Since November 2012, the world has been watching for the outcome of Japan’s experiment in “Abenomics,” a bold policy experiment that attempted to put the country on a faster growth track. The results are now coming in, and on balance the experiment appears to be failing. That’s not very surprising – one of its central planks rested on false Keynesian nostrums. However, the result won’t be pretty, and is likely to lead to a deep global recession starting within the next two years.

Abenomics consist of three interlinked policies, the combination of which is supposed to revive the Japanese economy. The first is a massive monetary “stimulus,” with Japan Government Bond (JGB) purchases of some 7 trillion yen ($70 billion) per month, about three times the size in terms of the Japanese economy as Ben Bernanke’s QE3 program at its greatest. This was supposed to revive the economy generally and, more particularly to weaken the yen against the dollar. The second is a program of fiscal “stimulus,” the latest supposed to offset the deflationary effect of a 3% rise in consumption tax to 8%, to be introduced in May 2014. The third was a program of reforms and opening up of Japanese institutions and trade restrictions, which together would increase output as well as making the Japanese economy more competitive.

The monetary stimulus has more or less worked as intended. The yen has fallen from 80 to the dollar before the program started to 102 to the dollar today. Inflation is running at 1.4% in the last 12 months, well on the way to the Bank of Japan’s target of 2%. The economy has recovered into moderate growth. Yet possibly because of the BOJ’s bond purchases, the yield on the 10 year JGB has fallen slightly, to 0.65%, now well below the rate of inflation.

The fiscal stimulus hasn’t worked so well, partly because it was ineffably foolish to begin with. Japan has a huge public debt problem, with government debt about 240% of GDP, close to the highest level ever brought down (250% of GDP by Britain in 1815 and 1945, the first time legitimately, the second time through debauching the currency as discussed further below.)

Public spending “stimulus” on anything like the scale to which Japan has been abusing it for decades, has to be borrowed and hence (in a closed financial system, like Japan’s, but somewhat unlike that of the United States where there are large contingents of foreign investors) drains resources from some other part of the system. Since public spending, even on infrastructure (of which Japan has plenty) is generally unproductively allocated, diverting resources from elsewhere to public spending generally reduces rather than increasing overall activity.

In Japan’s case, even the rise in consumption tax, brought in by the previous government to begin balancing the hopelessly lopsided Japanese budget, was neutralized by yet a further 5 trillion yen of public spending, unbalancing the budget yet further, although admittedly some of that payment would go to low-income families, where it might be spent optimally by those families.

As for the economic reforms, liberalizing Japan’s sclerotic and protectionist economic system, they simply haven’t happened. Labor laws have not been liberalized, no new trade agreements have been entered into (to be fair, the largest such agreement, the Trans Pacific Partnership is hopelessly the prisoner of the current dysfunctional administration in the United States, however hard Japan may try to complete it.)

Privatization of the Japan Post Bank, which had been put in place (albeit with an inordinately long lead time) by the Koizumi administration in 2006, was stopped by the last government and is now vaguely planned for 2015. The bank thus remains a giant slush fund for government projects, with 196 billion yen (almost $2 trillion) trapped in government bonds and other unproductive uses of its savers’ money. In addition, the state pension fund has 128 trillion yen ($1.3 trillion) of assets, almost all devoted likewise to holdings of JGBs. With these two behemoths preventing rational allocation of Japan’s bountiful store of capital, it’s no surprise that the economy is sclerotic and becoming more so.

There have recently been signals that Abenomics isn’t working. Japan’s GDP grew at only 1% in real terms in the fourth quarter of 2013. Admittedly that’s better than it looks, since Japan’s population and workforce are shrinking, but it doesn’t give the country anything like the “bounce” it needs to reduce debt. More ominously, in the year to March 2014 Japan appears to be heading towards its first current account deficit since 1980 with exports rising 9.8% in yen terms (almost entirely due to the weaker yen) while imports rise 14.1% in yen terms. While there may be a lagged “J-curve effect” that will kick in to offset this going forward, the balance of payments is currently doing nothing to reflate and enlarge the Japanese economy.

