MW-31 -- 21st Century Deflation 101

J@pan Inc Magazine Presents:
Weekly Financial Commentary from Tokyo

Issue No. 31
Tuesday, June 10, 2003

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Viewpoint: 21st Century Deflation 101

The Bottom Line:

o Contrary to what has been suggested repeatedly and as recently
as January, Japan's JGB market continues to make history as
yields continue sliding to 0 percent -- and maybe even
further. There will be no major reversal in bond prices until
investors are convinced that the government is totally
committed to eradicating deflation.

o In sifting through history for hints on how Japan should
attack its problem, one realizes that the US response to the
Great Depression was an example of what NOT to do. However,
Sweden's response in the 1930s gives hope for the efficacy of
inflation targeting, while Japan's own response to the Showa
Depression, albeit belated and after disastrous deflationary
policies which actually pushed Japan into depression, could be
a model for a well-coordinated and committed attempt to
eradicate the problem. What the response to the Showa
Depression also shows, however, is that once the inflation
genie is out of the bottle, the government will need to
quickly put on the brakes again to prevent an inflation

o The Japanese government was able to overcome a post-WWII
fiscal crisis thanks mainly to hyperinflation. Then, Japan's
real debts were reduced to less than one-third the original
amount in one year thanks to the hyperinflation of 1945; they
were eliminated by the subsequent inflation. In the 1930s, it
was the abandonment of the gold standard that got the
inflationary ball rolling. If post-Great Depression
interventionist policies do really work against deflation, the
cure for Japan's deflation could well be "all of the above,"
i.e., all the potential Keynesian (fiscal) and Monetarist
(monetary policy) options the government and the BOJ can
muster in an "overwhelming use of force" to convince market
participants that the end of deflation and the beginning of
inflation is just a matter of time.

o In reality, both the Japanese government and the world's
monetary authorities cannot afford to adopt a laissez-faire
approach to the risks presented by Japan's deflation without
potentially unleashing global derivatives, or as Warren Buffet
calls them, "financial weapons of mass destruction."

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21st Century Deflation 101
Zero is Not the Limit for Japanese Government Bonds

Early this year, some foreign investors were suggesting (again) that
Japan's bond market was due for a tumble. Yes, one could say that a
decade of nearly continuous capital gains in bond prices was very
unusual and that literally any good news on Japan could cause a nasty
tumble in bond prices. Reports of the death of the Japanese government
bond (JGB) market have proven premature. Kenichi Ohmae made his
warning in June 1998; Andrew Smithers made his in August 2000 and
followed with another one in August 2002, and Business Day quoted fund
managers on the bond market's precarious position in December 2002.
Conversely, in a January 7, 2003 piece (JGBs--Die Another Day), Money
Watch saw no reason why JGBs should not continue heading towards zero
in 2003.

Seemingly defying inevitable gravity, the yield on 10-year JGBs
recently dipped briefly to 0.49 percent last week. That's right, your
coupon on a JGB is only 49 basis points. The Nikkei's monthly survey
of 26 Japanese institutional investors shows an average weighting of
48.5 percent for bonds, up from 37.1 percent a year ago, and the
highest reading since the survey began to be taken in the 1980s. Why
buy what is essentially a "zero coupon" bond? Capital preservation for
one, and capital gains for another. Japan's 10-year JGB has gained 8.6
percent this year, versus a 0.9-percent gain for the Nikkei 225, and
losses of over 11 percent year to date at one point in late April.
Indeed, before the recent rally in the S&P 500 in the US, Japan's JGB
market was also outperforming US stocks.

The concept of negative bond yields is hard to get one's head around,
but JGB yields can easily and quickly go to zero or even negative.
Basically JGB yields are a reflection of investor risk aversion to
economic growth prospects, equity and credit market risk and exchange
rate risks, and are a symptom of serious structural deflation. In
other words, the slide towards zero bond yields eloquently and
succinctly describes the dire state of Japan's financial system and
its economic malaise. With the economy and policy ensnared in a
zero-interest-rate trap, investors should worry more about the
implications of zero or minus interest rates than a sustainable and
sharp reversal to the upside.

