Measuring Economic Policy Uncertainty

Scott R. Baker (Stanford)Nick Bloom (Stanford & NBER)Steve Davis (Chicago Booth & NBER)

Hoover Institution, Friday December 2nd 2011

The paper tries to investigate the claim that policy uncertainty contributed to the recession of 2008-2009

We find three preliminary results:

1. Policy uncertainty fluctuates over time, and since 2008 has reached all-time high levels

2. Policy uncertainty is now a large (and probably the largest) driver of overall economic uncertainty

3. Policy uncertainty appears to lower economic growth and raise stock-market volatility

We find three preliminary results:

1. Policy uncertainty fluctuates over time, and since 2008 has reached all time high levels

2. Policy uncertainty is now a large (and probably the largest) driver of overall economic uncertainty

3. Policy uncertainty appears to lower economic growth and raise stock-market volatility

The paper tries to investigate the claim that policy uncertainty deepened the recession of 2008-2009

Figure 1: Our main index of policy uncertaintyP

olic

y U

nc

ert

ain

ty In

de

x

1st Gulf War9/11Clinton Election

2nd Gulf War

Bush Election

Balanced Budget Act

Lehman and

TARP

Euro Crisis, 2010

Midterms

Large interest

rate cuts, Stimulus

Banking Crisis, Obama Election

Debt Ceiling;

Euro Debt

Source: “Measuring Economic Policy Uncertainty” by Scott Baker, Nicholas Bloom and Steven J.Davis, November 2011, at http://faculty.chicagobooth.edu/steven.davis/pdf/PolicyUncertainty.pdf.

Our economic policy uncertainty index is built from three sub-components

1. Newspaper coverage of policy-related economic uncertainty

2. Number of federal tax code provisions set to expire

3. Disagreement among economic forecasters over future:

a. levels of the CPI

b. federal government purchases of goods & services

The overall index is constructed from a 50% weight on the broad newspaper index and equal weight on the others (but results are pretty robust to different weighting measures)

Sub-component 1): News-based policy uncertainty indexP

olic

y U

nc

ert

ain

ty N

ew

s In

dex

1st Gulf War

9/11

Clinton Election

2nd Gulf War

Bush Election

Interest Rates,

Stimulus

Lehman and

TARP

Euro Crisis, 2010

Midterm

Russian Crisis/LTCM

Debt Ceiling;

Euro Debt

Obama Election, Banking

Crisis

Notes: Frequency of the triple of “economy/economic”, “uncertain/uncertainty” and one of a collection of policy terms (policy, regulation, federal reserve tax, spending, budget and deficit) in US Google news normalized by the smoothed frequency of the word “today”. Normalized to 100.

Fin

anci

al U

nce

rtai

nty

Ind

ex

1st Gulf War

9/11

Lehman Bankruptcy

2nd Gulf War

Asian Crisis

Russian Crisis/LTCMBlack Monday

Check of news based indices example: tracking financial uncertainty

Notes: Frequency of the triple of “economy/economic”, “uncertain/uncertainty” and one of a collection of financial market terms (e.g. stock price, equity price, stock market etc ) in US Google news normalized by the smoothed frequency of the word “today”. Both series scaled to same mean.

Wa

r a

nd

Te

rro

r U

nc

ert

ain

ty I

nd

ex

Notes: News-Based War and Terror Uncertainty Index composed of monthly number of news articles containing uncertain or uncertainty as well as the term ‘war’ or ‘terror’ (scaled by the smoothed number of articles containing ‘today’). Google query run June 15, 2011. Index covers January 1985-May 2011

1st Gulf War

2nd Gulf War

9/11

Bush Election

Check of news based indices example: tracking war and terror uncertainty

Notes: Utilizes List of Tax Expirations from the Joint Committee on Taxation. Each year’s forecast is a 10-year horizon of expiring tax laws. Future expirations weighted by 0.5^((T+1)/12) where T is the number of months until the tax expires

Tax

Le

gis

lati

on

Ex

pir

atio

n I

nd

exSub-component 2) Tax expiration index

Indexes of Scheduled Tax Code ExpirationsBased on CBO Data, Preliminary

Our dollar (rather than equal) weighted tax expiration index shows an even steeper rise

Notes: From the Philadelphia Federal Reserve Survey of Professional Forecasters. Takes the interquartile (IQ) range of the 1-year ahead forecasts (made every quarter) of total federal government expenditures relative to the mean forecast. Normalized to a mean 100 index prior to Aug 2011.

