Academic journal article Policy Review

Uncertainty and the Economy

Academic journal article Policy Review

Uncertainty and the Economy

Article excerpt

THE U S. ECONOMY hit bottom in June 2009. Thirty months later, output growth remains sluggish and unemployment still hovers above 8 percent. A critical question is why. One view attributes the weak recovery, at least in part, to high levels of uncertainty about economic policy. This view entails two claims: First, that economic policy uncertainty has been unusually high in recent years. Second, that high levels of economic policy uncertainty caused households and businesses to hold back significantly on spending, investment, and hiring. We take a look at both claims in this article.

We start by considering an index of economic policy uncertainty developed in our 2012 paper "Measuring Economic Policy Uncertainty." Figure 1, which plots our index, indicates that economic policy uncertainty fluctuates strongly over time. The index shows historically high levels of economic policy uncertainty in the last four years. It reached an all-time peak in August 2011.


As discussed below, we also find evidence that policy concerns account for an unusually high share of overall economic uncertainty in recent years. Moreover, short-term movements in overall economic uncertainty more closely track movements in policy-related uncertainty in the past decade than in earlier periods. In short, our analysis provides considerable support for the first claim of the policy uncertainty view.

The second claim is harder to assess because it raises the difficult issue of identifying a causal relationship. We do not provide a definitive analysis of the second claim. We find evidence that increases in economic policy uncertainty foreshadow declines in output, employment, and investment. While we cannot say that economic policy uncertainty necessarily causes these negative developments--since many factors move together in the economy--we can say with some confidence that high levels of policy uncertainty are associated with weaker growth prospects.

Economic policy uncertainty over time

FIGURE I PLOTS our monthly index of economic policy uncertainty from January 1985 to December 2011. Before describing the construction of the index, we briefly consider its evolution over time. The policy uncertainty index shows pronounced spikes associated with the Balanced Budget Act of 1985, other major policy developments, the Gulf Wars, the 9/11 terrorist attack, financial scares and crises, and consequential national elections. Policy uncertainty shoots upward around these events, and typically falls back down within a few months. The experience since January 2008 is distinctive, however, in that policy uncertainty rose sharply and stayed at high levels. The last two years are especially noteworthy in this respect. While the most threatening aspects of the financial crisis were contained by the middle of 2009, the policy uncertainty index stood at high levels throughout 2010 and 2011.

The index shows a sharp spike in January 2008, which saw two large, surprise interest rate cuts. The Economic Stimulus Act of 2008, signed into law on February 13, 2008, was also a major focus of economic policy concerns in January 2008. The policy uncertainty index jumps to yet higher levels with the collapse of Lehman Brothers on September 15, 2008, and the enactment in early October of the Emergency Economic Stabilization Act, which created the Troubled Asset Relief Program (TARP). A series of later developments and policy fights--including the debt-ceiling dispute between Republicans and Democrats in the summer of 2011, and ongoing banking and sovereign debt crises in the Eurozone area--kept economic policy uncertainty at very high levels throughout 2011.

So how do we construct our index? We build several index components and then aggregate over the components to obtain the index displayed in Figure I. Interested readers can consult our 2012 paper for more details.

Newsbased component. …

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