RealMoney

In part 1 and part 2 of this column series, I discussed the trend of a flight from risk by capital owners that began last year as consumer demand declined, especially in the U.S., and investors began slowing investment in developing countries, especially China.

That flight from risk as a temporary response to a decline in demand has since grown into a flight to the perceived safety of capital owners' home countries, as fear that the decrease in demand may not be as temporary as was originally believed.

That fear is exacerbated by consumer demand continuing to decrease in the face of extraordinary countercyclical measures being taken by monetary authorities to prevent it, as is most evident in the negative interest rate regimes in place in Europe and Japan.

Since the Lehman-crisis era, and prior to that in the case of Japan, governments globally have had to enhance their monetary stimulus efforts with fiscal support that has caused sovereign debt levels to rise dramatically.

In order to service that debt and provide the opportunity to issue more debt, these countries need the owners of capital to invest both domestically and in cross-border transactions.

If capital owners fail to do so, the risk of debt defaults increases and will logically cause the owners of capital to withdraw from participating even more quickly.

As critical as these issues are for the U.S. and European authorities, they are even more so for China and Japan.

China is caught in a vise between two bad options: allow foreign capital to continue to flee or implement capital controls to prevent it.

If it lets capital continue to flee, China risks an uncontrolled depreciation of the yuan, which could lead to civil unrest or worse.

If China implements capital controls and refuses to allow foreign capital to exit, it risks panicking those investors and others into not bringing new capital into the country in the future.

If that happens, the country risks becoming victim to the "middle income trap," economic activity collapses and the descent into civil unrest, or worse, begins.

As bad as that is, the situation for Japan may be even worse.

Although there are deep cultural divisions between China and Japan, as well as political and government divisions over claims to islands between the two countries, their economic and financial relationship is both synergistic and symbiotic.

They both need cross-border investment and trade with each other in order to survive economically.

That relationship is similar to that among the U.S., Canada and Mexico.

That's why Bank of Japan Governor Haruhiko Kuroda recently urged China to implement capital controls to prevent capital flight and followed that by instituting a negative interest rate regime in Japan.

If capital starts to flow out of China and back to Japan, as Japanese investors seek to park assets at home, the economic impact on Japan is negative, affecting the ability of Japan to continue to service its sovereign debt.

That's important for Japan because it has no public financial policy tools left to counteract a further retrenchment in economic activity, as I last discussed in the column, "Japan's Endgame Begins."

Japan, as a sovereign, is terminally insolvent and there's nothing the country's leaders can do to change that. Abenomics is simply the process of the government there trying to postpone the point at which investors realize that Japanese government bonds (JGBs) are a Ponzi scheme.

If China does not implement capital controls and the yuan enters a period of uncontrolled depreciation, the real risk is that investors will realize the insolvency of Japan and, like in a game of spoons, investors everywhere flee all assets, other than U.S. Treasuries for institutional investors, and hard assets like gold for individuals.  

The Catch-22 is that the same thing would likely happen, but perhaps over a longer time period, if China implements capital controls.

In either case, the capital fleeing China and the public advice from Japan to stop it by force are an indication that the era of globalization and the massive increase in debt issuance from public and private entities that have fueled it are coming to an end.

The result is balkanization, the fleeing "home" by global investors in search of the protection their governments and militaries can provide.

And that raises the possibility of the last economic policy tool available to everyone -- war -- as I discussed in the column, "When All Else Fails, Go to War."