The Certainty of Political Uncertainty

As the world economy limps into 2013 with an outlook of continued sluggish growth, it appears the greatest obstacle to economic recovery in the New Year is not only bad economic policies. It is also the threat of more bad economic policies, especially ones that threaten the very institutions underpinning the market economy. Policy uncertainty of this type continues to lurk in most major developed economies, with the budget machinations in the US and the threat of a “fiscal cliff” only the most recent (and visible) manifestation. Indeed, the sense is that, five years on from the start of the global financial crisis, we are still not sure what is going to happen with the world’s economic outlook. And this uncertainty is putting on hold precisely the private sector-led investment that is necessary to restart growth.

Uncertainty for Me and for Thee

The US media may have told us to rejoice brothers and sisters, for the United States has avoided a budget crisis, but the reality is much different.  Waiting beyond the last minute, the US House of Representatives approved an odd combination of tax increases and (paradoxically) spending increases designed to stave off the tax increases and spending cuts known as the “fiscal cliff.” Leaving aside the reality that US lawmakers created this mess and then congratulated themselves for “solving” it, the compromise between Republicans and Democrats merely postpones for two months other immediate fiscal issues for the US (including spending cuts and the debt ceiling). The compromise also does not tackle the staggering fiscal problems that loom for the US (and thus, the world) economy in 2013, including growing deficits, unchecked spending, and the effects of an array of new taxes from President Obama’s health care plan. Thus, while this specific fiscal drama is over in the US, the uncertainty of future fiscal cliffs remains.

Problematically for world growth, the travails in the US are not isolated. The slow-moving wreck that is the euro crisis is now entering its third official year with little resolution in sight. Talk of a “Grexit” (or “Greek exit”) from the euro continues to roil markets, as does continuing fiscal problems in Spain, Italy, and Portugal. Even the German government isn’t sure if the “worst of the crisis is over” (as Finance Minister Wolfgang Schaeuble said on January 4th) or if “the crisis is far from over” (as Prime Minister Angela Merkel said on January 5th). In either case, no one is saying that the crisis IS over, and debt ratios in the worst-afflicted Eurozone countries continue to rise. Added into the mix is the European Central Bank’s (ECB) promise to purchase unlimited amounts of bonds of the distressed governments of the Eurozone on the secondary market, a move intended to shock and awe the markets into submission; this it clearly did, but the even the medium-term consequences of such a blatant mixture of fiscal policy into the ECB’s monetary mandate are unclear.

Moreover, it has not just been the US and Eurozone that have seen policy uncertainty on the rise. Indeed, the policy environment in most OECD countries and many emerging markets has been remarkably volatile, with bad policies begetting instability begetting more bad policies. Even more pressing, however, has been the series of policies that have threatened the vital institutions necessary for the functioning of a market economy. For example, Figure 1 below shows the deterioration and fluctuations in property rights, as measured by the percentage of money held outside the formal financial system, in Croatia from 2007-2012. Already facing lower protection of property rights than other countries in the region (Estonia stands as an exemplar), Croatia’s property right regimes followed much of the world and began a cyclical drift downward in 2007. Similarly, Hungary, a country with even more of a buffer to its institutions (due to its inclusion in the EU but not yet the Eurozone), has seen wild political swings lead to gyrations in its property rights as well (Figure 2), even after an increase in confidence at the beginning of the global financial crisis.

Figure 1 – Deterioration of Property Rights in Croatia


Source: Author’s calculations from National Bank of Croatia data. Contract-intensive money is defined as the amount of money in the formal financial sector as a percentage of all broad money (M2)

Figure 2 – Property Rights in Hungary, 2007-12


Source: Author’s calculations from Magyar Nemzeti Bank data. Contract-intensive money defined as above.

The Effects of Political Uncertainty: Continually Shaking the Tree

A large literature exists in economics regarding policy expectations, especially in regards to inflation, and how that affects investment and consumption decisions today. But there is little work done on institutional uncertainty, and how political uncertainty affects the policies that may change institutions themselves. And even though the effects of institutional instability have been felt already across the world economy, it is only recently that political and institutional instability have been suggested as the cause for economic malaise.

