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By some accounts, the Treasury printed up another
$3 billion in fiat currency last week. And, says the
Mogambo Guru, "the Fed bought outright another $520
million of government debt."

The Mogambo Guru: "The lesson of Argentina is completely
lost on Americans. Fractional banking and monumental
debt loads work fine in an expanding economy. That is
because the amount of money available to the banks to
lend is thus multiplied as the reciprocal of the
leverage. You have a hundred bucks, and thus are able to
lend a thousand bucks or more. Nice leverage.

"The lesson is that the losses from such leverage are
exactly multiplied when things go bad. If the bank loses
a hundred bucks on the thousand dollar loan, the capital
(the original hundred bucks) of the bank is completely
wiped out.

"And not just banks. The use of leverage always plays
out, and is playing out right in front of your eyes
[Enron, Tyco and now IBM], exactly the same in
everything."

Meanwhile, the IMF and World Bank are trying to put a
debt relief package together for the former Soviet
republics of Georgia, Kyrgyzstan, and Moldova, but the
Financial Times reports that the three countries - plus
Tajikistan and Armenia - have an average ratio of debt
to gross domestic product of 73.5%…or nearly half that
of Japan's.

"Who knows," writes Strategic Investment editor Dan
Denning, "maybe the U.S. and Japan will get lucky - and
the rest of the world will forgive us our debt."

Eric, what happened on Wall Street?

                               ******

Eric Fry in New York…

- A lot of folks don't mind eating horse meat…unless
they paid for beef. But if you've been paying the
butcher for beef over the last few years, only to find
out that he's been selling you horse meat, you might be
a little upset.

- The first thing you'd do is stop paying beef prices
for horse meat…and that's exactly what investors are
doing. They stampeded for the exits again yesterday,
amidst persistent rumors of dubious accounting practices
within some of America's premier corporations.

- The spreading suspicions took a toll on IBM shares in
particular. Many investors are starting to wonder
whether IBM, the filet mignon of tech stocks, might be
little more than artfully prepared "hamburger a cheval?"
Big Blue's shares fell another $3.35 yesterday to
$99.54, bringing its losses over the last two sessions
to nearly 10%.

- The reeling tech stock had plenty of company, as the
Dow tumbled 157 points to 9,745. The Nasdaq tanked 3% to
1,750.

- IBM promises more complete disclosure in the future.
So why didn't Big Blue simply provide more complete
disclosure in the past? Do you suppose the company's
lavish executive-options program had anything to do with
the less-than-complete disclosure?

- In the stock market as a whole, who knows what the
marginal difference might be between the S&P 500's
beautified earnings and the real thing. But even
marginally lower earnings might be enough to cause
severe problems for our richly valued stock market.

- Sometimes, barely perceptible change at the margin can
be devastating. Consider, for example, the effect of an
arrow shot from William Tell's bow, were it to fly a
marginal inch or so below its target.

- More importantly, there is a world of difference
between candor and deception. The "fair value" on
exposed deception is probably not 35 times earnings.

- Let's take a little break from beating up on the U.S.
stock market to take some potshots at the Japanese bond
market. We've been reading for weeks - not to mention
for months and for years - that Japan's economy is
sliding into an abyss. And as it has been sliding, so
have the yen and the Nikkei 225 stock index.

- But miraculously, the Japanese bond market has
remained an isolated pillar of strength…until now.
"The country's government bond market, the world's
largest, has gone dead cold," the New York Times
reports. Investors are beginning to shun Japanese
government bonds, known as JGBs. As a result, yields
have been inching higher.

- Even so, the 10-year bond still yields a paltry 1.5%.
This nearly invisible yield has been a financial freak
of nature for several years now. How can a country as
indebted as Japan be able to borrow money for 10 years
at little more than 1%? No one really knows the answer.
Some things just are, even if they shouldn't be.

- Therefore, what is perhaps most astonishing about the
recent slide in the JGB market is not that it has caused
yields to drift slightly higher to about 1.5%, but that
it has NOT caused yields to skyrocket into double
digits.

- "In Japan, total government debt is already 140% of
GDP and an astounding 465% of government revenues," Dan
Denning reminds us. "That's the highest rate anywhere in
the industrialized world."

