The Policy Mess in Washington Is Hurting the Economy

Maybe it goes without saying that the wrangling and indecision among Federal government policymakers would have a detrimental effect on economic activity.  But a new report by an economic consulting firm we've known well during our Wall Street years actually puts this in some pretty clear context.  There's a measurable impact on employment and on the risk premium financial markets charge even fairly good quality corporate borrowers.  A separate study from one of the Federal Reserve Banks highlights the impact on small business expansion plans, the source of much economic growth in this country.

We're not talking about actual government policy actions and their impact, but the recent severe and protracted disagreements in government over what those policies should be.  Specific policies, such as tax increases, can slow the economy, as businesses and/or individual taxpayers set aside more of their income to pay the government.  But at least they can plan ahead and run their companies or scope out their own household purchasing and investments with the law in mind.  However, if there is disagreement about what the laws should be, then no one outside government can make any plan.  Some people might spend away, trying to get what they want before government takes their money.  But they'd likely hold up any financial investment decisions or long-range planning.  And businesses too would be hesitant to act.  If their specific company is doing well and they might want to open a new store or even a new plant, they don't want to get in the middle of such a major project and then see their taxes hiked or their regulations tightened or, if government spending cuts are being considered, they don't want to see their contract or grant cancelled in midstream, right after they've leased their new property or whatever.  So, most often, they will hang back and wait to do anything until they can see what laws are finally enacted.  Thus, economic activity would slow below what it otherwise might be while the policy debates play out.

The Economic Policy Uncertainty Index

This "hanging back" effect is visible and measurable.  Macroeconomic Advisers, LLC, based in St. Louis, calls our attention to the Economic Policy Uncertainty Index[1, 2].  This series was compiled by economists at Stanford and the University of Chicago.  It combines three items, a count of news stories in papers around the country about policy disagreements, a schedule of tax law changes (such as the expiration of the Bush tax cuts) and measures of the differences among various professional economists' economic forecasts as they try to take account of new policies.

Here's a picture of the policy uncertainty index since 2000.  You can see that its long-term average is 100, but since 2009, it has averaged 150, that is, 50% higher.  You can also see spikes when this got more extreme: one in September 2001, around 9/11, a second during the financial crisis of 2008-09, a third in the summer of 2011 over the first debt-ceiling fight, and the latest one.  The jump we show at the very end is an approximation of October's value based on a separate daily index of news story counts on these issues, compiled by the same Stanford and Chicago group.

The Macro Advisers firm has performed statistical analysis estimating the numerical relationship of the Economic Policy Uncertainty Index to financial market risk, GDP growth and the unemployment rate.  They find that the high levels of this index in recent years have resulted in GDP growth since 2009 that is 0.3% lower each year, cutting average growth to 2.1% from the 2.4% it would have been if policy decisions had been made more promptly.  Hitting closer to home, this is associated with an unemployment rate that has averaged 0.6% higher than it otherwise would have been.  So the unemployment rate that lately has been 7.2%, would be closer to 6.6%, and there could be as many as 900,000 more jobs by now.  Corporate borrowers in bond markets have paid nearly 0.40% higher in interest costs due to the policy uncertainty factor alone; this erodes some of benefit of the low interest rates being fostered by the Federal Reserve's recent bond buying programs.

Notably, the Macro Advisers analysis stops in mid-2013, so the very latest episode of policy wrangling is not yet factored in.  We have seen some estimates that GDP growth in the fourth quarter will be reduced by about 0.5% from the 17-day government shutdown, not counting the extra uncertainty element we describe here.

