(FORTUNE Magazine) – Judging from newspaper headlines these days, there are at least two Japans, one ready for the obituaries and one readying to conquer the world. The Japan with the deathly pallor has reportedly been done in by crushing bad-debt problems, wishy-washy deregulation, and bizarre economic management. How bizarre? Prime Minister Ryutaro Hashimoto has mandated a major tax hike and a cut in government spending, well before the economy is out of the woods.

Then there is Japan Inc., back from the dead. Though not quite the globe-striding colossus of the late 1980s, Japan's top performers, companies like Toyota and Sony, are fiercer then ever, earning near record profits and market share abroad. Japan's growth in the past fiscal year was a very respectable 3%, and, contrary to the obituaries, Japan is deregulating, here and there. Just look at the double-digit growth in telecommunications and Prime Minister Hashimoto's promise of a "Big Bang" reform in Tokyo's hidebound financial markets. "I think the weakness of Japan is emphasized too much," says Eisuke Sakakibara, director-general of the International Finance Bureau at the Ministry of Finance. "I would call it irrational pessimism. Japan is neither a miracle nor about to collapse. We're aiming at a mature, stable 2% to 3% growth."

Somehow, neither idea fully convinces. Japan isn't moribund, yet the Japanese have a lot to do before they can coast along on momentum--or until their economy's strength matches that of the U.S. In fact, like the Americans who studied Japanese concepts like "just-in-time inventory" a decade ago, Japanese business wonks today are looking for the secret of America's success. Their answer: deregulation, as launched by President Ronald Reagan in the 1980s. Says Makoto Utsumi, a retired former vice finance minister: "I know a U.S. Congressman who opposed Reagan when unemployment in his state was something like 21%. Now it's 5%. Now he says Reagan was right. And Reagan was right."

Hashimoto has a lot to prove before anyone calls him Japan's Reagan, especially considering the reluctance of Japan's powerful bureaucrats to admit that their "miracle" economy has seen its day. Yet time is running out on the tried and true methods of Japan Inc. From 1992 to 1994, Japan staggered along with practically no growth. Recovery since then has been erratic, marked by one-time, government-led tactics such as heavy public works spending, record-low interest rates, and an export-stimulating weak yen policy. In fact, Hashimoto underscored Japan's dependency on the weak yen on his trip to New York last month when he said Japan might "succumb to the temptation" to sell off U.S. Treasuries if Washington did not cooperate in stabilizing exchange rates--a comment that threw the Dow into an unnerving dive. It's on the strength of that weakened yen that Japan's blue-chip manufacturers have recovered, but for the first time they have not brought the rest of the economy along too--the financial sector, small industry, construction and real estate, and so on.

It's no wonder that Japanese frequently ask in popular newspaper and magazine commentary: "If the economy is recovering as well as the government claims, then why don't we feel better?" Japan is on its fifth Prime Minister in five years, and the nation's bureaucrats, once the most esteemed group in the country, are regarded with contempt. The situation is ripe for change, as long as some kamikaze (divine wind), like a further weakening of the yen, does not intervene to save the old system. More pain, more gain--at least from the reformist point of view.

Will the reformists prevail? They'll have to, at least in certain fields, like finance and information technology, where Japan must compete globally to survive. Hashimoto claims that he will stake his political future on change, but the question is how much, how fast. Six years into the hard lessons of Japan's economic setback, that question is still unanswerable. Says Minoru Makihara, president of Mitsubishi Corp.: "I think Japan will get there, but it all depends on timing. If Japan takes too long to deregulate, it will lose competitiveness. If in the financial sector, for example, people are really confident that it will open by 2001, there will be lots of business pouring into Japan. But if people believe it will take until 2020, there will be a problem."

The Hashimoto government retorts that the economy is coming along very well, thank you. Technically speaking, it has been recovering for some time. Corporate earnings have risen more than 50%, from their lows in 1993 and 1994. Growth in the first quarter of this year was 1.6%, which annualized would come out to a ripsnorting 6.4%.

So what's the problem? Simply put, no current source of growth is here to stay. A significant part of that spike in the first quarter, for example, was due to a 4.6% surge in consumer spending--the strongest in 37 years--in anticipation of an April rise in sales tax from 3% to 5%.

Exports contributed nearly 25% of net growth in the past three quarters. Top-tier exporters have cut costs dramatically, strengthened their balance sheets by borrowing at Japan's lowest interest rates in postwar history, and moved significant portions of their production chain overseas. Best of all, the yen steadily weakened in the past 23 months, reaching a 52-month low of 127.46 to the dollar on May 1. "Companies like Canon, Matsushita, Honda, and Toyota look like GE five years ago," says Kenneth Courtis, chief economist at Deutsche Bank. "They have tremendous momentum. They spent the recession cutting costs--Toyota by as much as 38%--and the results are nothing less than revolutionary."

