Off track: America's economy is losing its competitive edge, and Washington hasn't noticed.

There is a moment in the lifespan of every cool new gadget--two years after Bill Gates buys one, a year and a half after the popular press gets wind of it--that its price drops enough to show up in significant numbers on the shelves at Best Buy, the electronic superstore. At this instant, the product becomes accessible for middle class Americans, something they can imagine themselves buying, and so these electronics stores have become temples to innovation, the place most Americans go to get as close to the cutting edge as most of them dare. On weekend afternoons, Best Buy is as bustling as a souk, full of grandmothers and little kids tooling around with digital video cameras and geeked-out salesmen explaining to the moms that the cell phones in their hands have nearly the computing power of desktop PCs. But it's the men who are the most transported, moving from department to department with gawky reverence. At a Best Buy I visited recently in Alexandria, Va., I watched one dad gaze in wonder at row upon row of giant plasma televisions--elegant silver-framed screens that seemed not just to capture the way the world looks, but to improve upon it. He watched bees extract honey from flowers, and spiraling footballs drop into the hands of receivers, and you could almost see a two-part thought process play out over his face: First, If I wait a year, these sets will be half the price. Second, Screw it, I'm buying one now!

But there was something else I noticed: Whereas a decade ago the most creative, groundbreaking stuff came from Silicon Valley, now it all seemed to come from overseas. The plasma televisions were from Korea; the computer-like cell phones were from Finland; the feature-packed digital cameras were from Japan.

During the last six months, we have begun, quietly, to enter a newly tense moment, with university presidents, business leaders, and columnists delivering ominous-sounding reports and editorials about the threat to American innovation posed by a freshly competitive world--the renewed vitality of western Europe, Japan and Korea, and the ravenous growth of China and India. "We no longer have a lock on technology," David Baltimore, a Nobel laureate and the current president of the California Institute of Technology, wrote recently in the Los Angeles Times. "Europe

is increasingly competitive, and Asia has the potential to blow us out of the water."

What worriers like Baltimore are beginning to grasp is that these changes are emerging just as the American economy is being made more vulnerable by the movement of manufacturing and service jobs overseas. As a result, we've become increasingly dependent on maintaining our edge in discovering the new technologies and applications that create whole new industries--just as other countries are closing that gap.

This is a fundamentally new threat. In the '70s and '80s, Japanese and European firms adopted American technology and made key improvements in process and design to shave cost and increase quality. Now, foreign companies are making many of the most important breakthroughs themselves. This shift is part of a change in strategy: instead of copying our innovations, foreign governments have decided to copy our very model of innovating. They have studied our centers of invention, the Silicon Valleys and Research Triangles, where university scientists, venture capitalists, high-tech entrepreneurs, and educated, creative workers, many of them from overseas, congregate. These creative centers, our competitors have learned, were the result of federal policy--decades of investment in basic scientific research; patent law changes that allowed universities to capitalize on discoveries made in their labs; financial reforms that gave rise to the venture capital industry; and immigration laws that opened the door to talented foreigners.

Over the last decade, our competitors have implemented similar policies at home: They have built universities, reformed financial markets, invited in immigrants, and made the development and adoption of new technologies national goals. Now, they're reaping the benefits. The technologies behind plasma screens emerged have been refined and expanded in labs under a research partnership between the Korean government and the electronics maker Samsung. Europe established its lead in mobile phones when European countries set a single standard for mobile communications (American firms are hobbled by lower-quality spectrum and three competing standards).

Foreign competitors are edging out the United States not just in today's snazzy consumer goods, but in the technologies that will define the marketplace in the years to come. Most economists and new economy thinkers believe that the likeliest candidate for the Next Big Thing is the research being done in nanotechnology, a catch-all term for the manipulation of matter at the molecular level. Nanotechnology could someday be used to repair broken DNA to prevent cancer, create supercomputers the size of pinheads, or fabricate building materials 150 times the strength of steel. American scientists have been tinkering with nanotechnologies for 20 years. But some of the most cutting-edge research today is coming from overseas. Last August, Israeli scientists announced that they'd managed to develop manipulable nano-wires, tiny organic tools they could use to rearrange atoms and conduct electricity over microscopic spaces, a breakthrough a leading MIT nanotechnologist admitted American researchers had been chasing "for many years" In September, Japanese scientists announced that they would soon be able to use nano-engineering to build a computer chip 30 times more powerful than Intel's best. The breakthrough led American analysts to conclude that the United States was beginning to lose the race to bring nanotechnology products to market.

