Have no doubt, Japan's crisis will cost us all

The behaviour of financial markets in the last week confirms Lloyd George's observation that "financiers in a panic do not make a pretty sight". As little is known by the markets, much must be surmised.

The only certainty is that Japan's three known problem "Ds" - depression, deflation and demography - have now been joined by two new "Ds": disaster and destruction.

This toxic combination is exposing another "D" - debt.

Initial estimates suggest that the three most affected prefectures account for a combined 6-8% of Japanese GDP. This is roughly half that of the 1995 Kobe earthquake, making it economically less significant.

Direct losses are currently estimated at between US$100-200 billion (£62-£124 billion). Kobe resulted in approximately Yen 10 trillion of damage (around US$102 billion), around 2.5% of Japan's GDP at the time.

The disaster has disrupted economic activity. Industries have been forced to suspend production. Power blackouts are occurring and are expected to continue.

The fallout from Kobe was different, as it was one of the world's busiest ports, affecting Japanese trade more directly. Parallels to Kobe are misleading for other reasons. In 1995, many more of the country's industrial plants were based in Japan.

Since then, high costs and a strong Yen have forced Japanese manufacturers to relocate to lower cost locations within Asia or closer to their markets, like the US and Europe. Global supply chains are also now more flexible. This may allow manufacturing to be quickly relocated, minimising disruptions.

Japanese growth, which has been lacklustre in any case, may slow in the short run. As Japan is only around 6% of global GDP, the effect should be modest, but may compound problems elsewhere, such as weak employment, European debt issues and also rising inflation in many countries.

The key issue is how the rebuilding will be financed. Even before the disaster, Japan's government borrowing was over US$12 trillion, around 200% of its GDP. This debt reflects the effect of two decades of government spending in unsuccessful efforts to restore the Japanese economy to health after the crash in 1989.

While the additional financing needs for reconstruction will be accommodated in the short-run, it brings forward the day of reckoning. The cost of reconstruction may add additional debt, of as much as 5-10% of GDP. The major rating agencies - S&P and Moody's - have maintained Japan's credit rating at AA. However, both agencies have pointed out that the additional costs of the crisis exacerbate deep-seated problems.

Japan's current debt position is very different from the time of Kobe. In 1995, Japanese government debt levels were much lower (net government debt was around 25% versus 140% today).