Don't Blame Uncertainty for the Slow Recovery
A few years ago, when the economic recovery had not yet begun, a lot of people were asking why growth wasn’t picking up. One explanation was that the Federal Reserve wasn’t doing enough monetary easing. Another idea was that Congress needed to spend more. But free-marketers and conservatives, who are generally against government intervention, were very reluctant to embrace these explanations.
Many of them turned to an alternative answer: policy uncertainty. This was the hypothesis that businesses were holding back investment for fear of possible government intervention. Chief proponents of this view were economists Scott Baker of Northwestern University’s Kellogg School of Management and Steven Davis of the University of Chicago’s Booth School of Business. In 2011, Baker wrote an op-ed for Bloomberg View laying out the policy uncertainty thesis:
A major factor behind the weak recovery and gloomy outlook is a climate of policy-induced economic uncertainty...[T]he 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.
Baker went on to list a number of regulatory interventions, and also cited the debt-ceiling battle and legal challenges to Obamacare as sources of policy uncertainty.
Baker’s claims were based on research he had done with Davis and with Nicholas Bloom of Stanford University. The three economists mined news stories for stories about uncertainty, and found that their measure coincided with major geopolitical and market events. They then showed that increases in this uncertainty index tended to precede declines in investment, growth, employment and stock prices. They even created a website to track similar measures of policy uncertainty in various countries.
But despite these efforts, policy uncertainty has not been embraced by the macroeconomics profession as a major cause of economic fluctuations. The most likely reason is that there is a major weakness in the uncertainty argument -- it is difficult to show causality. Just as roosters don’t cause the sun to rise, policy uncertainty might be a result of deeper underlying uncertainty about the direction of the economy.
It’s easy to see how this would happen. Suppose stock and housing markets crash, threatening the financial system and the real economy. Obviously, policy makers will try to do something about this, but their response could be any number of things. They might decide to increase deficit spending, or regulate the financial industry, bail out banks or engage in quantitative easing. But the government’s reaction might simply be a sideshow to the real forces afflicting the economy. Alternatively, recessions might come from non-government sources such as financial crashes, but the possibility of botched government responses might exacerbate the downturns.
Since Baker, Bloom and Davis came out with their uncertainty hypothesis, there has been a large and sustained drop in the index of uncertainty. But the rate of the U.S. economic recovery has remained slow and steady, leading many to question whether uncertainty is just a sideshow.
A team of empirical macroeconomists recently set out to investigate the uncertainty issue more deeply. Sydney Ludvigson and Sai Ma of New York University and Serena Ng of Columbia University have a new paper in which they investigate whether uncertainty is exogenous or endogenous -- that is, whether it is the cause of economic disruption, or the effect. Their statistical technique requires some bold assumptions, but allows for interpretation of cause and effect.
Ludvigson, Ma and Ng find that financial uncertainty seems to cause every other type of economic uncertainty -- in other words, that financial uncertainty looks exogenous while other types of uncertainty seem to be endogenous. This reinforces what many other macroeconomists have found since the crisis -- finance often seems to drive the real economy.
So what does this result mean for the policy uncertainty hypothesis? On one hand, it reinforces the notion that uncertainty, in the general sense, is very bad for the economy. But it implies that for policy to be the cause of this uncertainty, it would have to do so through its impact on financial markets. Legal challenges to Obamacare or increased regulation of aircraft manufacturing would be unlikely causes of recessions.
So what policies, in 2008, threatened U.S. financial markets? Before the crash, financial regulation was not being emphasized by any credible presidential candidate -- certainly it wasn't a major plank of Barack Obama's or John McCain's presidential campaigns. Meanwhile, when financial regulation actually did come, in 2010 in the form of Dodd-Frank, it did very little to hurt asset markets.
Therefore there is good reason to be skeptical of the hypothesis of Baker, Bloom, and Davis. It is difficult to lay blame for the Great Recession, or the slow recovery from that recession, at the feet of either the Obama administration or the Republicans in Congress. It looks like the more likely explanation is that the financial industry imploded all on its own, and that the Great Recession was the result.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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