We are ready to take a look at the long financial travail Japan has been experiencing since 1990, the aftermath of wild speculation known as the Bubble. The meltdown of the stock market and property prices has wiped away assets worth $10 trillion, with another $3 trillion likely yet to go. These vanished assets are not trivial, for they make up one of the most grievous declines of wealth experienced in human history, the sort of loss that usually happens in war or at the fall of an empire. To see how Japan could have got itself into this incredible situation, we must go back to the heyday of Japanese financial power more than a decade ago.

When, toward the end of 1987, black limousines began lining UP each afternoon in front of Madame Onoe Nui's house in Osaka, the neighbors thought little of it. The cars disgorged blue-suited men carrying briefcases who disappeared inside, sometimes not to emerge until two or three the next morning. Nui operated a successful restaurant, and it appeared that she had expanded her dinner business into earlier daylight hours. Only later did the neighbors learn that Madame Nui's visitors were not coming for the good food. The men in blue suits were coming to pay homage to a shadowy resident of Nui's house, a figure later revealed to be the single most important player in the Japanese stock market at the time. He was Nui's pet ceramic toad.

Toads, as is well known, are magic beings that like badgers and foxes are adept at weaving spells, especially those involving money. People like to have as charms in their gardens ceramic statues of badgers with a jug of wine in one paw and ledgers of receipts in the other. Toads, though less popular, are more mysterious, as they can transform themselves into demon princesses, and they know ancient sorcery from China and India.

The blue-chip Industrial Bank of Japan (IBJ), Japan's J. P. Morgan, especially favored Madame Nui's toad. Department chiefs from IBJ's Tokyo headquarters would take the bullet train down from Tokyo to Osaka in order to attend a weekly ceremony presided over by the toad. On arriving at Nui's house, the IBJ bankers would join elite stockbrokers from Yamaichi Securities and other trading houses in a midnight vigil. First they would pat the head of the toad. Then they would recite prayers in front of a set of Buddhist statues in Nui's garden. Finally Madame Nui would seat herself in front of the toad, go into a trance, and deliver the oracle-which stocks to buy and which to sell. The financial markets in Tokyo trembled at the verdict. At his peak in 1990, the toad controlled more than $10 billion in financial instruments, making its owner the world's largest individual stock investor.

Madame Nui was also the world's largest individual bank borrower. «From the mouth of the toad,» she proclaimed, «comes money,» and she seems to have called considerable Chinese and Indian sorcery into play, for she parlayed a small initial set of loans made in 1986 into a vast financial empire. By 1991, in addition to IBJ, which lent Nui ?240 billion to buy IBJ bonds, twenty-nine other banks and financial institutions had extended her loans totaling more than ?2.8 trillion, equal to about $22 billion at the time.

Onoe Nui was riding the success of the so-called Bubble, when Japanese investors drove stocks and real estate to incredible heights in the late 1980s. In 1989, the capitalization of the Tokyo Stock Exchange (TSE) stood slightly higher than that of the New York Stock Exchange; real-estate assessors reckoned that the grounds of the Imperial Palace in Tokyo were worth more than all of California; the Nikkei index of the TSE rose to 39,000 points in the winter of 1989, after almost a decade of continuous climb. At that level, the average price-to-earnings ratios for stock (about 20 to 30 in the United States, the United Kingdom, and Hong Kong) reached 80 in Japan. Yet brokers were predicting that the stock market would soon rise to 60,000 or even 80,000. Euphoria was in the air. Japan's unique financial system-which is based on asset valuation, rather than on cash flow, as is the norm in the rest of the world-had triumphed.

When the crash came, it hit hard. In the first days of January 1990, the stock market began falling, and it lost 60 percent of its value over the next two years. Ten years later, the Nikkei has still not recovered, meandering in a range between 14,000 and 24,000. When the stock market collapsed, so did real-estate prices, which fell every year after 1991 and are now about one-fifth of Bubble-еrа values or lower. Many other types of speculative assets also evaporated. Golf-club memberships, which during their heyday could cost $1 million or more, today sell for 10 percent or less of their Bubble price, and bankruptcy looms over many golf-club developers, who must return tens of billions of dollars taken in as refundable deposits from members.

Despite the best efforts of Madame Nui's bankers and the toad, her empire crumbled. In August 1991 the police arrested her, and investigators found that she had based her first borrowings on fraudulent deposit vouchers forged by friendly bank managers. Nui's bankruptcy resulted in losses to lenders of almost ?270 billion, the resignation of the chairman of the Industrial Bank of Japan, and the collapse of two banks. The «Bubble Lady,» as the press called her, spent years in jail, along with her bank-manager patrons.

