Economic recovery and policy uncertainty in the US

Scott Baker, Nicholas Bloom, Steven J. Davis, John Van Reenen 29 October 2012

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The US continues to suffer a slow recovery from its biggest drop in output in the post-war period. Although the recession ‘officially’ ended in June 2009, unemployment currently stands at 7.8% - much higher than pre-crisis levels (unemployment was 4.4% in 2006).

There are many potential causes of slow recovery. One leading explanation (Ilzetzki and Pinder 2012) attributes low demand to the financial crisis and the consequent dislocation of capital markets. Although monetary policy has been aggressive, it has reached its limits. Interest rates are close to zero and quantitative easing has hit a point of diminishing returns. The winding down of stimulus spending authorised by the 2009 American Recovery and Reconstruction Act has moved fiscal policy in a contractionary direction.

Uncertainty matters

An additional – or perhaps alternative – explanation in this demand-shock story is an increase in uncertainty. Uncertainty can retard both investment and hiring as firms become reluctant to make costly decisions that may soon need to be reversed. It can also lead households to adopt a more cautious stance in their spending behaviour.

Greater uncertainty increases risk premiums in financial markets which in turn raises the cost of borrowing for firms and households. By slowing the reallocation of jobs, workers, and capital, uncertainty also undercuts productivity growth and thereby worsens medium- and long-term economic prospects.

Previous research has identified additional mechanisms whereby uncertainty undermines macroeconomic performance1. Baker et al.’s study (2012) emphasises that policy uncertainty is an important factor in explaining recent depressed US output growth. The authors find that high levels of policy uncertainty foreshadow lower levels of output, investment, and employment.

Figure 1 shows that the ‘US Economic Policy Uncertainty Index’ spiked during the financial crisis and jumped again in recent years due to both the debt ceiling crisis and stresses in the Eurozone. In recent months, uncertainty about the outcome of the US election and the approach of the so-called ‘fiscal cliff’ have contributed to a recurrence of high levels of policy uncertainty.

Bloom et al. (2012) try to separate the effect of policy uncertainty from other factors, such as low demand. Attempting to separate policy uncertainty from low demand is not easy; during a recession falling demand naturally tends to coincide with increased uncertainty. That said, their macro-econometric model estimates that the increase in policy uncertainty after 2007 reduced employment by 2.3 million.

Alongside quantitative research, qualitative evidence suggests a role for policy uncertainty. In a 2012 National Federation of Independent Businesses survey, 35% of small firms complained about ‘uncertainty of government actions’ as a critical problem. The category came joint-third alongside the ‘cost of fuel’, with businesses’ leading concerns being the ‘cost of health insurance’ (52%) and general ‘uncertainty over economic conditions’ (38%). Larger businesses and government agencies also cited policy uncertainty as a cause for concern2.

Figure 1. US Economic Policy Uncertainty Index

In our view, the responsibility for high levels of policy uncertainty rests with both US political parties. However, the same politicians see it otherwise.

  • Republicans are blaming the President and Congressional Democrats for creating regulatory uncertainty and introducing harmful regulations.
  • They further accuse the Democrats of failing to face up to the main long-term drivers of rising debt and press for the reform of social security, Medicare, Medicaid and other social insurance programmes.
  • Democrats, in turn, accuse Republicans of obstructionism, political brinksmanship and an obsessive focus on tax and spending cuts.
  • They fault Republicans for a lack of meaningful detail on their healthcare reform proposals3 and for failing to embrace a mix of both spending cuts and tax hikes in order to respond to US fiscal imbalances and.

The roots of political polarisation

Figure 2 shows voting patterns in Congress in 1967-8, 1987-8 and 2007-8. The 90th Congress of 1967-8 showed a considerable overlap in voting patterns between Democrats and Republicans on liberal and conservative issues (see Carroll et al. 2008 for details on the metrics used), which allowed for compromise on policy. Yet, there was essentially no voting overlap by the 100th Congress of 2007/08.

Figure 2. Political polarisation intensified over time in Congress

This move to the extremes can be partly explained by the ability of incumbents to gerrymander political districts, that is, to change Congressional district boundaries along partisan lines in order to maximise an incumbent’s chances of re-election. Gerrymandering, in turn, encourages primary election campaigns that focus on appealing to their more extreme political bases rather than to more moderate voters. That said, the increase in partisanship goes far beyond the gerrymander effect as evidenced by a Senate – for which State boundaries are fixed – that has also become more ideologically split.

The main explanation appears to be that the whole US has become more spatially segregated along political lines. Increasingly, Democrats only live near other Democrats and Republicans near Republicans (Bishop 2008). This is illustrated in Figure 3, which compares voting patterns by county in 1967 with 2008 (note that county borders are not subject to political manipulation). There are both far fewer competitive counties and far more landslide counties in 2008 than 40 years earlier. This development reflects the trend toward political polarisation in US society4.

Figure 3 The US has become a more politically segregated nation

Panel A

Panel B

Source: Orszag 2011, Bishop 2008.

Conclusions

It is unclear whether the November elections will significantly alleviate US policy uncertainty.

  • A clear victory for one party could greatly clarify the policy outlook, but that outcome appears unlikely based on polling data.
  • Regardless of who wins the presidency, the two houses of Congress are likely to remain divided by party.

Thus, the increasing political polarisation of the last 30 years is also very likely to continue.
Until the advent of a political mechanism that creates incentives to elect moderate representatives who can reach across the ideological divide, it seems the US is destined to entrench high levels of policy uncertainty.

References

Baker, Scott, Nicholas Bloom and Steven Davis (2012), “Measuring Economic Policy Uncertainty’, Stanford mimeo.

Bishop, Bill (2008) The Big Sort, Boston, MA, Houghton Mifflin.

Bloom, Nicholas (2009) “The Impact of Uncertainty Shocks”, Econometrica. 77(3): 623-685.

Bloom, Nicholas, Steven Bond and John Van Reenen (2007) “Uncertainty and Investment Dynamics”, Review of Economic Studies, 74: 391-415.

Bloom, Nicholas, Max Floetotto, Nir Jaimovich, Itay Saporta and Stephen Terry (2012) “Really Uncertain Business Cycles”, NBER Working Paper, No. 18245.

Carroll, Royce, Jeffrey Lewis, James Lo, Nolan McCarty, Keith Poole and Howard Rosenthal (2008) “Who Is More Liberal, Senator Obama or Senator Clinton?”, working paper, 18 April.

Ilzetzki, Ethan and Jonathan Pinder (2012) “Recession and Recovery: The US Policy Debate on Taxes, Spending and Public Debt”, US Election Analysis No. 1, Centre for Economic Performance, October.

Orszag, Peter (2011) “Healthcare, Political Polarization and our Fiscal Future”, CEP 21st Birthday Lecture.


1 See. Bloom et al. 2007, Bloom 2009, and Bloom et al. 2012.
2 See Mitchell, Charles, Rebecca L. Ray and Bart van Ark (2012) “Risky Business”, The Conference Board CEO Challenge and Federal Reserve (2012) Beige Book, October 11.
3 See Cooper, Zack (2012) “Healthcare Reform: The US Policy Debate”, CEP’s US Election Analysis No. 3 for a deeper analysis.
4 See CEP’s US Election Analysis on Inequality.
 

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Topics:  Politics and economics

Tags:  economic recovery, US presidential election, political uncertainty

Ph.D. candidate, Department of Economics, Stanford University

Assistant Professor of Economics at Stanford University

Professor of International Business and Economics, University of Chicago Booth School of Business

Director of the Centre for Economic Performance, Professor of Economics at the London School of Economics and CEPR Research Fellow