Why Policy Stability is Critical for Economic Growth

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Businesses unsure about future taxes, regulations or government spending tend to wait, postponing long-term investments and hiring, Federal Reserve researchers write. Households hold back too, saving more and putting off big purchases. Unclear rules can therefore slow hiring and spending before the government changes anything. Policy stability means rules dependable enough to plan around, not rules that never change.

One Federal Reserve study estimated that a rise in uncertainty over trade policy in the first half of 2018 lowered global economic output by about 0.8 percent by the first half of 2019. Such findings come with cautions: the economists who built a news-based index of policy uncertainty say their own results are not necessarily causal. Policy stability can help firms commit money, but government also needs room to respond when conditions change.

Why waiting can become the business decision

The logic is simple, researchers Brandon Julio and Youngsuk Yook explain: when an investment is costly to undo, a firm has a strong incentive to wait for some of the uncertainty to clear. If the rules change after the money is spent, the firm may be stuck with the loss.

Households respond in a similar way, a Federal Reserve note reports, saving more as a precaution and delaying major purchases when economic policy is uncertain. A business waiting to expand and a household waiting to buy can each make a cautious choice that adds to weakness in overall demand.

Policy uncertainty can run high during major elections, but policy stability is not the same as political stability. A change of leadership matters here when it changes what people expect the rules to be, not merely because a different person holds office.

What the research can and cannot show

Economists Scott R. Baker, Nicholas Bloom and Steven J. Davis built a U.S. index of policy uncertainty that counts articles in ten leading newspapers containing terms about the economy, uncertainty and government policy. They checked the automated count against human readings of 12,000 randomly selected newspaper articles. The index measures how prominently uncertainty appears in the news; it does not observe business decisions directly.

Using that index, they found higher policy uncertainty associated with reduced investment and employment in sectors including defense, health care, finance and infrastructure construction. Looking at the economy as a whole, they found that a rise in uncertainty as large as the one between 2005-2006 and 2011-2012 was followed by declines of about 6 percent in investment, 1.1 percent in industrial output and 0.35 percent in employment. They warned that the results were not necessarily causal.

One reason, the researchers explain, is that policy and policy uncertainty can themselves respond to current and expected economic conditions. That makes the direction of cause and effect difficult to untangle: uncertainty may discourage activity, but trouble in the economy can also make government decisions harder to anticipate. The findings are a reason to take uncertainty seriously, but they do not say how much growth a more predictable policy would produce.

Trade policy makes the risk tangible

A tariff is a tax on imported goods and services. Because one country’s exports are another’s imports, firms may hesitate to commit money to export contracts when future tariffs or trade barriers could make their products more costly. A firm that knows which tariff will apply can at least decide whether operating under it would be profitable.

In a 2019 Federal Reserve note, Dario Caldara and four coauthors measured trade-policy uncertainty using newspaper articles and transcripts of firms’ earnings calls. Among roughly 1,500 listed firms, they estimated that trade uncertainty reduced investment growth by an average of about 1.8 percentage points from the second quarter of 2018 through the first quarter of 2019. The estimate concerns investment growth in that sample and period, not a prediction that every trade dispute reduces national growth by the same amount.

In a separate model of the global economy, the researchers included actual U.S. import tariffs to separate genuine trade uncertainty from trade actions already carried out. They also cautioned that their news-based uncertainty measure could capture reports about future tariff changes, whether those changes happened or not.

Economists Kyle Handley and Nuno Limão studied one case in which a tariff threat was removed. In the 1990s, they write, Congress voted every year on a bill to revoke China’s normal trade status. Losing it in 2000 would have raised the average U.S. tariff on Chinese goods from 4 percent to 31 percent. The World Trade Organization is an international organization dealing with trade rules between nations. China joined the World Trade Organization on December 11, 2001, and the United States made that status permanent on January 1, 2002. Handley and Limão estimate that the end of the yearly threat can account for over one-third of the growth in China’s exports to the United States from 2000 to 2005.