Deflation Far into the Future
What the bond market is indicating is that investors see deflation
extending as they can see, perhaps for the next 10 years. Japan's
economic and financial distress is unprecedented among the industrial
economies in the last 70 years. Japan has long since moved into an
economic environment that no one alive has any experience with. The
developed world's last extensive deflationary experience was during
the Showa Depression in Japan around 1927 and the Great Depression of

Historically, there have been many "booms and busts" in asset prices,
and many stock market crashes. These asset price movements have
occurred under various economic systems, and in both fixed and
flexible exchange rate systems. Actually, "booms and busts" appear
more frequently in real estate prices than in equity prices (Bordo and
Jeanne, "Booms and busts in Asset Prices, Economic Instability and
Monetary Policy," US National Bureau Economic Research [NBER], June
2002). But simultaneous boom-busts in stock prices and real estate are
even more rare. Bordo and Jeanne found only two cases in their data,
covering the OECD nations between 1970 and 2001.

The US Response to the Great Depression: What Not to Do
Japan's policy makers evidently consider their problems unique, and in
many respects, they are. Japan's current situation only really has
qualitative similarities with the experience of the US, Sweden and
Japan in the 1930s. Both were characterized by chronic financial
distress in the form of insolvent financial institutions, large
amounts of outstanding debt and falling property as well as stock
prices. General price deflation in both periods exacerbated the
problem by increasing the real debt burden, damaging balance sheets,
and resulting in postponed spending and higher real interest rates.

Upon closer examination, the Great Depression in the US actually
consisted of four stages based on NBER reference turning points: the
great contraction period from August 1929-March 1933; recovery from
March 1933-May 1937; sharp contraction from May 1937-June 1938; and a
more substantial recovery after June 1938. During the critical
1929-1933 period, nominal GDP declined by 46 percent and real GDP
declined by 29 percent. The GDP deflator and the consumer price index
both declined by 24 percent. An increasing number of economists
attribute the August 1929 downturn to tightening by the US Federal
Reserve to curb the stock market boom; they also attribute the length
and severity of the Great Depression to restrictive monetary policy.
It was already becoming clear that the Fed was beginning to tighten
monetary policy by late 1928, as the discount rate was raised four
times -- from 3.5 percent to 6.0 percent ・ between January 1928 and
August 1929. For the next three years, money supply in the US imploded
by 30 percent. The failings of the Fed to prevent the deflationary
spiral included:

1. Its failure to appreciate the effects of its policies on
the money supply and price levels.

2. It apparently did not place a high priority on preventing
deflation, as it did on preventing inflation, and had an
asymmetrical view of its ability to do either.

3. It focused on legal and technical issues as excuses for
more aggressive action, while possessing adequate powers to
reverse the monetary decline at any point.

4. The Fed lacked any specific mandate, such as price
stability, which made it difficult to hold the Fed accountable
and permitted it to pursue other agendas contrary to providing
a stable financial and monetary framework.

5. The legal independence of the Fed may have constrained its
willingness to expand the money supply in subtle ways. The
irony was that the Fed, for all practical purposes, became in
a de facto manner dependent on the government. After 1933, the
Fed became passive in the face of Treasury actions to increase
price levels (i.e., not sterilizing gold inflows encouraged by

6. The Fed was excessively concerned about the quality of its
balance sheet as well as technical and legal limitations to
more aggressive action.

(Source: IMES Discussion Paper No. 2000-E-30, "Monetary Policy,
Deflation and Economic History: Lessons for the Bank of Japan, Thomas
F. Cargill)

However, the Fed was not the only institution contributing to the
depth and length of the Great Depression. In fact, given the
combination of fiscal and monetary policies during the period, it is
amazing that the US economy ever recovered. President Herbert Hoover's
economic policies during the onset of the Great Depression are often
mistakenly perceived as laissez-faire. But during the end of his
presidency, he signed into law such a raft of costly stimulus bills
that a Franklin Roosevelt aide later said that "practically the whole
New Deal was extrapolated from programs that President Hoover
started." The greatest folly of the Hoover administration was the
Smoot-Hawley Tariff, passed in June 1930, but he also signed into law
the Revenue Act of 1932 that doubled the income tax for most
Americans, with the top bracket going from 24 percent to 63 percent.
Exemptions were lowered, the earned income credit abolished, and
corporate as well as estate taxes were raised.