Sub-component 3a): CPI disagreement indexC

PI F

ore

cast

ers

IQ R

ang

e In

dex

2nd Gulf War/Fed Drops Interest Rates

1st Gulf War

Clinton Election

Obama Election, Banking

Crisis

Balanced Budget Act

Budget Battle

Fed

eral

Exp

end

itu

res

Fo

reca

ster

s IQ

Ran

ge

Ind

ex

Balanced Budget Act

Clinton Election

9/11

Budget Battle

Obama Election,

Banking Crisis

Notes: From the Philadelphia Federal Reserve Survey of Professional Forecasters. Takes the interquartile (IQ) range of the 1-year ahead forecasts (made every quarter) of total federal government expenditures relative to the mean forecast. Normalized to a mean 100 index prior to Aug 2011.

Sub-component 3b): Federal expenditure disagreement

1. Policy uncertainty fluctuates over time, and since 2008 has reached all time high levels

2. Policy uncertainty is now a large (and probably the largest) driver of overall economic uncertainty

3. Policy uncertainty appears to lower economic growth and raise stock-market volatility

Figure 6: Overall & Policy-Related Economic UncertaintyN

orm

ali

zed

Nu

mb

er

of

Ne

ws

Art

icle

s

Notes: Overall News-Based Economic Uncertainty Index composed of monthly number of news articles containing uncertain or uncertainty as well as economic or economy (scaled by the smoothed number containing ‘today’). Policy Index set such that monthly average value is 100. Index covers January 1985-July 2011. Axis shown as a log scale. Query run on August 11, 2011.

Bush Election

Asian Financial Crisis

Gulf War I

Russian Financial

Crisis/LTCM

Clinton Election

Dissolution of USSR

1987 StockMarket Crash

Recession Fears

Recession Fears

Note: analysis uses Google news index data

Another indicator of the importance of policy uncertainty is it now seems to be the most frequent factor causing stock-market jumps

Frequency of 2.5% or greater jumps in the S&P 500 stock market index and the factors underlying this

1. Policy uncertainty fluctuates over time, and since 2008 has reached all time high levels

2. Policy uncertainty is now a large (and probably the largest) driver of overall economic uncertainty

3. Policy uncertainty appears to lower economic growth and raise stock-market volatility

Why might uncertainty impact the real economy?

Economics literature has mainly focused on three channels:

• “Real-options effects”: Uncertainty can make firms cautious about investing and hiring

• “Financing costs”: Uncertainty can increase risk-premia

• “Precautionary savings”: Uncertainty can reduce consumption

Figure 8: VAR Estimated Industrial Production and Employment changes after a Policy Uncertainty Shock

Ind

ust

rial

Pro

du

ctio

n Im

pac

t(%

dev

iati

on

) Notes: This shows the impulse response function for Industrial Production and employment to an 124 unit increase in the policy-related uncertainty index, the increase from 2006 (the year before the current crisis) until the first 8 months of 2011. The central (black) solid line is the mean estimate while the dashed (red) outer lines are the one-standard-error bands. Estimated using a monthly Cholesky Vector Auto Regression (VAR) of the uncertainty index, log(S&P 500 index), federal reserve funds rate, log employment, log industrial production and time trend. Data from 1985 to 2011.

