How do we know if we have a policy uncertainty problem?

August 8, 2012

One study that the Romney camp has been leaning on heavily lately is a paper (pdf) by Stanford professor Nicholas Bloom, University of Chicago professor Steven Davis, and Stanford grad student Scott Baker called "Measuring Economic Policy Uncertainty." As the title implies, the paper is about how economists can try to quantify how uncertain businesses and consumers are about the future of economic policy. The authors develop a measure which relies on a combination of:

  1. A count of stories mentioning with the words "uncertainty" and "economy," as well as keywords related to government policy ("deficit," "budget," "taxes," etc.) in 10 major U.S. newspapers.
  2. The size of disagreements between economic forecasters about what future inflation and government purchase levels are going to be.
  3. The number of tax provisions set to expire in the next couple of years.

They conclude that changes in uncertainty can account for big swings in output and unemployment, concluding that uncertainty can explain a 3.2 percent decline in GDP growth during the most recent downturn.

Mike Konczal has a great post pointing out the ways in which the first and third elements of the Baker/Bloom/Davis metric can sometimes reflect uncertainty not caused by an administration's policy. For instance, if administration critics are quoted in a lot of articles talking about the uncertainty the president is causing, those quotes will get picked up in the newspaper count and be counted as increasing uncertainty. And the number of tax provisions expiring could have nothing to do with the current person in power; say what you will about Barack Obama's handling of the Bush tax cuts, but it was President George W. Bush's decision to have them expire in 2010.

That being said, the metric Baker, Bloom and Davis use is picking up real uncertainty. The expiration of the Bush tax cuts was real policy uncertainty, whoever is to blame, and if enough people make a stink about uncertainty to newspaper reporters, some newspaper readers (including business owners, consumers, etc.) are presumably going to grow uncertain about future economic policy.

The larger issue is that, as Baker, Bloom and Davis concede, the biggest driver of economic policy uncertainty is usually a bad economy, full stop. This past fall, Mark Schweitzer and Scott Shane of the Cleveland Fed tried to figure out whether Baker, Bloom and Davis were picking up real effects of uncertainty, or whether the uncertainty itself was just an outgrowth of a bad economy, and had no further bad economic effects of its own. Their conclusion was that while uncertainty does reduce small business hiring and purchases, the weak economic fundamentals are a much more important factor:

The blue line is expected small business hiring under Schweitzer and Shane's model, and the brown line expected hiring in the absence of uncertainty. The models show, the authors conclude, "statistically significant negative effects of policy uncertainty on small business owners’ plans to hire and make capital expenditures." But they also note that a model that doesn't take uncertainty into account explains 79 percent of variation in hiring and 76 percent of variation in business spending. So while uncertainty can explain some variation in hiring and spending by businesses, other factors (like economy-wide hiring and interest rates) are needed to explain the vast majority of it.

So should you worry about policy uncertainty? Probably, but not nearly as much as you should worry about weak demand. Schweitzer and Shane's research suggests it's a real concern. But whether that policy uncertainty is the fault of the administration, of Republicans in Congress, the Federal Reserve, or the Bush administration is, as Konczal points out, another question entirely.

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