The problem with economic puzzles is that nobody has the full box. The pieces are legion and keep changing shape. Just when you think you've got it, it morphs into something else. Not all is lost, however. Economic science has a few relentless laws, which will not be denied. It is best to search in economic structure, when things get murky and answers hide in the overwhelming fog of modern information technology. I offer you some pieces of the puzzle, held in place with basic economic and accounting laws. It shows a picture, a clear picture, and a decent piece of the bigger picture.

It all starts with money. What exactly is modern money? It is still only an IOU from government, no more no less. They no longer offer to exchange for gold nor to print the promise on its face. If they do, accounting rules will require them to account for it as debt, but without the implicit promise of government it is just a worthless piece of paper. Commodity monies usually had some intrinsic value and escaped the curse of debt. Paper money has no value but the implied promise of government. That makes it a promissory note even in the absence of an explicit promise. Government has only one means of honouring the promise and that is by taking value from its citizens, i.e. through taxation.

Central banks are the appointed agents of government for the creation and distribution of these "promissory" notes. Central banks used to hold commodity monies as reserves, now they hold very little other than another government's debt, or the cardinal sin, their own government's debt. We merrily hoard these IOU's, borrow them, swap them, hold them, use them and believe in them.

How do they enter the system? Government prints them or creates them electronically but they can only enter the system in two ways. That's all! The first is that government can print them and hand them out for free. It actually happens all the time in the many social programmes where government hands over money in exchange for nothing. The only other way is to introduce the money via debt systems. Government will simply create and "advance" money to the system, or create money and "purchase other debt". Please do not get me wrong, both the giving away of money and providing liquidity to the economy are vital functions of any government. Central banks will pretend not to be government but in reality can be nothing but an extension of government, irrespective of the legal entity that they may use.

As with all good things, too much is always the problem. These are the three things to hang on for now, money without intrinsic value is still only a government IOU, it mostly enters the system via the banking sector and too much of it is bad. Why does any of this matter, its all very archaic and boring, you may ask? Inflation will just rise and warn us when we get to too much and in the modern economy we have inflation beaten, not so? Unfortunately it is only partially true.

Inflation is a monetary phenomenon and will most definitely do the job, but one needs to understand that inflation is not restricted to a narrow definition of price increases in only a select group of assets. Money has no fixed address, yet everybody searches for the signs of inflation in everyday consumer goods only. Few think of inflation in terms of the true capital stock of any country. Fixed Property, Equities and Bonds are the most common long-life assets and the most representative by value. Everything is wonderful in a world of low inflation in consumer and durable goods. The new economy arrives where this type of inflation is low and long-life assets inflate wildly. Everybody gets rich, what's wrong with that? The sad truth is this, long life asset inflation has arrived and what a party it is, for a while...

The Japanese found out and this is how it turned out.

A weak currency, export driven economic policy created a persistent monetary stimulus for the economy. I'll explain in more detail later. The effect was to initially create the illusionary economic miracle of perpetual growth, which eventually led to over-investment in long life assets. Long-life assets inflated to manic proportions and crashed spectacularly. Quantitative stimulus was and is used to address the problem; it simply means that unlimited liquidity (money creation) was offered as the remedy, the very cause of the problem in the first place. The perpetuation of monetary stimulus prevented a large scale banking failure but trapped the economy in a state of perpetual stasis and long-term bankruptcy. It is 14 years later and still the Japanese Government persist with this policy, bailing out banks or via banks, bailing out corporates, retailers, exporters, in fact any of its economic institutions, the failure of which is perceived as potentially harmful to the economy. Yet, the Japanese Government considers the only true remedy untenable, that of implementing policies of liquidating the excessive debt, including the debt represented by vast amounts of money creation. This is not the Keynesian Liquidity Trap; I would call it the "Quantitative Stimulus Trap".