The worry of economists and business leaders is not simply that Japan, Israel, or South Korea will beat us, like one football team does to another. It is, more precisely, that we'll only be able to take advantage of rising wages in those countries (and afford our own here) if we continue to create new, cutting-edge products and services to sell to those countries--and right now America does not seem to be doing as much of that as we were just a few years ago.

This new competition from other developed countries, and the failure of America to fully keep pace, is one cause of our anemic job creation, three years after what was, by historical standards, a brief and fairly light recession. Another mason, of course, is the rise of China and India, where U.S. firms have not only moved manufacturing plants but also "outsourced" service sector jobs. America's employment base is being squeezed by these two pincers--China and India from below, and the developed world innovating from above. Over time, those pincers may come together, as China and India also become proficient in high-end innovation. China is already opening universities at a breathtaking clip, while Intel, Hewlett-Packard, Microsoft, and Verizon have all opened research labs there--the kind that anchored the development of Silicon Valley. "It's become inevitable," says Ross Armbrecht, president of the Industrial Research Institute, which is the think tank for the research arms of America's corporations, "that more and more of the most far-reaching innovations will be going overseas, to India and China, in the near future."

Economics is a negotiation in uncertainties, and so nobody's really sure what all of these changes will mean for the well-being of the American middle class. But when you survey economists, policymakers, and business leaders about America's long-term future, it's hard to find many rank optimists; there are the Panicked, and then there are the Merely Tense. Richard Lester, the head of MIT'S Center for Innovation, told me he belongs in the latter camp: "Things look somewhat bleak in the long-term, but if you look around Boston, at the incredible concentration of talent and opportunity here, we've still got a head start, and if we're smart we can probably build on it." Among the Panicked are economists such as MIT Nobelist Paul Samuelson, who has recently argued that the rapid spread of innovative capacity to other countries with lower labor costs makes him doubt the whole doctrine of "comparative advantage," on which much of modern economics rests.

If there's a way to escape this grim future, economists agree, it is for America to reverse its slowly slumping innovation machine. Perhaps the hottest area of economic research right now centers around technology, trying to figure out what exactly the United States did in the '90s and how we can do it again. In university economics departments and corporate executive suites across the country, the sense that we're in a pivotal fight for continued economic preeminence is already common knowledge.

But in Washington, these new economic realities have barely been noticed.

The heroism of the 30-year mortgage

On an overcast (lay in mid-December, President Bush assembled a group of CEOs at the Reagan Building--a behemoth of a federal office complex that has become the favorite venue for small-government conservatives--for a conference to promote his economic agenda. The tone of the conference, so soon after a winning election, was upbeat, cheery, back-slapping, the happy Chamber of Commerce banter of executives who have recognized a problem that they know how to fix. At the end of the day, the president himself took the stage. He said the economy was fundamentally strong and that government's role would be to "create an environment that encourages capital flows and job creation through wise fiscal policy." To do this, he said, he would ask for Congress to privatize Social Security. and make his tax cuts permanent. He compared himself favorably to Franklin Roosevelt. He left the stage.

During the same conference, two floors up in the very same building, a group called the Council on Competitiveness held another event for the press, in which it laid out a very different vision. This group, comprised of 400 blue-chip business executives (the CEOs of IBM, Pepsi, and General Motors, among others) and university presidents--as rough an approximation of the American establishment as you could fit in a single room--was nearly as downbeat as the president was buoyant. The astonishingly fast rise of international competitors, they warned, has meant that the American economy has reached an "inflection point," a "unique and delicate historic juncture" at which America, "for the first time in our history ... is confronting the prospect of a reverse brain drain."

The report made a point of noting that the United States remains the world's dominant economy, the leader in fields ranging from biotechnology to computers to entertainment, but the CEOs nevertheless cited worrying evidence that this dominance might not last. For decades, the United States ranked first in the world in the percentage of its GDP devoted to scientific research; now, we've dropped behind Japan, Korea, Israel, Sweden, and Finland. The number of scientific papers published by Americans peaked in 1992 and has fallen 10 percent; a decade ago, the United States led the world in scientific publications, but now it trails Europe. For two centuries, a higher proportion of Americans had gone to university than have citizens of any other country; now several nations in Asia and Europe have caught up. "Those competitor countries ... are not only wide awake," said Shirley Ann Jackson, the president of the American Association for the Advancement of Sciences, "but they are running a marathon ... and we tend to run sprints."

