Is policy uncertainty the problem?

by on August 14, 2010 at 8:10 am in Current Affairs, Economics | Permalink

Pete Boettke says "policy is the problem."  Ezra says he can't find evidence that policy is the problem.

I hold the intermediate view that policy uncertainty is a problem but not the problem.  On one hand, policy uncertainty probably has been greatest for the health care sector, yet job growth in that sector has been relatively robust.  Furthermore, Obamacare may bring uncertainty, but part of the uncertainty is about whether employers can get away with dumping their workers onto the subsidized exchanges.  Arguably that should help hiring rather than hurt it.

I expect electoral gridlock by November yet no one seems to be welcoming that "certainty" very much.

Perhaps most importantly, deleveraging recessions usually take a long time to recover from in any case and there's not a lot of good cheer along the way.

I would be more convinced by the uncertainty view if it were combined into a larger, coherent story, consistent with reported corporate profits being fairly high.

Do the implicit volatilities embedded in option prices show a lot of expected uncertainty?  Maybe, but again I'm waiting to see the evidence.  If so, this one should be staring us right in the face.

On the other side of the ledger, the tax code remains highly uncertain, to our detriment, and monetary policy is some mix of uncertain and baffling (though see the above point on implicit volatilities). 

There is also behavioral economics.  An image or speech or proposed law can crush a mood, whether or not that is rational.  I can't cite a lot of systematic evidence for this having happened, but I know from talking to people how many of them think, rightly or wrongly, that Obama is very very bad for the American economy.  I believe that is a factor in our slow recovery. 

Be careful to separate your positive and normative views here.  Maybe the audience is "at fault," rather than the messenger, but still some people are very upset.  Every time I read a left-wing writer dismantling "right-wing media" I think they are actually providing another data point for the policy uncertainty hypothesis, although that is hardly their intent.  In many circles there is a perceived problem with our country, regardless how much that is based on fact or not.  If food consumers can be irrational and moody, political consumers (who are also investors) can be the same.  Still, I don't know how significant this factor is.

Temporary hiring is quite high, while permanent hiring is not.  However that need not show that the decisive uncertainty comes from politics.  Furthermore it instead could mean that the fixed cost of hiring labor full-time is high but not uncertain.

A lot of the current uncertainty is about a higher estimate of overall systemic risk, rather than from politics per se.  Such risk worries may be a blend of private and public sector factors, such as worries about Europe or China.  Economic and political uncertainty are not always separable categories.

Overall I don't see a lot of clear evidence on this question but I think policy uncertainty is one factor, albeit an exaggerated factor in many circles.

1 E. Barandiaran August 14, 2010 at 8:28 am

Tyler, please name three important questions related to the U.S. macroeconomy on which you see “clear evidence” and detail this evidence. Thanks.

2 Manto August 14, 2010 at 8:50 am

I expect electoral gridlock by November yet no one seems to be welcoming that “certainty” very much.

I am very much looking forward to this.

3 Neal August 14, 2010 at 9:00 am

This is one of the best blog posts I have read this year.

4 Andrew August 14, 2010 at 9:39 am

I just want to pinch Ezra’s little cheeks. He needs to add to his chart the time when mark-to-market uncertainty was resolved. Here’s a hint, almost to the day of the bottom of the stock market.

Not to be ignored is that Keynesians classically ignore balance sheet considerations. And, bankruptcy IS a government program.

5 Chaitanya August 14, 2010 at 9:44 am

Indeed one of the most well-reasoned posts in a while, Mr. Cowen.

6 pierre August 14, 2010 at 10:48 am

yler, please name three important questions related to the U.S. macroeconomy on which you see “clear evidence” and detail this evidence. Thanks.
Pierre

7 kebko August 14, 2010 at 11:50 am

“I would be more convinced by the uncertainty view if it were combined into a larger, coherent story, consistent with reported corporate profits being fairly high.”

Corporate profits would be high. Do you work with a model that says required rates of return are lower when there is more uncertainty? I frequently give you the benefit of the doubth when I don’t understand you, but this is just a blatantly backwards statement.

8 andy August 14, 2010 at 12:25 pm

I don’t understand why effects of policy uncertainty on implied volatilities of firm payoffs should be staring us in the face. The payoff is the outcome of the uncertain policy as well as the corporation’s investment policy which may or may not consider the shock to policy uncertainty. You can argue that managers will make only partial adjustments and so we should see an increase in equity volatilities. But you could also argue that higher volatility is exactly what we would observe if managers were ignoring policy uncertainty when making investment decisions.

Isn’t an increase in cash levels with little corresponding effects on payoff volatilities a likely outcome if policy uncertainty shapes corporate investment?

9 Sunset Shazz August 14, 2010 at 12:47 pm

Tyler,

Here is a long run VIX chart:

http://finance.yahoo.com/q/bc?s=^VIX&t=my&l=on&z=m&q=l&c=

The reason Goldman had a bad 2Q10 is that their trend-following and mean-reversion models were both signalling that volatility was falling, and returning to its pre-crisis levels. Unfortunately for them, volatility spiked and they took a loss on their short vol positions. Volatility is presently clearly higher than its most recent medium term average; moreover, the “tail risk” vol implied by well out-of-money options on various underlying products such as equity markets, commodities, bond yields, short money rates, etc all point to large uncertainty and a desire by participants to insure against extreme events.

10 Robert Olson August 14, 2010 at 1:01 pm

If the economy grew from 1933-1937, how much can REALLY be attributed to political uncertainty? I’d say still look a big things like monetary policy

11 Bill August 14, 2010 at 10:15 pm

In reading the responses above, it is pretty clear that the “uncertainty” argument is simply a polical one based on the language of the posts and the absence of content.

You could take any period of recovery from a recession and attach the word uncertainty to it. Otherwise, everyone would be “acting as if” the recession were over and the recession would be over.

12 Larry August 16, 2010 at 1:57 am

“deleveraging recessions usually take a long time to recover from in any case and there’s not a lot of good cheer along the way”

OK, but how does Germany fit this model?

Also, on the “preventing job loss speeds recovery” meme, can we look cross-sectionally at states for more datapoints? I.e., do states which cut fewer jobs/$ of spending cuts, have lower unemployment?

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