In their model, the cost of entering an export market cannot be recovered, so a firm gains by waiting when policy is uncertain. A lasting commitment removes that particular risk; it does not settle whether everyone benefits from the resulting trade. The paper also cites evidence that China’s integration into global trade contributed to lower U.S. prices and to declines in manufacturing employment and local wages.

Taxes and funding put a clock on uncertainty

Temporary tax provisions that Congress regularly extends as a group are often called tax extenders. The Congressional Research Service explains that investment incentives are most effective when enacted before investment decisions, when the tax policy can still influence the choice. A benefit approved after the commitment may reward a decision already made rather than persuade a business to make a different one.

Congress may use temporary tax provisions to evaluate a policy before renewal, respond to economic weakness or disasters, or meet budgetary objectives, according to the Congressional Research Service. An expiration date is therefore not automatically a policy defect. The planning problem is whether a business can rely on the rule when it makes the decision the incentive is meant to affect.

A lapse in government funding upsets plans more directly. During the 2013 government shutdown, the Government Accountability Office (GAO) found, the Merchant Marine Academy closed and had to change its academic calendar so eligible students could graduate on time.

GAO also reported that stop-work orders at the Department of Energy’s Office of Environmental Management led more than 1,700 contractor employees to be laid off or required to use leave. Office of Environmental Management officials said some programs needed four months to return to their pre-shutdown level of contract activity. These disruptions show how a funding interruption can continue to affect work after the interruption ends. Officials at the reviewed departments cautioned that longer-term effects were difficult to separate from other budgetary events, including sequestration, or spending cuts.

The debt limit, Congress’s cap on total federal debt, limits Treasury’s authority to finance spending and revenue decisions Congress has already made; raising it does not authorize new spending, GAO explains. As the projected date nears when the government would be unable to pay all its obligations, GAO found, investors often demand higher interest rates on new Treasury debt maturing near that date to compensate for the added risk. That increases the government’s borrowing costs, which taxpayers bear. In this case, uncertainty can make financing existing obligations more expensive even before a payment is missed. GAO has recommended that Congress replace the current process with one that links debt decisions to spending and revenue decisions at the time they are made.

Predictability does not mean freezing policy

The Federal Reserve’s monetary-policy committee says that explaining its decisions as clearly as possible helps households and businesses make well-informed choices and reduces economic and financial uncertainty. Congress’s statutory mandate for the Fed includes maximum employment, stable prices and moderate long-term interest rates. The Fed’s strategy responds to economic disturbances, primarily by changing the target range for the federal funds rate, its main policy interest rate. A predictable response to changing conditions is different from a promise that interest rates will never move.

The World Bank says countries with predictable regulations, skilled labor and stable financial systems, along with the potential to develop local suppliers, have the edge in attracting investment. Knowing the rules is one part of an investment decision; it cannot replace the resources and institutions needed to make the project succeed. Likewise, preserving a rule is not evidence that the rule itself promotes growth.

Who can make the rules easier to anticipate

Congress delegates rulemaking to agencies partly because agencies have the technical expertise to work out the details of programs Congress creates in law, the Congressional Research Service explains. Congress retains oversight and legislative power to change regulations or amend the laws granting agencies their authority. A commitment is easier to assess when it is clear who has the power to make it and who can change it.

Under ordinary federal notice-and-comment procedures, agencies allow comments on proposed rules, review those comments and explain the basis and purpose of the final rule. Agencies commonly collect those comments through Regulations.gov. There are exceptions, including interpretive guidance and certain other matters, and agencies may bypass ordinary procedures when they are impracticable, unnecessary or contrary to the public interest. Public procedures make a policy change visible and give affected people a way to respond, but they do not promise that the old policy will survive.

When judging a promise of policy stability, look for a concrete commitment: what rule is being made predictable, who can change it, and whether it lasts long enough to matter to the decision at hand. The economic value lies in making a commitment possible before the money is spent, not in declaring that government has finished changing its mind forever.