A decade ago, Japan terrified the world with its economic strength. The country had rebuilt itself so effectively after the second world war that it was challenging the US as the world's largest economy.

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These days Japan is alarming the Group of Seven with its weakness. A full two decades after the 1980s asset price bubble burst, the country remains mired in economic stagnation, with falling asset prices and a deeply distressed financial system. Instead of setting records for growth, Japan is making history by becoming the first country since the 1930s US depression to show signs of a full-blown liquidity trap.

A couple of years ago, this situation provoked only mild concern. As long as the US economy continued to expand rapidly, this more than offset Japan's weakness. But now, with the world apparently poised on the brink of recession, and Japanese capital still a cornerstone of the global financial system, its problems are looking more pernicious - not just for Asia, but the rest of the world. Consequently, the question the world is asking this winter is what, if anything, could pull this vast country out of its stagnant hole?

The challenge is immense because there are at least four interlocking woes dragging Japan down. First, the country's productivity levels have slipped dramatically in recent years, as the economy has stagnated. During the past decade, the country has recorded three recessions, and is widely believed to have slipped into another one this autumn (although data is not yet available to show this).

Indeed, the government itself is forecasting a contraction of 0.9 per cent in the year to March 2002 - a projection that would represent the worst post-war performance. "The economy is very weak and it is unlikely to grow at its potential rate for the next few years," admits Haruhiko Kuroda, vice finance minister.

Second, the country has experienced steady deflation since the mid-1990s, according to the GDP deflator index. Indeed, even according to the unreliable CPI data, prices are now falling at around 1 per cent a year.

By the standards of the 1930s US depression, this may not seem too dramatic. But it marks the first sustained bout of price declines seen in the industrialised world for 70 years. And this, coupled with anaemic growth, has produced a phenomenon seen equally rarely: an economy that is shrinking in absolute terms.

This is exacerbating a third problem: debt. A decade ago Japan had little borrowing. But after 10 years of heavy fiscal spending, debt has soared to 130 per cent of gross domestic product.

Thus far, low long-term interest rates - and the fact that domestic savers own most of the debt - have prevented panic in the markets. But, with the economy shrinking, debt levels are projected to hit 200 per cent in the next few years, threatening to unnerve even compliant domestic savers.

The fourth challenge is the financial system. As asset prices fall, the banks are facing a rising tide of bad loans, yet their spare capital is almost exhausted. This means that the only way to rapidly clean up the bad loans is to give the banks more public capital - a step that the government can ill-afford, given the pressure on public finances.

As Paul Sheard, economist at Lehman Brothers, says: "Japan faces a multitude of structural problems, but top of the list must come deflation and a financial system burdened with non-performing assets."

So far, so alarming. What makes this cocktail of problems doubly pernicious is that the country has almost exhausted all the usual policy options to create growth. The government has spent much of the past decade attempting to reflate the economy with higher public spending.

However, this route looks increasingly difficult, given the high debt. Meanwhile, orthodox monetary policy tools have been almost exhausted, since the Bank of Japan has already cut short-term rates effectively to zero. Some economists suggest that another policy option might be to seek a weaker yen.

However, the recent slowdown in the US economy leaves Washington less ready to tolerate this. And, even if the US did accept a weaker yen, Japan's neighbours are unlikely to do so, given that their own exports are suffering, as a result of the shrinking global demand.

There is a fourth option that the government of Junichiro Koizumi is pursuing - faster restructuring. Since he swept to power in April, Mr Koizumi has pledged to curb the issuance of new bonds to below Y30,000bn a year, force the banks to write off Y11,700bn of bad loans in the next two years, radically reform government spending and promote the type of corporate restructuring that could boost Japan's competitiveness.

But, although most economists accept that these measures are needed to tackle the medium-term productivity problems in Japan, in the short-term they could make the slump worse.

So is there a solution? Probably the least bad policy route would be to use a combination of these measures: namely, to introduce some restructuring, combined with some unorthodox monetary policy tools to halt deflation, while keeping fiscal spending neutral - and aiming for a weaker yen.

However, to do this would require considerable policy co-ordination and diplomatic finesse. And Japan's single biggest Achilles heel is its fragmented power structures, which make it extremely difficult for Michiyo Koizumi, the prime minister, or any leader, to produce pro-active, co-ordinated economic plans, except when there is a serious crisis.

"Mr Koizumi is precariously floating above an economic policy team that is increasingly at a loss about how to proceed," argues Richard Katz, of the Oriental Economist. Barring a miracle, in other words, Japan's problems look set to grow worse, not better, in the next year ahead. The outside world has every reason to be worried.