While the president's talk focused almost exclusively on the need to free up capital for investment, these CEOs barely mentioned that as a problem. Instead, they stressed various below-the-radar government actions that they felt were undermining America's competitive edge: security arrangements that have crimped the supply of educated immigrants; recent cuts in science funding (the president's 2005 budget sliced money for research in 21 of 24 areas); and the reassigning of what research funding remains to applied research, most of it in homeland security and the military, and away from the basic scientific research that economists say is the essential engine of future economic growth. They also expressed concern about those policies Washington was not pursuing but should be: broadening access to patents; increasing research into alternative fuels; and bringing information technology into the health care market.

When the newspapers reported the event the next day, the president's speech got front-page treatment. The CEO's presentation received only a short item on page E3 of The Washington Post, and no mention at all in The New York Times. This gap in media coverage reflected not only the power of a newly elected president to dominate the news, but also what might be called a macroeconomic bias. When the press and most Americans think of economic policy, they think of macroeconomic matters--tax rates, budget deficits, trade balances--whose fluctuations have instant, tangible effects on interest rates, stock prices, and exchange rates--things newspaper readers and casual investors can see, track, and relate to.

But there is another set of ways in which Washington has always affected the long-term health of the economy: by making investments, regulatory changes, and infrastructure improvement to spur the economy forward, creating new industries and giving new tools to old ones. This category of policies has not traditionally been given a single name but might best be called "microeconomic policy." Historically, this has been the heroic side of economic policy: The Louisiana Purchase may have been a shrewd maneuver for continental expansion, but it was also a jobs program for landless citizens eager to carve their own farms in the wilderness--which is how Jefferson sold the treaty to Congress. The land grant college system, signed into law by Abraham Lincoln, provided the nation's farmers with expert guidance on the latest agricultural techniques to improve their crop yields. No entrepreneur could figure out how to mass produce cars profitably, writes Harold Evans in his excellent new book They Made America, until Henry Ford fought an aggressive bid against restrictive patents. The pharmaceutical, financial, and airline industries blossomed thanks to the creation of the FDA, SEC, and FAA, which gave customers some assurance of safety when they popped pills, traded stocks, or boarded flights. The G.I. Bill provided a generation of veterans with the college educations they needed to build the post-war middle class. The creation of the federally-guaranteed 30-year mortgage proved the decisive tool in the growth of the post-war American suburb.

These investments and regulatory changes aren't merely tools of the past; it is impossible to imagine the '90s boom emerging without them. Early investment from the Pentagon helped nurture the Internet. The algorithm that powered Google was developed when cofounder Larry Page, then a Stanford graduate student, won a federal grant to write a more efficient sorting and search engine for libraries. The innovative new medicines that have driven the expansion of the biotech and pharmaceutical industries arose from university research largely financed by the National Institutes of Health. The commercialization of these and other discoveries was financed by a venture capital industry that developed only after legislation, sponsored by Republican lawmakers and signed by President Jimmy Carter, enabled an advisory firm to hold significant stock in a start-up.

For most of the country's history, both political parties have favored various microeconomic initiatives--though Democrats have been more comfortable with using government to intervene in the marketplace, while Republicans have tended towards a laissez-faire approach that stressed lowering the cost of capital. These tensions sparked big debates in the 1980s about "industrial policy," with (mostly) Democrats arguing for various kinds of sector-specific technology investments and relief from Japanese competition and (mostly) Republicans arguing that the federal government should cut taxes, trust the market, and not "pick winners and losers." Still, each party has traditionally played on both the macro and microeconomic policy fields. Kennedy cut marginal tax rates when they were excessively high in the early 1960s. Clinton cut the deficit to reduce interest rates. Eisenhower built the interstate highway system. Reagan gave crucial tariff protection to America's then-ailing semiconductor industry.

