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"It began," says James Grant in his book, The "Trouble with Prosperity," "with the Plaza Accord." Grant refers to the Japanese Bubble. But, as you will see, the bubble in the United States actually got its first big puff of air here, too.

The Plaza Hotel, by the way, looms large in conspiracy history. It was at this same hotel in the 1950s, according to Janet Reno, that tobacco executives met and agreed to keep quiet about the health consequences of smoking. Reno contends that this silence shortened the lifespans of the tobacco industry's most loyal customers. 

But the conspiracy we are concerned with occurred 30 years later -- in 1985. The G-5 central bankers at the Plaza colluded to rig international currency markets so that the dollar would fall. They thus set in motion a chain of events that would ultimately create the world's two biggest bubbles.

The first bubble was in the world's second largest economy -- Japan. The second, for which I must use the present tense, is still in the world's largest economy -- America. 

The first bubble popped decisively 10 years ago. Only in the last couple of months does it appear that the air has stopped going out. Deflation seems to have bottomed out in Japan -- 10 years later.

The actual events are infinitely complex. But realizing that we cannot explain everything, I will caricature them: The Japanese were in a bit of a jam because of the falling dollar. The United States was their biggest market. How could they continue to sell to Americans at higher prices? The solution, they reasoned, was to invest vast amounts of money in order to create better quality and get more market share. Forget the profits; the Japanese ignored profit margins. Like Internet companies, the Japanese figured they'd get serious about earning money later. Besides, as we will see, the real profits were on the Nikkei stock market...not in the factories and showrooms.

The Bank of Japan led the way...reducing rates from 5% in '85 to 2.5% in '87. Naturally, the abundance of credit had a perverse effect. Only so much capital could be fruitfully invested in new machinery. So a lot of money began to find its way into the stock and real estate markets. Prices soared. Investors were sure Japan was different from other economies. It was fail-safe. Stocks soon reached an average P/E of 70. People paid millions for Gold Club memberships. A single piece of real estate, the ground on which the Imperial Palace in Tokyo stood, was valued at more than the entire state of California.

By June '89, Japanese central bank officials were worried. Unlike Mr. Greenspan, they knew a bubble when they saw one. So they raised the official discount rate above 3%. Nothing happened. Then, on Christmas Day, this did the trick -- more so than they imagined. The market crashed.

To this point, the U.S. market was behaving sensibly. A panic in '87 had taken some of the wind from investors' sails. Prices were rising...but the Dow was well below 4,000 and the Nasdaq had barely been noticed....

But the Japanese were in trouble. Having punctured the bubble, they now sought to plug the hole. They tried the familiar patch -- more money. Over the next few years they reduced interest rates to the point where they were, in effect, giving away money. The "Financial Times" described interest rates in Japan as "effectively zero."

But an economy in deflation mode has little use for borrowed funds. Instead, it was speculators who took up the cash offered by the Bank of Japan. They created what is known as the "yen carry trade." The idea was very simple. Borrow money in yen at low rates...lend it or invest it in America, where rates of return were much higher. 

This had the effect of exporting Japan's credit expansion policies to the United States. Plus it allowed the United States to export its inflation overseas. Incoming capital lifted the dollar and lowered the cost of imported items. Dollars went out of the United States in the consumer economy -- to pay for Toyotas and Walkmen -- and came back to Wall Street, raising the prices of stocks and bonds. No finer or more fortuitous set of economic circumstances has ever been experienced by any economy in the world. The Japanese save. We spend. The Japanese toil. We consume. The Japanese are idiots. We are geniuses. 

But the "best of times" cannot last forever. There must be "the worst of times," too. And a lot of times in between.

The yen carry trade came to an end when the yen rose against the dollar. Traders were caught short yen and long dollars -- and lost money. The great bull market in America probably would have turned into a great bear market late in 1998 except for another few happy events: The Asian economies melted down first. And Long Term Capital Management needed a bailout. So the world's central bankers got to work again. This time they were led by Alan Greenspan who had a clear idea of how to handle the situation: flood the market with liquidity. 

His solution worked. It turned the world's greatest bull market into the world's most grotesque bubble market. Most stocks on the NYSE were already in bear patterns, so the new credit tended to focus itself on the few that were still going up. These were the leading Dow and S&P stocks...and, of course, the Nasdaq -- all of which reached bubble heights. The distance between Wall Street, which enjoyed the credit, and Main Street, which did not, grew to levels never before seen. In a nation in which everyone was supposed to be getting rich, most people clearly were not. They were going in debt. And working longer hours for only marginally more money. And holding stocks that went down, not up.

Then, in the last half of '99, the trick was tried again. This time, it was the Y2K threat that loomed over the world's markets. Again credit was expanded. This time it was the Nasdaq that got most of the loot. During the last quarter of last year, the Nasdaq seemed to reach new highs almost every business day.

But what now? A study done by the Economic Cycle Research Institute, reported by James Grant, says that the Japanese deflationary cycle bottomed out in March of last year. If that is so, the people on the other side of the world who have been so contentedly absorbing U.S. inflation and so cheerfully providing money to the entire world may be changing their habits. 

Maybe they will want to consume as well as produce and spend as well as save. Maybe the world still turns. 

Regards,

Bill Bonner 

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