CURRENCY market chaos may have abated, but the fear of what lies ahead is prompting new theories to explain the huge shift in the world's biggest and most liquid financial market. At its weakest, the US dollar shed 20 per cent against the Japanese yen and 10 per cent against the deutschmark. Commentators reckon the greenback's sell-off went too far, but few know why it happened in the first place. Conventional wisdom says that when US Federal Reserve chairman Alan Greenspan hinted at easing interest rates at a time when the administration was facing off the Japanese over trade talks, markets were spooked, making the dollar's fall a one-way bet. Peter Everington, managing director at Regent Fund Management, said this was true but was not enough to explain the huge fluctuations since the beginning of the year. Aside from currency volatility, the Japanese bond market had rallied 10 per cent and the stock market was down 20 per cent since the beginning of the year. He has argued two separate events are central to understanding these moves. When the US Government gave Mexico a US$20 billion line of credit to stabilise its currency, a cash injection equal to about 40 months' monetary growth was put into the US dollar system. Then, on the other side of the Pacific, the Kobe earthquake hit Japan. The event so shocked the population - which saw the rich flee the city to havens in surrounding towns - that there was a significant reduction in money circulating in the economy. While the monetary statistics are not yet available to prove the theory, if correct, it would have amounted to a major contraction in the money supply, tipping Japan into a deflationary spiral. The problem was worsened because the Japanese authorities continued to tackle the problem by increasing government spending, while monetary conditions remained extremely tight, Mr Everington said. Last month the Japanese economy experienced a fall in nominal GDP growth, indicating an economy deflating in a way not witnessed in any major economy since the depression of the 1930s. Miron Mushkat, chief regional economist at Lehman Brothers, agreed the severity of currency movements was caused by factors as yet unexplained by economists. He said it was possible transactions in the Japanese economy had fallen dramatically and cash was being hoarded - so reducing the speed at which money circulates, but statistical evidence has yet to prove this. Currency markets were like any system in nature, which reach a point of maximum resistance after a huge build-up of pressure - and then collapse. Economists rely on a 'coefficient of ignorance' to explain this type of event and it is possible world currency markets were reacting to years of pressure produced by structural trade imbalances. Mr Everington, of Regent Fund Management, said: 'It is clear that the tremendous ructions in the currency markets are sympathetic of powerfully conflicting forces at work in the international arena.' Warning that the worst might not be over, he said: 'We believe these forces to be very dangerous and bring with them a tremendous danger of whiplash in general.' The policy choices being made by the Japanese Government bear a strong resemblance to those followed in Britain during the 1920s when an attempt was made to depress wages in the domestic economy to improve export competitiveness. The ill-fated attempt to preserve the gold standard ended in unemployment and years of recession in Britain, and that was the apparent choice top Japanese bureaucrats had made, according to Andrew Hunt, chief regional economist at Thornton Management. A lethal cocktail of tight-money and booming government spending had forced Japan's already weak banks to dump foreign bond holdings to fund the expansion - so causing an inflow of capital which was forcing the currency up. He said the idea of Japan's money circulation falling was a red herring and dollar weakness was the result of banks being unable to fund bank credit growth in the US. US credit growth was running at 10 to 11 per cent, while deposit growth was only four to five per cent, with the funding gap having to be raised offshore. The US had in effect become a 'distressed borrower' which exacerbated the run on the currency. The Fed had shown a reluctance to tackle inflation and the excessive credit funding gap which had led to an evaporation of confidence in the dollar. Mr Hunt said Japan would be the main loser if it did not take immediate action to tackle the deflationary cycle it was entering. What it needed was a huge injection of money into its banking system - at least US$100 billion - and active intervention by the Bank of Japan to pump cash through. Failure to do so would cause unemployment and the value of the yen to keep falling. A continually rising yen would cause havoc in Asia to trade flows and the budgets of governments with heavy yen-denominated debt exposure. Already the effect on companies using Japanese components in manufacturing is being felt. Then again the US dollar might recover. Financial markets had grossly underestimated the real inflation level in the US, which would require an inevitable further tightening of rates, according to Mr Everington. In that case the dollar could yet rebound.