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Abenomics - the new economic policy of Japan's Prime Minister Shinzo Abe - has set out to defeat deflation. This is not the entirety of Mr. Abe's plans, and there are certainly some intelligent reforms that he aims to make. But he and Kuroda (the head of Bank of Japan, BOJ) - along with numerous economists - believe that defeating deflation is an essential prerequisite to a sustained economic recovery.

There are numerous explanations as to what has caused Japan's persistent deflation, and depending on what view one takes as to the underlying causes, it can be understood as either benign (or rather, I would argue, inevitable), or destructive. Policies should in turn be informed by a careful analysis of the underlying causes.

On the one hand, price declines have essentially been a natural - and healthy - readjustment after the bubble burst in the early nineties. Land prices - especially in Tokyo - had been artificially raised to ridiculous heights during the property bubble, and as they've come down, landlords have been forced to hand on lower rents to tenants, and commercial renters have in turn lowered the prices of their goods or services in order to stay competitive. There has also been an increase in efficiency in terms of production. This has happened both inside and outside of the country. Inside Japan, technological advances have meant that assembly lines have become increasingly automated, lowering labor costs; outside of the country, neighboring China has been able to massively undercut Japan in terms of production costs and thus flood the Japanese market with cheap consumer products.

And then there is the issue of a consistent decline in aggregate demand. On the one hand it is argued that this is the result of deflation: deflation begets deflation. In other words, if prices are decreasing year on year, consumers put off making purchases in the knowledge that things will be cheaper in the future. True, consumers do put off purchases in anticipation of a near-term significant reduction in prices: say for instance something is about to go on sale. Moreover, purchases may be delayed under serious deflationary conditions. But in the past two decades prices in Japan have only been declining at roughly 1 percent per year. Therefore, is it realistic to think that someone would wait three years to buy a television to save roughly three percent on their purchase? Would a woman wait ten years to have a baby in the hope that diapers will be cheaper in the future? It seems unlikely.

The fact that women have not been having babies as young - or at all - is a result of far more complex societal changes, the reasons for which are the topic for another discussion. Simply put the population of Japan is in decline. The country has three workers for every retiree, and a negative birthrate. This leads to the inescapable conclusion that unless this situation is reversed - either through an active immigration program, or a sudden increase in the birth rate - Japan will continue to experience a consistent decline in demand.

There are other reasons commonly cited when discussing Japan's deflation. Companies have been hoarding cash and not reinvesting it in the society, because there are fewer opportunities in the domestic market. Thus money has been hoarded or consistently flowed out of the country. Individuals likewise have been happy to leave their money in the bank instead of actively seeking investments - again because there aren't as many opportunities as there were in the past when Japan had a young and growing population. Despite rounds of quantitative easing - and Japan's already enormous cash reserves - much money has flowed out of the country seeking investments in foreign, more productive societies. These factors may have contributed to Japan's deflation but they are, again, symptoms of underlying issues. If there had been opportunities for domestic reinvestment, people would not have hoarded their money or sent it overseas in the first place.

A further reason often cited is simple deflation itself. Just as inflationary expectations drive inflation, so too can deflationary expectations drive deflation. Of all of the possible causes for deflation this is the only one that monetary policy could, perhaps, actively counter. Indeed if the central bank were able to engineer inflation - through printing enough money (simultaneously weakening the currency as they have already done) - citizens and companies might well stop hoarding their cash. Money may flow back into the country as off-shore investments are wound up, or dividend streams offer better real returns in the weakened currency. Prices may rise and stocks may perform well, as indeed they have been. We might temporarily witness some of the trappings of a society experiencing inflation. But this will just be window dressing. The symptoms may temporarily subside, but the underlying causes will remain.

Japan finds itself in a unique position in human history. Never before has there been a fully industrialized society with a population in apparently irreversible decline. And as such there is no historical data on which we can draw. There are no economic or monetary policies or models that have been tried and tested under these conditions. The government and BOJ either do not recognize this or cannot openly acknowledge it. And so they are implementing policies that may have worked under different conditions in the past - specifically, in societies that were growing but had stalled due to either a misallocation of capital, faulty monetary or economic policy, or any other combination of factors - but will not work now under these new conditions: at least not on a sustainable basis.

