Because economic policy affects economic outcomes, policy uncertainty matters (Hallward-Driemeier and Pritchett 2010, Bloom 2009, and Bloom et al. 2007). Reading the business press, one gets the impression that the world of policy (taxation, regulation, fiscal stimulus, etc.) is in a very uncertain state in the US, Europe, Japan, and several of the biggest emerging markets. This has led to a debate over whether policy uncertainty is holding back the recovery (Mishel 2011).
Evidence on US policy uncertainty
In our October 2011 Vox column (Baker et al. 2011), we argued that policy uncertainty was holding back the US recovery. Compared to just four months ago, however, the volcanic US policy landscape has calmed dramatically.
- The budget ceiling debate has passed;
- discussions of regulatory and tax reforms have subsided; and
- attention has moved on to the Republican primaries.
Figure 1 shows our index of economic policy uncertainty from January 1985 to January 2012, which is displaying a drop of almost 40% from its August 2011 peak to its latest January 2012 value.
Figure 1. Index of economic policy uncertainty
Notes: Index of policy-related economic uncertainty composed of 4 series: Monthly news articles containing uncertain or uncertainty, economic or economy, and policy relevant terms (scaled by the smoothed number of articles containing ‘today’); the number of tax laws expiring in coming years, and a composite of IQ ranges for quarterly forecasts of federal, state, and local government expenditures and 1-year CPI from the Phil. Fed Survey of Forecasters. Weights: 1/2 News-based, 1/6 tax expirations, 1/6 CPI disagreement, 1/6 expenditures disagreement after each index normalized to have a standard-deviation of 1. News query run Feb 3, 2011. Index normalized mean 100 from 1985-2009. Data at www.policyuncertainty.com
We construct this index of policy uncertainty by combining three types of information:
- The frequency of newspaper articles that reference economic uncertainty and the role of policy.
- The number of federal tax code provisions that are set to expire in coming years.
- The extent of disagreement among economic forecasters about future inflation and future government spending on goods and services.
Our index shows sharp spikes in economic policy uncertainty around major elections, wars and the 9/11 terrorist attacks. More recently, it spiked sharply after the Lehman bankruptcy in September 2008 and the passage of the Troubled Asset Relief Program (TARP) legislation shortly afterwards. It remained high until late 2011, driven by continuing policy uncertainty around the 2010 mid-term elections, the debt ceiling dispute and the crisis of the Eurozone. Only over the last couple of months has policy uncertainty finally started to drop back down to more normal levels.
We previously argued that policy uncertainty was a key factor stalling the recovery. When businesses are uncertain about taxes, healthcare costs and regulatory initiatives, they adopt a cautious stance. Because it is costly to make a hiring or investment mistake, many businesses naturally wait for calmer times to expand. If too many businesses wait to expand, the recovery never takes off. Weak investments in capital goods, product development and worker training also undermine longer-run growth.
But now, alongside the sudden drop in policy uncertainty, economic prospects in the US appear to have improved considerably. Last Friday’s announcement of a 250,000 drop in unemployment led to a surging stock market as investors began to believe the recovery had finally begun. Our research suggests this has been aided by the calming of policy uncertainty.
Unfortunately, policy uncertainty still appears extremely high in Europe with the Eurozone crisis. When this finally calms down, European growth should then have additional impetus to recover.
Authors' note: The full dataset underlying Figure 1 and the methodology for generating the data are available at www.policyuncertainty.com.
Baker, Scott, Nicholas Bloom, and Steven J. Davis (2011), “Policy uncertainty and the stalled recovery”, VoxEU.org, 22 October.
Bloom, Nicholas (2009). “The impact of uncertainty shocks”, Econometrica, May 2009.
Bloom, Nicholas, Steve Bond and John Van Reenen, “Uncertainty and investment dynamics”, Review of Economic Studies, April 2007
Hallward-Driemeier and Pritchett (2010),”Send lawyers, guns, and money: Deals versus rules in Africa”, VoxEU.org, 23 July.
Mishel, Lawrence (2011) Regulatory uncertainty A phony explanation for our jobs problem, EPI briefing paper, 27 September.