Question: Will Japan’s low interest rates continue to have a negative impact on the Japanese economy?

Recently a comforting theory of Japan's woes has taken hold in respectable circles: it's all a banking problem. Fix Japan's banks, the conventional wisdom has it, and the economy will regain its vitality. This is why the recent passage of a large bank rescue package is seen as a turning point.

The problem with this theory is not just that it is almost surely wrong. The fact that smart people are putting their faith in such a dubious explanation is an indicator of the continuing reluctance of the policy elite, in Japan and outside, to face up to the unsettling implications of the country's recent experience.

The immediate problem with Japan's economy is not in question: even at a near-zero interest rate, aggregate demand is inadequate to employ the country's productive capacity. Or to put the same point differently, at full employment Japanese savings would exceed Japanese investment by more than the country's current account surplus.

To believe that banking reform will heal the Japanese economy, you must believe that it will sharply reduce this savings-investment gap. Call it the "clogged pipe" theory: it says that the weakness of Japan's banks depresses investment, because it prevents liquidity from getting through to credit-constrained firms.

Does this make any sense? Japan has not suffered from bank runs and massive disintermediation: the public continues to believe, correctly, that its deposits will be protected. And as long as this belief holds, the logic of moral hazard says that bad banks - banks with low or negative capital - tend to be more, not less, willing to make risky loans than they should, because they have an incentive to play the game "heads I win, tails the taxpayers lose".

The same logic says that such banks will actually not want more capital, since it reduces the value of their deposit insurance "put" - and indeed, Japanese banks that have applied for capital injections have made it clear that they are doing so only as a favour to the government, to avoid making its rescue plan look foolish.

Experience confirms this logic: overlending by undercapitalised banks was the driving force behind America's savings and loan crisis in the 1980s. But if you accept this logic, you should believe that increasing the capital of Japanese banks will reduce rather than increase their willingness to lend - actually worsening the savings-investment gap.

True, in the past year or so there have been many complaints about a credit crunch in Japan. (Before then there is no evidence at all that credit conditions were a source of economic stagnation).

The timing of these complaints is no mystery: they began when the government announced new capital standards for banks, and in general signaled that it was unwilling to allow the questionable lending that had persisted through the previous six years of stagnation to continue. But consider what this timing implies for the nature of the "crunch". It says that the problem is not that there are currently loans Japanese banks should be making, but aren't; it is that a year or two ago there were loans banks shouldn't have been making, but were.

Suppose that even (or especially) with healthy banks, and even with near-zero interest rates, Japan still suffers from an excess of savings over profitable investments. Then one cannot avoid concluding that some kind of deeply unconventional response is necessary. You don't have to accept my own notorious proposal for "managed inflation", although to me the case for believing that Japan's economy needs a negative real interest rate, and hence needs inflation, seems overwhelming.

But you must accept that something radical, something that would normally be considered unsound policy, is the only way out. The real significance of the fixation on banks as the be-all and end-all of the problem, then, is that it means that Japan and those who advise it are not yet prepared to rethink their ideas of what constitutes sound policy. And that, I fear, means that there is not yet even a glimmer of light at the end of this tunnel.