- Now Moody's is threatening to downgrade Japan's yen-
denominated debt by as many as two notches. "Since we
last downgraded [Japan] in December," Moody's reports,
"the situation has deteriorated and the pace of
deterioration, from the point of view of credit
worthiness, has accelerated."

- "Deflation is the foremost challenge facing Japanese
authorities, exacerbating overall credit risks
throughout the economy as debt rises in real terms,"
Moody's continues. "Deflation is making a serious
government debt problem worse. A policy mix that
produces large fiscal deficits is unsustainable in the
medium term."

- Meanwhile, the Japanese yen continues its inexorable
downtrend, causing a few anxious Japanese citizens to
exchange their feeble currency for less feeble gold
bullion. This trickle spilling over the Japanese
monetary dam has not yet become a flood.

- But just the same, I wouldn't build a house anywhere
near the flood plain.

                               ******

Back to Addison in the Daily Reckoning HQ…

*** Interesting, isn't it, that some of today's most
popular investments are stocks selling for 35 times
overstated earnings and bonds paying 1.5% annual
interest from one of the world's most indebted
governments?

*** "This constant monetization of government debt,"
writes Richard Daughty, "is a blatant fraud perpetrated
by the Fed, and every person in the USA will be a victim
when the whole mess falls apart, as it must."

*** And still no one wants gold! What might debt - and
it's evil twin deflation - reap in the U.S. economy? I
don't know…but the Japanese have been experimenting
with the recipe for about a decade. More below…

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The Daily Reckoning PRESENTS: Strategic Investments
editor Dan Denning explores Japan's latest contribution
to the story of capitalism: the two-headed monster of
Debt and Deflation that has taken the world's second
largest economy to the edge of catastrophe.

HUMPTY DUMPTY-SAN

by Daniel Denning

Call it the latest strain of the recurring cyclical
disease: global financial bust. The entire Japanese
financial sector is on the edge of bankruptcy.

In the 1980s we called them a nation of imitators, not
innovators. Now, the land of cheap electronics and
Godzilla movies is leading the world to the brink of
disaster. Most troubling, the whole gruesome affair may
be a chilling preview of what debt and deflation could
wreak in the United States.

First, let's take a look at the debt problem. The
government says banks have 43 trillion yen ($US320
billion) in non-performing loans on the books. That's
four times the size of Enron.

Private estimates put the figure closer 237 trillion yen
(US$1.7 trillion). That's the equivalent of 20 Enrons…
it ain't a pretty picture.

All that bad debt - and all that unproductive investment
- have created an environment where Japanese businesses
have very little pricing power. And that brings up the
second big "D", deflation.

Deflation runs at a 4% annual pace in Japan. "Deflation
has for years been wrecking efforts to revive the
flagging economy," the Financial Times reports, "by
depressing consumer demand as shoppers wait for prices
to fall further, and reducing the incentive for
companies to invest in new capacity."

Falling prices. Falling demand. Falling investment. It's
a viscious cycle. Not a virtuous one. And not one that
is likely to be reversed with a few shifts in monetary
policy.

Japan has had near zero interest rates for years, to no
effect. "A 16.4 percent expansion in the monetary base
last year has had no noticeable effect on money supply,"
the FT reports, "nor on bank lending or on prices, which
have been falling for three years."

The Nippon government - doing what it does best - has
tried to spend it's way out of the problem. The result?
Total government debt in Japan is now 140% of GDP and an
astounding 465% of government revenues. That's the
highest rate anywhere in the industrialized world.

What's more, with high-profile government bail-outs
peppering the financial press, the government has
encouraged an environment where mal-investment and
corruption reign as the business practice of choice.

Case in point, Snow Brand Milk. Snow Brand is a dairy
company accused, by the government, of fraudulently
obtaining subsidies…courtesy of the government. In a
model of foolish consistency, it's the government who's
bailing out Snow Brand through an alliance of three
agricultural cooperatives.

Nestle wanted to make a bid for Snow Brand. But the
government intervened and arranged a buyout. By doing
so, it perpetuates the existence of an enterprise that
should be allowed to fail.

One wonders how, in an era of excess capacity and
deflation, prices can rise when the government deems
every enterprise "too big to fail"? Free markets work
best when failure gets punished so that businesses die
out, allowing the more efficient ones to succeed. Free
markets work when prices are not artificially suppressed
by an excess of government subsidized production.