That's a bummer if you happen to be Detroit or IBM, but it does not mean that Japan is back on its feet. "We've had very good growth of exports relative to everything else," says Ronald Bevacqua, economist at Merrill Lynch in Tokyo, "but it's an environment where the Nikkei is going nowhere, bank loans are not growing, and small firms are not doing well. Japan is like a four-cylinder engine with only one cylinder working." And that one cylinder could easily blow out if Japan's partners in the G-7, unhappy about Japan Inc.'s export windfall, have their way.

No one is warier of the export issue than Robert Rubin, U.S. Secretary of the Treasury, now the most prominent player in U.S.-Japan relations. Japan's export blitz puts Rubin on the spot because, ironically enough, the U.S. Treasury made it possible in a backhanded way. In late 1995, just as then-U.S. Trade Representative Mickey Kantor declared a dubious victory in trade talks with Japan, Rubin reached an informal, nonpublic understanding with the Finance Ministry's Sakakibara to help weaken the yen to put Japan's economy back on its feet. Tokyo's side of the bargain was to encourage capital flows into U.S. securities, which contributed in a big way to the health of U.S. markets and Clinton's reelection last year. Tokyo also agreed to two conditions: first, to push domestic-demand-led growth; second, to keep the trade surplus under control. Tokyo, however, let Rubin down on both counts.

When the yen got weaker, Japanese manufacturers did what comes naturally: export like hell. As a share of GDP, exports had declined from 3.1% in 1993 to 1.4% early this year, but that ratio is now mounting fast. In May alone, Japan's merchandise trade surplus jumped 222.2% from a year earlier, and exports jumped 20.5%, led by a 43.3% rise in car exports. In the first five months of this year, for example, U.S. sales of Toyota's popular 4Runner were up 37%. It was no surprise when the G-7 Summit in Denver last month pointed a finger at Japan, insisting that Tokyo do more to create more growth at home.

But Japan has already embarked on a risky course domestically. Hashimoto's government in May agreed to a dramatic fiscal contraction plan that flies in the face of Tokyo's pledges to strengthen domestic growth. From Washington's point of view the plan is madness: Why would Japan want to raise taxes the equivalent of 2.4% of GDP and reduce overall government spending 0.5%, including a 10% cut in public works, at a time when the domestic economy is still unsteady? Says one U.S. official: "Hashimoto's macro policy is a train wreck waiting to happen."

At the Ministry of Finance, the argument in favor of deficit reduction is simple if unconvincing. As a result of five massive supplementary budgets and tax cuts, Japan's budget deficit is now nearly 7% of GDP. That's on par with Italy's--a shocking development to a nation of proud penny pinchers. What is more, goes the argument, the rapid aging of Japan's population means that social welfare payouts will escalate sharply in the years ahead and the tax base will shrink, a recipe for still more fiscal trouble. Better to mop it up now. Those arguments have taken a profound hold not only in Hashimoto's government but in the press and with the public as well.

U.S. officials believe that the plan puts the recovery needlessly at risk. With a third of the world's savings in its banks and virtually no demand for capital at home, Japan can afford to lend to itself. And interest rates are at an all-time low, so borrowing is cheap. Richard Koo, a senior economist at the Nomura Research Institute, argues that the ministry's move makes sense only as a way to restore its battered prestige and recapture the moral high ground after a series of unprecedented scandals in the past few years. Says Koo: "The Ministry of Finance is willing to punish the rest of Japan in order to survive."

The result is a standoff between Washington and Tokyo, but a standoff that's largely behind the screen. To some extent, Sakakibara is trying to head off a conflict. This spring the Ministry of Finance quietly engineered a strengthening of the yen. The yen fell 15%, from 127 on May 1 to 110 on June 11, a rapid drop that angered Japanese manufacturers. Treasury officials, however, are still repeating their mantra that Japan must show domestic-led growth and contain the trade surplus. Look for a move of the yen to 100 before year-end.

If exports slow, where will Japan's growth come from? Hashimoto has opted to raise taxes and cut spending, so there is no hope for government pump priming. Consumers? Part of the government's current policy centers on talking up the economy to loosen pocketbooks, but so far it hasn't worked: Japanese savings rates are near all-time highs.

What's left is deregulation, the structural reform of the economy. Despite all the enthusiasm for Reagan-era reforms, though, there will not be any sweeping moves. Japan's regulatory scene is heavily Balkanized: Ministries control their own turf, and few are eager to give up the power and influence that comes from the more than 10,000 regulations that govern Japan's business scene. The idea of the traditionally passive Diet taking matters into its own hands is almost inconceivable, and in any case, deregulation across the board would have disastrous consequences because so many sectors have far too many employees. "No one is stupid enough to really want deregulation in every industry," says Jesper Koll, chief of economic research at J.P. Morgan Securities Asia. "There would be nothing left."

