The years following the global economic crisis of 2008-2009 have been marked by policy uncertainty, both in the US and across the world. In new research, Scott R. Baker, Nicholas Bloom, and Steven Davis develop an index of economic policy uncertainty to examine how this uncertainty shapes economic outcomes. Using data going back to 1900 and extending coverage to 11 major economies, they find that heightened levels of policy uncertainty leads to firms reducing investment and employment, which in turn contributes to the sluggish growth which many economies have experienced in recent years

Baker, Scott R.

Bloom, Nick

Davis, Steven J.

LSE Research Online

blogs.lse.ac.uk http://blogs.lse.ac.uk/usappblog/2015/12/04/heightened-economic-policy-uncertainty-likely-curbs-growth/Higher policy uncertainty curbs business investment andemployment growthThe years following the global economic crisis of 2008-2009 have been marked by policy uncertainty,both in the US and across the world. In new research, Scott R. Baker, Nicholas Bloom, and StevenDavis develop an index of economic policy uncertainty to examine how this uncertainty shapeseconomic outcomes. Using data going back to 1900 and extending coverage to 11 major economies,they find that heightened levels of policy uncertainty leads to firms reducing investment andemployment, which in turn contributes to the sluggish growth which many economies haveexperienced in recent years.Concerns about policy uncertainty have intensified in recent years, both in the United States andacross the globe. Factors such as polarized electorates, the economic upheaval from the GlobalFinancial Crisis, and continual crises in the Eurozone have all contributed to a tumultuous policyenvironment and uncertain future.  Among others, the Federal Open Market Committee and the IMFsuggest that uncertainty about US and European fiscal, regulatory, and monetary policies havecontributed to a steep economic decline in 2008-09 and slow recoveries afterwards. In new researchwe investigate the role of policy uncertainty in shaping economic outcomes, finding that elevatedpolicy uncertainty in many countries around the world has contributed to sluggish growth in recentyears.Measuring Policy UncertaintyTo investigate the role of policy uncertainty in shaping economic outcomes, we first developed anindex of economic policy uncertainty (EPU) for the United States and examine its evolution since1985.  Our index reflects the frequency of articles in 10 leading US newspapers that contain thefollowing triplet: “economic” or “economy”; “uncertain” or “uncertainty”; and one or more of “congress”, “deficit”,“Federal Reserve”, “legislation”, “regulation” or “White House”. As seen in Figure 1, the index spikes near tightpresidential elections, Gulf Wars I and II, the 9/11 attacks, the 2011 debt-ceiling dispute and other major battles overfiscal policy.Figure 1 – Economic Policy Uncertainty Index for the US, 1985 to 2015Notes: Index reflects scaled monthly counts of articles containing ‘uncertain’ or ‘uncertainty’,‘economic’ or ‘economy’, and one or more policy relevant terms: ‘regulation’, ‘federal reserve’,‘deficit’, ‘congress’, ‘legislation’, or ‘white house’. The series is normalized to mean 100 from1985-2009 and based on queries run in the USA Today, Miami Herald, Chicago Tribune,Washington Post, LA Times, Boston Globe, SF Chronicle, Dallas Morning News, NY Times,and the Wall Street Journal.We extended our newspaper-based approach to measuring policy uncertainty along three dimensions: back in time,to specific policy categories, and across countries. For instance, Figure 2 shows the evolution of policy uncertainty inthe United States back to 1900. This long-span EPU index highlights pre- World War II political developments andshocks like the Gold Standard Act of 1900, the outbreak of World War I, the Versailles conference in 1919, and asustained surge in policy uncertainty from late 1931 when President Hoover, and then President Roosevelt,introduced a rash of major new policies. The index also shows an upward drift since the 1960s, perhaps due to risingpolitical polarization or the growing economic role for government.Figure 2 – US Historical Index of Economic Policy UncertaintyNotes: Index reflects scaled monthly counts of articles in 6 major newspapers (WashingtonPost, Boston Globe, LA Times, NY Times, Wall Street Journal, and Chicago Tribune) thatcontain the same triple as in Figure 1, except the economy term set includes “business”,“commerce” and “industry” and the policy term set includes “tariffs” and “war”. Datanormalized to 100 from 1900-2011.We were also able to break down the key policy terms leading to changes in uncertainty over time by flaggingnewspaper articles about particular aspects of policy uncertainty. We find that in the United States, taxes, governmentspending and healthcare regulatory uncertainty are the largest factors driving the increases since 2008.  Ournewspaper-based approach points to unusually high levels of uncertainty in recent years about future tax rates andgovernment spending, and about the passage and implementation of the Affordable Care Act.Intriguingly, our approach does not show unusually high levels of monetary policy uncertainty after the GlobalFinancial Crisis, at least in the United States. This result might seem surprising, given the attention amongprofessional economists to unconventional monetary policies and concerns related to the zero lower bound.  Itappears that low and stable inflation and interest rates have muted concerns about monetary policy uncertainty inmainstream US newspapers.We then extended our methods to cover 11 other major economies: the United Kingdom, France, Germany, Italy,Spain, Canada, China, Japan, South Korea, India, and Russia. For these countries, we employ local languagenewspapers and a similar set of policy-related terms.Effects of Policy UncertaintySince our indices point to historically high uncertainty related to economic policy in recent years, it’s natural toinvestigate the effects of policy uncertainty on economic performance.We do this in two ways. First, we exploit firm-level differences in exposure to a particular aspect of policy –government purchases of goods and services – to estimate the effects of policy uncertainty working through onechannel. We use micro data from the Federal Registry of Contracts and data on government healthcare spending tocalculate the share of firm and industry revenues derived from sales to the government. In firm-level regressions thatinclude time and firm fixed effects and other controls, we find that firms with greater exposure to governmentpurchases respond to policy uncertainty with heightened stock price volatility and reduced investment andemployment.  