EUROPE teeters at the edge of an
economic abyss, its fate in the hands of political leaders at odds over how to
solve the continent’s twin debt and bank crises. America may be pushed over a
“fiscal cliff” at the end of the year by political dysfunction.
And even China, although unlikely
to take a deep dive, is hostage to the will and ability of its government to
stimulate growth. More than at any point in recent history, the global
economy’s fate is tied to the capriciousness of policymakers.
How much does
such uncertainty cost?
Anecdotal evidence suggests that
it costs a lot. Customers of Cisco Systems, the world’s biggest maker of
internet gear, are taking longer to make decisions, according to John Chambers,
the company’s boss.
Their orders tend to be smaller than before, and to require
more in-house approvals. They say they are planning to buy more stuff later
this year, reported Mr Chambers recently, but “then in the very next breath
they say it depends on what happens on a global and macro scale.”
In Europe firms must reckon not
only with recession but also with the risk that their investments may be
redenominated in a different currency or locked in by capital controls. Robert
Bergqvist of SEB, a Swedish bank, says that several Swedish corporate customers
have put investment projects on hold because they don’t know how the euro
crisis will unfold.
If America falls over the “fiscal
cliff”, it would suffer a fiscal squeeze of 5% of GDP, easily enough to push
the economy into recession. Last summer, as America’s government came
perilously close to exhausting its legal authority to borrow, Barack Obama and
Republicans in Congress could not resolve their fiscal differences. Instead,
they kicked the can down the road, agreeing on huge automatic spending cuts
that would start on January 2nd, just as all of George Bush’s tax cuts are due
to expire, along with a separate temporary payroll tax cut.
No deal to avoid this double
whammy is likely before the November 6th election. So any firm that sells to
the federal government is left in limbo. Mike Lawrie, head of Computer Sciences
Corporation, a big technology-services firm, recently told investors: “I just
don’t know what’s going to happen...None of us [knows].” The debt-ceiling
showdown makes last summer’s weak economy weaker, said James Tisch, the boss of
Loews Corporation, a conglomerate, last month. And “this fiscal cliff is the
summer of ’11 but on steroids.”
Economists have long suspected
that uncertainty could hurt growth. John Maynard Keynes said investment was
based on expectations that are “subject to sudden and violent changes”. In a
1980 paper Ben Bernanke, now chairman of the Federal Reserve, formalised this
effect: since most investment is irreversible, uncertainty “increases the value
of waiting for new information [and thus] retards the current rate of
investment.”
In the 1990s Avinash Dixit and Robert Pindyck went further, making
an analogy between an investment opportunity and a stock option, the value of
which rises with the volatility of the stock price but disappears once the
option is exercised. If an investment is irreversible, uncertainty raises the
value of hoarding cash and waiting to see what happens.
Gauging the fog
Quantifying uncertainty is a more
recent sport. To measure it, Nick Bloom and Scott Baker of Stanford University
and Steve Davis of the University of Chicago constructed an index. It counts
how often uncertainty related to policy is mentioned in newspapers, the number
of temporary provisions in the tax code and the degree to which forecasts of
inflation and federal spending differ from each other.
That index hit its
highest in 25 years during last summer’s debt-ceiling battle and remains high
(by contrast, the Vix index of stock market volatility, a conventional gauge of
uncertainty, remains below its peak of 2009; see chart). A simpler index for
Europe that tracks news reports of uncertainty has similarly spiked.
Mr Bloom and his co-authors fed
their index into a model of growth that seeks to filter out purely economic
factors by controlling for interest rates and stock prices. They conclude that
the rise in uncertainty between 2006 and 2011 reduced real GDP by 3.2% and cost
2.3m jobs.
Such estimates should be taken
with a grain of salt. They demonstrate that policy uncertainty and weaker
economic growth are related, not that the first causes the second. Many radical
policy actions, from the TARP bail-out programme to the Federal Reserve’s
quantitative easing and the Dodd-Frank law on financial reform, were responses
to unprecedented economic trauma: collapsing house prices, failing financial
institutions and the deepest recession since the second world war.
That trauma
did most of the damage to growth, not any uncertainty about the policy
response. Had policymakers stood still, the result would have been less policy
uncertainty but a far more damaging crisis.
Clearly some policies, such as Mr
Obama’s health-care reform, generate uncertainty independent of economic
developments. But at least Obamacare comes with benefits as well as risks; that
cannot be said for the current political brinkmanship. As the fiscal cliff
draws nearer, argues Ethan Harris, Bank of America’s economist for North
America, the incentive to defer hiring and investment will grow, putting
pressure on the economy. “The process is as important as the outcome,” he says,
“and the process is a disaster.”
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