As Roosevelt assumed office in 1933, a crisis gripped the banking
system. Roosevelt responded by declaring a banking holiday on March 6,
1933. More than 5,000 banks still in operation when the banking
holiday was declared did not reopen when it ended, and over 2,000
never did thereafter. In the first year of the New Deal, Roosevelt
proposed spending $10 billion while revenues were only $3 billion.
Between 1933 and 1936, government expenditures rose by more than 83
percent. Federal debt skyrocketed by 73 percent. But the most
reflationary move was probably Roosevelt's decision to drop the gold

However, while he was spending record amounts of taxpayer money,
Roosevelt was aggressively raising taxes. He secured passage of the
Agricultural Adjustment Act, which levied a new tax on agricultural
processors. The National Industrial Recovery Act was passed in June
1933 and created a massive new bureaucracy called the National
Recovery Administration. Under this administration, most manufacturing
industries were forced into government-mandated cartels. Roosevelt
next signed into law steep hikes in income tax rates on the high tax
brackets and introduced a 5 percent withholding tax on corporate
dividends. Tax hikes became a favorite policy of Roosevelt over the
next 10 years, culminating in a top income tax rate of 90 percent. The
US economy was not relieved of some of the worst excesses of the New
Deal until 1935, when the Supreme Court outlawed the National Recovery
Administration, followed by a similar move to outlaw the Agricultural
Adjustment Act in 1936. But the government responded with the National
Labor Relations Act. Armed with sweeping new powers, labor unions went
on a militant organizing frenzy. Threats, boycotts, strikes, seizures
of plants and widespread labor violence pushed productivity sharply
downward and unemployment sharply upward.

On the eve of America's entry into World War II and 12 years after the
stock market crash in 1929, 10 million Americans were still jobless,
versus 13 million jobless at the peak. Roosevelt had pledged in 1932
to end the crisis, but it persisted two presidential terms and
countless interventions later. Thus, while the Great Depression was
precipitated by monetary policy mistakes, it was prolonged and
exacerbated by a litany of political missteps, including but not
limited to trade-crushing tariffs, incentive-sapping taxes,
mind-numbing controls on production and competition, and coercive
labor laws.

(Source: Great Myths of the Great Depression, Lawrence W. Reed,
Mackinac Center for Public Policy)

Sweden's Experience in the 1930s
These days, if you want to start a heated argument with academics,
government policy makers and economists, just mention inflation
targeting. Sweden left the gold standard in the fall of 1931 and
adopted an explicit price level target (Berg and Jonung, 1998).
Swedish consumer prices had been falling gradually and wholesale
prices had been falling sharply since late 1928. Industrial production
declined by 21 percent during 1929-1931, versus a 46-percent drop in
the US. The key features of the program included a clear and
transparent objective that was communicated to the public through
several channels. By most measures, price-level targeting in the 1930s
in Sweden was an effective way to stop price deflation and mitigate
the depression. The depression in Sweden did not abruptly stop with
the introduction of price-level targeting, but the output declines
appear to have been mitigated and recovery enhanced by the monetary
program. By the end of 1933, Swedish industrial production had
recovered to the 1928 level, and climbed an additional 28 percent by
the end of 1934.

(Source: IMES, )

Japan's Reflation in the Showa Depression
Japan's problems actually preceded the crash in the US market in 1929.
Indeed, Japan's economy in the 1920s has been described as being in
chronic recession. Further, the Great Kanto Earthquake in September
1923 and the financial crisis from March to May of 1927 triggered
recurring turmoil in the financial system. The Bank of Japan responded
with a series of relief loans to help prop up ailing banks and prevent
major bankruptcies with loans from the deposit bureau and with its own
special loans. But business restructuring through mergers was also
vigorously pursued in various industries, including the electricity,
railroads, spinning and fertilizer sectors.

