Policy

Policy uncertainty matters

By Steven J. Davis     

From: Magazine

For a period last spring and summer, it seemed that some semblance of stability had returned to the US policy environment. And in that lull, an index I created with Stanford University’s Scott Ross Baker and Nick Bloom dropped to levels not seen since 2008. Our Economic Policy Uncertainty (EPU) Index fell to 100 in July, down from 202 in December 2012.

Shortly after our index hit that low, Paul Krugman made the following argument in a New York Times article: because the economy did not roar ahead when the EPU index plunged, policy uncertainty hadn’t been a problem. That argument fails to persuade because many factors affect economic performance. Working against the beneficial effects of lower policy uncertainty were tax hikes at the start of 2013, sequester-imposed restraints on federal spending, tight budgets for state and local governments, and dimming growth prospects in China and many other emerging markets. In addition, the financial crisis, real-estate bust, and worker displacements of recent years cast a long shadow. So slow US growth in 2013 hardly refutes the claim that policy uncertainty matters.

Recent political events reinforce the view that high levels of policy uncertainty harm the economy. At this writing in mid-October, it remains unclear when the federal government will emerge from partial shutdown mode, and whether and when Congressional leaders will reach a deal that averts a breach of the federal debt ceiling. The resulting uncertainty creates anxiety for households, complicates planning for businesses, injects additional volatility into financial markets, and chips away at the US dollar’s status as the world’s major reserve currency.

Our index provides a gauge for the intensity of policy-related economic uncertainty. The index relies in part on the frequency of newspaper articles that refer to policy matters and economic uncertainty. We quantify the frequency of such articles using automated text-searching methods and evaluate the results based on a human audit of a few thousand randomly sampled articles.

In addition to the news-based piece, our EPU index has three other components. All of them show elevated levels from 2009 to 2012, followed by declines over much of 2013. The widest swings occur in our index component for federal tax code provisions scheduled to expire in coming years. These swings reflect the fiscal cliff resolution and earlier political battles over extending the Bush-era tax cuts. Our other two index components, one measuring disagreement among professional forecasters about expected future inflation and the other measuring disagreement about expected future government purchases, show smaller swings. All components of our index support the view that policy uncertainty has been at high levels in recent years.

Our research paper considers other evidence about movements in economic policy uncertainty over time. One of our investigations relies on the Beige Book reports issued every six weeks by the Federal Reserve System. These reports summarize anecdotal information about current economic conditions gathered by regional Fed banks in advance of Federal Open Market Committee meetings. The Beige Book reports yield a story about the evolution of policy uncertainty that is similar to that told by the news-based component of our EPU index. In particular, the phrase “economic uncertainty” appears in the Beige Book reports with historically high frequency from 2010 to 2012, and the frequency drops sharply after January 2013. This pattern is even more pronounced for Beige Book passages that attribute concerns about economic uncertainty to policy-related factors.

Some critics regard the claim that policy uncertainty matters as a propaganda campaign promulgated by Republicans and acolytes of Rupert Murdoch, the media magnate whose US properties include the Wall Street Journal and Fox News. Are Republican talking points and Rupert Murdoch acolytes also driving the frequent expressions of concerns about policy-related economic uncertainty in the Beige Books? Or do business people, market experts, and professional economists express concerns about economic uncertainty to the Fed when they actually have those concerns? Taking the straightforward interpretation, the Beige Book analysis reinforces the view that emerges from our EPU index, the news-based component in particular.

To be sure, there are serious questions about how accurately frequency counts of newspaper articles mirror an underlying economic reality. Political organizations, government officials, journalists, and pundits seek to influence perceptions about policy issues through newspapers and other popular media. It’s plausible that they succeed to some extent, and that newspapers slant their coverage in one direction or another. My coauthors and I find evidence of political slant in newspaper coverage of policy uncertainty. Positioning newspapers on a left-right ideological scale, using the measure developed by two of my Chicago Booth colleagues, Matthew Gentzkow, Richard O. Ryan Professor of Economics and Neubauer Family Faculty Fellow, and Professor of Economics Jesse M. Shapiro, we find that right-wing newspapers play up policy uncertainty relative to left-wing papers when a Democrat holds the presidency, and vice versa when a Republican sits in the Oval Office. These media-slant effects are modest in size for the set of mainstream newspapers that inform our index. More to the point, “left” and “right” versions of our news-based EPU index tell very similar stories about the evolution of policy-related uncertainty over time.

Many recent studies use our EPU index and other indicators to investigate the effects of policy uncertainty on investment, employment, output, and financial markets. In an analysis of firm-level panel data, my coauthors and I find that increases in policy uncertainty reduce investment and employment, more so at firms with greater exposure to government contract awards. At the macro level, positive shocks to our US EPU index foreshadow declines in US investment, output, and employment. An interesting analysis by researchers at the International Monetary Fund in April 2013 finds that policy uncertainty emanating from the United States and Europe depresses output in other regions of the world. These results suggest that our index is either a real and important factor, or it proxies for an important factor that is otherwise missing in the standard measures considered by economists. Either way, the EPU index—and related indices we created to measure policy uncertainty in other major economies—are proving useful in research and financial applications.

An important question is whether instability in and lack of clarity about policy matters have played a role in the disappointing performance of the US economy in recent years—and in Europe, for that matter. The evidence suggests they have. To quote from a short paper I wrote with Baker and Bloom in February 2012, the lesson is obvious: “If US policymakers can deliver a policy environment characterized by greater certainty and stability, there will likely be a positive payoff in the form of improved macroeconomic performance.” Unfortunately, the recent practice of US policymakers honors this lesson mainly in the breach. 

Works cited

Scott Ross Baker, Nicholas Bloom, and Steven J. Davis, “Has Economic Policy Uncertainty Hampered the Recovery?” February 2012. Published in Government Policies and the Delayed Economic Recovery, Hoover Press: 2013.

Scott Ross Baker, Nicholas Bloom, and Steven J. Davis, “Measuring Economic Policy Uncertainty,” Working paper, May 2013.