Policy uncertainty and the slow recovery


From: Magazine

Financial turmoil, the Great Recession of 2007 to 2009, and the weak recovery that followed ushered in a period of heightened uncertainty in the United States. Even a year after the recession ended, Federal Reserve chairman Ben Bernanke described the economic outlook as "unusually uncertain."

Many analysts claim that uncertainty about economic policies and their consequences has been an important factor slowing recovery. Uncertainty about taxes and the effects of policy on interest rates, prices, health costs, and other economic variables can lead households to defer consumer spending, and companies to cut back on capital investments, new product development, hiring, and worker training. Because new projects are expensive to reverse and because workers are costly to hire and fire, companies have an incentive to wait for greater political stability and policy certainty before proceeding with new business undertakings. If too many companies adopt a cautious stance in response to policy uncertainties, economic recovery may not take hold.

The price of policy uncertainty indeed could be high, according to a recent study titled, "Measuring Economic Policy Uncertainty" by Chicago Booth professor Steven J. Davis, with Stanford University professor Nicholas Bloom and Stanford University graduate student Scott R. Baker. The authors developed a new index of policy-related economic uncertainty. The index reaches historically high levels after the Lehman Brothers bankruptcy and again over the past year in reaction to the euro-zone crisis and the US debtceiling impasse. The authors estimate that an increase in policy uncertainty of the size experienced from 2006 to 2011 leads to a fall in real Gross Domestic Product of 3.2 percent, a sharp drop in business investment spending of 16 percent, and a loss of about 2.3 million jobs.

The financial crisis and recession presented new and difficult challenges for policy makers. Davis believes that unusual policy challenges created by extraordinary economic disturbances were the main sources of elevated policy uncertainty in 2008 and 2009. The most threatening aspects of the financial crisis were contained by the middle of 2009, causing the authors' policy uncertainty index to fall substantially in the latter part of 2009.

The index rises again in 2010 and 2011, however, reaching even higher levels than it did at the peak of the financial crisis. High levels of policy uncertainty in the past two years partly reflect deliberate policy choices and political gridlock, in Davis's view. A clear example is the debt-ceiling dispute in the summer of 2011 between Democrats and Republicans, which created a real threat of a partial government shutdown. Congress eventually raised the debt ceiling, but agreement came at the last minute and with huge market volatility. "Much of the high levels of policy uncertainty in 2011 were caused by policy decisions and policy maker conflicts over how to proceed," Davis says.

Constructing a Policy Uncertainty Index

The authors' policy-related economic uncertainty index combines three components.

The first component quantifies the frequency of references to the economy and policy uncertainty in newspaper articles. Starting from January 1985, Baker, Bloom, and Davis performed month-by-month searches and counted the number of articles in 10 major US newspapers that contained terms pertaining to uncertainty, the economy, and policy areas, including phrases and words such as "federal reserve," "tax," "deficit," and "regulation." They scaled the raw count of these newspaper articles by the number of articles containing the term "today," to account for trends in the length and number of news articles.

The second component captures the importance and number of federal tax code provisions set to expire over the next 10 years, based on reports from the Joint Committee on Taxation of the US Congress. Scheduled tax code provisions are an important source of uncertainty for households and businesses, because Congress often extends or modifies the provisions at the last minute after big political fights, thereby undermining stability and certainty about the tax code, the authors say.

An important recent example is the Bush-era income tax cuts originally set to expire at the end of 2010. After an acrimonious and protracted political battle about whether the tax cuts should be reversed and, if so, for which taxpayers, Congress finally decided in December 2010 to extend the tax cuts for all taxpayers. However, the tax cuts were extended for only two years, setting the stage for another partisan battle as the deadline approaches, and leaving households unsure about tax rates beyond 2012.

The third component of the policy uncertainty index summarizes the extent of disagreement among economic forecasters about future government purchases and about consumer prices, variables that are influenced by fiscal and monetary policy, respectively. Using data from the Federal Reserve Bank of Philadelphia Survey of Professional Forecasters, the authors treat the dispersion in the fourquarter- ahead forecasts of these variables as proxies for uncertainty about future monetary policy and future government spending.

The aggregated measure of policy uncertainty shows clear spikes corresponding to several well-known events including presidential elections, the Gulf wars, the 9/11 terrorist attack, and contentious budget battles. The index also shows a substantially higher level of policy uncertainty since the onset of the Great Recession in 2007. In fact, the index more than doubled between 2006-the last year before the unfolding of the financial crisis - and 2011.

Policy Uncertainties as Roadblocks

Concerns about policy-related economic uncertainty became increasingly important after September 2001, the study finds. Since then, there has been a higher level of uncertainty and a much closer link between overall economic uncertainty and policy-related uncertainty. Stock market volatility also rose dramatically in the past four years compared with the previous three decades, and policyrelated news developments became a much more important source of equity market volatility.

An important aspect of high policy uncertainty in recent years, according to the authors, involves uncertainty about the direction and consequences of monetary policy. The federal funds rate, an important monetary policy variable, has pressed against the "zero lower bound" on nominal interest rates since 2008. There has been uncertainty about how long the Fed would maintain a near-zero rate and about the effects of Fed actions in this unusual economic environment.

The Fed also engaged in a number of large-scale programs to purchase longer-term debt securities in an effort to stimulate the economy. The impact of these policy actions on interest rates and the real economy were, and remain, imperfectly understood. Observers also have speculated about whether the Fed will conduct additional rounds of debt purchases, and about how the Fed will eventually unwind the huge recent expansions of its balance sheet. Another issue is whether the unconventional policy actions taken by the Fed in response to the financial crisis will erode its independence and undermine its ability to withstand political pressures, Davis says.

Fiscal and tax policies also have caused extraordinary policy uncertainty in recent years, according to the study. The United States faces a large fiscal imbalance over the long term, Davis says, because the government is set to spend much more under current policies and demographic trends than it will collect in future revenues under the current tax system. "The longer policy makers wait to resolve these fiscal imbalances, the greater the uncertainties about the ultimate resolution and the impact of large fiscal imbalances on future economic performance," says Davis.

Other contributors to elevated policy uncertainty levels in recent years include sovereign debt problems in Europe, financial regulation, labor regulation, energy and environmental policies, and health care policy.

In Davis's view, the Patient Protection and Affordable Care Act signed into law in March 2010 intensified rather than reduced the economic, political, and legal uncertainties surrounding the US health care system. The law imposes new burdens on businesses and individuals, seeks to remake much of the health care delivery system, and rests heavily on unproven initiatives that supporters think will reduce costs.

In pushing the legislation through Congress, the Democratic leadership opted to pursue the most radical plan that could muster 60 votes in the Senate and a thin majority in the House. As a result, the legislation failed to attract a single Republican vote in either house. That political strategy ensured the law would become the focus of future electoral battles and rollback efforts. There were also grave legal challenges: key provisions of the health care law faced constitutional challenges before the Supreme Court. "A simpler, more transparent, and less aggressive health care reform with a broader base of political support would have involved much less uncertainty," says Davis.

Uncertainty is a fact of economic life, and will never be eliminated entirely. But Davis thinks policy makers' actions and, in some cases, lack thereof, can greatly influence the degree of economic uncertainty facing businesses and households.

“Measuring Economic Policy Uncertainty.” Scott R. Baker, Nicholas Bloom, and Steven J. Davis. Working paper, June 2012.