Economic Uncertainty and Institutions

What prudent merchant will hazard his fortunes in any new branch of commerce when he knows not but that his plans may be rendered unlawful before they can be executed? What farmer or manufacturer will lay himself out for the encouragement given to any particular cultivation or establishment, when he can have no assurance that his preparatory labors will not render him a victim to an inconstant government? In a word, no great improvement or laudable enterprise can go forward which requires the auspices of a steady system of national policy.

James Madison, Federalist 62

Mr. Madison’s splendid point about the perils of a “mutable government” rings a bell, no? Open any newspaper and day of the week, and you’ll find dire stories about policy-induced uncertainty both abroad (the EU, for instance) and at home. In a recent AEI paper, John H. Makin discusses economic policy uncertainty and its impact, along with recent research on the question.

The notion that policy uncertainty all by itself may have very bad consequences is widely shared among professional economists, and some have attempted to measure the phenomenon. Scott R. Baker, Nicholas Bloom, and Steven J. Davis have constructed an index based on a combination of factors, including the frequency of media references to economic policy uncertainty, the number of tax code preferences set to expire, and the degree of forecasters’ disagreement over future inflation and government purchases. I can’t speak to the technical merits of the enterprise (the authors’ terrific website features monthly updates plus all the technical razzle-dazzle you might want) but the results look highly plausible:

Source: Scott R. Baker, Nicholas Bloom, and Steven J. Davis, “Measuring Economic Policy Uncertainty,” June 4, 2012, http://policyuncertainty.com/media/BakerBloomDavis.pdf.

In my darker moments I’ve begun to wonder why anybody in this country is still investing or writing a mortgage. The authors don’t fully explain that puzzle, but they do show that uncertainty is taking its toll. Their estimates “show that an increase in policy uncertainty equal to the actual change between 2006 and 2011 foreshadows large and persistent declines in aggregate outcomes, with peak declines of 3.2% in real GDP, 16% in private investment and 2.3 million in aggregate employment.”

The biggest spikes in the authors’ index are associated with things you can’t do much about: 9/11, wars, consequential elections, banking collapse. As noted by Makin and above, though, there’s also the stuff dished out by the Fed and by Congress: QE3, the fiscal cliff, Obamacare and Dodd-Frank, the deficit, unsustainable entitlement programs….

None of these uncertainties will evaporate automatically after the election. Each would have to be removed deliberately, in a fashion that promises to prove economically sustainable and politically stable over time. For reasons explained elsewhere, I doubt that our institutions are capable of such a feat. They make a big show of reducing risks—financial, environmental, health, you name it. In fact, however, our institutions do no such thing. They are the risk.