Em

plo

ymen

t Im

pac

t(m

illio

ns)

-5-4

-3-2

-10

12

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36

-3-2

-10

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36

Months

Months

Policy uncertainty also seems to make stock markets more risky (as stocks move together more)

Reproduced from “Political Uncertainty and Risk Premia,” by Lubos Pastor and Pietro Veronesi, University of Chicago, 20 November 2011. “Political UncertaintyIndex” is the Economic Policy Uncertainty Index from Baker, Bloom and Davis.

Conclusion

We are developing a methodology to try and measure economic policy uncertainty over time, with three preliminary results:

• Policy uncertainty since 2008 has been at all time high levels

• Policy uncertainty is now a large component (potentially the largest component) of general economic uncertainty

• Higher policy uncertainty is followed by reduced growth over the following 18 months and increased stock co-movement

Continuing to refine the index and extend it back to about 1900

BACK-UP SLIDES

More on Economic Policy Uncertainty

Paper:

“Measuring economic policy uncertainty”, Scott Baker, Nick Bloom and Steve Davis, Stanford mimeo

http://www.stanford.edu/~nbloom/PolicyUncertainty.pdf

“Policy Uncertainty and the Stalled Recovery,” Scott R. Baker, Nicholas Bloom and Steven J. Davis, VOX, 22 October 2011.

http://voxeu.org/index.php?q=node/7137

Figure 7: Relationship of News-Based Index of Overall Economic Uncertainty to News-Based Index of Policy-Related Economic Uncertainty

R-Squared: 0.68Slope: 0.79 (0.05)

R-Squared: 0.88Slope: 0.98 (0.03)

R-Squared: 0.53Slope: 1.50 (0.19)

Figure 9: Robustness of Estimates to Different VAR Specifications

Months after the policy uncertainty shockNotes: This shows the impulse response function for GDP and employment to an 124 unit increase in the policy-related uncertainty index. Estimated using a monthly Cholesky Vector Auto Regression (VAR) of the uncertainty index, log(S&P 500 index), federal reserve funds rate, log employment, log industrial production and time trend unless otherwise specified. Data from 1985 to 2011.

Ind

ust

rial

Pro

du

ctio

n Im

pac

t(%

dev

iati

on

)

BaselineReverse order

Bivariate (uncertainty and log industrial production)

-5-4

-3-2

-10

Est

imat

ed im

pact

on

indu

stria

l pro

duct

ion

0 5 10 15 20 25 30 35

Three months of lags

Nine months of lags

Uncertainty index has equal weight on measures

Adding VIX first as a control for economic uncertainty

Figure 10: Quarterly VAR estimates for GDP and investment

Months after the policy uncertainty shock

GD

P Im

pac

t(%

dev

iati

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)

-4-3

-2-1

0

0 2 4 6 8 10 12

Inve

stm

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Imp

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(% d

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Notes: Shows the impulse response function to an 124 unit increase in the policy-related uncertainty index, the increase from 2006 (the year before the current crisis) until the first 8 months of 2011. The central (black) solid line is the mean estimate while the dashed (red) outer lines are the one-standard-error bands. Estimated using a quarterly Cholesky VAR: the uncertainty index, log(S&P 500 index), federal reserve funds rate, log employment, log investment, log consumption and log GDP. Data from 1985 to 2011.

-20

-15

-10

-50

5

0 2 4 6 8 10 12

Figure 11: Estimates after including controls for consumer confidence

Months after the economics policy uncertainty shock

-5-4

-3-2

-10

12

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36

-5-4

-3-2

-10

12

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36

Notes: This shows the impulse response function for Industrial Production and employment to an 124 unit increase in the policy-related uncertainty index, the increase from 2006 (the year before the current crisis) until the first 8 months of 2011. The central (black) solid line is the mean estimate while the dashed (red) outer lines are the one-standard-error bands. Estimated using a monthly Cholesky Vector Auto Regression (VAR) of the uncertainty index, log(S&P 500 index), federal reserve funds rate, log employment, log industrial production and time trend. Data from 1985 to 2011. Top panel includes the Michigan Consumer confidence index included as the second variable after our uncertainty index, and the bottom panel includes the Michigan Consumer Confidence index included as the first variable.