The Hamaguchi cabinet, which took office in July 1929, has the same
historical distinction as Hoover, dubbed in the US as "Mr.
Depression." Osachi Hamaguchi himself was a charismatic individual
known as "The Lion," and he appealed directly to the Japanese people
on the need to endure pain in the service of national revival.
Junnosuke Inoue, his finance minister, was imbued with extraordinary
enthusiasm and a sense of mission. He toured Japan, preaching
deflation for the sake of a strong yen. Ironically, descriptions of
these gentlemen resemble Junichiro Koizumi and Heizo Takenaka, in
terms of the policies and profile they had during the period. The
Hamaguchi cabinet implemented an austere fiscal policy, and made good
its election promises to lift the gold embargo, which was eventually
lifted in January 1930. These policies now are considered to have been
instrumental in pushing Japan's economy into its most serious
depression on record. The new Japanese government decided to return to
the gold standard at its prewar value. Since Japan's wholesale price
levels were 65 percent higher than the prewar level and higher than
the US or the UK, deflation was a strong possibility. Austere fiscal
measures and restrictive monetary policy were tried to reduce prices,
but the worldwide depression and its damage to Japanese exports
resulted in output declines and rapid deflation. Wholesale prices fell
by more than 30 percent in less than two years, from December 1929 to
October 1931. The decline in property prices in Japan during the
period continued for 14 years.

But a continued loss of reserves forced Japan to abandon the gold
standard in December 1931. Korekiyo Takahashi was appointed finance
minister in the Inukai cabinet in December 1931. He implemented the
gold embargo on the day of his appointment. Once the gold standard was
abandoned, the Inukai cabinet implemented a successful combination of
fiscal policies (with large-scale deficit financing and the Bank of
Japan underwriting government bond issues), monetary stimulus,
exchange rate depreciation (with the abandonment of the gold standard)
and capital controls -- all known as the Takahashi Economic Policy.
From 1931 to 1933, government spending rose 26 percent, and net
domestic product rose at a comparable rate. After falling about 30
percent between 1930-1931, wholesale prices rose 28 percent in Japan
between 1932-1933.

What followed, however, was an inflation blowout. The inflation rate
accelerated after 1935 in response to monetization of government
deficits, and the consumer price index increased by 21 percent from
1935 to 1938, driven by intense war mobilization efforts. Indeed, when
the finance minister tried to brake spiraling military spending and
deficit-covering bonds during the formation of the 1936 budget, he was
assassinated in an attempted coup d'etat in February 1936.

(Source: Bank of Japan,

An Historical Theory of Depressions
Irving Fisher penned "The Debt Deflation Theory of Great Depressions."
According to Fisher, deflation occurs when debt levels become
unmanageable. Money that might otherwise be spent on value-added
activities instead goes into debt reduction. Debt deflation comes
first and is followed by price deflation. Nominal over-debtedness and
deflation, according to Fisher, were the dominant forces that
accounted for the "great" depressions. There are no silver bullets for
this, went the reasoning. Neither monetary policy (changing interest
rates) nor fiscal policy (stimulating the economy with new government
spending) could do much.

Hyman Minsky's version of debt deflation was "Minsky's Financial
Instability Hypothesis." He identified in the corporate sector three
distinct income-debt relations: hedge, speculative and Ponzi. Hedge
companies have a strong equity base and can fulfill all of their debt
requirements by their cash flows. Speculative ones can meet their
interest payments out of cash flow but are unable to repay principal.
They roll over their liabilities. For Ponzi units, the cash flows from
operations are not sufficient to fulfill either the repayment of
principal or the interest on outstanding debts. Minsky argued that,
over a protracted period of good times, capitalist economies tend to
move to a financial structure in which there is a large weight of
companies engaged in speculative and Ponzi finance. Then, when
conditions deteriorate, either through tightened monetary policy or a
bubble collapsing, speculative companies become Ponzi companies.
Ponzis are liquidated. The purging of bubble-induced excess then
becomes a self-feeding contagion of debt deflation that leads to
collapsing asset values.

(Macrodynamics of Debt Deflation:

John Maynard Keynes' version, however, is the one that endured,
perhaps because it offered hope to governments and particularly
politicians that something could actually be done to prevent economic
downturns. He authored two famous pieces in condemnation of
laissez-faire economic policy and advocated the use of public works to
reduce unemployment. He condemned the UK Treasury's fear of "budget
deficits." In "The General Theory of Employment, Interest and Money,"
he introduced the possibility of using government fiscal and monetary
policy to help eliminate recessions and control economic booms.
Indeed, with this book, he almost single-handedly constructed the
fundamental relationships and ideas behind what became known as
"macroeconomics," and created a whole generation of "Keynesians."

