Trying to bail out a rapidly filling boat while rowing upstream can be difficult enough, but it is practically impossible when your bailing bucket has lost its bottom. For the debt-deluged American economy, the end of the “yen carry trade” could be the blow that breaks the bailing bucket and lets the boat sink.

On March 9, the Bank of Japan announced that it was ending its “easy money” policy, which has kept interest rates near zero for almost 10 years and kept much foreign investment flowing into the U.S. Low Japanese interest rates allow an investment strategy that investors refer to as the Japanese yen carry trade.

The termination of the yen carry trade could have serious ramifications for the U.S. dollar—if events unfold the same way as they did in Iceland, New Zealand and Brazil.

Jim Willie, financial analyst and editor of the Hat Trick Letter, says, “The yen carry trade unwind is probably the biggest potential change factor in the financial world this year …. When it unwinds, the damage will be pervasive …” (Daily Reckoning, March 20).

The yen carry trade is simply the borrowing of Japanese yen at low interest rates and investing the proceeds in higher-yielding currencies like the U.S. dollar or Icelandic krona.

While the investors make money from the interest rate differential, it also has the side effect of keeping the yen value relatively low and the recipient countries’ currencies stronger. Stated another way, the yen carry trade has buoyed up the U.S. dollar, Icelandic krona, and the currencies of other recipient countries.

This trade works as long as interest rates and the value of the yen remain stable compared to other currencies (Bullion Management Services Inc., March 3). If Japanese interest rates or the yen value rises, it destroys the profitability of the yen carry trade and results in investors unwinding their trades.

This could be very significant for the U.S. because, as analyst David Chapman says, all the major players—including “investment dealers, banks, insurance companies, hedge funds and mutual funds”—are involved in the trade. What’s worse, the banks, investment dealers and hedge funds have leveraged themselves by speculative borrowing (ibid.).

The Economist agrees, saying, “[I]nvestors have good reason to fear the Bank of Japan” especially in a world where so many financial institutions are “leveraged to the gills” (National Business Review, March 17).

Carry trades account for hundreds of billions of dollars globally. David Chapman warns that as they start to unwind, it will affect foreign exchange, interest rates and the derivatives markets, which total some $2.4 trillion per day—an astronomical amount. If the unwinding process becomes disorderly, it could easily develop into a major crisis.

The crash of the Icelandic krona could be the tip of the iceberg of a coming carry-trade-induced financial problem.

According to the Wall Street Journal, foreign investor retreat, triggered by the downgrading of Icelandic debt by Fitch ratings agency, resulted in the rapid unwinding of the carry trade in Iceland, and has left the nation “trying to stave off a financial meltdown” (April 10). So far this year, the Icelandic krona has fallen 12 percent against the U.S. dollar (msnbc, March 31), despite increases in Iceland’s central bank’s lending rate (which is now 11.5 percent). The Icelandic stock market too has tumbled, nearly 20 percent—including its biggest one-day loss in 13 years—over recent weeks.

Denmark’s Danske Bank is warning that the Icelandic economy could shrink by 5 to 10 percent over the next couple years and is predicting that its currency could fall by 25 percent.

The krona’s meltdown set off a chain reaction that hit New Zealand, Poland, Hungary, and Brazil.

In New Zealand for example, a little over a year ago, one NZ dollar bought 74 cents U.S. Just over two months ago, it was valued at around 71 cents. Today it is only worth around 60.8 cents U.S. (New Zealand Limited, April 4).

As David Chapman points out, the Iceland crisis “didn’t turn into a debacle this time just yet”; however, it is reminiscent of the 1997 Asian currency crisis. At that time it was the little-known Thailand Baht that helped set off a chain reaction leading to multiple currency devaluations and the Russian ruble and debt disaster.

Eventually, even America felt the pain of the Asian currency crisis when in 1998 the massive hedge fund Long Term Capital Management (ltcm) went bankrupt (Bullion Management Services Inc., op. cit.). At that time, the acting U.S. Federal Reserve Bank Chairman Alan Greenspan considered the ltcm bankruptcy so serious that he personally organized its bailout in order to prevent the stability of the entire U.S. market from being compromised.

Interestingly, the wsj points out that in contrast to the Asian currency meltdown in 1997, today it is the “advanced economies” of the industrialized world “with the biggest economic imbalances” (April 10). Back in 1997, at the time of the Asian crisis, it was the developing world that had huge trade imbalances and national debts. Now these same countries, like Thailand and Russia, have built up their foreign exchange reserves and have turned trade deficits into surpluses.

However, many economists feel that for Americans, the end of the yen carry trade is no cause for worry because the U.S. is a “special case” and that America shouldn’t be lumped in with smaller industrialized economies. America is the largest economy in the world; the U.S. dollar is the world’s reserve currency; U.S. Treasury bills are considered the safest investment available—so Americans have no need to worry.

But is that utopian view really true? America has many of the same problems as Iceland, including record trade deficits, massive debts, heavy reliance on foreign nations to buy their securities, and lending booms that have fostered soaring property values (wsj, April 10).

Nevertheless, the utopians might be partly right. By itself, the end of the yen carry trade may not be a catastrophic threat to the U.S. dollar and economy. However, taken together with America’s debt-loaded, industry-atrophied, housing-bubbled economy, America looks to be in a very precarious position. Add into that mix, the fact that the euro is continually gaining status as a reserve currency alternative to the dollar, and the U.S. greenback could be in very serious trouble.

Whether or not the end of the yen carry trade will be the final factor that sinks America’s economic boat remains to be seen, but even putting the yen carry trade aside, the boat is sinking. That alone should be a warning sign to take action.

For more information on the fundamental reasons that America’s economy is in the situation it is today, please read our book The United States and Britain in Prophecy.