Sean O'Grady: For now this is a natural disaster. If it becomes nuclear, the economic fallout will affect us all

Serious nuclear contamination might make the Japanese – already inclined to save rather than spend – more fearful

(EPA)

Distressing, appalling and traumatic as they are in human terms, the basic economic template for natural disasters is that they cause disruption, but are essentially ephemeral; and the longer-term boost to spending from reconstruction and development may even help an economy.

That, for example, is pretty much what happened after the Kobe earthquake in 1995, after the South Asian tsunami of 2004, Hurricane Katrina a year later and many others, including, on a trivial scale, our own recent volcanic dust and snow episodes. The Kobe shock, and rogue trader Nick Leeson, helped to bring Barings down, to be sure, but it did not trigger any wider systemic financial crisis. The earthquake cost about $100bn – material, but dwarfed by Japan's $5,000bn annual GDP.

Yesterday the Nikkei share index was down 6 per cent; Japan's Electric Power company was particularly badly hit, with shares losing 24 per cent. Nissan's shares lost 9.5 per cent, while Toshiba, a developer of nuclear reactors, dropped 16 per cent and Hitachi, another industrial giant, also fell 16 per cent. Western markets, for now, remain calmer.

The problem for Japan, and the rest of the world, will be if this natural disaster turns into a nuclear one. Once we start thinking in nuclear terms the outlook for the world's third largest economy (about $1 in every $10 of economic output generated around the world comes from Japan) and the rest of the planet is much less reassuring. For a nuclear meltdown will trigger an economic meltdown, and at just the moment when the world least needs it.

On the potential scale we are looking at, this sort of nuclear contamination is simply unprecedented in a major industrialised economy, and would deal a far more grievous and permanent blow to Japan's already fragile prospects for growth.

The economic aftershocks will hit every corner of the earth; think of the jobs in this country that rely on Japanese companies, most clearly in the car industry and in the City of London.

For now, the physical damage is the most obvious. Sendai is not the heart of Japanese manufacturing or finance, though there are major employers there such as Sapporo and Kirin, the breweries, and it is, as we know now, a major nuclear power supplier. And that is serious; Japan obtains 30 per cent of its electricity from nuclear, a strategic, though risky, decision taken by a nation with few natural resources and no fossil fuels. Until this disaster, Japan looked better placed than most to cope with the spike in the price of oil and gas.

Now it looks less wise. Major corporations have declared that they will limit production and Tokyo may suffer some power cuts. Given the strains on the transport system, the government has also asked people not to go to school or work; that again will reduce GDP. The ports will also be blocked – bad news for a nation that needs to import much of its food.

Against all that are the medium- to long-term prospects for reconstruction. Over the past 20 years, as Japanese governments have tried, and failed, to spend their way out of stagnation, the country has been bequeathed many "bridges to nowhere" – infrastructure projects with little economic rationale other than to get cash into the economy.

Of more use, though, on the day of limited efficacy, Japan also invested heavily in anti-tsunami defences. Now they have the opportunity to spend more productively in new homes, factories, offices, shops, hospitals and schools to replace those reduced to matchwood.

The Bank of Japan has pushed an extra 22 trillion yen (£166bn) into the system to calm markets, ensure financial stability and help to start a recovery. The Government ought to be able to borrow and invest even more – but there are concerns about that.

If – and it remains for now no more than a fear, though a plausible one – the legacy of this storm is a permanently contaminated landscape then the economic costs rise dramatically. A series of Chernobyl-style no-go zones would cost many billions to police and clean up. Even if they could ever be satisfactorily cleansed, they would also be a dead loss, yielding no economic return beyond making the rest of the country habitable.

The pollution could spread many miles; the fallout from the Chernobyl disaster in 1986 reached as far as Wales. Japan would have to turn away from nuclear power – she may have to in any case under pressure of public opinion – and turn back to fossil and greener energy, with an orderly but rapid shut–down of one-tenth of the entire world's nuclear capacity.

The West's nuclear renaissance is still-born. If many other nations follow Angela Merkel's example yesterday and call a halt to nuclear development then the pressure on fossil fuels will become even more intense, and the science-fiction world of oil at $200 a barrel or more could become reality in a surprisingly short time.

Global economic recovery could not long survive that level of inflation. All around the world, and especially around the Pacific Rim, the flight from nuclear will take hold. In those circumstances, Japan's ability to fund a clean-up and move away from nuclear power could become unsustainable, and her government would be unable to raise the necessary funds.

One of the great curiosities in the global economy is Japan's public debt; while we regard a debt-to-national income ratio of 60 per cent as a crisis, and the Greeks and Irish are running into the risk of default with a ratio of around 100 per cent, Japan has merrily chugged along with a ratio of close to 200 per cent for some years, a product of her slow growth and those official attempts to stimulate the economy through public spending.

Japan's gigantic mortgage has, so far, been easy for her to fund because she has almost exclusively funded it internally; Japanese salarymen still earn good money and they choose to save rather than spend it.

So Japan hasn't needed to tap the international markets because of those plentiful savings; but there was always the longer-term danger that, as her workforce ages and shrinks, and her old folk make more demands on pensions and health, that equation would not last.

This nuclear/natural disaster will hasten her down that path, and in those circumstances she might find borrowing on the sort of in the interest payments she has been used to quite unsustainable, and a Greek-style financial crisis, on top of everything else, would also overwhelm her.

Even more serious than that is what a serious nuclear contamination would do to business and consumer confidence. Already inclined to save rather than spend, the Japanese might well come still more fearful, and foreign investment might also dry up.

In the sell-off in Japanese shares and the repatriation of funds back to Japan we have already seen some of that. The effects on the West could be even more serious; giants such as Toyota provide jobs and investment globally, but remain rooted in their homeland, and trouble there could easily weaken their ability to fund their foreign operations.

This repatriation of funds has already had the perverse and unhelpful effect of pushing the value of the yen higher, which will be bad for Japan's exporters. It's because dollar, euro and sterling assets are being sold and the money converted to yen as it heads back home.

It must all be bewildering, even humiliating, for a nation that is rightly used to regarding itself as in the front rank of economic powers. In the 1950s Japan's goods were regarded as shoddy jokes, tin robot toys being the typical fare; by the 1970s Toyotas, Suzukis, Hondas, Kawasakis and Nissans were increasingly familiar sights on our roads; Sony, Panasonic and Nintendo products littered our living rooms and kitchens; Canon and Konica invaded workplaces.

By the 1980s the world was gripped with conspiratorial theories that Japan would take over the world, that the 21st would be "Japan's century", and the land in the emperor's garden in Tokyo was worth more than all the real estate in California.

Sumitomo, Mitsubishi and Nomura were the largest financial institutions in the world. Then the bubble economy burst, and Japan stagnated. Now the fall and fall of Japan threatens to be as dramatic – and much more precipitous – than her earlier rise and rise. The Prime Minister, Naoto Kan, calls it is the most severe crisis since the Second World War. That may even be prey to the traditional Japanese habit of understatement.