It’s hard to remember that in the 1980s Japan had the world’s most admired economy. It would, people widely believed, achieve the highest living standards and pioneer the niftiest technologies. Nowadays, all we hear are warnings not to repeat the mistakes that resulted in Japan’s “lost decade” of economic growth. Japan’s cardinal sins, we’re told, were skimping on economic “stimulus” and permitting paralyzing “deflation”. People postponed buying, because they expected prices to go lower. That’s the conventional wisdom—and it’s wrong.

Japans economic eclipse shows the limits of economic stimulus and, at least in modest doses, the exaggerated threat of deflation. There is no substitute for vigorous private-sector job creation and investment, and that’s missing in Japan. This is a lesson we should heed.

Japan’s economic problems, like ours, originated in huge asset “bubbles.” From 1985 to 1989, Japan’s stock market tripled. Land prices in major cities also tripled by 1991. The crash was brutal. By year-end 1992, stocks had dropped 57 percent from 1989. Land prices fell in 1992 and are now at early-1980s levels. Wealth declined. Banks—having lent on the collateral of inflated land values— weakened. Some became insolvent. The economy sputtered. It grew about 1 percent annually in the 1990s, down from more than 4 percent in the 1980s.

Despite massive stimulus, rapid growth hasn’t resumed two decades later. Although the Japanese reacted slowly, they adopted the advice of economics textbooks. They raised spending, cut taxes, and let budget deficits balloon. Gross government debt soared from 63 percent of the economy’s gross domestic product in 1991 to 101 percent of GDP by 1997. It’s now about 200 percent. The Bank of Japan (its Federal Reserve) cut interest rates, going to zero in 1999—a policy that, with some interruptions, endures.

Japan’s lackluster performance has two main causes. One is the “dual economy”: a highly efficient export sector (the Toyotas and Toshibas) offset by a less dynamic domestic sector. Until the 1980s, Japan depended on export-led growth that created jobs and investment. An undervalued yen helped. "You had 20 percent of the economy carrying the other 80 percent/’ says Richard Katz of The Oriental Economist.

But the yen’s appreciation in the mid-1980s—making Japan’s exports more expensive—doomed this economic strategy. Ever since, Japan has searched in vain for a substitute. Cheap credit (which fueled the original “bubbles”) and many “reforms” haven’t sufficed. Japan’s domestic sector remains arthritic. Japan has the lowest rates of business creation among major industrial countries. Indeed, its best recent years of economic growth, from 2003 to 2007, occurred when a weaker yen revived exports.

The second problem is an aging, declining population, which dampens domestic spending. For decades, Japan’s traditional family—a workaholic husband, a stay-at-home wife, and two children— has been besieged, as anthropologist Merry White of Boston University shows in her book Perfectly Japanese. Even in 1989, the fertility rate (children per adult woman) of 1.57 was below the replacement rate of about two. The poor economy further discourages family formation. For men, the age of first marriage is 35, up from 27 in 1990, says White. The fertility rate is about 1.3.

So Japan’s economy is trapped: a high yen penalizes exports; low births and sclerotic firms hurt domestic growth. The lesson for us is that massive budget deficits and cheap credit are, at best, necessary stopgaps. They can’t correct underlying economic deficiencies. “Stimulus” policies are now the main focus of U.S. economic debate—but shouldn’t be. Success or failure ultimately depends on private firms. We ought to encourage their expansion by reducing regulatory burdens and policy uncertainty. If we don’t, our mediocre recovery could mimic Japan’s.