by Don Alexander, MBA
Associate, RSD Solutions Inc.
The waning confidence in US political leadership threatens global financial markets as the super committee has failed to reach a plan for deficit reduction. This failure is leading investors to wonder how long the debt overhang will impact the struggling economy. There is concern that an impasse could last until the November 2012 election as politicians haggle over mandatory spending cuts.
The political gridlock in Washington has a cost and that is the focus of this communique. There are two lessons for risk management: decision paralysis has a cost and an adverse incentive system can lead to gridlock. This outcome would not be tolerated in the private sector.
In a recent column, we reviewed the cost of policy uncertainty. Policy uncertainty and the stalled recovery (Scott Baker, Nicholas Bloom & Steve Davis, VOXEU, October 22nd). The authors distinguish between economic uncertainty and economic policy uncertainty, constructing an index to measure policy-related uncertainty and argue that reducing policy uncertainty would raise output and add dramatically to job creation.
Prior to the financial crisis of 2008, stock markets moved in response to economic numbers such as GDP or employment and corporate earnings. But today, it is politicians and government regulators making comments about bailouts, budgets and regulatory reforms that are driving the markets. As a result of diverse comments from politicians and government officials, have generated massive economic uncertainty. This policy uncertainty is a key factor in stalling the recovery and contributing to the risk of a double dip.
Baker et al constructed a new index of US policy uncertainty by combining three types of information: frequency of articles that reference economic uncertainty and policy, references to expiration of various federal tax code provisions and disparity among forecasts about inflation and government purchases of goods and services. In addition, the authors are able to separate an indicator of economic uncertainty from that of policy uncertainty. They note the key drivers of policy uncertainty are dominated by monetary and tax issues. When businesses and investors are uncertain about taxes, health care costs, budget prospects and regulatory initiatives, they adopt a cautious stance. They find it costly to make a hiring or investment mistake, waiting for calmer times to expand or consider riskier investments.
As a result, the recovery never takes off as business remains cautious on making investments in capital goods, research and worker training – key determinants for long-run sustainable growth. Investors remain on the sidelines in “safe” investments avoiding risk. The authors noted that if their index for policy uncertainty was restored to 2006 levels, it could result in a rise of industrial production by 4% and the creation of 2.5 million jobs over 18 months. This may not be enough to create a booming economy, but it is a step in the right direction.
The lesson for the continued political fiasco is that it comes at a cost. The lesson for risk management is that inaction on risk mitigation also has a cost.
For more on this follow the link: www.voxeu.org/index.php?q=node/7137
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