Milton Friedman, on the other hand, was the most famous of the
Monetarists, who believed that the world's economic problems could be
solved with the equation, MV = PT. In other words, the amount of money
in circulation times the velocity of that money equals the price of
that money (interest rates) times the number of transactions taking
place. In its simplest form, if one pumps up the supply of money, it
will eventually lead to higher prices. Thus deflation, in this regard,
is essentially a monetary phenomenon.

What Has All of this Got to Do With Japan's Malaise?
The Liberal Democratic Party's entrenched policy makers continue to
live in a world of economic fiction, waiting for Godot or whomever to
wave the magic wand of recovery. But without the historical background
as just described, it is very easy to lose one's way when wading
through the raging debate within and without Japan on how to fix
Japan's economy and financial markets. The LDP and past
administrations have been died-in-the wool Keynesians. The Bank of
Japan has naturally pursued a Monetarist approach. But the combination
has been almost as schizophrenic as the Hoover and Roosevelt measures
to counter the Great Depression in the US. The BOJ was for the most
part pursuing a restrictive monetary policy, while the government was
pulling out all the stops on fiscal policy. Some economists argue that
the Japanese government actually did not stimulate enough and that the
stimulus they did offer helped prevent Japan form falling into
depression. Others (including the US Fed) argue that the BOJ responded
with an accommodative policy that was too little, too late. Those that
argue for inflation targeting and asset inflation are basically
advocating a Monetarist solution. Nearly all (except the Koizumi
administration and its "reformists") believe that prime minister
Koizumi's "pain before gain" policies now threaten to push Japan down
the slippery slope of depression, thereby making Koizumi and economics
and finance minister Takenaka modern day "Mr. Depressions."

Typical of the growing "consensus" Monetarist view is Fed deflation
point man Ben Bernanke, who believes that by cranking up the printing
presses, expanding the scale of asset purchases and offering
low-interest loans collateralized by various private assets (among
others), Japan could in a fairly straightforward way inflate its way
out of the problem. In essence, these measures are aimed at
"bypassing" a dysfunctional banking system that has ceased to act as a
"money multiplier" for the economy, thereby avoiding the "liquidity
trap," where conventional monetary policy is rendered ineffective
because the banks can no longer act as the conduit for monetary policy
to directly impact the economy. Problem is, the BOJ is still not
convinced. Takenaka, on the other hand, is convinced that the banks
must be cleaned up in order to restore their ability to act as a
conduit for monetary policy, and in so doing, facilitate instead of
hinder efforts to eradicate deflation.

Monetization and Currency Depreciation; That's the Ticket?
Japan is well past the "ounce of prevention" stage. Moreover, whoever
(in the government) leads a coordinated package of fiscal and monetary
policies is irrelevant from an economic perspective. Japan will need
bucket-loads of both. But contrary to what the world has been saying
to Japan for some time, i.e., "just do it," the slow-motion crisis
could very well continue, with the path of least resistance being
dithering as long as possible and then paying a very high price.

In early postwar Japan, the government was able to ride out its
postwar fiscal crisis thanks mainly to hyperinflation. Then, Japan's
real debts were reduced to less than one-third of the original amount
in one year thanks to the hyperinflation of 1945; they were eliminated
by the subsequent inflation. In the 1930s, it was the abandonment of
the gold standard that got the inflationary ball rolling, again with
relative currency depreciation. This time, we would need around 250
yen to the dollar for a sustained period of time. And that is not all.
Unconventional monetary stimulus (as suggested by Bernanke), more
deficit financing and more underwriting of bond issues by the BOJ
would represent an "overwhelming use of force" believed needed to
convince market participants that the end of deflation was nigh. In
other words, the cure for Japan's deflation is everything both the
government and the BOJ can muster in as much quantity and in as much
concentration as possible.

