Policy uncertainty: trying to estimate the

uncertainty impact of Brexit

Scott Baker (Northwestern), Nick Bloom (Stanford) and

Steve Davis (Chicago)

September 2nd 2016

1) Measuring policy uncertainty

2) Evaluating our measure

3) Estimating the uncertainty impact of Brexit

Our proxy for Economic Policy Uncertainty (EPU)

comes from computer searches of newspapers

• For 10 major US papers get monthly counts of articles with:

E {economic or economy}, and

P {regulation or deficit or federal reserve or congress or legislation or white house}, and

U {uncertain or uncertainty}

• Divide the count for each month by the count of all articles

• Normalize and sum 10 papers to get the U.S monthly index

50

10

015

020

025

030

0

1985 1990 1995 2000 2005 2010 2015

Gulf

War I

9/11

Clinton

Election

Gulf

War IIBush

Election

Stimulus

Debate

Lehman

and TARP

Russian

Crisis/LTCM

Debt Ceiling

Debate

Black

Monday

Fis

cal C

liff

Shutd

ow

n

Po

licy U

ncert

ain

ty I

nd

ex

US News-based economic policy uncertainty index

Source: “Measuring Economic Policy Uncertainty” by Scott R. Baker, Nicholas Bloom and Steven J. Davis, all data at

www.policyuncertainty.com. Monthly data normalized to 100 prior to 2010. Data to July 2016

Bre

xit

Can focus on narrower areas or economic policy

uncertainty, e.g. : Defense and Healthcare0

10

02

00

30

04

00

1985 1990 1995 2000 2005 2010 2015Year

Defense Uncertainty

Health Uncertainty

Cate

go

rical

Po

licy U

ncert

ain

ty I

nd

exes

Gulf War I

Gulf War II

9/11Clinton healthcare

initiative

Affordable

care act

5Source: “Measuring Economic Policy Uncertainty” by Scott R. Baker, Nicholas Bloom and Steven J. Davis, all

data at www.policyuncertainty.com. Data normalized to 100 prior to 2010.

0

20

040

060

080

010

00

1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

UK Policy Uncertainty Index – striking Brexit spike

Source: www.policyuncertainty.com. Monthly data from 2 UK newspapers (Times and Financial

Times). Data to July 2016

Po

licy U

ncert

ain

ty I

nd

ex

Treaty of

Accession/

Gulf War II

Russian

Crisis/LTCM

Northern

Rock &

Global

Financial

Crisis

General

Election

Euro Crisis

Scottis

h R

efe

rendum

9/11

Ele

ctio

n b

uild

-up

Brexit

020

040

060

080

010

00

UK

EP

U inde

x

02

46

810

BoE

unce

rta

inty

in

de

x

2000 2002 2004 2006 2008 2010 2012 2014 2016

News EPU index vs the Bank Uncertainty Index

Source: Data to July 2016. Thanks to Phil Bunn for BoE data

Correlation=0.458 (p-value 0.001)

0.2

.4.6

01

00

20

03

00

1885 1895 1905 1915 1925 1935 1945 1955 1965 1975 1985 1995 2005

Notes: Index of Policy-Related Economic Uncertainty composed of quarterly news articles containing uncertain or uncertainty, economic or

economy, and policy relevant terms (scaled by the smoothed total number of articles) in the Guardian and the Times

UK Policy Uncertainty since 1885 – even against this

Brexit looks like a large uncertainty shock

3-day week

and 2 national

elections

ERM exit,

Major

election

Thatcher

forced to

resign

Falklands warAtlee-

Churchill

election

Pound

devalues

30%

Boer war

Start of

WWI

Start of

WWII

MacMillan

resigns

Irish

war

IMF

crisis

Salisbury

loses NCV

Salisbury

resignation

040

80

12

016

0

0

50

010

00

15

00

20

00

2002 2004 2006 2008 2010 2012 2014 2016Year

UK Daily EPU: large Brexit shock in EPU news index

but no stock-market volatility shock

Source: www.policyuncertainty.com. Data from Access World News database on 650 UK

newspapers. Daily data to August 25th 2016

Daily

New

s P

olic

y U

ncert

ain

ty I

ndex

Daily

Implie

d V

ol In

dex (IV

I)

0

10

020

030

040

0

1998 2000 2002 2004 2006 2008 2010 2012 2014 2016Year

Po

licy

Un

cert

ain

ty I

nd

ex

9/11

Papandreou calls

for referendum,

then resignsLehman

Bros.Greek

Bailout

Request,

Rating

Cuts

Northern

Rock &

Ensuing

Financial

Turmoil

Treaty of

Accession/

Gulf War II

Nice Treaty

Referendum

Source: www.policyuncertainty.com. From 10 papers (El Pais, El Mundo, Corriere della Sera, La

