Policy Uncertainty Paralyzes the Economy

[Editor’s Note: This article in the Wall Street Journal on September 25, 2013 provides interesting insight that perhaps ending the “fight” between the President and both houses of Congress is more important to adding jobs than who is right]

Policy Uncertainty Paralyzes the Economy

Getting back to the 2006 level of uncertainty would add 2.3 million jobs.

By WILLIAM A. GALSTON

Endless strife over public policy increases uncertainty, and greater uncertainty slows growth. Beyond all the damage that political hyperpolarization inflicts on public trust, it undermines what the American people want most—jobs for themselves and expanded opportunity for their children.

A growing body of economic research supports this linkage between policy-based uncertainty and the real economy.

Over the past few years, Stanford-based economists Scott Baker and Nicholas Bloom teamed up with the University of Chicago's Steven Davis to develop a measure of economic policy uncertainty and to explore the effects of changing levels of uncertainty on the economy. Between 1985 and 2007, they found, uncertainty varied within a narrow and mostly predictable range, moving up in response to presidential elections and international conflicts and then subsiding. Since then, however, policy uncertainty has risen to historically elevated levels, with the peaks—corresponding to events such as the collapse of Lehman Brothers and the initial defeat of the TARP legislation—surging above that after the 9/11 terror attacks.

In a finding that today's policy makers would do well to ponder, the highest level of policy uncertainty ever recorded—in mid-2011 as Washington struggled with the debt ceiling and narrowly averted default—stood at two-and-a-half times the average of the past quarter century. Since 2007, policy-induced uncertainty has become a larger and larger share of overall economic uncertainty.

 Policy uncertainty directly affects economic activity. Messrs. Baker, Bloom and Scott summarize their case: "When  businesses are uncertain about taxes, health-care costs, and regulatory initiatives, they adopt a cautious stance.      Because it is costly to make a hiring or investment mistake, many businesses naturally wait for calmer times to expand.  If too many businesses wait to expand, the recovery never takes off." The evidence also suggests that policy uncertainty   increasing affects the performance of the stock market.

This story makes intuitive sense. But how much of a difference does uncertainty make in the real economy? To answer this question, Messrs. Baker, Bloom and Scott make use of a statistical technique for which Christopher Sims won a 2011 Nobel Prize in economics. They find that restoring 2006 levels of policy uncertainty could increase industrial production by 4% and employment by 2.3 million jobs over current baseline estimates—enough to bring unemployment down by about 1.5 percentage points.

It's easy to dismiss a single innovative study: Every index is controversial, as is every model and statistical technique. But in July 2013, Sylvain Leduc and Zheng Liu, two researchers at the Federal Reserve Bank of San Francisco, published a paper that took a different route to a very similar result. Their point of departure was a historical relationship known as the Beveridge curve: As job openings increase, the unemployment rate tends to fall. The Great Recession has disrupted the terms of this relationship, however. The unemployment rate has fallen much less than the rise in job openings suggests that it should have, and there are more jobless workers per job opening than in previous recoveries.

The San Francisco Fed researchers find that heightened policy uncertainty has become increasingly important in the job market. It turns out that as uncertainty rises, the intensity of businesses' recruitment activities wanes, lowering the rate at which firms fill jobs. By the end of 2012, the researchers calculate, heightened policy uncertainty accounted for about two-thirds of the shift in the Beveridge curve. Their bottom line: "[I]f there had been no policy uncertainty shocks, the unemployment rate would have been close to 6.5% instead of the reported 7.8%"—a result that aligns remarkably well with the Stanford/Chicago team's conclusion.

In testimony before the Senate Budget Committee on Tuesday, an intellectually and politically diverse panel—Allan Meltzer (Carnegie Mellon), Chad Stone (Center on Budget and Policy Priorities) and Mark Zandi (Moody's Analytics)—agreed that policy uncertainty is a drag on the economy. Mr. Zandi's model suggests if political uncertainty had remained at pre-recession levels, output would be $150 billion higher and unemployment would be 0.7% lower than they are today—smaller effects than the other studies indicate, but still very significant.

If this emerging body of research is correct—and it is more than plausible—then elected officials should ask themselves some hard questions. Both parties are sure they are right about what's needed for economic growth. But when our governing institutions are closely as well as deeply divided, as they are today, neither side can get its way. Each party faces the same choice: It can fight on in the hope that a governing majority of the people will come to see things its way, or it can compromise with the other party to bring the fight to a close.

So far, both parties have chosen to fight, believing that their preferred prescriptions for the economy would yield much better results than could any feasible compromise. But the fight itself is taking a toll on the economy and is making life worse for millions of Americans. Maybe that's why the people are pleading with their elected officials to compromise. It's time for Washington to start paying attention.

A version of this article appeared September 25, 2013, on page A15 in the U.S. edition of The Wall Street Journal, with the headline: Policy Uncertainty Paralyzes the Economy.

 What do you think?