Correct, you answered your own question. Central Bankers don't actually control the flow of money. They have direct control over a very small portion of it, and they can only try to channel the rest into various instruments. Think of monetary pressure like water pressure. In trying to keep their currency from rising, as it would have under normal conditions, the Japanese cb's simply caused the pressure to exert itself elsewhere, as excess liquidity channeled itself into speculative fuel for stock and real estate bets. This also highlights the main danger of inflation: when prices are rising across the board, the true value fundamentals become obscured. If you don't know whether prices are rising for valid reasons or simply because of a monetary phenomenon, your ability to make accurate investment decisions is lost. And the eternal optimists run wild on the strength of false evidence. Normally when central bankers intervene to keep a currency down, they practice something called 'sterilization' to keep liquidity induced asset inflation from happening. To sterilize an intervention, they will issue a large volume of government debt alongside in order to 'mop up' the excess cash. In other words, they try to get the banks and the speculators to buy government securities instead of making foolhardy bets. Of course, sterilization doesn't always work, and getting the mix right is very tricky. The more complex the process, the easier it is to screw up. We saw a similar process of redirection after the dot com bubble burst. When deflation sets in, it's the equivalent of water pressure dropping to dangerously weak levels. Central bankers live in fear of deflation because stimulative policies are no good when the water pressure is not there- it's like 'pushing on a string.' In an effort to stop this from happening, Greenspan preemptively flooded the markets with liquidity- and that liquidity was promptly redirected into the housing market, acting as the driver for the real estate bubble we now see in the USA. The key thing to remember is that for every action there is an equal and opposite reaction. Governments are forever fighting this, and the whole mandate of central bankers is to create an artificially smooth economic curve and keep nature (human nature?) from taking its course. Under normal conditions, central bankers can control the money flow and channel it as they choose. But pressures continue to build the entire time, even as things look like they are under control, and nature eventually wreaks havoc: dams burst, droughts decimate, floods destroy, etc. etc. The more you try to artificially control a natural process, the more violent the eventual backlash will be. You'll find this principle at the heart of Austrian economics: that booms and busts are created by government intervention policies that foolishly attempt to repeal natural laws.
Great post - appreciate it. But the above made me realize I'd forgotten something: how much control does the Fed have on buying/selling government securites? What I'm asking is this: isn't the amount of foreign debt more controlled by largely market forces including our export/import ratio, i.e. not the Fed's actions? Hope that makes sense...