Policy Uncertainty Is Choking Recovery: Baker, Bloom and Davis
The recovery from the recession of 2008-09 remains anemic. Job growth has stalled, unemployment stands above 9 percent, and there are renewed fears of another output drop.
A major factor behind the weak recovery and gloomy outlook is a climate of policy-induced economic uncertainty. An index we devised (see attached chart) shows U.S. policy uncertainty at historically high levels.
We constructed our index by combining three types of information: the frequency of newspaper articles that refer to economic uncertainty and the role of policy, the number of federal tax code provisions set to expire in coming years, and the extent of disagreement among forecasters about future inflation and government spending.
Our index shows prominent surges in policy uncertainty around the time of major elections, the outbreak of wars and after the Sept. 11 attacks. It shows another surge after the bankruptcy of Lehman Brothers Holding Inc. in September 2008. Policy uncertainty has remained at high levels ever since.
Of course, policy uncertainty could be high simply because general economic uncertainty is high. To evaluate this view, we used Google News listings to construct a broad index of economic uncertainty and a narrower index focused on policy uncertainty.
Types of Uncertainty
Comparing the two reveals several episodes that involve large surges in economic uncertainty but little or no jump in policy uncertainty. Examples include the Asian financial crisis of 1997 and several instances of recession jitters in the second half of the 1980s. In short, the data refute the view that economic uncertainty necessarily breeds policy uncertainty.
In the last decade, however, policy became a larger source of movements in overall economic uncertainty and an increasingly important concern for businesses and households.
Why has policy uncertainty increased so much? One argument holds that the recent financial crisis created an atmosphere of extreme uncertainty, bringing new and difficult policy issues to the fore. No doubt, the crisis presented policy makers with difficult choices in 2008 and 2009. But the persistence of policy uncertainty wasn’t inevitable. Rather, it reflects deliberate policy decisions, harmful rhetorical attacks on business and “millionaires,” failure to tackle entitlement reforms and fiscal imbalances, and political brinkmanship.
The wave of uncertainty during the debt-ceiling dispute between Democrats and Republicans this summer was, quite clearly, an outcome of the political process. Day by day, markets swung wildly as politicians parried and counter-parried.
At the regulatory level, efforts by the National Labor Relations Board to prevent Boeing Co. from operating its aircraft-assembly line in South Carolina have injected another source of uncertainty into business investment decisions.
The Patient Protection and Affordable Care Act that President Barack Obama signed into law in March 2010 is another example. Rather than simple reforms aimed at efficiency improvements and cost savings, the law seeks to remake the U.S. health-care delivery system, dramatically expanding the role of government and imposing new burdens on businesses and individuals. Even in narrowly economic terms, the measure adds to the uncertainty facing households and businesses.
Moreover, its political durability is in doubt. The Democratic leadership in Congress opted to pursue the most radical plan that could muster the necessary 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 chamber. That political strategy ensured the act would become the focus of future electoral battles and rollback efforts.
The health-care act also faces major legal challenges. The U.S. Court of Appeals for the 11th Circuit struck down the law on constitutional grounds, concluding that Congress lacks the authority to require individuals to purchase health insurance or pay a penalty. The legality of the individual mandate will remain unsettled until the Supreme Court rules on the matter. In sum, the new law has intensified the economic, political and legal uncertainties surrounding the U.S. health-care system.
To identify the drivers of policy uncertainty, we drilled into the Google News listings and quantified the factors at work. Several factors account for the high levels of policy uncertainty in 2010 and 2011, but monetary and tax issues predominate. Uncertainties related to health-care policy, labor regulations, national security and sovereign-debt concerns play contributing roles.
Expiring Tax Cuts
One important example involves the Bush-era tax cuts, originally set to expire at the end of 2010. Democrats and Republicans disagreed over whether to extend all or some of these tax cuts. Rather than resolving the uncertainty in advance, Congress waited until the final hour before deciding to extend the provisions. Unfortunately, the extension is for only two years, setting the stage for another major political battle in 2012 and more taxpayer uncertainty.
The partisan tax-cut fight in 2010 highlights a broader and unwelcome trend. Scheduled expirations of federal tax code provisions were rare before 2000 but have grown rapidly. More than 130 provisions are slated to expire in 2011 and 2012, in many cases setting the stage for new political battles. The $447 billion jobs plan unveiled by the president last month involves several new proposals for temporary tax code changes that, if implemented, may or may not prove temporary.
Across the Atlantic, European policy makers have failed to develop a coherent and credible response to the Greek debt crisis. The lack of resolution has dragged down equity markets worldwide and stoked fears of contagion to other European sovereign borrowers. The crisis also raises serious questions about the solvency of major European financial institutions and the viability of the euro. These uncertainties undermine growth prospects in Europe and diminish trade opportunities for U.S. producers.
Negative economic effects of uncertainty operate through multiple, reinforcing channels. When households are fearful about job loss, wages, taxes and retirement funds, they cut back on expenditures. The drop in consumer spending means weak sales for businesses and lower sales-tax collections for governments.
When businesses are uncertain about taxes, health-care costs and regulatory initiatives, they adopt a cautious stance. Because it is costly to make a hiring or investment mistake, many companies will wait for calmer times to expand. If too many businesses wait, the recovery never takes off. Weak investments in capital goods, product development and worker training also undermine longer-run growth.
So how much near-term improvement could we gain from a stable, certainty-enhancing policy regime? We estimate that restoring 2006 levels of policy uncertainty would yield an additional 2.5 million jobs over 18 months. Not a full solution to the jobs shortfall, but a big step in the right direction.
(Scott R. Baker and Nicholas Bloom are economists at Stanford University. Steven J. Davis, an economist at the University of Chicago Booth School of Business, is a contributor to Business Class. The opinions expressed are their own.)
To contact the writers of this column: Scott R. Baker at firstname.lastname@example.org; Nicholas Bloom at email@example.com; Steven J. Davis at Steven.Davis@chicagobooth.edu.
To contact the editor responsible for this column: Max Berley at firstname.lastname@example.org.