Can Anyone Steer This Economy?

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Policymakers now face the unenviable task of managing the economy in the face of an overwhelming flow of goods and money back and forth across national borders. "The federal government affects the economy only on the margins," says Charles R. Black Jr., Republican consultant and outside adviser to President Bush. Adds Timothy J. Penny, a former Democratic representative from Minnesota who is now at the University of Minnesota: "Washington is far less relevant than it used to be. You don't have to be an economics professional to see the evidence."

Uncharted Territory

And get this: We don't even know how to measure whether we as a country are succeeding or failing. The traditional metrics for economic security and prosperity are capturing impressive signs of life. Unemployment, inflation, and interest rates are low by historical standards. The stock market is rising, and household wealth is higher than it was at the peak of the 1990s boom, even after adjusting for inflation. To a large extent, this is thanks to the global economy, which has been fueling the U.S. expansion with cheap goods and cheap money. Yet real wages are down over the past five years, the trade deficit is enormous, and there are widespread worries about America's continued ability to compete.

Washington has responded to these concerns, in large part, with a series of small fixes, like tinkering with the pension system. But what's needed is a new Big Idea for economic policy—or two or three competing Big Ideas—that accounts for the verities of the global economy.

The first step is to get a better handle on what's really happening to U.S. workers and businesses in today's economy, where wealth is as important as income, and where events in Shanghai are as important as events in Chicago. If the value of a family's home goes way up, but its income dips a bit, is the family better or worse off? If a U.S.-based company opens up an R&D facility in India or China, does its employment of American workers go up or down—and, does its overall contribution to U.S. growth increase or decrease? We don't have the statistics needed to answer these questions.

Second, we need to take hold of the main unused lever of economic policy: health care. Politicians and economists have mainly thought of health care as a cost that is dragging down competitiveness. Health-care spending is the main source of long-term federal, state, and local budget deficits, the prime gobbler of national savings, and one of the biggest tax distortions, in the form of the tax exemption for company-provided health insurance.

All these things are true. But health care is also a huge source of private sector jobs, one of the most technologically advanced sectors of the economy, and frankly, the provider of a service people can't get enough of. It can even be thought of as an investment, to the degree that better health allows Americans to work longer and to better enjoy their lives. We have to view health care as a force for growth, rather than an impediment.

Global Institutions

Finally, a Big Big Idea—probably too big to even consider right now—would be the creation of global institutions for governing the world economy. History tells us that market economies are prone to financial crises, to which the only solution is a strong central bank. During the Asian financial crisis of the 1990s, for example, the Fed played that role.

But with the explosive growth of China and India, that sort of role for the Fed is no longer feasible, and no new institution has arisen to take its place. As former Treasury Secretary Robert E. Rubin, now a top official at Citigroup (C), recently said: "There's no policy mechanism for bringing together the countries that really matter in the global economy." The best solution would be some sort of global central bank with real powers—but that's not going to happen until there's a big enough financial crisis to truly scare people.

Policy Classic Losing Traction

Economic policy, in the sense that we understand it today, is a comparatively recent invention. It started with John Maynard Keynes in the 1930s. He put forth the Big Idea that governments had the ability to soften a downturn. Keynesian economics, as it was termed, calls for reducing interest rates, cutting taxes, and hiking government spending to ease the worst effects of recession.

Today, Keynes's prescriptions could be called Policy Classic, since even diehard free marketeers agree that fighting recessions is the right thing for governments to do. What's more, Policy Classic still works in the modern global economy, up to a point. When a fire starts in your house, you should still try as hard as you can to douse it with water, even if your hose is leaky.

Consider how Washington responded to the recession of 2001. One could quibble with the exact timing of Greenspan's rate cuts, and the Democrats weren't particularly happy with the Bush tax cuts. But there's no disputing that massive amounts of fiscal and monetary stimulus made the 2001 downturn one of the mildest on record. And the recovery hasn't been half bad, either. Since the economy peaked in the second quarter of 2001, economic growth has averaged a decent 2.8%.

Yet the recovery could have been a lot stronger, given the amount of stimulus pumped into the economy. Consumers and businesses aren't fools: They used their extra money to buy cheap imports rather than more expensive American-made goods and services. Between 2001 and today, imports rose by three percentage points as a share of GDP, one of the main reasons that job growth was so slow. By comparison, the import share rose by only one percentage point or so in the recoveries of the early 1980s and the early 1990s.

In an open economy, Policy Classic loses its punch. The inability to create jobs after a recession is bad enough. What really should concern us all, though, is what might happen in the next recession. Foreign investors have been extraordinarily willing to put their money into the U.S. But let's suppose, just for the sake of argument, that a recession here makes other countries look like a better bet. Then foreign investors pull out their money, pushing interest rates way up and the dollar way down. The higher rates slow the economy, and the lower dollar makes imports more expensive, triggering higher inflation.

Poof! Instant stagflation. And what's worse, Bernanke and the Fed will be forced to keep interest rates high to fight inflation.