Under President Bush, however, the GOP's natural economic policy tendencies have been hyper-charged by a grand political vision. Karl Rove, Grover Norquist, and other Republican strategists have argued that massive annual tax cuts and the privatization of Social Security will not only increase the flow of capital into the marketplace, but will also put Democrats at a long-term electoral disadvantage and usher in a new era of GOP dominance. That these policies also require the government to take on trillions of dollars in extra debt, just as the first baby boomers are reaching retirement and trade imbalances are reaching historic levels, is seen by GOP leaders as a risk worth taking. And so the White House and Congress have pursued tax cutting and Social Security privatization with relentless focus, to the exclusion of almost everything else. As The New York Times columnist Daniel Altman has written, the president has chosen economic advisers such as N. Gregory Mankiw, Lawrence Lindsey, and R. Glenn Hubbard who support this singular view. "What you have in Washington now is an inability to get beyond the macroeconomic, to understand that there are so many other investments government needs to be making and actions it ought to be taking, and that our future is going to hinge in large part on what decisions we make there," Michael Mandel, the influential economist and columnist for Business Week, told me in January. "And right now in Washington, they're not even looking at any of that."

Even when the Bush administration's leading economists discuss innovation, it is mostly in this light--they argue that reducing the cost of capital will lead companies to invest in new technologies. They rely in part on the research of economists such as Dan Sichel of the Federal Reserve and Dale Jorgenson of Harvard, who examined the sources of the '90s boom and found that capital availability played an important role. But not even Jorgenson thinks this was the whole story: "You need something to invest in, and so all those other things you're talking about were crucially important too, in the long run," he told me in January. "If you're looking at Washington today, you have to ask, what are they doing to make those investments now?"

Bush v. Newt

The same White House that has been bold, and recklessly so, on macroeconomic policy has been timid, and recklessly so, on microeconomic policy. It has made only a few feints at such policies and investments, and compared to the relentless energy with which the administration has pursued tax cuts and Social Security reform, its attention to such microeconomic strategies has been only tepid, intermittent, Potemkin-like--done to quiet a constituency or send a political signal.

A good example is broadband. Most experts predict that when a critical mass of homes and businesses acquire high-speed Internet connections, an explosion of economic growth will follow as whole new industries, such as video-conferencing and online video gaming, become possible. But these new industries are likely to flourish in whichever countries achieve near-universal broadband first, and at the current pace, that won't be the United States. For four years, the FCC has pursued a "deregulatory" telecommunications policy that has effectively blocked competition, giving phone companies little incentive to build out their broadband networks. Over the same period, the United States has dropped from 4th to 10th in the world in percentage of its homes and businesses with broadband. Not surprisingly, South Korea, which is first on the list, is now the world's leader in developing online video games, the fastest-growing segment of an industry that's bigger than movies, and its software companies are beginning to lure top American programmers to Seoul.

Early last year, Sen. John Kerry (D-Mass.) began to use a line in his stump speeches that challenged the president on America's declining broadband position. The president responded by proposing the goal of achieving "90 percent broadband access" by 2007. The goal was bold-sounding but empty: By most measures, 90 percent of Americans already have "access" to broadband in the sense that they could, if they wished, sign up for it; the problem is that, compared to other countries, relatively few Americans have done so.

A similar inattention has held in wireless--a technology that venture capitalists believe would explode if the government would make a simple regulatory change. Since the president came into office, bankers, venture capitalists and economists have been urging the FCC to reassign unused, high-quality spectrum that is now reserved for television broadcasters and the military. "Nobody was using this," says Wharton's Kevin Werbach; reassigning it was "a no-brainer" The FCC, under Chairman Michael Powell, did nothing for two years and then delegated the matter to a Task Force to investigate how best to reassign spectrum. The task force reported two years ago, but the commission has still not begun to reassign spectrum. Meanwhile, the United States has fallen only farther behind in wireless technologies to European and Asian firms.

But there is perhaps no economic sector that is undergoing a more profound evolution, or in which government investments could make a bigger difference, than energy. As India and China continue their rapid industrialization, and with it their need for oil, analysts predict that the price of oil, already sky-high, will grow even more prohibitive--which means that whichever companies develop the most effective alternative fuels and energy-efficiency technology will revolutionize the industry, and whichever countries can produce those breakthroughs may become rich on it, the Bahrains of the 21st century.

Right now, however, the United States is not poised to be one of those countries. Demand in America for electric-gas hybrid cars already outstrips supply, but Ford is so behind the curve that it's leasing its hybrid technology from Toyota. Europe, meanwhile, is setting the pace on the next promising auto technology; clean diesel-electric hybrids. Companies in Europe and Asia have also made more progress than have their American counterparts in developing the technology for crafting energy-efficient appliances, offices, and factories--a consequence of higher energy taxes and stricter environmental regulations in those countries.

