Uncertainty regarding economic and other policies has been cited as one of the factors contributing to the prolonged period of slow growth the United States is experiencing.
Recently, the American Enterprise Institute (AEI) held a panel to discuss this topic. The presenter was Steven Davis, a visiting scholar at AEI and professor of international business and economics at the University of Chicago Booth School of Business, and the discussants were Greg Ip, U.S. economics editor for The Economist, and John Makin, resident scholar at AEI.
Davis began by observing that policy uncertainty dominates the economic landscape more than any other period prior to 2008. One of the areas of uncertainty includes taxes and spending due to the fiscal cliff. There is uncertainty both as to what the policymakers will do and what the consequences will be.
A list of the factors driving uncertainty begins with who the policymakers will be after the elections, which Davis characterized as uncertain. Second, there is uncertainty as to what the policies will be, regardless of who wins. Third, experts disagree over what the consequences of policies such as Obamacare will be. Fourth, uncertainty can be caused by inaction, as is the case with the failure to address long-term fiscal stresses. Finally, uncertainty can also be affected by non-economic factors, such as national security.
Davis explained that he has developed a monthly index of economic policy uncertainty from 1985 through September 2012, and it has many spikes. (The indexes of uncertainty he developed are displayed for various countries at www.policyuncertainty.com.)
The first event he considered as an example that was clearly external to economic policy was the 9/11 terrorist attack. There were spikes for the first elections of Presidents Bill Clinton, George W. Bush and Barack Obama, and the index shows a lot of uncertainty about this year's election.
In 2008 there was uncertainty about what should be done about the financial crisis and what the consequences would be. The U.S. index includes scheduled tax-code expirations, issues where there are differences in forecasts and news-based issues. The tax-cut uncertainty is a new feature in that the practice of Congress of making temporary changes has come into common use within the last few years. The amount of revenue at stake is $4 trillion to $5 trillion over the next decade.
The last four years have produced 120 stock market moves of 2.5 percent or more. In the last 28 years, there was a total of 170. Whereas the experience for many years was that only one such move per year was attributed by the press as related to policy, in the last four years there have been 12 such moves per year.
Lastly, Davis found that sustained economic uncertainty has an adverse impact on future economic performance, cutting 2 million to 2.5 million jobs over two years. He argued that the increased uncertainty is due to an increase in polarization between the parties, and he attributed this to the parties moving away from the center. Intriguingly he found that at the county level, parties have become more segregated over the last several decades.
Ip responded that he has been writing in The Economist that the issue of uncertainty is so important that more research like that of Davis’ is needed, and that his research has gone further than anyone else’s. He called for policymakers to address what to do about the uncertainty. He compared the current recession to that of 30 years ago, when the Federal Reserve decided in 1970 to target excess reserves and credit controls were imposed six months later. What ensued was a period of extraordinary volatility in interest rates. By the summer of 1982, the Fed concluded that this system had broken down, and they abandoned it.
Makin began his comments with a reference to work he had done in 1981 when he studied the effects of inflation on real growth and found that inflation penalized real growth. But he said Davis’ work is broader, and the effects of uncertainty on financial crises need to be better appreciated and understood.
Makin found what he considered the necessary extemporization by the Fed after the 2008 crisis instructive regarding the uncertainty of monetary policy. At the time, he said, he was acutely aware of the "persistent denial by most of the authorities that there was a financial crisis, and that induced a lot of uncertainty in the financial markets, where people realized that there was a financial crisis."
The Bear Stearns crisis occurred in the spring of 2008 and set up the Lehman crisis. After Bear Stearns was rescued, it looked like the Fed would rescue Lehman, too, and it was a shock when that didn't happen. There was tremendous uncertainty as to what the Fed would do and what the effect would be.
Makin argued that uncertainty grew because the Fed had room to use its traditional policy tools by cutting rates to zero, then embarked on the first round of quantitative easing (QE1) and expanded its balance sheet by buying financial assets to support the economy. There was a move to cash, due to uncertainty as to the values of assets because of the crisis. This tends to reduce inflationary pressure and might even cause deflation, as occurred in Japan.
In 2010, there were signs of deflation, and the Fed responded with QE2 and further additions to the Fed's balance sheet, and it continued to satisfy the demand for liquidity.
By 2012, the economy had not responded very much to QE, and unemployment remained high. The Fed moved to QE3, which, according to Makin, raised the level of uncertainty because the Fed was trying to respond to the persistent high unemployment. Fed Chairman Ben Bernanke resolved to continue to expand the Fed's balance sheet until the unemployment rate responds, and the Fed would also delay tightening when the economy starts to recover.
This increases uncertainty, because the public begins to wonder whether the Fed wants higher inflation. Also, Bernanke has promised to maintain this policy through 2015, but his term ends early in 2014. Makin questioned whether the size of the Fed's balance sheet could have much impact on the unemployment rate, given that interest rates are already zero and there remains a large demand for liquidity.
He suggested that the earlier uncertainty might have been necessary, but perhaps the Fed has crossed the line with QE3. Makin concluded by calling for policymakers to find a path back to more reliable monetary and fiscal policies that would reduce uncertainty in markets.
Robert Feinberg served on the staff of the House Banking Committee for the 10 years that encompassed the savings-and-loan debacle and the beginning of its migration to the banking sector. Subsequently, he has consulted on issues related to the crisis for law firms, accounting firms, securities firms and trade associations.
Feinberg holds a BS.E. from the Wharton School and a J.D. from the Law School of the University of Pennsylvania. He has drafted dissenting views on landmark banking legislation, contributed to a financial blog and written hundreds of reports for clients to document the course of the financial crisis as it has unfolded over the past three decades.
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