Research / BFI Working PaperFeb 01, 2012

Has Economic Policy Uncertainty Hampered the Recovery?

Steven J. Davis, Scott Baker, Nicholas Bloom

The U.S. economy hit bottom in June 2009. Thirty months later, output growth remains sluggish and unemployment still hovers above 8%. A critical question is why. One view attributes the weak recovery, at least in part, to high levels of uncertainty about economic policy. This view entails two claims: First, that policy uncertainty is unusually high in recent years. Second, that high levels of policy uncertainty caused households and businesses to hold back significantly on spending, investment and hiring. We take a look at both claims in this article. We start by considering an index of economic policy uncertainty developed in Baker, Bloom and Davis (2012). Figure 1, which plots our index, indicates that economic policy uncertainty fluctuates strongly over time. The index shows historically high levels of economic policy uncertainty in the last four years. It reached an all-time peak in August 2011. As discussed below, we also find evidence that policy concerns account for an unusually high share of overall economic uncertainty in recent years. Moreover, short-term movements in overall economic uncertainty more closely track movements in policy-related uncertainty in the past decade than earlier. In short, our analysis provides considerable support for the first claim of the policy uncertainty view. The second claim is harder to assess because it raises difficult issues of what causes what. We do not provide a definitive analysis of the second claim. Nevertheless, our evidence suggests that policy uncertainty can damage the economy, and that high levels of policy uncertainty have been an important factor hampering the recovery. We find evidence that increases in economic policy uncertainty foreshadow declines in output, employment and investment. While we cannot say that economic policy uncertainty necessarily causes these negative developments – since many factors move together in the economy – we can say with some confidence that high levels of policy uncertainty are associated with weaker growth prospects.

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