Small Business Gets Hurt Too

Another study of the effect of policy uncertainty on business came in the summer and fall of 2011 during and immediately after the upset then over the federal government's debt ceiling and the credit downgrade by one of the financial rating companies.  Publicity at the time about the ramifications of the disagreements for business plans was based on anecdotes and scattered commentaries by pundits, politicians and the occasional CEO.  Some argued that the developing recovery in employment and capital spending was being hamstrung, while others said citing the policy brouhaha was just some sort of excuse.  Economists at the Federal Reserve Bank of Cleveland thus did some work on the relationship of the Economic Policy Uncertainty Index to small business hiring and expansion plans.[3]  Such data from small businesses are collected monthly through a survey by the National Federation of Independent Business, a nonpartisan, nonprofit advocacy organization of some 350,000 small businesses owners.[4]

The Cleveland Fed analysts calculated statistical relationships between the EPU Index and the NFIB measures of small business hiring plans and capital spending plans.  These regression measures imply that during the 2011 policy-making debacle, heightened policy uncertainty was associated with a reduction of 6 percentage points in the share of businesses planning net increases in the number of employees; so instead of the 4% or 5% actually reported in the survey, the share could have been 10-11%, closer to the long-term average of 14%.  Recent readings have been 9-10%, a substandard level surely related to the policy uncertainty issue.  The Cleveland study calculated a similar 6% cut in the share of businesses planning some form of construction or capital equipment purchases, holding that at around 22% in 2011 instead of the 28% that might otherwise apply.  The long-run average is 33%.  Recent figures have been about 25%, which is thus also subpar.

Another of the NFIB survey items asks participants if "now is a good time to expand the business".  That question got yes answers from an average of 18% of survey participants prior to the economy's peak in December 2007; it fell, of course, after that, but has not recovered at all, hovering in a range of 5 to no more than 10% since the middle of 2008.  This measure has a decisive 70% negative correlation with the EPU Index, suggesting that at least some of its recent sluggishness is tied to the government's disarray.

How Can We Encourage Government To Be More Responsible?

We were going to write an article for you on the government policy disputes anyway, and an economist friend lately sent us a note giving us even more inspiration: "You need to write an article on the hypocrisy and self-interest of politicians who are putting self-interest ahead of the best interest of their country."  As we began our work on these issues, we had expected that our commentary would be mainly some kind of rant expressing that view.  What we learned in doing our research the last few days is more substantive: there are in fact real, identifiable costs to this in terms of fewer jobs and higher financing rates.  Small business leaders seem especially discouraged.  These come over and above the direct costs generated by any actual tax hikes, spending cuts, or most currently, the 17-day shutdown.

We wish we knew something to do about it all.  We might say, "write your Representatives and Senators and urge them to respect each other's views and work together toward middle-ground solutions".  So we did say it.  Send your letters to your local newspapers; post them on your Facebook pages; get the word out.  More such text might be "stop the blame-game; that doesn't help anyone".  Finally, "most concretely, can the Conference Committee, chaired by conservative Paul Ryan and liberal Patty Murray, fulfill their mission to devise a real budget for the fiscal year that's already a month old?!  What do we pay you to do there in Washington?"

-------------------------

[1]Macroeconomic Advisers, LLC. "The Cost of Crisis-Driven Fiscal Policy".  Prepared for the Peter G. Peterson Foundation.  October 2013.  Available on the Peterson website: http://pgpf.org/special-reports/the-cost-of-crisis-driven-fiscal-policy; accessed November 1, 2013.

[2]Scott R. Baker, Nick Bloom and Steven J. Davis.  "Measuring Economic Policy Uncertainty."  May 19, 2013. http://www.policyuncertainty.com/media/BakerBloomDavis.pdf  See the home page of this website for access to all the data, which can be downloaded for free.

[3]Mark E. Schweitzer and Scott Shane.  "Economic Policy Uncertainty and Small Business Expansion".  Federal Reserve Bank of Cleveland: Economic Commentary.  November 29, 2011.  http://www.clevelandfed.org/research/commentary/2011/2011-24.cfm; accessed November 1, 2013.

[4]National Federation of Independent Business. See survey reports on http://www.nfib.com/research-foundation "Small Business Optimism Index".