Globalization and Declining Policy Effectiveness

This was suggested in a email (thanks). It's by Michael Mandel of BusinessWeek and it discusses the change in the effectiveness of economic policy due to globalization, an important issue. Economists do not yet fully understand how traditional monetary and fiscal policies, supply-side policies, etc. have changed due to globalization and that has made it difficult propose effective policy responses when economic conditions change within our borders:

Can Anyone Steer This Economy?, by Michael Mandel, BusinessWeek Online: ...This will come as a rude shock to ... newly enfranchised leaders in the Democratic Party. Sure, they're likely to have the power to pass legislation, including boosting the minimum wage. But ... [t]he broad-based drop in incomes is being driven more by the ... intensification of global competition. And there is little Democrats can do to reverse these trends. ... Globalization has overwhelmed Washington's ability to control the economy. ...[L]evers 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 ... 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 ... were felt as minor bumps.

That has changed. ...[T]he U.S. is more open to the global economy than ever before... 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... 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... [T]he 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." ...

On the campaign trail, Pelosi promised to contain the budget deficit...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...

Even the Big Idea of devoting more tax dollars to research and development to make the U.S. more competitive ... 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...

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. ...

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... Yet real wages are down over the past five years, the trade deficit is enormous...

Washington has responded to these concerns, in large part, with a series of small fixes... 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... 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-- ... does ... 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. ... 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. ... [H]ealth care is also a huge source of private sector jobs, one of the most technologically advanced sectors of the economy...

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. ...

As former Treasury Secretary Robert E. Rubin ... 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.

Economic policy, in the sense that we understand it today, is a comparatively recent invention. It started with John Maynard Keynes in the 1930s. ... 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. ...

[But in] an open economy, Policy Classic loses its punch. ... The question to ask is this: How does globalization affect the long-term policies for growth, both liberal and conservative, rolled out by the U.S. in recent decades? Probably the best known is supply-side economics... [T]he logic behind supply-side economics is clear: Lower tax rates give workers an incentive to put in more hours, encourage savings and investment ..., and spur entrepreneurs to expand their businesses...

According to Kevin A. Hassett, director of economic policy studies at the American Enterprise Institute, globalization actually increases the pressure to cut taxes. If tax rates are too high, "corporate income is so mobile that the money just leaves," says Hassett. "There's an international tax competition, and everyone is playing."

Yet economists are hard-pressed to find evidence that tax cuts have a big effect on growth. ... It's also clear that having a low tax rate is only one factor among many determining international competitiveness. It's equally important to have an honest government, or an efficient health-care system, or an educated workforce. "There isn't a single blueprint for a successful economy," says Robert E. Hall, a Stanford University economist who was one of the main advocates of a flat tax in the 1980s.

On to the next Big Idea: deficit reduction ... that the Democrats have made the centerpiece of their political and economic agenda. ... The case for deficit reduction as a long-term growth strategy is ... straightforward. Smaller budget deficits are supposed to boost national savings, which leads to lower interest rates, smaller trade deficits, increased investment by businesses, and more job creation. And certainly that's the way it worked in the 1990s...

But this line of reasoning doesn't hold up so well in an economy that is far more exposed to global forces.... The financial markets have become far more seamlessly global, making the U.S. budget deficit a much smaller influence on interest rates...

"What starts to break down is the simple link between encouraging savings and encouraging investment," says James S. Poterba, a Massachusetts Institute of Technology economist appointed by Bush to his tax reform commission in 2005. "If Joe in Pittsburgh saves, we can't say that we benefit this factory in Harrisburg. The jobs we generate might be jobs somewhere else"--like overseas.

So if globalization weakens the usefulness of tax cuts and deficit reduction as policy tools, what's left? ...[T]echnological change and innovation. The logical way to rekindle the magic, then, is to boost government spending for r&d and education. Just listen to Daron Acemoglu of MIT, the most recent winner of the John Bates Clark Medal... "The U.S. is a frontier country," says Acemoglu, meaning that its competitive advantage comes from being at the forefront of new technology. As a result, he says "if any policy is going to have a beneficial effect, it has to help the innovation sector."

This Big Idea was first suggested by Paul Romer, now at Stanford University, in the 1980s, and named New Growth Theory. ... The problem is that it's tough to make a direct connection between federal r&d spending and the creation of high-tech jobs....

The truth is. China and India are increasingly attractive places for companies to do research and development (using ideas, perhaps, that were originally developed using U.S. tax dollars). Money is following as well, with U.S. venture capitalists investing more than $400 million in Chinese and Indian companies in the third quarter alone.. There's a growing sense that at a time of scarce resources, the U.S. may not be getting enough bang for its buck from R&D spending. "The question about funding basic R&D for health care is the same as for funding other basic R&D," says Robert B. Reich... "How long can and should the U.S. continue to subsidize the rest of the world?"

This question becomes especially pressing if the newly resurgent Democrats carry through on their promise to put in place a "pay-as-you-go" budget system... The last bout of meaningful deficit reduction, during Clinton's first term, did serious damage to R&D spending, which dropped by 3.9% in real terms.

Education poses a different set of issues. Clearly, education is key to competitiveness. ... There are two problems. First, real wages for young Americans with a bachelor's degree have declined by almost 8% over the past three years. Nobody knows the reason for sure, but some economists suspect that global competition has something to do with it. ...

[T]he idea of a national economic policy may be fundamentally out of date in a world of global markets. Washington is no longer the center of the economic universe. That's a basic fact that Democrats and Republicans alike will need to get their heads around.

For more discussion of this article, see James Crabtree at NDN.