Quantifying Policy Uncertainty
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While there has been much survey data to indicate policy uncertainty weighs down the economy, until recently no one tried to systematically measure it and its effects on the economy. Along came Steven Davis of the American Enterprise Institute and the University of Chicago, and Scott Baker and Nicholas Bloom both from Stanford University with their Economic Policy Uncertainty Index. I’ve written about their work a few times.
Davis discussed this research project at AEI in Washington, DC.
He listed a few types of policy uncertainty:
- Who will the political decision makers be?
- What policies will they make?
- What will be the consequences?
- What happens if there’s inaction?
The index attempts to boil down these questions into a single number by measuring three components:
- The number of upcoming expirations in the tax code.
- The level of disagreement among economic forecasters.
- Media mentions of economic uncertainty.
Davis said that based on the news-based component, which makes up one-half of the index, taxes and monetary policy have been the two main drivers of policy uncertainty in last two years. Last year’s fight over raising the debt ceiling and the impending threat of tax increases and automatic spending cuts, i.e. the “fiscal cliff,” are two examples he mentioned.
This policy uncertainty is hurting the economy. In March, Davis, Baker, and Bloom estimated that if the United States returned to 2006-levels of uncertainty industrial production would increase 4% and 2.3 million jobs would be created.
In commenting on Davis’ talk, Greg Ip, U.S. economics editor for The Economist, said that the index confirmed his assumption that “Increased policy uncertainty is bad for growth,” and he hoped that government offices like the Congressional Budget Office and the Office of Information and Regulatory Affairs would include this kind of policy uncertainty work in their analysis of potential legislation and regulations.
However, Ip cited two concerns with the work. First, he noted that “uncertainty hasn’t always been a barrier to good economic performance.” He used the example of the 1980s, which experienced high growth despite uncertainty surrounding tax policy. A second concern stems from differentiating between not knowing what future policy will be versus worry of possible ill effects from the policy itself.
As you can see, the index is nearing a 2012 high. Some of that probably has to do with the upcoming election.
Despite the index being a work-in-progress, it's already a helpful tool for making the concept of policy uncertainty less vague, and hopefully it will guide policymakers.
UPDATE: Here's video from the talk: