Everyone knows, or has heard the cliche, that markets hate uncertainty. It’s also a given that the future is always uncertain. How, then, do markets ever manage to function -- or, for that matter, businesses, which must make decisions today about investments that will pay off in the future?
Faced with the inherent contradiction, some economists have decided to -- what else? -- create a model to quantify the effect of policy uncertainty on the economy.
Regular readers know I’m a skeptic when it comes to uncertainty as the explanation for every wiggle in the markets, every downtick in consumer confidence, every percentage-point decline in business investment. In many cases, uncertainty is a euphemism for pessimism. So I approached the subject, not to mention the idea that a model could capture policy uncertainty with some degree of certainty, with a strong negative bias. After looking at some of the research, let’s just say I’m a little more receptive, but I’m not sold on the idea just yet.
Faced with an anemic recovery from the deep 2007-2009 recession, economists Scott R. Baker and Nicholas Bloom of Stanford University and Steven J. Davis of the University of Chicago, decided to design an index that would encapsulate policy uncertainty. Their index is made up of three types of information: the frequency of references to policy-related uncertainty in newspaper articles, the number of federal-tax-code provisions set to expire in future years and their revenue impact, and the extent of disagreement among forecasters about inflation and government spending.
The economists perform lots of cross-checks on their data, control for political slant, even scan 4,300 news stories to make sure their sample -- 10 leading U.S. newspapers -- is a good reflection of the trend, all of which the authors explain in their most recent paper.
Not surprisingly, their Economic Policy Uncertainty Index, or EPU Index, shows a surge in uncertainty around presidential elections, at the outbreak of wars and after the Sept. 11, 2001, terrorist attacks. The 1997 Asian financial crisis, on the other hand, didn’t produce an increase in policy uncertainty as measured by the index, leading the authors to conclude that policy uncertainty and ordinary economic uncertainty are different and can be distinguished from each other.
After the collapse of Lehman Brothers Holdings Inc. in September 2008, the EPU Index went up and stayed at elevated levels. Economic uncertainty? For sure. Pessimism? You bet. Aren’t they all of a piece?
In a telephone interview this week, Davis acknowledged the difficulty of isolating uncertainty from pessimism, of differentiating between economic and policy uncertainty “even at the conceptual level, since often they go hand in hand.” Still, he and his colleagues have managed to document situations in which economic uncertainty didn’t breed policy uncertainty.
It isn’t hard to understand why the extreme readings during the debt-ceiling debate in the summer of 2011 and again at year-end 2012 (the fiscal cliff) were policy-related. But the authors maintain that policy uncertainty -- specifically about tax, spending and regulatory (but not monetary) policies -- explains the sustained high level since the recession.
Other metrics paint a different picture. For example, an index of 30-day implied volatility on the Standard & Poor’s 500 Index, or VIX, has been declining since late 2008. Davis explains the divergence between the VIX and EPU Index by their different time horizons: 30-day versus open-ended. In addition, “the VIX only covers part of the economy reflected by publicly traded corporations,” and two-thirds of private-sector workers are employed elsewhere, he says.
Davis is the first to admit that not all policy uncertainty yields bad results. For example, a debate in Congress about various alternatives for corporate tax reform would be a plus. “I’ll take that kind of uncertainty any day,” he says.
Now comes the “but.” Policy uncertainly surely is a factor in business decision-making, but it can’t be all that it’s cracked up to be. Why do I say that? More than half the companies on the 2009 Fortune 500 list were started during a recession or a bear market, according to a study by the Kauffman Foundation. The government is always fiddling with tax-and-spend policies during recessions, which is a source of policy uncertainty. Who can tell how long that timely, targeted and temporary fiscal stimulus is going to last?
“Policy is not that important to companies that turn out to be really successful,” says Robert Litan, director of research at Bloomberg Government, a part of Bloomberg LP. “Are the Steve Jobses of tomorrow sitting around worrying about the debt ceiling?”
Heavens, no. They’re too busy following their dream. Big companies are more cautious, have a greater fear of failure, but that isn’t where job growth comes from anyway. Entrepreneurs thrive in a world of uncertainty. They aren’t trying to meet existing demand for goods and services. They’re busy dreaming up something you never imagined you wanted or needed.
Even if entrepreneurs hated uncertainty, now that it’s become the norm -- and the EPU Index suggests that it has -- what’s the alternative?
(Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist.)
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