What are the Costs of Political Uncertainty?

There has been a lot of talk about policy uncertainty and its impact on the economy. Back in June, Verizon CEO and Business Roundtable Chairman Ivan Seidenberg argued:

In the search for short-term revenue fixes, we’re doing long-term damage to growth.  By reaching into virtually every sector of economic life, government is injecting uncertainty into the marketplace and making it harder to raise capital and create new businesses.

Since then, a lot of political and pundit breath has been spent talking about the rampant uncertainty that continues to dog the economic environment. I take the uncertainty concerns seriously. There are, indeed, a lot of things that are unclear now. Top on the list are taxes. Will top marginal rates rise to 39.6 percent on January 1, 2011? Will all rates rise? Will all rates stay where they are? And what about the new health care law? Is it constitutional? Will it be repealed? And financial regulation? As far as I understand, the legislation left a lot of discretion to the regulators.

These are not just political talking points. It turns out there have been some serious attempts to quantify the impact of political uncertainty on business activity. A 2001 study by Harvard’s Abdiweli Ali is worth emphasizing. Ali noted that a lot of the previous work in this area had focused on what he calls “political instability.” These are coups, revolutions, and other big-time political disruptions. Thankfully, these aren’t exactly relevant to our current situation. But Ali goes on to define and quantify more mundane sources of uncertainty, what he calls “policy uncertainty.” He writes:

It is important to understand that the decisions of private investors depend on factors that are partly under the control of the government. Uncertainties about future prices, wages, and interest rates, exchange rates, trade regimes, taxes, and regulatory policies are all incorporated and taken into account in the determination of the optimal timing of investment.

Ali gathered data from 119 countries, covering 25 years and then tested the relevance of 12 fiscal, monetary, and trade variables to assess the impact of uncertainty on economic outcomes. He concluded:

Policy uncertainty is strongly and negatively correlated with economic growth….policy instability variables account for a significant portion of growth differences across countries.

In particular, he found:

The negative and significant effect of policy instability on economic growth are particularly strong for the case of domestic credit, interest rate, and inflation volatility, as well as the expenditure share of the GDP and the ratio of taxes to GDP.

In other words, the ill-effects of policy uncertainty are particularly strong in those areas of policy that are least-certain today.

Now, new research by Ruediger Bachmann, Steffen Elstner, and Eric R. Sims sheds more light on the impact of uncertainty. They use a different approach than Ali. Instead of relying on international macro data, they rely on confidential business survey data. The NBER Digest reports:

[The authors] consistently find that increases in uncertainty are associated with protracted negative effects on economic activity.  

Unfortunately, they do not see a significant rebound in economic activity when uncertainty is resolved.