But increasingly Tokyo really is willing to open up key industries, all of which share one element: a fear of falling behind. Right now there is a lot of anxiety in Japan about the U.S. edge in information technology and finance--two sectors that have recently started to deregulate.

In telecommunications, for example, the Ministry of Posts and Telecommunications has ended NTT's monopoly in many areas, including local phone service, and also pushed through a plan to break up the telecom giant. The result is a boom in businesses like portable phones. Prices have fallen to almost nothing for Personal Handiphone System phones, a sort of poor man's cellular. Basic PHS service is only about $20 per month, plus a few cents for each minute, no matter the distance. Virtually every college student now has a PHS, and there is serious discussion that they will soon make public phones extinct. Both usage and revenue for the PHS companies, which include NTT Personal, DDI Pocket, and Astel, more than doubled in the past year. PHS is Japan's first major telecommunications system export--to Hong Kong. Overall, the telecommunications sector grew 19% last year.

"Usually we think of deregulation as a paper tiger in Japan," says Richard Kaye, a telecommunications analyst at Merrill Lynch in Tokyo. "But in telecommunications we have to give them the benefit of the doubt. All the walls are coming down, and actual beneficial effects are visible in the economy." One example of the benefits for foreign companies: In March, Motorola won a $2 billion contract to build infrastructure for a new digital cellular phone system.

But when it comes to deregulation the real headline grabber is Hashimoto's declaration in November that he would set free Japan's financial markets by the year 2001. In fact, gradual deregulation has been going on for years, and foreign financial institutions like Goldman Sachs, Merrill Lynch, and Fidelity are already making big plays (see box). But Hashimoto, at the Finance Ministry's prodding, is determined to go much further. Next April, foreign-exchange controls will be lifted completely, and legislation is in the works that should--if it lives up to its promise--throw wide open the banking, trading, and insurance businesses.

The Finance Ministry also insists that it will end its dominating, behind-the-scenes micromanagement of the financial sector. Foreign bankers are drooling at the prospect of an open field in Tokyo. Virtually every major foreign bank is increasing its staff to handle new business in areas like mutual funds and future business such as securitizing troubled loan portfolios. Bankers Trust's announcement in April that it would assist Nippon Credit, a major but ailing bank, was motivated partly by eagerness to play in securitization, where Japanese banks are clueless.

Why did the Finance Ministry have such a change of heart? Officially it wants to increase the return on Japan's $13 trillion in savings, which now earn a meager 0.25% in a postal savings account, the most common place for savers to put their cash. That's undoubtedly a part of the story, but the ministry is also eager to ensure the safety of the industry. So far, 16 banks and related financial institutions have closed, and many other banks and life insurance companies are at risk due to bad-debt problems. The ministry closed Nissan Life, a $16 billion company, in April, the first insurance company to collapse since the war. The arrival of foreign banks will mean not only more competition but also more capital and know-how to extend a bigger safety net under the ailing financial institutions.

If the bureaucrats in the ministry's banking division have learned one lesson in the 1990s, it is that they cannot begin to supervise the detailed operations of banks with trillions in assets and global operations. "They now feel that telling the banks what to do got out of hand," says Noboru Sakata, a senior adviser at Nippon Credit Bank, "and if they continue to do it, Japanese banks will be left behind."

Tokyo also wants its markets to become world-class and the financial center for Asia. Officials say that the turning point for Hashimoto was the G-7 meeting in Lyon last year, where he realized that the euro might overshadow the yen unless Japanese banks became more competitive. The question is whether the Hashimoto government can really face up to the closures, consolidations, and huge personnel cuts that everyone agrees are an inevitable part of a real Big Bang. "I doubt that Hashimoto really understands the significant pain that will result from Big Bang," says Shinji Okabe, a bank analyst at Moody's Japan. "But if the Japanese banking system does not change, many banks will die anyway."

Japan's economic managers tried to avoid the main lesson from the blowout of the early 1990s--that the country needed a fundamental overhaul of its economic system--for as long as possible, but now the message is seeping through. Big Bang, if it really comes to pass, is exhibit A, and other fitful deregulatory efforts also point to progress. But Japan has just started down a long road. Change is going to come in fits and starts, following the imperatives of Japan's bureaucratic landscape. "We have to make changes in the system that led to Japan's success," says Akio Mikuni, president of Mikuni & Co., a credit-rating agency in Tokyo, "and that's not easy." Japan has made radical changes before, but they've always unfolded frustratingly slowly. It will take years, not months, before its economy is hitting on all cylinders again.

REPORTER ASSOCIATES Cindy Kano, Andrea Prochniak