Repubblica, Le Monde, Le Figaro, the Financial Times, Times, Handelsblatt, FAZ.) Data to July 2016

Russian

Crisis/LTCM French &

Dutch Voters

Reject

European

Constitution

Ongoing

Eurozone

Stresses

European Economic Policy Uncertainty IndexBrexit

1) Measuring policy uncertainty

2) Evaluating our policy uncertainty measure

3) Estimating the uncertainty impact of Brexit

A) Evaluation of Policy Uncertainty Index: Market Use

Market use suggests some information in our EPU data

I) Numerous users including: Goldman Sachs, Citibank, JP

Morgan, Blackrock, Wells Fargo, IMF, Fed, ECB etc

II) This has led Bloomberg, FRED, Reuters and Haver to stream

our data for their financial and policy users

B) Evaluation: comparison to stock volatility (e.g. VIX)

10

20

30

40

50

60

50

10

01

50

20

02

50

30

0

1990 1995 2000 2005 2010 2015

US

VIX

(re

d)

US

Ec

on

om

ic P

olic

y U

nc

ert

ain

ty In

de

x (

Blu

e -

--) 9/11

WorldCom

Fraud

Gulf

War II

Lehman

Failure, TARP

Asian

Financial

Crisis

Gulf

War I

Euro-

zone

Crisis

Debt Ceiling

Dispute

Russian

Crisis,

LTCM

DefaultStimulus

DebateClinton

Election

Notes: The figure shows the U.S. EPU Index from Figure 1 and the monthly average of daily values for the 30-day VIX.

Bush

Election

Fis

ca

l C

liff

Go

ve

rnm

en

t

Sh

utd

ow

n

C) Running Detailed Human Audits

10 undergraduates read ≈ 10,000 newspaper articles to date using a 63-page audit guide to code articles if they discuss “economic uncertainty” and “economic policy uncertainty”

14

Find humans and computers give similar results in

large samples (in fact both make mistakes)

Po

lic

y U

nc

ert

ain

ty I

nd

ex

01

00

20

03

00

1985 1990 1995 2000 2005 2010

Computer

Human

Correlation=0.76

1) Measuring policy uncertainty

2) Evaluating our measure

3) Estimating the uncertainty impact of Brexit

Best guess using VARs based on the Baker,

Bloom and Davis (2016) numbers

• BBD (2016) estimated impact of Great Recession (GR) shock

• GR raised global EPU by 100 points (2011-12 vs 2005-06)

• Brexit raised UK EPU probably by 800 points at maximum, but probably 200 points on average (Q3 2016 to Q2 2017)?

• Both shocks have possibly similar persistence, but Brexit is national (GR was global) so maybe scale down Brexit impact?

• So our guess is uncertainty impact Brexit GR impact, but very hard to tell – large, unprecedented uncertainty shock

Ind

ustr

ial

Pro

du

cti

on

, (%

)

Months after the economics policy uncertainty shock

Notes: Plots the impulse

response function for

Industrial Production and

employment to an increase

in the policy-related

uncertainty index from the

2005-2006 average value to

the 2011-2012 average

value. The central (black)

solid line is the mean

estimate while the dashed

(red) outer lines are the 90%

confidence bands.

Estimated using a monthly

Cholesky Vector Auto

Regression (VAR) with 3

lags on the EPU index,

log(S&P 500 index),

unemployment rate, and log

industrial production, plus a

full set of country, year and

month fixed-effects. Country

data weighted by the

number of newspapers used

to make the EPU series. Fit

to monthly data from

1985M1 to 2012M12 where

available. Estimated on data

from Canada, China,

France, Germany, India,

Italy, Japan, Korea, Russia,

Spain, UK and the USA.Un

em

plo

ym

en

t Im

pac

t, (

%)

0.1

.2.3

.4

0 6 12 18 24 30 36

-1.5

-1-.

50

0 6 12 18 24 30 36

12 country VAR for Great Recession (from BBD 2016)

Assuming Brexit similar impact predicts drop

of up to 1% (vs trend) in Q42016 & Q1 2017

Ind

ustr

ial

Pro

du

cti

on

, (%

)

Months after the economics policy uncertainty shock

Em

plo

ym

en

t Im

pact,

(%

)UK VAR for Great Recession – but small sample so

large standard errors, so I prefer 12 country sample-4

-3-2

-10

0 6 12 18 24 30 36month

0.2

.4.6

.8

0 6 12 18 24 30 36month

Notes: Plots the impulse

response function for

Industrial Production and

employment to an increase

in the policy-related

uncertainty index from the

2005-2006 average value to

the 2011-2012 average

value. The central (black)

solid line is the mean

estimate while the dashed

(red) outer lines are the 90%

confidence bands.