This neglect may finally be beginning to change. Exciting research from professors at the Booth School of Business at the University of Chicago has recently attempted to quantify policy uncertainty (see their website,; backing up their thesis that economic policy uncertainty can create real stresses in the economy, one only need look at their index from January 2009 to today (Figure 3).[i] This modern view has been backed up by historical research from Nauro Campos and Menelaos Karanasos, who  showed in a 2008 paper that political instability has been a major contributing factor to Argentina’s economic deterioration over 1896-2000.[ii] Additionally, ongoing but preliminary research done by the Institute for Emerging Market Studies (IEMS) in Moscow shows that institutional volatility in transition economies has led directly to financial sector volatility, with changes in property rights having the most influence on both the financial and real sector.

Figure 3 – Economic Policy Uncertainty 2009-2013

Source:, accessed January 4, 2013

The reason behind why policy uncertainty would harm growth is simple: put plainly, the private sector grows and thrives in an environment of stability. While bad policies may affect business at the margins or in times of transition (e.g. during a changeover in healthcare regulations), businesses eventually settle to an equilibrium point in their operating environment (even if it’s not the optimal equilibrium). That is, when it comes to the economic environment, even the largest firms in the world are “price takers,” in that they cannot influence the overall policy environment but are instead handed it. Thus, stability allows businesses to continue their actual work without worries about shifts in the external policy environment that they must react to. However, changes in policies that may threaten basic institutions such as property rights or contract enforcement cause even more adjustments, as does the threat of those changes. What makes institutions “institutions” is their slow-moving nature: they are not meant to change abruptly, and thus policies that threaten such changes cause even more consternation than tinkering with tax rates. Austrian economist Robert Higgs has termed  this “regime uncertainty,”[iii] as a “pervasive uncertainty about the property-rights regime” translates into under-investment, under-hiring, and continued stagnation. In a situation where policies threaten the rules of the game, expectations cannot form rationally, for who knows what will come next?

How to Get out of the Mess?

The policy implications of these findings are clear and echo both the simple tenets of the “Washington Consensus” from decades past and the “big bang” approach of many countries in transition: governments should get the institutions right and get out of the way. Threatening the basic institutions of property rights and contractual enforcement is the easiest way to ensure economic stagnation, and thus policymakers should avoid policies that re-write the social contract if they wish to see growth.

Squaring this circle with the messiness of democracy is a more difficult task, as democratic shifts can result in drastically different policies overnight (many researchers, including myself, have found a negative correlation between democracy and growth). However, democracies rarely vote for major institutional changes, preferring to tinker at the margins. One only need look at the US presidential elections in November 2012 to see this: with a majority of the country believing that the US was on the wrong path, widespread disdain for Obama’s policies, and Congressional approval levels at all-time lows, the electorate returned the status quo to power.

The answer, thus, to decreasing instability (whether of the policy or institutional type) may be to decrease the power of the executive as a check on deleterious, foundation-shaking economic changes. While democratic changes such as in the US in 2012 have only helped to enshrine policy instability, the regularity of elections means that instability does not have to last forever. Indeed, it has been in eras of one-party or one-person rule that institutional stability has been most threatened (one need only look at the administration of Franklin Delano Roosevelt in the 1930s, or the Peron regime in Argentina). In this sense, removing the power of government to re-write the rules of the game may be the precise cure for what ails the world economy.

[i] See the background paper for this index, S. Baker, N. Bloom, and S.J. Davis (2011), “Measuring Economic Policy Uncertainty,” available at (accessed January 7, 2013).

[ii] Campos, N. F., and Karanasos, M. (2008).  “Growth, Volatility, and Political Instability: Non-Linear Time-Series Evidence for Argentina, 1896-2000.” Economics Letters, 100, pp. 135-137.

[iii] Robert Higgs, “Regime Uncertainty, Then and Now,” accessed January 4, 2013 from: