The World's Consumer Of Last Resort.

One of the great hoped for market scenarios for the late summer of 2001 has been the big take-off in the Japanese stock market. The theory goes that new Prime Minister Junichiro Koizumi is so wildly popular that his radical reform package will sweep through the Diet later this year once the upper house elections have been completed. The thinking is that a fearful LDP will have no choice but to follow the prime minister's lead.

Maybe so. But one has to wonder because Koizumi's archrival within the LDP--the Hashimoto faction, led by former Prime Minister Ryutaro Hashimoto--is in complete control of the upper house. Today the Hashimoto acolytes smile politely at the prime minister's reform suggestions, but once the actual agenda is offered, they clearly will be in a position to weaken if not destroy, if simply by inaction, the Koizumi agenda. Don't forget, too, that Koizumi has very little staff to help push through major legislative initiatives.

With reform still an uncertainty, that then leaves the yen as Tokyo's last remaining tool for recovery of an economy experiencing persistent deflationary tendencies. Travel around Tokyo policy circles these days, and it seems that everyone, with the exception of the Ministry of Finance, believes the yen desperately needs to weaken if Japan is to claw its way out of the current morass. Even the Bank of Japan is said to prefer a weaker yen.

So why has the yen remained stable (and in recent months, even strengthened a bit against the dollar)? The obvious argument offered is that the Ministry of Finance fears the effect of yen weakness on the banking sector, which is chock full of long-term Japanese government debt. It is also suggested that U.S. financial authorities may be less enamored of yen weakness, unless and until Tokyo deals with its bank balance sheet problem.

But a less obvious, and more interesting, explanation says that Japanese policymakers are reluctant to let the yen go for fear of how the Chinese will react. The Chinese, no doubt also doing the bidding for their Asian neighbors, are said to exert enormous behind-the-scenes pressure on Tokyo anytime it looks as if the yen is about to move against the dollar in either direction. Indeed, U.S. officials may not fully appreciate the increased strength of China's influence in Tokyo policymaking. New Foreign Minister Makiko Tanaka, for instance, is said to side so much with the Chinese in internal discussions, she gives the impression to colleagues of being anti-American (LDP detractors suggest she blames the CIA for destroying the political career of her father during the 1994-95 Lockheed scandal).

In any event, this Japanese/Chinese/Asian currency dilemma highlights what may soon become the No. 1 issue for G7 policymakers: the problem of global overcapacity during a time of diminished pricing power and the resulting potential for protectionist pressures to skyrocket.

The late 1990's saw an unprecedented, technologically driven global expansion. Yet the fact is that for every two years of steady technological advancement, global capacity increases by up to four times. Overcapacity in the fiber optic field, for example, is now so enormous, the current unused capacity is such that a fiber optic line could be run between planet Earth and the sun.

Today it is hard to look at the Asian economies and not see the potential for another Asian currency crisis, particularly if the dollar continues to strengthen. Meanwhile, Tokyo must contend with a bullying Chinese government that wants no change in the yen while looking skeptically at all those Japanese imports (Japan is now running a trade deficit with China, yet China has already threatened Tokyo with trade action). In this era of global overcapacity, the great "Pacific question" in this region of non-consuming hyper-producers may come down to whether China, with its permanently fixed cheap cost of labor and endless supply, will become to the world's labor market what Saudi Arabia has been to the oil market.

True, demand in any economy normally meets the supply of capacity -- that is, unless there is a policy failure. In this regard, it is hard to characterize Japanese and, to a lesser extent, European monetary policymakers as having been wildly successful of late.

How this all turns out will no doubt depend foremost once again on the level of U.S. demand and whether the American consumer, assuming monetary policy still works as a stimulative tool, continues to spend to allow for a U.S. rebound by early next year at the latest. Clearly the American disease is this uncontrollable urge to spend, not save. But this narcissistic tendency, particularly with Europe weakening fast, represents ironically the one economic engine that may well help the world economy avoid some serious consequences.