Can Anyone Steer This Economy?

Global forces have taken control of the economy. And government, regardless of party, will have less influence than ever

by Michael Mandel

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Sometime next year—perhaps around Christmas 2007, if current trends continue—the U.S. will hit a milestone. For the first time in recent memory, the cost of imported goods and services will exceed federal revenues. In other words, Americans will soon pay more to foreigners than they do to their national government.

We're almost there now. Imports cost us about $2.2 trillion a year; the federal government collects $2.4 trillion in revenues. Why is that important? Because for the past 70 years, Washington has been the 800-pound gorilla, more powerful by far than any other force in the U.S. economy. That's not true anymore. The federal government remains plenty influential, but the global economy is more so.

This will come as a rude shock to Representative Nancy Pelosi (D-Calif.), the presumptive Speaker of the House, Charles B. Rangel (D-N.Y.), the likely chairman of the House Ways & Means Committee, and other newly enfranchised leaders in the Democratic Party. Sure, they're likely to have the power to pass legislation, including boosting the minimum wage. But such a measure, even if President George W. Bush signed it, would help only a small fraction of the workforce. It would do almost nothing to ameliorate the weak wage growth that has plagued most Americans, including college graduates, in recent years. The broad-based drop in incomes is being driven more by the rise of China and India and the intensification of global competition. And there is little Democrats can do to reverse these trends.

Outdated Financial Levers

No matter which party you belong to, or which Big Idea or school of economic policy you subscribe to, one thing is clear: Globalization has overwhelmed Washington's ability to control the economy. Whether you're a Republican supply-side tax-cutter, a Wall Street deficit hawk of either party, or a Silicon Valley techie type, your preferred levers of economic policy just don't work as well as they once did.

As recently as 10 years ago, the U.S. economy was still relatively self-contained. Then-Federal Reserve Chairman Alan Greenspan—often called the most powerful man in the world—could be sure that the U.S. economic machine would eventually respond when he called for higher or lower rates. Tax and spending decisions made in Washington could set the course for growth, while economic events in the rest of the world, such as the Asian financial crisis of the mid-1990s, were felt as minor bumps.

That has changed. Since 1995 imports have risen from 12% of gross domestic product to about 17%. And foreign money finances about 32% of U.S. domestic investment, up from 7% in 1995. In other words, the U.S. is more open to the global economy than ever before, and the links run in both directions. Now many of the levers affecting the U.S. economy are located not in Washington but in Beijing, London, and even Mexico City.

Unintended Consequences

Greenspan and his successor, Ben S. Bernanke, have found this out the hard way. To restrain economic growth and cool the housing market, the two Fed heads have raised short-term interest rates 17 times since 2004, for a total increase of more than four percentage points. But even as the Fed tightened up on the domestic money supply, foreign investors made up the difference.

As a result, the interest rate on 10-year government bonds today is 4.6%, exactly where it was in 2004, when the Fed started raising rates. Good news for home buyers who want mortgages. Not so good news for the policymakers trying for a soft landing.

President Bush encountered a similar problem. His huge tax cuts poured hundreds of billions into the economy and kept output rising at a decent clip. Nevertheless, the fiscal stimulus generated far fewer jobs than anyone expected, as more and more production headed overseas. "Traditional macro policies are less effective than they used to be," says Robert S. Shapiro, a top economic adviser to President Bill Clinton who now runs a Washington economic consulting firm. "We don't know how to ensure strong job creation and strong wage growth anymore."

Fiscal Restraint and R&D

Pelosi and the congressional Democrats, who embraced fiscal restraint as their pre-election mantra, shouldn't expect much better economic results by pulling the deficit-cutting lever. On the campaign trail, Pelosi promised to contain the budget deficit, telling one Washington audience that "if American families are expected to balance their checkbooks, so, too, should the Congress of the United States." While that commitment may resonate politically, there's growing economic evidence that reducing the budget deficit won't do much to jazz up business investment and growth. A new study from the Federal Reserve Bank of New York, as nonpolitical an organization as you will find, reports that "investment has exhibited only a tenuous response to fiscal policy changes."

Even the Big Idea of devoting more tax dollars to research and development to make the U.S. more competitive—an idea repeatedly advocated by such tech leaders as John T. Chambers of Cisco Systems (CSCO) and John Doerr of venture capital giant Kleiner Perkins Caufield & Byers—is beginning to look economically and politically troublesome. True, increased funding for R&D appears to be a rare area of agreement between the two parties: Pelosi and the House Democrats came out with their "Innovation Agenda" last November, and Bush followed with his innovation-based "Competitiveness Initiative" in the January State of the Union speech.

But in the brave new world of the global economy, where companies move factories and facilities around the world like game pieces, it's no longer a given that U.S. workers benefit directly from U.S.-funded research. One worrisome example: Despite federal outlays of over $125 billion for medical research over the past five years, the U.S. has a large and growing trade deficit in advanced biotech and medical goods. "The era in which we could assume that increased U.S. public investment in R&D automatically generates domestic growth is over," says Jeff Faux of the liberal Economic Policy Institute.