Wednesday, February 8, 2012

Is "Policy Uncertainty" Endogenous?

At Vox, Nicholas Bloom and Scott Baker argue "falling policy uncertainty is igniting the US recovery."

Since the idea that the economy weighted down by "uncertainty" induced by the Obama administration seems to have become a right-wing talking point, I'm instinctively skeptical.  However, the underlying premise that uncertainty could reduce investment and consumption is sensible (even if I don't think it explains much about the current slump).  So, perhaps its a worthwhile academic endeavor to try to quantify it and make an empirical study of its impact.

According to Bloom and Baker, their index of "policy uncertainty" has three components:
  • 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.
The difficulty with this arises from the possibility that an economic downturn causes the measures of policy uncertainty to rise, rather than vice-versa.

Certainly a downturn means more news about the economy, and it also leads policymakers to try to respond.  The process of negotiating a policy response through the political system is naturally uncertain, and leads to newspaper articles which discuss the various, uncertain, policy outcomes.  In the Obama era, for the sake of "fairness," in their stories about administration proposals, the media will quote critics, many of whom like to argue that the administration is destroying the economy by creating more "policy uncertainty."  The frequent repetition of this argument causes the measure of policy uncertainty to rise, regardless of whether it has merit.

One set of policy responses to a slump involve temporary tax cuts.  This leads to expiring tax code provisions, which increase the measure of policy uncertainty.  (Though in the US case, the main uncertainty was arguably created in 2001 and 2003 when Congressional Republicans passed tax cuts that were scheduled to expire in 2010).  Furthermore, if there is uncertainty about the state of the economy - which there often is during slumps - there will also be uncertainty among forecasters about future policies.

Overall, I would expect more "policy uncertainty" as Baker and Bloom measure it, during economic downturns - but I think it is primarily a consequence of a bad economy, rather than the cause.


Anonymous said...

Great post and totally agreed - hard to tell frankly what causes what and my take is it is partly endogeneous and partly exogneous. So excellent and exaclty what we are working on now, but hard to get any good identification.


Luis Enrique said...

Doesn't economic uncertainty have more to do with concerns regarding demand, than policy choices?

Bill C said...

Thanks for the response. Its a tricky task, separating out "exogenous" uncertainty.

Yes, I think the main story is about demand... to the extent policy uncertainty matters, I think much of it would be uncertainty about demand, which would be affected by policies.