Indecisive economic policy takes a lasting toll on financial markets

October 31, 2012

Politicians like to champion the enactment of decisive economic policy—so long as it’s their party that gets to decide.

Partisan squabbling aside, there's a real cost to government dithering. According to a new study from the University of Washington Foster School of Business, excessive debate and/or ambiguity on national tax, spending, regulation and debt decisions creates an environment of uncertainty that has an ill effect on financial markets. And this malaise can outlast the uncertainty itself.

The study—by Jonathan Brogaard, an assistant professor of finance, and Andrew Detzel, a doctoral student at Foster—demonstrates that when economic policy uncertainty increases, asset prices fall concurrently, and market volatility jumps significantly. What’s more, the negative effect of government-induced uncertainty persists.

“We’re finding,” says Brogaard, “that the lack of a decision can be just as bad as a bad decision.”

Measuring uncertainty

Many academic studies have sought to pinpoint the economic toll of policy uncertainty. Brogaard and Detzel are the first to connect a high-frequency measure with its effect on that most telling gauge of the economy: the financial markets.

They might have zeroed in on particularly contentious moments in recent policy history: Iraq war funding, Sarbanes-Oxley and Dodd-Frank reforms, the Affordable Care Act, the debt ceiling crisis, the sunsetting of Bush-era tax credits.

Instead, they measured uncertainty itself. Brogaard and Detzel built a web crawler that captures media mentions of terms commonly associated with economic policy uncertainty. The crawler scanned millions of articles in prominent magazines and newspapers over a 20-year period, monitoring the frequency of policy uncertainty reported in 21 geographically dispersed nations, among them the United States.

Separating policy uncertainty from trigger events affords a clearer picture of the life cycle of economic policy uncertainty. It allows for continuous tracking that takes into account periods of policy debate, inaction, inclusive action, ineffectual action, and anxiety over the need for future action.

“The passing of a bill does not necessarily indicate the resolution of all uncertainty,” Brogaard says.

Downside of dithering

Once they identified periods of heightened uncertainty about economic policy, Brogaard and Detzel analyzed the corresponding stock market returns representing each nation in the study. An uptick in uncertainty sinks asset prices across the economy.

The reason, Brogaard explains, is that nationwide uncertainty signals a decrease in future cash flows and an increase in the risk premium—the amount an investor demands to hold an asset. On average, the cash flow impact lasts six months and the risk premium is heightened for over a year. The overall negative effect can last long beyond the period of uncertainty caused by any specific policy event.

“The shock persists,” Brogaard says.

Safe harbors?

In addition to looking at the markets as a whole, Brogaard and Detzel found that individual firms have differing exposures to economic policy uncertainty. They even ranked firms according to their degree of exposure. High exposure means a firm is more likely to be negatively affected by shocks in economic policy uncertainty; low exposure means its more protected.

This EPU “score” can be used as a trading strategy, according to Brogaard. By investing in companies with high exposure to economic policy uncertainty and selling short those with low exposure, investors can generate high abnormal returns.

“Over time, investors are compensated for holding this type of risk,” he says. “While individuals can profit from this uncertainty, the overall economy suffers because firms’ cost of capital increases.”

Policy implications

The study’s message to policy makers is clear: be more decisive.

This is certainly a tall order in a democracy, especially a democracy as starkly polarized as the American variety. Brogaard says that the United States is about average in its amount of government indecision among the 21 nations in the study. But with federal, state and local government expenditures comprising more than 42 percent of the nation’s GDP in 2009, “the ubiquity of US government policy makes it very hard to diversify against uncertainty,” Brogaard adds.

And uncertainly is growing. While marking its frequency across 20 years of media reports, Brogaard and Detzel charted a recent rise in American economic policy uncertainty over the past five years, and a spike since 2008.

Something to consider as the nation hurtles toward a “fiscal cliff” of automatic tax hikes and spending cuts set to begin in 2013 unless Congress takes action. Decisive action would be best.

“Any new bout of economic policy uncertainty will have market implications,” Brogaard says. “And they will last a long time.”