Estimated using a monthly

Cholesky Vector Auto

Regression (VAR) with 3

lags on the EPU index,

log(S&P 500 index),

unemployment rate, and log

industrial production, plus a

full set of country, year and

month fixed-effects. Country

data weighted by the

number of newspapers used

to make the EPU series. Fit

to monthly data from

1985M1 to 2012M12 where

available. Estimated on

data from the UK only

Assuming Brexit similar impact predicts drop

of up to 2% (vs trend) in Q42016 & Q1 2017

-8-6

-4-2

0

0 6 12Quarters

-2-1

.5-1

-.5

0

0 6 12Quarters

US VAR for Impact on GDP and Investment (quarterly)G

DP

Re

sp

on

se

, %

Notes: VAR-estimated

impulse response

functions for GDP and

Gross Fixed

investment to an EPU

innovation equal to the

increase in the EPU

index from its 2005-

2006 to its 2011-2012

average value, with 90

percent confidence

bands. Identification

based on three lags

and a Cholesky

decomposition with the

following ordering:

EPU index, log(S&P

500 index), federal

reserve funds rate, log

gross investment, log

gross domestic

product). Fit to data

from 195 to 2014.

Investm

en

t R

esp

on

se,

%

Assuming Brexit similar impact predicts GDP

drop of 1% (vs trend) in Q42016 & Q1 2017

-6-4

-20

0 6 12Quarters

Investment is the part of GDP that reacts by far the

most - I think because investment is dominated by

larger firms, which are forward lookingNotes: VAR-

estimated impulse

response functions

for GDP,

Consumption and

Gross Fixed

investment to an

EPU innovation

equal to the

increase in the EPU

index from its 2005-

2006 to its 2011-

2012 average

value, with 90

percent confidence

bands. Identification

based on three lags

and a Cholesky

decomposition with

the following

ordering: EPU

index, log(S&P 500

index), federal

reserve funds rate,

log gross

investment, log

gross domestic

product). Fit to data

from 195 to 2014.

Investment

GDP

Consumption

%Im

pa

ct

Conclusions

- Policy uncertainty rose dramatically globally after Brexit,

particularly in the UK

- Estimating the impact is frankly very hard! For the UK maybe

a 1% hit to GDP (would be bigger except offsetting exchange

rate and interest rate movements)

- Likely to be spread out over the next year, with initial impact in

production side of economy followed by household side

Prior Q&A

Q1) What are the best uncertainty measures to look at?

A) Given implied volatility did not rise post Brexit, we are less

keen on this. News feels attractive as focused on current beliefs

Q2) Will uncertainty metrics (news, IVI etc) capture uncertainty

around Brexit?

A) Probably not – this is a unique event and these are only

rough measures. News at least has the ability to search by word

Q3) How should uncertainty metrics evolve over next few years?

A) Hard to tell – except for the Great Recession, prior uncertainty

shocks have been very quick, but Brexit likely to persist, I fear

Prior Q&A

Q4) How quickly will Brexit uncertainty show in the data?

A) Firms likely to respond far faster (although exchange rate

drop at same time). Consumers probably only respond when

employment and wages respond, so with 1 or 2 quarters lag

Q5) How does Brexit interact with credit (is it a credit shock)?

A) Credit conditions likely to worsen as the left tail of outcomes

have grown. Recently working on “The uncertainty-finance

multiplier” & seems real and financial frictions amplify each other

Q6) Will uncertainty impact supply side (e.g. via productivity)

A) Probably, but evidence limited. Uncertainty likely to

particularly reduce most irreversible investment – R&D, training,

management reorganizations – which will would cut TFP growth

Prior Q&A

Q7) What channels will Brexit work through – e.g. housing?

A) My guess is that commercial property will be hit (firms are

forward looking) but private housing hit only once the economy

starts to drop (consumers less forward looking). Also vary

heavily by sector because of large exchange rate cut.

Q8) Is the uncertainty impact different from the direct impact?

A) Historically all uncertainty shocks if the data are bad news, so

have a direct and an uncertainty component. In the case of

Brexit I would think the uncertainty component is particularly

large early on (not much has happened) and direct effects larger

later.