japanese-style economic trap but also exhibited a Japanese-style unwillingness to do whatever it takes to get out of that trap. But I think, or at least hope, that our economic leaders would be bolder and more imaginative. The Fed, in particular, is a smarter institution than the Bank of Japan, with a lot more talent on hand, and historically has shown a willingness to take responsibility for the economy rather than interpret its job narrowly.

So should we be worried about the world economy in the aftermath of the terrorist attack? Yes, we should -- but not because of the attack. In fact, I've been worried about the world economy for several years, ever since I realized that depression-style economic problems could happen in the modern world, and even here in America.

It has become a cliche to say that everything is different now. What worries me is the prospect that some things may be the same -- the same as they were here in the 1930's, the same as they have been in Japan for the last 10 years.

What would make things really different, in a good way, would be effective leadership that recognizes the gravity of the situation, does not fail to act for fear of political repercussions or, worse yet, try to exploit the crisis for political ends -- leadership that is prepared to try unorthodox remedies if conventional solutions fail. Do we have that kind of leadership? We may find out.

Originally published in The New York Times, 9.30.01