Twenty years of recession - or near-recession - and a potent dash of deflation may not seem like a recipe for economic success. The struggle to emerge from a global recession looks as if it could drag on for several more years. The US and Europe are wasting time exploring the same muddled policies that cost Japan its two "lost decades". Having already wasted time testing these theories, Japan could jump out in front of the crowd and become the first economy to return to growth.

The root of the current economic downturn is excess capacity, and the country that solves the dilemma of excess supply capacity will be the first to return to durable growth. During economic bubbles, people spend based on illusions of rapidly increasing wealth. As a result, companies invest in anticipation of continued strong growth in revenue from consumption. When bubbles burst they leave a huge gap between supply capacity and spending demand that crashes to earth. The logical solution to this problem is to cut supply capacity down to the new level of demand, but scrapping capacity cannot be accomplished without making cuts in the workforce - not popular in any country.

Rather than accepting the painful step of cuts in capacity and the workforce, Japan's government, like many others, has been using fiscal and monetary policy measures to stimulate demand without having a clear vision of how to permanently reduce the supply-demand gap. As it turned out, the gap was so large that its measures were inadequate. And the existence of the gap exacerbated the problem. Capital expenditure declined and companies capped wage increases, leading to further weakness of demand and consumption. Despite aggressive fiscal and monetary policies, the capacity-utilisation rate continued to decline and increased corporate inefficiencies.

This inefficiency is caused by excess capacity. Japan's manufacturing industry operates with at least 30 per cent of unused supply capacity. Using figures from the Statistics on Incorporated Enterprises, a 30 per cent reduction in capacity and employment would lead to a rise in profits from Y4,000bn to Y25,000bn (an increase of Y21,000bn or 4.5 per cent of GDP), partly through a big reduction in depreciation and wage costs.

The remaining workforce would share some of the benefits of the increased efficiency as wages would rise without hurting profits. It would also help the government trim its budget deficit as increased corporate profits would produce additional government revenue.

There would be drawbacks.

David Fuller's view Over the last twenty years Japan has tried practically everything in an effort to stem deflation and generate economic growth. Everything that is, except for 'creative destruction'.

Few democratically elected governments would encourage 'creative destruction', because of the social and therefore political consequences of surging unemployment.

The USA has far less stringent employment policies than most developed countries, especially those of Euroland. As US companies have shed labour, their productivity has soared, boosting corporate profits despite the Great Recession. However these gains are partially eroded for companies primarily geared to the domestic economy, by America's overdependence on consumer spending. The unemployed, and more importantly everyone else concerned with job security, spend less and save more where possible. The US government is creating more public sector jobs but these are usually less productive for an economy.

The UK has a grossly inflated public sector following ten years of Labour government. Euroland also has a large public sector and the least flexible employment laws. Japanese companies, post WW2, had a tradition of 'jobs for life'. Not any more and I was impressed to hear recently, in a subscriber's email quoting Ed Merner of the Atlantis Japan Growth Fund, that 70% of Cannon's workforce today is on part time contracts. This is not quite creative destruction but I suspect Schumpeter would approve.

Subject to the yen weakening, and it has begun to weaken following a failed upside break (JPY/USD), Japan is a catch-up candidate in the global stock market recovery.