Policy Uncertainty Stalls Global Investment
Citi GPS Opinion Article
24 February 2014 – The narrow-based and still-tepid expansion in Advanced Economies continues to raise fears of secular stagnation. Investment levels (as a % of GDP) trail those seen prior to the Great-Recession despite “once-in-a-generation” low levels for global interest rates. Without stronger investment to spur a broad-based sustainable recovery, the likelihood of raising productivity to support higher wages and incomes diminishes, as do hopes for more robust long-term growth. In response, economic policy makers have geared up with new approaches and policy tools. Unfortunately “no good deed goes unpunished,” as the unintended consequences of recent policy actions may have inadvertently worsened investment prospects. Substantial empirical evidence suggests that investment has been weakened by policy-induced uncertainty stemming from the dizzying array of monetary, fiscal, and regulatory policy measures implemented since the crisis.
Post-Crisis Policy Uncertainty Runs Rampant
Monetary, fiscal, and regulatory policy makers globally have had to discard historical practices and become more discretionary, interventionist, and politically-contentious to limit the severity of the Great Recession, and repair the global financial system. On net, these policies collectively have heightened global uncertainty. The post-crisis financial environment has become less familiar: Interest rates have plummeted down to their theoretical limits; public balance sheets remain bloated; and European banks continue to regroup as supervisors and regulators reassess asset quality and capital requirements.
Monetary Policy: The Federal Reserve (Fed) has resorted to unconventional policies to rebalance portfolios by encouraging investor risk-taking and “reach for yield” behavior. Other central banks (e.g., the Bank of England, Bank of Japan, and the European Central Bank) have also followed with similarly aggressive unconventional policies designed to lower long-term interest rates and raise equity prices. The goal of inducing these portfolio shifts was to strengthen aggregate demand, particularly investment, even at the risk of distorting asset prices.
Unfortunately, central banks lack experience implementing their new policy strategies. Monetary policy has shifted from familiar rules-based and inflation-targeting frameworks to using new tools (e.g., LSAPs, LTROs, and forward guidance) that often are highly dependent on clear communications for their effectiveness. The September 2013 “tapering debacle” shows the difficulties with mastering the art of communicating appropriate forward guidance, and the severe consequences of failing to do so. Nor have central banks been able to signal well the timing of a shift in the policy stance.(1) Goodhart’s Law has plagued the Fed’s and Bank of England’s use of forward guidance with respect to using the unemployment rate as a guide for anticipating policy changes: “When a measure becomes a target, it ceases to be a good measure.” Meanwhile, global markets and other central banks (especially in emerging markets) must learn to be more vigilant in this uncertain central bank environment.
Fiscal Policy: Globally, fiscal policy turned from austerity programs designed to alleviate long-standing and growing concerns about sovereign debt sustainability, toward fiscal forbearance, which eases the timeline for previously set fiscal austerity targets. Unfortunately, such steps did little to spur investment. They certainly did not ensure a more sustainable recovery with credible prospects for higher aggregate demand by strengthening permanent income, consumption, and productivity. In some of the peripheral European countries, balkanized and contentious political factions have actually prevented implementation and continuation of needed fiscal and structural reforms.
In the US, ongoing fiscal measures contributed to political infighting that led to legislative impasses, and heightened financial market concerns, especially about possible default on US Treasury obligations, which raised anxiety about the feasibility of using US fiscal policy to revive growth.(2) At the same time, financial market concerns snowballed regarding the sustainability of euro area membership for some periphery countries as sovereign debt levels rose. Still unknown are the size and distribution of required future official sector bail-ins, as well as the (recapitalization) costs associated with financial reforms that center on a European banking union. Moreover, needed structural reforms to improve long-term competitiveness among Euro Area members will likely be politically disruptive, and heavily tax the political and economic capital of member countries.
Regulatory Policy: Large financial institutions were at the center of the 2008 crisis and have become the focal point of regulatory actions that attempt to reduce systemic risk and financial vulnerabilities. In 2008, regulatory uncertainty ballooned regarding the execution of the “too big to fail” doctrine (especially concerning the on-off-on sequence of events whereby the Fed and US Treasury rescued creditors of Bear Stearns and AIG but not Lehman). Moreover, European financial regulatory reform has focused on restoring the role of European banks as financial intermediaries. The objective is to sever the link between sovereigns and banks to limit “too big to fail” government interventions. Unfortunately, with so little done, and so much to do, there remains tremendous scope for stalled or incomplete reforms. Concern grows about how such overwhelming forces may reshape the future operating environment for European banks.
