US Economic Recovery and Risk of Policy Gridlock

by Don Alexander
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

The US recovery is painfully slow and monetary policy is at its limits in a balance sheet recession. Pervasive economic uncertainty appears to be holding the US back in terms of lost output and job creation. But what is the root cause of this uncertainty?

This is what Nicholas Bloom, Scott Baker, Steven J. Davis, John Van Reenen attempt to answer in a VOXEU communique dated Oct. 29^th called  Economic recovery and policy uncertainty in the US . The authors argue that a polarized political system is to blame. Without a political mechanism that incentivizes the election of moderate politicians, the authors predict further political divergence between Republicans and Democrats and a consequent intensification of policy uncertainty.

There are several potential causes of slow recovery:  (1.) one explanation attributes low demand to the financial crisis and the consequent dislocation of capital markets.   Although monetary policy has been aggressive, it has reached its limits as quantitative easing has hit a point of diminishing returns. (2.) An additional explanation in this demand-shock story is an increase in uncertainty. Uncertainty can retard both investment and hiring as firms become reluctant to make costly decisions.

Greater uncertainty increases risk premiums in financial markets which in turn raises the cost of borrowing for firms and households.  Previous research has identified additional mechanisms whereby uncertainty undermines macroeconomic performance. The authors find that high levels of policy uncertainty foreshadow lower levels of output, investment, and employment.  In recent months, uncertainty about the US election and the ‘fiscal cliff’ has contributed to a recurrence of policy uncertainty.

The authors try to separate the effect of policy uncertainty from other factors, such as low demand and estimate that the increase in policy uncertainty after 2007 reduced employment by 2.3 million.

The authors blame high levels of policy uncertainty with both political parties. However, politicians see it otherwise: Republicans are blaming the President and Democrats for creating regulatory uncertainty, and failing to face up to the main long-term social programs causing rising debt. Democrats accuse Republicans of obstructionism on tax and spending cuts while not providing meaningful details on their healthcare reform proposals and fiscal programs.

This move to the extremes can be partly explained by the ability of incumbents to gerrymander political districts, that is, to change Congressional district boundaries along partisan lines in order to maximize an incumbent’s chances of re-election. Gerrymandering, in turn, encourages primary election campaigns that focus on appealing to extreme political bases rather than moderate voters.

It is unclear whether the November elections will significantly alleviate US policy uncertainty.  A clear victory for one party could greatly clarify the policy outlook, but that outcome appears unlikely based on polling data.  Regardless of who wins the presidency, the two houses of Congress are likely to remain divided by party.  Thus, the increasing political polarization of the last 30 years is also very likely to continue.  Until the advent of a political mechanism that creates incentives to elect moderate representatives who can reach across the ideological divide, it seems the US is destined to entrench high levels of policy uncertainty with below trend output growth and job creation.

www.voxeu.org/article/economic-recovery-and-policy

Policy uncertainty website:  www.policyuncertainty.com