But this is precisely what the Austrian economists say is the wrong
thing to do. Indeed, Japan's dithering on their slow-motion crisis may
be just what the Austrian economists ordered: Do nothing. According to
the Austrian Business Cycle Theory as propounded by Ludwig Von Mises
and Murray N. Rothbard, the only way to recovery is to permit the full
liquidation of mal-invested capital and resources that occurred during
the boom (an attitude that prevailed prior to the Great Depression in
the US). Liquidation of capital and other mal-investments are going to
happen whether the government wants it to happen or not. It is thus
best to permit nature to run its course, which hastens the economic

Japan: The Great 21st Century Experiment
The Japan malaise and structural deflation are the great 21st century
economic experiment. After having pulled out all the stops in using
"overwhelming use of force" to convince market participants that the
end of deflation is nigh, if the end result in Japan is still
depression, this failure of "activist" economic policies to prevent a
depression could well produce the same result as the Great Depression
in the US -- the scrapping of the theoretical economic framework that
has dominated fiscal and monetary policy for the past 70 years for a
new theory, maybe even laissez-faire and/or shrinking "globalization."
But it would be a Pyrrhic victory for the Austrian economists. For the
global economy and financial markets, Japanese reflation, even if it
leads beyond price stability to (excessive) inflation, is a better
strategy than default. The default approach (John Makin, January 2002,
American Enterprise Institute) toward which Japan is heading would be
more abrupt, arbitrary and disruptive. Abrupt default would entail
impoverishment in Japan and constitute serious systemic risk to the
global economy.

Japan's Depression and Financial Weapons of Mass Destruction
In either case (the Austrian do nothing and let the depression happen,
or the demonstrated failure of Keynesian and Monetarist policies), the
strong implications are: major currency deflations, massive debt
liquidations and significantly higher gold prices. In truth, the
effort to rescue Japan has created a credit bubble bigger than that
which caused Japan's troubles in the first place, and this bubble has
now left the G-7 countries hostage to events over which they have
little or no control. A continued absence of recovery in Japan (or
slippage into depression) must at some point adversely impact the yen.
And if the Japanese currency collapses against the dollar, this turn
of events would export Japan's deflation and crisis to the rest of the

This, in turn, would put a serious crimp on the gold carry trade,
where outstanding off balance sheet gold derivative positions at the
40 bullion banks around the world exceed the level of US official gold
reserves by as much as three times and annual gold production by as
much as 10 times. The bullion banks have been using gold borrowed from
central banks as a source of cheap capital, with the proceeds being
invested in other financial market instruments. In other words, the
central banks have let the bullion banks engage in gold banking
without maintaining prudent reserves.

Sharply rising OTC gold derivatives in the face of reduced incentives
for gold lending or borrowing, and against falling LBMA volumes and
declining open interest in Comex gold options suggest that the bullion
banks have been unable to wind down their pyramid of gold derivatives
in an orderly manner. A failure of confidence in the promise of gold
banks to deliver gold would be the equivalent of gold $1000 bid, none
offered, i.e., a gold banking crisis with gold bullion bank customers
demanding delivery of physical gold. Gold bullion banks would have to
scramble to deliver gold by selling positions in other financial

Thus the highest-risk transmission mechanism given an abrupt and
arbitrary disruption in Japan is the presence of the large and growing
global exposure to derivatives transactions. The Bank of International
Settlements estimates that the notational value of global OTC
derivatives is $141.7 trillion, with a gross market value of $6.4
trillion as of December 2002. This compares to the output of the
global economy of some $44 trillion (IMF, 2002) and a global credit
market size (without derivatives) of some $15 trillion (Lehman
Brothers). Warren Buffett has described derivatives as "time bombs,
both for the parties that deal in them and the economic system." He
warned that derivatives were "financial weapons of mass destruction"
and that they were "potentially lethal" to the economic system. The
growing presence of derivatives has greatly increased the global
financial system's exposure to contagion by the international nature
of markets and free global capital flows, and Warren Buffett isn't the
only one concerned. Unregulated hedge funds, collateralized debt
obligations and poorly structured derivatives of all kinds that
redistribute risk but don't eliminate it portend the likelihood of
another debacle like the one sparked by the hedge fund Long Term
Capital Management in 1998 or worse given a major disruptive "event"
such as a financial crisis in Japan.

What this means is that both the Japanese government and the world's
monetary authorities cannot afford to adopt a laissez-faire or the
Austrian approach to the risks presented by Japan's deflation without
potentially unleashing the "financial weapons of mass destruction," as
Warren Buffett calls them. The failure of Long Term Capital Management
nearly brought financial markets to a standstill and forced the Fed to
organize a bailout. As was seen by the Fed's prompt and surprising (to
some) response to the debacle, the global financial system is in many
respects a fragile house of cards.

-- Darrel Whitten

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