In the medium to long term Japanese society and the Japanese economy are going to undergo some serious changes. As I described in this article I do not believe it is possible for Abe to succeed at his stated aim of achieving 2% inflation per annum and continue to successfully fund his government's enormous deficits. In the short term however he is working hand in hand with his trusty central banker Kuroda to try and create something that resembles success.

Central bankers are masters of conjuring up illusions and in the end they will be exposed for what they are. But illusions can be maintained for surprisingly long, and provided that the market continues to buy into the current one there will be great opportunities for speculators (not, I would argue, long-term investors).

Since the beginning of the year the Nikkei has made massive gains - at its peak, up nearly 60% in six months. As money moved away from bonds into the stock market there were a series of interest rate spikes. Then there was a sudden panic - a temporary loss of faith in the plan - and the Nikkei lost almost 20% in ten days. In the last two weeks, however, the Nikkei has gained 6% - performing better than all other major indices. Interest rates on bonds have fluctuated, first falling back down from 0.93% to 0.85%, and then in the last few days rising up again to 0.90%. This last move coincided with the stock market recovering. All this seems to suggest that for the meantime the market is happily buying into Abe and Kuroda's magical fantasy creation. And provided that everyone continues to buy into it, it will remain a - temporary - reality.

One should also not discount the determination of Japan's leader, Mr. Abe. Remember this is not his first time in politics. He was booted out back in 2007 and has come back with serious determination to kick-start inflation and show the world that Japan means business. He also enjoys enormous popularity with a large segment of the Japanese population. After all, the dream he's selling is a very appealing one: the use of financial wizardry to bring an end to the 'lost decades', and a return of Japan to economic preeminence. Moreover - at the time of writing - the Nikkei 225 is trading at around 14,000, and at its peak in 1990 it traded at just under 40,000. So, by historical standards, it still has a very long way to go. The Japanese population want to see it go there, and so do many international money managers who still believe that Japanese shares are very cheap - certainly in comparison with those in other major markets.

In the US, Ben Bernanke has inflated one of the greatest asset bubbles in history, and along the way made some people very rich. It seems probable that Abe and Kuroda will do the same thing in Japan. In the US despite the S&P hitting all time highs, unemployment has remained higher than it's been since The Great Depression. This helps illustrate the fact that central bank smoke and mirror operations cannot counter reality - and that there is often a massive disconnect between the stock market and the underlying economy. In Japan we will see that in the long run, neither inflation nor a soaring stock market will be able to reverse population decline, lower the national average age, or fix the real structural issues the country faces.

But for those interested in short to medium-term gains, there are several options. The safest would simply be to go - or remain - long Japanese stocks. The WisdomTree Japan Hedged Equity Fund (NYSEARCA:DXJ) provides foreign investors with such an opportunity. Investors who started shorting the yen over a year ago have already made significant profits. At this point, with the yen sitting at around 100 to the dollar it is quite a risky a trade. It would require some significant change in sentiment for the yen to move lower.

However - if one wants to take a long-term perspective - it is worth remembering that the yen traded at around 300 to the dollar prior to the 1985 Plaza Accord. Much of its strength in recent years has been due to its status as an alternative reserve currency - and because previous central bankers have been unwilling to print with as much enthusiasm as Kuroda. With talk of QE winding up in the US (at the moment it's just talk) and the dollar strengthening against other currencies, there is every chance that the yen could fall through the 100 to the dollar psychological mark and continue to decline from there: easily to 120 in the short term.

For the brave, PowerShares offers inverse exposure to Japanese government bonds - the JGBS -1X. And for the extremely brave there's the JBBD -3X. At this point however, shorting Japanese government bonds is very risky, because as the market has shown, the world is still buying into the current fantastical narrative: Japan can re-inflate its way back to prosperity and Kuroda can keep yields on government bonds low by buying up debt with freshly printed money. How long will this last? We'll have to wait and see.

Source: Japan: Printing Up Miracles And Mirages