We obtain similar results using alternative measures of firm-level exposure to policy uncertainty. Wealso find that firms in the defense, healthcare and financial sectors are especially responsive to their own category-specific economic policy uncertainty (EPU) measures, confirming the information value of these measures andproviding additional evidence of policy uncertainty effects.These firm-level results point to a causal impact of policy uncertainty on investment and employment in sectors thatrely heavily on government spending. For instance, in an environment with more uncertainty about future policy, firmsmay be hesitant to make irreversible or costly investment and hiring decisions.  However, the results offer limitedguidance about the magnitude of aggregate effects, in part because they focus on one specific policy uncertaintychannel (government purchases of goods and services).Our second approach fits vector autoregressive (VAR) models to US data and to an international panel that exploitsour EPU indices for 12 countries. The US VAR results indicate that a policy uncertainty innovation equivalent to theactual EPU increase from 2005-06 to 2011-12 foreshadows declines of about 6 percent in gross investment, 1.2percent in industrial production and 0.35 percent in employment. The 12-country panel VAR yields similar results, asseen in Figure 3. These VAR results are not necessarily causal, but they suggest policy uncertainty shocks havematerial effects. One interpretation of the micro and macro evidence is that policy uncertainty retards investment,hiring and growth in policy sensitive sectors like defense, healthcare and construction, and these sectors areimportant enough for policy uncertainty to matter at the aggregate level.Figure 3 – Responses to an EPU Shock in a Twelve-Country Panel VARNotes: Panel-VAR estimated impulse response functions for industrial production andunemployment to an EPU innovation equal to the increase in the average US EPU value from2005-2006 to 2011-2012, with 90 percent confidence bands. Identification based on three lagsand a Cholesky decomposition with the following ordering: EPU index, log(stock marketindex), unemployment rate, and log industrial production.  We use own-country data and a fullset of country fixed-effects in the panel VAR. Country-level data are weighted by the squareroot of the number of newspapers used in the EPU index. Fit to monthly data for Canada,China, France, Germany, India, Italy, Japan, Korea, Russia, Spain, UK and the US from January1985 to December 2012, where available. Policy uncertainty contributes to sluggish economic growthWe develop new measures of economic policy uncertainty for the United States and eleven other major economies,and we use these measures to investigate the effects of policy uncertainty on firm-level stock price volatility, firm-levelinvestment rates and employment growth rates and on aggregate investment, output and employment. Our findingsare broadly consistent with theories that highlight negative economic effects of uncertainty shocks. Overall, ourresults suggest that elevated policy uncertainty in many countries around the world contributes to sluggish growth inrecent years. This article is based on the LSE CEP discussion paper, ‘Measuring Economic Policy Uncertainty’ Featured image credit: Anne (Flickr, CC-BY-NC-SA-2.0)Please read our comments policy before commenting.       Note:  This article gives the views of the author, and not the position of USAPP – American Politics and Policy, nor theLondon School of Economics.Shortened URL for this post: http://bit.ly/1XF3dFt _________________________________About the authorsScott Ross Baker –Northwestern UniversityScott Ross Baker is an Assistant Professor of Finance in the Kellogg School of Management atNorthwestern University. His research is concentrated in empirical finance and macroeconomics.Recent work examines the impact of household leverage and credit constraints in driving sensitivity toboth income and asset shocks. Scott was born and raised in San Diego, California and receivedB.A.’s in Economics and Political Science from the University of California, Berkeley. He received aPh.D. in Economics from Stanford University.Nick Bloom – Stanford UniversityNick Bloom is a Professor of Economics at Stanford University. His research interests areinvestigating the causes and consequences of economic uncertainty. He also works onunderstanding differences in management and organizational practices across firms and countries.He previously worked as a research economist at the Institute for Fiscal Studies, a policy advisor atHM Treasury and as a management consultant at McKinsey & Company. He is a graduate ofCambridge University, with an MPhil from Oxford University, and a PhD from University CollegeLondon.Steven J. Davis – Chicago Booth School of BusinessSteven J. Davis is the William H. Abbott Professor of International Business and Economics at theUniversity of Chicago Booth School of Business and a visiting fellow at the Hoover Institution. Hisresearch interests include employment and wage behavior, worker mobility, job loss, labor marketinstitutions, business dynamics, economic fluctuations, national economic performance, and publicpolicy. He is a research associate with the NBER, advisor to the US Congressional Budget Office, asenior adviser to the Brookings Papers on Economic Activity, senior academic fellow with the AsianBureau of Finance and Economics Research and visiting scholar and consultant, respectively, withthe Federal Reserve Banks of Atlanta and Chicago.CC BY-NC 3.0 2015 LSE USAPP

Higher policy uncertainty curbs business investment and employment growth

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