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By Root 1188 0

firms and the government left these dollars abroad, while funding their external balance with «virtual yen» – that is, yen borrowed at almost no interest from domestic lenders. This system worked well for decades, but by the 1990s it had come under huge strain. It is now more difficult than ever for Japan to repatriate its foreign reserves, since if it did, the dollar would drop like a stone, which would drive up inflation in the United States, raise interest rates, and put an end to America's long economic expansion; at the same time, it would result in a shockingly high yen, bringing Japan's exports to a crawl. So it is not only Japan that wields power over the United States; it goes both ways. Murphy says, «Japan and the United States have realized the financial equivalent of the nuclear balance of terror-mutually assured destruction.»

It's sobering to realize that the supposedly «rational» United States, too, relies on an artificial system to support its economy, persistently ignoring the mountain of dollars piling up in foreign ownership-it has been called America's «deficit without tears.» For the time being, foreigners continue to finance the U.S. economy with money earned from America's huge trade deficits, but sooner or later they will cash in those dollars and the American economy will suffer severe pain.

Or maybe not. If Japan suddenly sold off its dollars, it would hurt the U.S. economy but damage Japan's far more. Furthermore, Japan is not the only country to hold dollars; all of America's trading partners do, and China, running the largest trading surplus with the United States, is building up the biggest reserves of all. In coming years, Japan may not necessarily exert the determining influence on what happens to the dollar. The very existence of so many dollars abroad is also a plus for the United States, because it makes the dollar the de facto world currency-so there is less need for foreign nations to trade their dollars in for local money. Perhaps the United States will turn out to have practiced a bit of financial magic of its own, holding those dollars hostage indefinitely-or, at least, until a time beyond the horizon when economists can make predictions.

Meanwhile, Japan continues to keep most of its dollars abroad, diverting ever more «virtual yen» at home to fund its huge external surpluses, and this is getting harder and harder to do. Uncontrolled bank lending in the 1980s (the Bubble) could be seen as an early attempt to inflate the domestic money supply without bringing the dollars home. We have seen what the effects of the Bubble were. In the 1990s, the government tried another approach: pumping money into the economy through public works, paid for with a burgeoning national debt. This, too, cannot go on forever. Another crash may be coming, and this one could drag Japan down – and with it the entire world economy.

It might seem incongruous that while a great sword hangs over the world's head in the form of Japan's external dollars, its domestic markets are becoming irrelevant. The paradox, however, lies in the fact that each is the complement of the other: Japan's external reserves exist only because domestic markets, in order to preserve MOF's system, are cut off from the world.

The most vivid demonstration of the irrelevance of domestic markets to world finance is the collapse of the Tokyo Stock Exchange's foreign section, launched in the late 1970s in a bid to make Tokyo an international capital market. At its height in 1990, the TSE's foreign section boasted 125 companies. However, the rules hedging in foreign firms were so restrictive that fees far outweighed the anemic trading in foreign stocks. By the spring of 2000, the number of companies had dropped to 43. Average trading volume shrank nearly to the vanishing point: during the week of June 1-5, 1999, only 19 of the remaining companies traded at all on an average day. In an era of international finance, such a foreign section goes beyond failure to farce.

In the meantime, foreign listings on other stock markets skyrocketed. By