The Fiscal Cliff and Policy Uncertainty

In today’s issue of the Wall Street Journal, economics editor David Wessel has a useful column about policy uncertainty—worries about government spending, the expiration of provisions in the tax code, inflationary expectations, and the like—and its role in hampering economic growth by discouraging private investment. (The piece is available online to WSJ subscribers here.)

The topic is one of growing interest. Wessel reports that Ben Bernanke emphasized the connection between uncertainty and sluggish investment in his 1979 Ph.D. dissertation on the business cycle, in which the future Federal Reserve chairman wrote, “Increased uncertainty provides an incentive to defer investments in order to wait for new information.” (This, coming from the man who earlier this year popularized the scare term “fiscal cliff” and has initiated three rounds of “quantitative easing” that have ruffled the feathers of inflation hawks.)

But as Beacon readers know, the basic idea gathered momentum after Robert Higgs argued that regime uncertainty—investors’ anxieties about the possibility of major changes in fundamental policies, such as the government’s respect for private property—played a decisive role in prolonging the Great Depression (see, for example, here and here).

So, how can we measure policy uncertainty? And what do those measurements say about worries regarding the looming Fiscal Cliff?

Economists Steven Davis, Scott Baker, and Nicholas Bloom have created the U.S. Economic Policy Uncertainty Index, a composite that takes into account newspaper reports, expiring tax-code provisions, and economists’ disagreements about forecasts for inflation and government spending. Their website, which is updated frequently with data of these proxies of uncertainty, also contains several interesting graphs that track changes in the index.

The graph below (taken from their website) indicates that policy uncertainty peaked during the debt-ceiling showdown in August 2011 and is now on the rebound.

Whether or not the index will reach a new peak in response to the Fiscal Cliff remains to be seen, but one thing is certain: Fiscally speaking, we live in interesting times.

The U.S. Economic Policy Uncertainty Index is a key indicator to watch as the Fiscal Cliff nears. Source:

Carl Close is Research Fellow and Senior Editor for The Independent Institute and Assistant Editor of The Independent Review and editor of The Lighthouse, The Independent Institute’s weekly e-mail newsletter.
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