The lifts went up, the lifts came down and then the lifts got stuck on the ground floor. The worst is, few acknowledged the risk and fewer still are the voices that acknowledge the true reality of the Japanese problem. It is total systemic banking failure. Attributing such an outcome to monetary policies of lowering interest rates and quantitative easing would be unthinkable to any central banker. Time to take a look at a similar picture for the USA; for it surely cannot happen to the USA, the economic variables are just too different in a million and one ways!

The observation of recorded long-life asset inflation in the USA starts in the early 1990's. Equity inflation really took off from 1995 onwards and property inflation only slowly built momentum from 1997 onwards. Yet the compounding effect of property inflation has caught up with equity inflation. The FED also discovered the bountiful monetary policy of lower interest rates and quantitative easing and we say hello to long-life asset inflation in the USA. Does this remind of the early 1990 economic position of Japan?

Witness the reality of long-life asset inflation in the Nikkei and Urban Property on a same scale basis. How does it look in the USA?

Japan says beware long-life asset inflation; 14 years later and we suffer still. Maybe Japan just got it wrong and the USA has discovered the missing keys to economic perpetual motion? It was said that Japan simply did not lower interest rates fast enough; or Japan did not provide enough liquidity early enough; or not enough was done to encourage consumers to spend more; or the Bank of Japan was less effective in communicating with the markets. The FED dropped rates faster, liquidity was supplied in abundance at the very first signs of distress, consumers were actively encouraged to take on debt and to refinance long term debt, ultimately to stimulate aggregate demand; and the FED actively "communicated" with the markets to encourage predetermined outcomes. Did it work? Yes, it did, but not to avoid long-life asset inflation, nor to prevent long-life asset inflation. In fact, it helped to maintain inflated prices for longer and stimulated the growth in property inflation. One only needs to observe the trends in Equity prices, property prices, real estate debt and money supply. The USA must be facing a real and imminent risk of repeating the Japanese monetary policy outcome.

A quick detour to look at what happens to household balance sheets under long-life asset inflation conditions. We'll ignore wasting assets as those will just make things look worst and will detract from the real problem. The increase in the asset "values" encourages an increase in debt. The falling interest rates make debt very affordable. Everybody increase their debt loads and now the economy is poised for a fall, right. Not true. The debt will make things much worse, yes, but the debt is not the only cause. We are also very familiar with the refrain that the eastern nations are notoriously frugal. It follows that given the differences in propensity to consume and propensity to save, that the vivid decline in Japan is not a foregone conclusion for the USA, even though there seems to be some similarities. Sadly, that argument may also be wrong. The answers can be found in the IOU's.

Japan followed an undervalued currency policy aimed at export promotion. It worked and in fact worked very well for a long time. Only one little problem, to keep the currency weak, government had to buy all export proceeds. They mostly did not use taxes. No, they simply "gave" exporters Yen IOU's and in exchange bought USA IOU's with it. So far so good but for the little problem of Yen IOU's entering the Japanese economy. Those IOU's found their way into export promoting investments and in time into massive levels of Equity, Commercial Property, Industrial Property and even Residential Property investments. Long-life assets, all of them. The economic miracle of perpetual growth was unveiled to the world. Then something happened, it all collapsed. Why? The seemingly innocent IOU's did in fact cause inflation on a grand scale. The New Economy was just a grand repetition of the old money game played on a much smaller scale by banks when they were the creators of new money. The active participation of governments and central banks elevated the stakes but also created a framework for a disastrous economic outcome, one that will linger for many years.

The only macro difference between the Japanese model and the USA model is the point of entry of the IOU's. In Japan it entered via export promotion debt, in the USA it enters via more direct debt. Something tells me that the latter is also more menacing. More about that later. One thing is certain, long-life asset inflation turned out bad for Japan. Yet, it was not debt that caused the implosion. The answer is right there in fundamental economic law of supply and demand. Seemingly as invisible as the reality of long-life asset inflation. Again it is those pesky IOU's doing the damage.

