Japan-not the U.S.-may have been the ultimate safe haven at the peak of the financial crisis. In 2008 and 2009, the yen soared against all currencies as the Japanese banking system was considered the safest in the world. How is this possible in a country that has dramatic fiscal deficits and is known to monetize its debt?

To understand what has been happening in Japan and to gauge how dynamics in the world of global finance and currencies may play out, we first have to get over the myth that a country needs to have economic growth in order to have a strong currency. In our analysis, this generally applies only when a country is dependent on financing its deficits from abroad, i.e., it has a current account deficit. Historically, though, Japan finances its deficits domestically, despite an economy that has been struggling to show any growth for years.

CONSTRUCTIVE DYSFUNCTION

The yen's strength may well have been a consequence of Japan's dysfunctional government. In September 2007, Shinzo Abe resigned as Japan's prime minister after months of mounting political pressure; the yen strengthened as Japan churned through two more prime ministers. In early 2009, the minister of finance appeared drunk at a G-7 meeting, giving the state of affairs a rather public display. (Japan has had six finance ministers since August 2008.)

In our assessment, the yen strengthened during the period because market forces were allowed to play out. A dysfunctional government is less effective at spending and printing money. Consumers saved more and spent less, allowing deflationary forces do their work.

Last September, the opposition Democratic Party of Japan (DPJ) unseated the ruling party that had held power with barely any interruption since 1955. The DPJ, with a manifest lacking in clear direction, appointed fiscal conservative Hirohisa Fujii, 77, minister of finance, known for his hands-off approach to the Bank of Japan.

YEN'S DOWNFALL

In early January, Fujii abruptly resigned due to what he said were health reasons. (Some observers say his resignation was due to a dispute with DPJ Chairman Ichiro Ozawa.) When his successor, Naoto Kan, was appointed by Prime Minister Yukio Hatoyama a day later, my company opined that the yen had lost its status as a hard currency. So what happened?

With the appointment of an outspoken spender and interventionist influencing industry and the yen, Japan may once again be back on a clear path: Fiscal and monetary largesse should lead to a weaker yen and may boost short-term economic growth. It's a dangerous road, especially since Japan may soon have a current account deficit, and thus depend on the mercy of foreigners to support its currency.

In the U.S., we are also witnessing an epic battle between market and government forces. Unlike previous downturns, though, this time we have not forced consumers or businesses to deleverage. And as a result, fiscal and monetary efforts face an uphill battle, which could lead to an unstable recovery.

In our view, for example, the Fed's actions mostly replace-rather than encourage-private sector activity. This means a lot more money will need to be spent or printed than many anticipate.

Note, however, that in the U.S., unlike in Japan, inflation expectations have already moved beyond the traditional comfort zone of the Fed. The trouble is, the Fed may not be able to tighten without pushing the economy right back into a severe recession. The U.S. dollar may continue to be in for a rough ride as these conflicting dynamics play out.

Axel Merk is president and chief investment officer of Merk Mutual Funds, and founder and president of Merk Investments in Palo Alto, Calif.