Banks, which lent heavily to speculators like Madame Nui to buy stock and land, found themselves saddled with an enormous weight of nonperforming loans. For years the Ministry of Finance claimed that bad loans amounted to ?35 trillion, only grudgingly admitting, in 1999, that they surpass ?77 trillion. Even so, most analysts believe the figure is much higher-perhaps twice that. Taking the more conservative figure favored by many analysts, ?120 trillion, Japan's bank fiasco dwarfs the savings-and-loan crisis of the 1980s in the United States. The S amp;L bailout, at $160 billion, came to about 2.7 percent of GNP at the time, but the cost of rescuing Japan's banks could reach as much as 23 percent of GNP, a crushing burden. By the end of the century, despite a decade of rock-bottom interest rates maintained by the government to support banks, and despite a massive ?7.45 trillion bailout in 1999, Japan's financial institutions had written off only a fraction – perhaps 20 percent – of the loan overhang.

What were the policies that caused a supposedly mature financial market to fall prey to a mania completely askew with economic realities? The answer is simple. It applies not only to this question of finance but to questions in almost every area in which Japan is presently suffering: Japan's financial system rests on bureaucratic fiat, not on something that has intrinsic value. What occurred in Japan is an elegant test case, better even than that of the U.S.S.R., of what happens when controlled markets defy reality. For fifty years, the Ministry of Finance (MOF), the most powerful of Japan's government agencies, has set levels for stocks, bonds, and interest rates that nobody has dared to disobey. The financial system was designed to enrich Japan's manufacturing companies by providing cheap capital, and in this it succeeded spectacularly well for thirty years. Money from savings flowed to the big manufacturers at very low rates-in the late 1980s, the cost of capital in Japan was about 0.5 percent. (In contrast, American and European companies paid rates ranging from 5 percent at the lowest to more than 20 percent.) And while in other countries investors and savers expected returns and dividends, in Japan they did not.

In the West, financial gurus sometimes lament that Wall Street holds corporate earnings captive to shortsighted demands for profit, whereas in Japan, rather than paying dividends to greedy stockholders, companies retain most of their earnings and pour them back into capital investment. Even though they didn't pay dividends, stocks kept climbing throughout the 1970s and 1980s. Thus arose the myth that stocks in Japan were different from those in other countries: they would always rise. When in 1990 Morgan Stanley began issuing an advisory that included warnings of which stocks to sell, MOF viewed this as an ethical lapse out of tune with the moral tradition of the Japanese stock market.

Concentrating only on the benefits to companies that need not pay dividends leaves out several important factors. We all know there are various standard ways to value stock. Most important of these is the price-to-earnings ratio (P/E ratio), which tells you what percent of your investment you can expect a company to make as earnings. A P/E ratio of 20 means that in one year the company will earn one-twentieth, or 5 percent, of the price of the stock, some or all of which it will pay out to you, the shareholder, in the form of dividends. These dividends will be your basic return on investment.

Calculating the true value of a stock gets complicated if you expect the company's earnings to grow dramatically in the future-which is why investors have snapped up Internet stocks in America even though many dot-coms have never made profits and have even suffered losses. But the general principle still applies; that is, the investor expects to be paid dividends, now or in the future, on earnings.

This has not been true in Japan, where the accepted wisdom held that stocks needn't pay out earnings; before the Bubble burst, P/E ratios reached levels undreamed of elsewhere in the world. The Dow Jones average, at its most inflated in early 2000, averaged P/E ratios of about 30, at which point analysts screamed that it was overheated. In contrast, average P/E ratios in depressed Japan reached 106.5 in 1999, more than three times the American level. A P/E ratio of 106.5 means that the average earnings per share of companies listed in the Japanese market is essentially zero.

A situation like this is paradise for industry, because it means that companies can raise money from the public for practically nothing. It works for investors, however, only if stocks always magically rise somehow, despite producing no earnings. That is to say, it works only as long as the stocks continue to find eager buyers. As part of the recovery after World War II, Japan's Ministry of Finance engineered just such a system, and it was a modern miracle. It worked partly because there was then relatively little stock available to the public, given a policy called «stable stockholding,» by which companies bought and held each other's stock, which they never sold. The purpose, as with many of MOF's stratagems, was not economic (which is why Japan's system baffles classical Western theorists) but political, in the sense that it was a means of control. It prevented mergers and acquisitions, which MOF could not allow: the threat of a takeover forces a company's management to manage assets to produce high returns, and this would go against the government policy of building up industrial capacity at any cost.