In less-than-free markets (the U.S. included) government
bailouts keep inefficient companies in business and
perpetuate excess capacity. And by keeping bad companies
afloat, they prevent banks from writing off trillions of
yen in unproductive, non-economic, and wasteful loans.
But it's not just bailouts and subsidies that cause
problems. It's also interest rates.

Artificially low interest rates - those designed to
"stimulate" economic activity - don't do anyone any
favors. The create cheap credit. And that credit leads
to "uneconomic" investment and outright speculation.

In Japan, that speculation was concentrated mostly in
the Asian real estate market. In the United States, it's
been concentrated mostly in financial assets. But in
both cases, years of speculation has had the same
effect: billions of dollars wasted on uneconomic assets,
non-performing loans, and excess capacity.

The Japanese are finding out that wasted capital is not
good for stock prices. In early February, the Nikkei 225
fell to an 18-year low. And for the first time in 45
years, it closed below the average on the Dow Jones
Industrials. "Can't happen here," you say?

The facts suggest otherwise. America's debt and
deflation problems look very much like Japan's: lots of
wasted capital, lots of excess capacity, and lots of bad
debt. The only thing that remains to be seen is if
America's debt orgy will cost it as much as Japan's has
cost the Japanese. And unfortunately, all the factors
are in place for us to imitate Japan's slow motion
depression.

Take corporate debt. U.S. corporations have about $4.9
trillion in debt. But in the last few weeks, corporate
debt markets have virtually dried up. Spreads between
the yield on the 10-year Treasury and corporate bonds
are widening. Accounting scandals - and sometimes just
boneheaded business decisions - have locked companies
like Xerox, Enron, Tyco, and Qwest out of the market for
cheap short-term debt used as working capital.

As one corporate giant after another falls, investors
are fleeing the commercial paper market for Treasuries.

Investors are showing they have little confidence in
businesses that must turn to bank lenders (rather than
cash flow) in times of need. And what confidence they
have left in corporate America might be further eroded
by the fact that both capacity utilization and prices
continue to fall.

Capacity utilization in January was down to 74.2%.
That's its lowest level since 1983. It's fallen seven
straight months for a total decline of 2.7% points.
That's certainly no sign that the recession is over or
that the economy is recovering. If businesses aren't
using existing capacity - if they're idling it at higher
rates - they don't see recovery and inflation.

They see deflation.

Core producer prices fell 0.1% in January. From raw
materials to finished goods, prices aren't rising.
They're falling. My friend Greg Weldon at Weldon's Money
Monitor reports that the January reading on the year-
year pace of PPI is the lowest since 1950. And while the
Fed may be worried about inflation, the broader trend is
deflation.

That's not good news for corporate profits, and by
extension, the stock market. Stocks are priced for
earnings growth. Not shrinking earnings. At some point,
they will have to more accurately reflect corporate
reality.

Will that lead to an 18-year low in America as it has in
Japan?

Maybe. But even if it's only a long sideways meandering,
investors would see little or no growth from most
stocks. We may not have the luxury of a long
convalescence.

Dan Denning
for The Daily Reckoning

P.S. On April 1, the Japanese government will no longer
fully guarantee time deposits in Japanese banks.
Removing this insurance is causing savers at smaller
banks to worry about their banks' solvency.

Japanese savers are responding by taking their cash
while they can get it. And they're beginning to trade
that cash in for something more reliable: gold.

Yoshihiro Matsumoto, who runs the gold retail division
at Mitsubishi Materials, says, "Normally, our customers
buy 1kg-5kg of gold, but recently, they're buying huge
amounts. And most people want to take their gold home
rather than have it in a bank deposit box."

"Customers tell me that even if the price of gold
falls," says Yoshiko Mizutani, manager of The Gold Shop,
"it'll never fall to zero. But if their bank goes under,
they worry their savings could disappear."

The flight to gold in Japan is just the beginning of
what we call "Epic Reversals"..

Daniel K. Denning is the editor of Strategic Investment.
Before joining the Daily Reckoning team, Mr. Denning had
launched his own investment advisory service focusing on
very small innovative companies and had cut his teeth in
the competitive world of Internet start-ups, helping to
launch a software solutions company.

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