Nations Twist in the Global Financial Winds : Policy: Governments are rapidly losing influence over their own economic affairs as instantaneous international trading takes command.

The day of reckoning for the U.S. economy was supposed to be just around the corner. For years, respected economists have warned that the nation’s huge budget and trade deficits could cause foreign investors to lose confidence in the currency at any moment, forcing the central bank to jack up interest rates sharply, weakening the economy and plunging the stock market into a sickening dive.

There’s only one problem with this popular “hard-landing” scenario: Something like it is happening today in Japan--not the United States.

What’s going on here? The explanation lies in the power of global financial markets. Even Japan cannot insulate itself, despite a massive trade surplus, an envied savings rate and an industrial economy in perpetual motion.

Ever since the United States moved a few years ago from being the world’s leading creditor nation to a large net debtor, many analysts have argued that America’s addiction to foreign capital in the 1980s would mean vulnerability to the whims of foreign investors and a loss of control over our economic future. But Federal Reserve Chairman Alan Greenspan is not the only one finding it increasingly difficult to steer an economy.

It’s also true for Japan’s once-unassailable but newly bickering economic bureaucrats; for British Chancellor John Major, who has been forced to keep interest rates high despite Britain’s faltering economy and the adverse political fallout on Prime Minister Margaret Thatcher, and for the West German Bundesbank, which has seen interest rates take off because of market fears that the political drive to unify West Germany with East on generous terms will produce a burst of inflation.

The unsettling reality is that today every nation has lost a large measure of economic independence.

“When people in Washington talk about losing control of our economic destiny, what they are really saying is that they are frustrated over their inability to control events,” says Jerry Jordan, chief economist at First Interstate Bank in Los Angeles. “What is happening is that governments all over the world are rapidly losing influence over economic affairs.”

Although the loss of control to global financial markets has been evident to economic insiders for years, many government officials are only beginning to acknowledge its effects publicly.

At a recent congressional hearing, Greenspan raised the issue. “To what extent have we lost control of our economic destiny?” he asked. As a result of rapidly growing links between U.S. and foreign economies, he argued, the Fed’s job is “more difficult” than it was two or three decades ago, but still not impossible.

Greenspan conceded, though, that “the influence of economic policies abroad and other foreign developments on the U.S. economy is profound. . . . The globalization of financial markets has meant that events in one market or in one country can affect within minutes developments in markets throughout the world.”

In hopes of overcoming some of their current difficulties, top economic officials from the seven largest industrial democracies are scheduled to get together in Paris on April 7. International economic policy coordination has languished since 1988, when James A. Baker stepped down as Treasury secretary to run President Bush’s political campaign and former Japanese Finance Minister Kiichi Miyazawa was forced out of office because of the recruit scandal.

“Alone, even a government as powerful as the United States or Japan is looking more and more helpless to influence economic trends,” said Harald Malmgren, a well-known international economic consultant here. “Their only hope is to work together.”

But the new teams of economic policy-makers probably will make little headway. For one thing, just as Japan’s central bankers and finance ministers are warring with each other, the Federal Reserve and the Bush Administration are at odds over basic U.S. economic policy objectives.

For several months, Treasury officials have been campaigning quietly--and not so quietly--for the Fed to nudge interest rates down. Undersecretary for International Affairs David Mulford, in particular, wants rates lower to help reverse the recent climb in the dollar’s value on currency markets. Driving down the value of the dollar through lower interest rates, such officials argue, would help shrink the trade deficit by making foreign goods more expensive.

But top Fed officials reject that approach, contending that a lower dollar would fuel higher U.S. prices, undermining the central bank’s efforts to keep inflation under control.

Moreover, Fed officials insist that any move to ease credit could easily backfire. If investors fear that the central bank’s action to lower short-term rates might lead to higher inflation, they could defeat the effort by pushing up long-term rates to protect themselves against the erosion in the value of their bond holdings. And when such rates rise, it puts a brake on the borrowing and spending that drives the economy.

That’s one factor in what happened to interest rates early this year, says Fed Governor Wayne D. Angell. The central bank went too far in late December when it cut a key short-term rate in an effort to spur the economy, only to see the bond market react adversely by driving long-term borrowing costs up.

Complicating the Fed’s job even more is the grip that global financial markets have on U.S. interest rates. Money these days moves with ease across national borders, a development that was accelerated in the late 1970s and 1980s as more and more countries dismantled export controls on capital.

UC Berkeley economics professor Jeffrey Frankel has found that, as a result, much of the industrial world now dips into the same giant pool of capital, drawing funds from wealthy investors who are constantly on the lookout for the highest return on their money.

All this makes it much harder for central bankers to use interest rates purely as a lever to affect the domestic economy.

“The impact of monetary policy has been diluted,” says Lyle E. Gramley, a former Fed governor who is now chief economist at the Mortgage Bankers Assn. “When rates recently moved up abroad, the Fed ended up spitting into a high wind and having it blown back into its face.”

Much to the surprise of some economists, countries--such as the United States--that are dependent on inflows of foreign capital to finance their trade deficits are not the only ones that must take global markets into account.

“What’s happening in Japan is a paradox,” admits Fred Bergsten, president of the Institute for International Economics, a leading exponent of the U.S. hard-landing theory. “They’ve got the strongest economy in the world with the weakest currency and it’s hard to explain.”

But it comes as no surprise to many other analysts.

“It doesn’t matter whether you are a deficit nation like the United States or a surplus nation like Japan or West Germany,” says Robert Solomon, an international economist at the Brookings Institution here. “When so much capital can move so freely, we’re all in the same boat.”

To be sure, the United States, by borrowing so much money from abroad over the past decade, has put itself in a potentially awkward position.

“In an emergency, a creditor nation has the option of imposing constraints on capital outflows, but a country that is deeply in debt can’t force the money to keep coming in,” says Paul Krugman, a leading international economist at the Massachusetts Institute of Technology. “We benefited from our ability to dip into global markets in the 1980s, but we may not be so lucky in the future.”

For all the growing anguish in the United States over the rising tide of foreign investment, much of what is happening is nothing new to most of the world. Most other nations--not only in the Third World but also Canada, Australia and Europe--have had to live with foreign takeovers of important domestic industries, foreign investment in their economies and the difficulties that these factors create for the conduct of economic policies.

“What is new is that American exceptionalism has expired,” writes Steven Kelman, a professor of public policy at Harvard’s Kennedy School of Government. “Previously . . . it was we who broke down walls in other lands with our appealing products, our appealing ways of running businesses and our appealing culture. Now, America is no longer simply the internationalizer but also the internationalized.”

Like many economists, First Interstate’s Jordan considers the growing sway of global markets and foreign investment an enormously positive development, in large part because it serves as a check against the power of government officials to make big mistakes that might destabilize the economy.

But not everyone is so sanguine. Says Krugman: “Currency markets make mistakes too.”