What is policy uncertainty?

By Robin Mordfin     
September 02, 2014

From: Magazine

Government-related uncertainty is a relatively new concept that researchers are in the process of defining. Chicago Booth's Steven J. Davis defines “policy uncertainty” as having three components.

1. Uncertainty about who will be making the policy decisions that have economic consequences. In the midst of elections, or party shakeups, or even revolutions, and when it’s unclear who will end up in charge, people who have money to invest or businesses to run will likely pause before writing a check.

2. Uncertainty about what policy decisions the people who end up in charge will make. If businesses and investors see policy decisions delayed by political-party friction, or problems hampered by a lack of ideas, or perhaps are waiting on clarity regarding tax policy, they once again may wait before making their own decisions. 

3. Uncertainty about how particular policy decisions will affect the economy. Will trade sanctions made by the United States against Russia affect how certain manufacturers can sell their products, and will those potential effects cause job losses?  

Professors Lubos Pastor and Pietro Veronesi model two components in their theory—political uncertainty and impact uncertainty. Political uncertainty, or uncertainty about future government actions, pools the first two components highlighted by Davis into one. Impact uncertainty is uncertainty about the impact of those future actions, and it is closely related to Davis’s third component.

Imagine that you anticipate potential changes in the banking structure or regulations. “If you don’t know what the government will do in the future, we call that political uncertainty,” explains Veronesi. “Clearly, because we don’t know what’s going to happen, news about it is going to move the stock market.” Then imagine that the new banking rules are put in place. “Even if we know exactly what the new regulations look like, we don’t know what the long-term impact of that policy is going to be.”