Meanwhile the debt level heads inexorably upwards. While in December’s budget for the year to March 2015, only 43% of public spending was to be financed by deficit bond issuance, compared with 46% in the previous year, even that lower level is still far too high for the debt to be stabilized. Japan’s household savings rate is now only 1.9%, far too low to finance the gigantic government deficits, let alone leave anything over for business investment and expansion. Hence there are only two sources of net finance for the government deficits: the Bank of Japan and foreigners. Since the country is now running a balance of payments of deficit, foreign finance will naturally increase, but at some point foreign appetite for JGB’s will dry up, as buyers realize that a 10 year yield that is well below inflation and a currency that is being continually debauched by the central bank, with no immediate prospect of a balance of payments surplus, are a fundamentally unstable combination.

Abenomics was a bold experiment. Had it not included the appalling mistake of extra “stimulus” spending – avoided by Junichiro Koizumi in the last attempt to stabilize Japan’s economy — it might well have worked. A decline in the yen and an increase in inflation, accompanied by austerity in the public sector, would have quickly brought the deficit down to a manageable level, and begun to reverse the relentless increase in the debt/GDP ratio. As it is, the curse of Keynesianism, which began the destabilization of the Japanese economy with spending stimulus in the late 1990s, has struck again. There was some chance that the expansion caused by monetary stimulus and yen devaluation, perhaps speeded by structural reforms, would have outrun the inexorable growth of the debt, but on the evidence of the latest figures, this target is almost certainly going to be missed.

There are three possible paths that the Japanese economy may now follow:

Japanese bureaucrats are, I suspect, looking longingly at the British experience post-1945, where a captive and docile middle class was suckered into investing in government bonds at negative real interest rates, while inflation spiraled out of control. The middle classes, especially the elderly, were disgracefully impoverished by this tactic, and the country as a whole grossly underperformed all its competitors in terms of economic growth, to the extent that inflationary stagnation became known as the “British disease.” Double-digit inflation and economic stagnation are what most likely awaits Japan on current policies, with Japan’s elderly being made to pay for the follies of the government by effective confiscation of their savings, especially those in the Post Savings Bank and the government pension system. If Japan follows this path, the yen will be very weak, JGBs will involve their investors in massive losses in real terms, and the Japanese stock market, while rising in yen terms, will fall in dollar terms as investors discover the economy’s stagnation.

The second possible route is outright default. If the Bank of Japan can’t get inflation up fast enough, so that it remains in its current 1-2% range while the debt continues to rise inexorably, with foreigners being asked to buy increasing amounts of it, then at some point the market will suffer a crisis of confidence and it will become impossible to sell enough JGBs to cover maturities and the budget deficit. This will cause economic collapse, while the write-off of Japanese savings will come explicitly through a debt write-down and restructuring. The British stagnation route is preferable to this in the short term, but outright default and debt restructuring has the advantage that the Japanese political class will be prevented from spending more money than they take in. Over a 20-year period, this route may thus involve only a partial destruction of Japanese wealth and incomes, while the post-war Britain route will bring at least a 90% destruction of wealth and probably more income hardship too.

There is one reform which Abe could carry out now which might avoid a JGB default. That is to privatize the Post Office Bank immediately and liberate the pension system immediately to buy a full range of investments, perhaps putting a foreign investment manager in to ensure it does so (but a long-term oriented, value-oriented conservative manager, not an investment bank or a hedge fund.) This would result in a huge loss of support for the JGB market, but with foreign JGB holdings still relatively small and global liquidity immense, there would be an international “bid” for the immense amount currently being issued, even if the Bank of Japan scales back bond purchases, as it probably should.

The effect domestically would be to deploy $3 trillion of purchasing power towards optimal capital uses, whatever they are but in any case in the private sector. With higher interest rates, domestic savings would also rise, stimulating the economy further. There would almost certainly be a major boom on the Japanese stock market, and the confidence effect of such a bold “reform” would attract a flood of new investment projects, pushing the Japanese economy into rapid expansion. Removing artificial restrictions in retailing, agriculture and land usage would enhance this effect, and the political pressure to remove these restrictions would become overwhelming, thus ensuring that some of them were actually removed.

Unfortunately, I think it unlikely Abe will do this. He, the Ministry of Finance and the Bank of Japan are well aware of the unpleasantness of a government bond default, but believe they can avoid it without major structural reform. At this point, they can’t. And as a former Brit of the right age, let me give them my informed opinion: the postwar Britain path is in the long run the most unpleasant of all.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)