Monetary stimulation and cheap credit are managed to promote "investment" in long-life assets. Unlimited supply of money (quantitative easing) suspends the orderly functioning of the market for money. Rising aggregate demand for long-life assets causes supply shortages, which manifests in rising prices. The rising asset prices cause an explosion in investment for new supplies of those assets. The rising prices also encourage greater levels of debt backed by rising values in long-life assets. The more IOU's enter the system the more the prices increase and the more supply expands. It's the "the cranes are everywhere you look" and the "mergers and acquisitions" investor stories that everybody so love. The time lag from when demand and higher prices initiated investment, to when new supply reaches the market causes over-investment in response to the highly inflated prices. New supplies cause prices to initially stabilise but prices start falling as new supplies continue to come onto the market. Supplies continue to increase due to the investment previously committed to supply. Prices continue to fall precipitously and the over-supply has to be carried by investors. Banks have to accommodate the "carrying" of the over-supply by investors or face bankruptcy. The market cannot return to equilibrium until the market is allowed to liquidate. Government is not prepared to allow liquidation and stasis ensues. Curious thing this supply and demand law of economics. It refuses to be suspended. The huge supply, high prices, excessive debt and demand dynamics eventually meets. Nobody wants to bid more for the assets; nobody can afford them any more and too many economic entities have more of those assets than they should hold. That age old law always seems to defy monetary stimulus. Asset prices crash, but that is not the end of the story. The annoying "long-life" characterisation now haunts the investor, the banks and central banks alike. These assets hang around for a long time and the oversupply with them. At this point debt enters as the menacing complication.

Banks financed the whole process as the conduit for the central bank's monetary stimulus, the export promotion policy of Japan (seeing China yet?), the skyscrapers, the factories, and the residential developments, even the equities, all courtesy of an almost limitless supply of IOU's. The nasty thing about debt is that it always remains. There is no mitigation for the fall in asset prices. Japan, when the long-life asset prices crashed, immediately went into systemic bank shock, a fearsome thing for central banks all over the world. It had to be stopped. There was only one way, the Bank of Japan simply provided as much IOU's to the banks as they needed to counteract any liquidity losses to provide an unlimited amount and unlimited period "carry" for bankrupt banks and debtors alike. Time was the only remedy; time to repay all the excess debt spent on ill-advised investments. Again enters the basic economic law of supply and demand. Unlimited money for a long time is the policy, thus the price also fell to almost nothing with the official Discount Rate at 0.1%. The lifts got stuck on the ground floor.

Armed with understanding the Japanese dilemma, I ask myself how China will suspend the law of supply and demand with basically the exact same recipe, or will the law of supply and demand suspend China's economy as it did to Japan? Both Japan and China are following export promotion under a weak currency dispensation, achieving current account surpluses and accumulation of savings. That protection is not afforded the importing countries. Debt and deficits are its inheritance. Which brings us back to the USA. Will the USA perhaps succeed where the exporters failed; or will this simple archaic law of supply and demand get to rule all?

Will all the citizens of the world get sucked into an economic black hole of systemic paralysis flooded in fiat money or have we got time left to repair the damage wrought by long-life asset inflation? Will we ignore the need to pay homage to the humble law of supply and demand?

Sarel Oberholster
Bcom (Cum Laude), CAIB (SA)
16 October 2004
E-mail: ccpt@iafrica.com

Acknowledgements: - The data for the DJIA and the Nikkei were downloaded from Yahoo and reworked into 21-day moving averages. All other data used and reworked for the graphs on Japan was obtained from the Bank of Japan's official statistics on their website in a downloadable file called "skeall", it has no page numbering. The reworked property index data for the USA was obtained from the website of Freddie Mac, the "Conventional Mortgage Home Price Index", in a downloadable file called "census9". The remaining time series for the USA graphs were obtained from the "Board of Governors of the Federal Reserve System"; series M3NS, REALLN & GS10.