Ind

ust

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Pro

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pac

t(%

dev

iati

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)Consumer confidence included second in the VAR

Consumer confidence included first in the VAR

Ch

ina

and

Jap

an C

om

pet

itio

n In

dex

Figure 13: News-Based China and Japan Competition Indexes

Notes: News-Based China and Japan Competition Index composed of monthly number of news articles containing competition and economy and Japan or China (scaled by the smoothed number of articles containing ‘today’). Query run August 26, 2011. Index covers Jan 1985-Aug 2011.

Appendix Figure A1: News-Based Energy Uncertainty IndexE

ne

rgy

Un

ce

rta

inty

In

de

x

Notes: Energy Uncertainty Index composed of monthly number of news articles containing uncertain or uncertainty as well as the term ‘energy’ (scaled by the smoothed number of articles containing ‘today’). Google query run June 15, 2011. Index covers January 1985-May 2011

1st Gulf War2nd Gulf War

Arab Spring

Oil Spike

Oil Spike

Appendix Figure A3: News-Based Middle East Uncertainty IndexM

idd

le E

as

t U

nc

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Notes: News-Based Middle East Uncertainty Index composed of monthly number of news articles containing uncertain or uncertainty as well as the term ‘Middle East’ (scaled by the smoothed number of articles containing ‘today’). Google query run June 15, 2011. Index covers January 1985-May 2011

1st Gulf War

9/11

2nd Gulf War

Arab Spring

Po

lic

y U

nc

ert

ain

ty I

nd

ex

1st Gulf War

9/11Clinton Election

2nd Gulf War

Bush Election

Balanced Budget Act

Lehman and

TARP

Budget Battle

Appendix Figure A4: Equal Weighted Indexof Economic Policy Uncertainty

Euro Crisis, 2010

Midterms

Stimulus Debate

Obama Election, Banking Crash

Debt Ceiling;

Euro Debt

Notes: Index of Policy-Related Economic Uncertainty composed of 4 series: monthly news articles containing uncertain or uncertainty, economic or economy, and policy relevant terms (scaled by the smoothed number of articles containing ‘today’); the number of tax laws expiring in coming years, and a composite of IQ ranges for quarterly forecasts of federal government expenditures and 1-year CPI from the Phil. Fed Survey of Forecasters. Weights: .33 Google News, .33 tax expirations, .167 CPI disagreement, .167 Fed. expenditures after each index normalized to have a standard-deviation of 1. Google query run August 11, 2011, updated Sept 25 and Nov 8. Index normalized mean 100 before Aug 2011.

Po

lic

y U

nc

ert

ain

ty I

nd

ex

1st Gulf War 9/11Clinton Election

2nd Gulf War

Bush Election

Lehman and

TARP

Appendix Figure A5: Principal Component WeightedIndex of Economic Policy Uncertainty

Euro Crisis, 2010

Midterms

Stimulus Debate

Obama Election, Banking Crash

Notes: Index of Policy-Related Economic Uncertainty composed of 4 series: monthly news articles containing uncertain or uncertainty, economic or economy, and policy relevant terms (scaled by the smoothed number of articles containing ‘today’); the number of tax laws expiring in coming years, and a composite of IQ ranges for quarterly forecasts of federal government expenditures and 1-year CPI from the Phil. Fed Survey of Forecasters. Weights: .35 Google News, .37 tax expirations, .24 CPI disagreement, .04 Federal exp. disagreement after each index normalized to have a standard-deviation of 1. Google query run August 11, 2011, updated Sept 25 and Nov 8. Index normalized mean 100 before Aug 2011.

Debt Ceiling;

Euro Debt

Google economic policy uncertainty citation index is highly correlated with a narrower 5-paper index

5 paper index is the frequency of “uncertain”, “economic/y” and our key policy terms in the USA Today, Miami Herald, LA Times, Wash Post, and Chicago Tribune, normalized by “today”

Correlation=0.82