The Bush administration's most vigorous response to all this has been to increase the funding for research into hydrogen-powered cars. Hydrogen technology is promising. But it is also decades away from the market, and even hydrogen buffs believe the administration has gone about its program the wrong way, trying to build fuel cells before figuring out the more daunting challenges of how to extract and transport hydrogen. Moreover, there's a creeping suspicion that hydrogen may end up being far too expensive to compete with other, more feasible, and probably cheaper fuels like biomass ethanol, a technology in which America happens to be a leader. Betting on a single alternative fuel source, hydrogen, at the expense of others is a classic case of "picking winners and losers." The truth is, no one knows yet which technologies or energy sources will define the future.

A better strategy, says Harvard's John Holdren, would be for the federal government to raise automobile fuel efficiency (CAFE) standards, impose a carbon cap-and-trade system for factories and power-plants, and let the market decide which new energy sources and technologies are the best. These ideas now have broader backing than they did a decade ago. The bipartisan National Commission on Energy Policy issued a report in December calling such measures the most critical to ensure America's energy future--and that commission's members includes the CEOs of old-line energy giants such as Exelon and Conoco Phillips. And, Holdren told me, executives at old economy companies from Monsanto to Dow Chemical have signed on. "Five years ago, we didn't have a shot at getting them on board," said Holdren, "but the situation is getting dire enough that now they're leading the charge." Still, many sectors, including the automobile and power industries, vehemently oppose higher CAFE standards and carbon emission limits, and the president has repeatedly rejected them.

There is no better example of the administration's Potemkin-style microeconomic policy than the way it has handled the issue of rising medical costs. Here, the administration has talked a good game. During last year's presidential campaign, the president vowed to bring health care out of the "buggy and horse days" by getting the industry to adopt information technologies, such as electronic medical records-keeping and systematic case-management systems, which experts say could save hundreds of billions of dollars and tens of thousands of lives. To this end, he promised a new $50 million health care IT initiative. It was an absurdly small amount, and probably no match for the perverse incentives that keep for-profit medicine from investing in these technologies (see "Best Care Anywhere," January/February 2005). But at least it was something.

That is, until the president signed his 2005 budget into law, which zeroed out the $50 million program. David Brailer, the economist and physician the White House had put in charge of the program, wound up with no money to do anything to install information technology in hospitals--no pilot programs, no cash for education, no seminars for hospital executives. Newt Gingrich, the right's high priest of health IT, told The New York Times that the president's defunding of his own program was a "disgrace." (After Gingrich's hue and cry, the White House put the money back in the proposed 2006 budget it submitted to Congress, though some insiders remain skeptical that the program will survive).

Faster, faster

Technology today is diffusing faster than ever. As the Council on Competitiveness has noted, it took 55 years for the automobile to spread to a quarter of the country, 35 years for the telephone, 22 years for the radio, 16 years for the personal computer, 13 years for the cell phone, and only seven years for the Internet. Because technologies are adopted so quickly, it has become more important than ever for a country's industries to be at the cutting edge--there's simply much less catch-up time. (Fall five years behind on building car factories in the early 20th century and you lost some profits; Fall five years behind on hybrid cars and you may have lost an industry).

For this reason, the last four years of drift may have already done significant damage to America's long-term economic prospects. The pity is, there was no good reason for the drift. Finding ways to strengthen border security while still providing enough visas for educated immigrants and graduate students is hardly the world's most difficult public policy challenge, and every Fortune 500 corporation in America would cheer such moves. There are no serious ideological reasons why both parties couldn't support reform of patent laws (though certain powerful interest groups would object). It's hard to find a good excuse for why we're falling behind on broadband, or have failed so far to reassign valuable wireless spectrum. (Indeed, a country which until recently had large budget surpluses should by now have found the money to begin wiring the country with fiber-optics, providing higher-quality streams which can transport large data files far faster than broadband.) And even the most politically difficult actions, such as raising CAFE standards and imposing a flexible carbon emissions cap to spur energy innovation, should have been possible after 9/11, with the nation willing to make sacrifices and dire warnings from all political wings about our dependence on Middle Eastern oil.

But what worries economists even more than the past four years of drift is the prospect of continued inaction. The speed of technological change is now too fast, and the economic competition too fierce, for America to afford that. There is no law that says the United States will be the world's preeminent economic power forever. But neither is there any reason we can't rise to the challenge, as we did in the 1980s and 1990s. Then, as now, becoming more innovative is the solution to our problem. But first, we must recognize that we have a problem.

Benjamin Wallace-Wells is an editor of The Washington Monthly.