Policy Uncertainty is Measurable and Restrains Investment
Economic uncertainty, like the weather, is often used as the “catch-all” explanation for poor economic performance. Like the weather, economic policy-induced uncertainty is perceived as becoming more severe since the 2008 crisis. This view is reinforced by the wide range of interventionist policies enacted to protect the global financial system from future shocks and crises (as discussed above), and by headline-grabbing political impasses owing to the balkanization of political factions.(3)
Fortunately, pioneering work was done by Scott Baker, Nicolas Bloom, and Steven Davis in “Measuring Economic Policy Uncertainty” (4) which measures and quantifies changes in policy uncertainty. Their economic policy uncertainty (EPU) index is constructed from three components: 1) newspaper accounts of economic uncertainty; 2) federal tax code provisions set to expire in the next three years; and 3) dispersions among economists’ forecasts. For the United States and the Euro Area collectively, the respective EPU indices imply post-crisis levels of policy uncertainty have risen by approximately fifty percent.
Post-Crisis Investment Shares Dropped Sharply as Policy Uncertainty Rose
The popular “Reinhart-Rogoff” explanation of the post-crisis slowdown says slow growth regularly follows the very deep downturn after a global financial crisis. More recently, Larry Summers revived the secular stagnation hypothesis to highlight the need for very low, perhaps negative, real interest rates to spur investment. However, neither hypothesis identifies the source of the (exogenous) restraint on investment. The EPU index provides compelling evidence that policy uncertainty may be a powerful headwind.
The US and Euro Area Investment Share of GDP Declined Sharply Following the 2008 Crisis
While investment is expected grow at the same pace as GDP in equilibrium, the data show a sharp drop in the investment-GDP ratio following the 2008 crisis. Compared with its 1995-2007 average value of 13 percent of GDP, the US investment share averaged 1.1 percentage points lower in the 2007-2012 period. The Euro Area decline was less severe (0.7 percentage points), and averaged 13.9 percent in the post-crisis period.
Policy Uncertainty Accounts for the Sharp Investment Decline
There is an inverse relationship between investment and policy uncertainty evident in the US and German data (See Information Insights). Moreover, statistical tests confirm that increases in the uncertainty index precede declines in the investment share in the United States as well as for some Euro Area countries including Germany. This result rules out the possibility that the changes in the uncertainty index are measuring overly pessimistic or optimistic investment behavior (i.e., reverse causality).
Econometric estimates confirm that along with GDP growth and real interest rates, the policy uncertainty index is also a significant (negative) influence on investment. Model simulations imply that during the four-year period from 2007 to 2012, the rise in policy uncertainty accounted for 57 and 36 percent of the investment share decline in the United States and Germany, respectively. Offsetting this policy-induced headwind would require large reductions in real interest rates and/or considerable increases in GDP growth. To restore the investment share back to 2007 levels, estimates imply US real interest rates would have to decline by over 6 percentage points, or (nominal) GDP growth must rise by an additional 4 percentage points. For Germany, whose economy is very dependent on credit flows to finance investment, offsetting the impact of uncertainty would require that non-financial credit growth rises by over 8 percentage points, or that GDP growth rises more than 4½ percentage points more.
Since 2008, muted investment along with a tepid recovery has spawned proposals for more activist and demand-bolstering policies to offset the stagnation. With growing uncertainty about the outcome of these unprecedented policy changes, investment plans were delayed or canceled, and aggregate demand faltered. Indeed, it is time to amend the old maxim that “the path to Hell is lined with good intentions and unintended consequences.” The evidence implies that having more predictable policies may be the best remedy to ease headwinds restraining investment. Otherwise, historically out-sized changes in interest rates, inflation, and GDP growth will be required to offset the uncertainty-related headwinds generated by the otherwise well-intentioned policy initiatives.
1. The potency and appropriate use of forward guidance and other unconventional monetary policy tools is discussed in greater detail in William Lee “Global Economics View – Some Guidance on Forward Guidance: Not Ready to Solo” 10 September 2013. Also, a proposal to incentivize central banks to do as they say is presented in Willem Buiter “Global Economics View – Forward Guidance: More than Old Wine in New Bottles and Cheap Talk?” 25 September 2013.
2. Further analysis of the macro impact of political impasse, high structural deficits, and high debt levels (the “trifecta of looming fiscal issues”) is in: Robert DiClemente and William Lee “Global Economics View – Debt Limit—Indecision Raises Long-Term Risks” 10 October 2013.”
3. It is assumed that economic uncertainty encompasses all financial and economic variables and their interplay in the global economic and financial system. Economic policy uncertainty is a subset centered on the future course of fiscal, monetary, and regulatory variables.
A more extensive analysis can be found in the unabridged version of this report: William Lee “Global Economics View – Policy Uncertainty and Investment—How Much Lower Must Real Interest Rates Go?” 3 February 2014