Policy uncertainty is driven by three key catalysts, says Stanford Professor of Economics Nick Bloom: recessions, elections, and major events like war or natural disasters. But how do you measure something as nebulous as “uncertainty”?
To track this riddle, Bloom created an index that examines economics stories in the top 10 major American newspapers that reference uncertainty, any federal tax codes set to expire over the next 10 years to highlight uncertainty in taxing, and disagreement among the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters, particularly their predictions of state and federal expenditures and levels of inflation.
He has found that uncertainty has steadily increased in the U.S. since the 1960s, with a big jump during the Great Recession. Blame two trends: the growth of government and the increased polarization of U.S. politics. The former causes new, untried policy, he says, while the later means more squabbling or down-to-the-wire decisions in Congress. In the European Union, the Eurozone crisis that began in 2009 set off a spike in uncertainty.
Besides the U.S. and Europe, Bloom also produces indices for the United Kingdom, Germany, France, Italy, Spain, Canada, China, India, Russia, and soon Japan and South Korea. Here Bloom discusses the impact of uncertainty in the business realm, how Europe compares to the U.S., and how uncertainty can be a good thing.
What causes the greatest levels of uncertainty for Americans?
Policy uncertainty tends to be driven by three things. One is recessions. When recessions happen, typically policymakers want to respond, and that creates some uncertainty — they’re doing new and untried actions. TARP is classic — it’s come out of a totally new policy playbook. Not surprisingly there was a lot of uncertainty about whether it would work. The second driving force is elections, particularly tight elections. So Bush vs. Gore caused an uncertainty spike. Clinton vs. Bush Senior was also a tight election. Thirdly? After major events, like 9/11 and Gulf War I and II, because a lot of big events — typically terrorist attacks or wars — induce a policy response, but it’s never clear exactly what it will be.
What are some business impacts from upticks?
We have an index of exposure to government. This index is built from looking at federal contracts and what sectors they go to. Defense, healthcare, and construction are very exposed. Something like 25% of their revenue comes from government sector. When policy uncertainty is higher, the stock market volatility of these firms is a lot higher. So defense and healthcare firms’ stock prices jump around a lot more. It’s also the case that they tend to have lower levels of investment because they’re being more cautious.
Are we more or less certain than in past decades?
Policy uncertainty has been trending up since the 1960s. One view was it’s the rise of government — the government’s much bigger as a share of GDP. Government was about 25% and now it’s about 45% of all expenditure.
The other issue is that the U.S. political system has gotten much more polarized. On various measures, the Republicans and Democrats are much farther apart on issues than they were in the 1960s. The end product is always squabbling in Congress.
How much more polarized is it?
There are measures of polarization that look at how party-aligned voting is in Congress and in the Senate. If you go back to the 1980s, the most left-wing Republicans were voting with the Democrats and the most right-wing Democrats were voting with the Republicans. There was a lot of overlap in the Senate. Now there’s zero. Literally zero. And because of the combination of being zero and being pretty balanced in both houses of Congress means you get real knife-edge outcomes. It’s like the fight scene at the end of all these action movies where there’s only one gun and two people, and they’re pretty evenly balanced, but whoever gets it wins big time and whoever loses gets shot. That’s what’s happened in the U.S. It’s become very unpredictable.
Do you see this elsewhere?
It’s not a global movement. It’s particular to North America. It’s not obvious why that is. Voters in the U.S. aren’t more polarized. You see this in presidential elections — voters tend to be in the center. It’s more a story about how politicians operate than what the voters want. Maybe it’s around campaign finance, maybe around computers and targeting voters. It is not clear what is causing this, and we are continuing to work on it.
Tell me about uncertainty in Europe.
Europe is still higher than the U.S. There are still big questions over the performance of southern Europe. The Euro crisis has been heavily driven by excessive borrowing and stagnation of Southern Europe, where historically they’ve been very regulated, been very high tax, and that’s killed growth. In order to keep up spending, they’ve had to borrow. If you’ve borrowed a lot in the past, you’re heavily regulated and you can’t grow, eventually you run into a brick wall, and that’s what’s happened. Now they’re cutting spending so they’re trying to get the books in order, but it’s not clear if they’ve deregulated enough.
For example, in countries like Greece and Italy, there are amazing regulations. It’s so complicated to start a business, you need to fill out dozens of forms and get forms stamped and pay all kinds of taxes, and not surprisingly, many people either leave the country or give up. And that’s killing growth. There’s a lot of uncertainty over whether politicians will actually be able to take steps necessary to revive growth. The reason that’s so hard is the electorate in Southern Europe seems to keep voting for politicians that do not deliver on the necessary reforms.
Will European uncertainty level off in the near future?
I think it’s hard. In Southern Europe, the electorate is too left wing to deliver rapid reform. Too many voters don’t want to see deregulation and weakening of union power and lower taxes.
Can uncertainty be good?
It can be good in the sense you get the positive upside. Silicon Valley thrives on uncertainty. Venture capitalists look for businesses with a lot of uncertainty because that provides the upside.
But policy uncertainty is typically not that helpful. It’s like cholesterol — there’s good and bad cholesterol. There’s good and bad uncertainty. Market uncertainty is good for some businesses to take advantage of risk. Policy uncertainty is typically just harmful.
What do you predict will be the next big event to send your index spiking?
I predict there will be a next big event. It’s hard to know what. Who would have predicted 9/11? Who would have predicted the war in Ukraine? It’s safe to say there’s predictably an unpredicted event. Maybe an assassination. Maybe a war. Maybe a big natural disaster. The only thing that is certain is more uncertainty shocks.
Why measure policy uncertainty?
I think policy uncertainty is like the side effects from a medicine. For example — many chemotherapies help patients with cancer but have some horrible side effects. Likewise policy uncertainty often arises from well-intentioned policy interventions. Policies like TARP, stimulus, and quantitative easing have I think helped the economy to recover, but they have a big negative side effect of inducing higher uncertainty. Economists, politicians, and businesses are divided on whether their benefits outweigh the side effects. My broad view is that most of the stimulus has been good, and the policy uncertainty has been a side effect, but it’s a side effect worth paying. I had knee surgery three times for cartilage problems. The surgery had side effects, but I’m much better with it than without it.
We’re measuring the policy uncertainty, so we’re measuring the side effects, and this is clearly negative. But in terms of evaluating the treatment, you want to know both the benefits and side effects. Historically people tend to focus on the benefits, so we’re just trying to complete the picture.