How Does Political Uncertainty Affect Economies?

Box 2. How Does Political Uncertainty Affect Economies?

Economists have long suspected that increased uncertainty causes people to become more cautious and have proposed a number of channels by which heightened uncertainty could affect the economy.

 Firms will postpone investment and hiring and wait before entering new markets —as uncertainty increases, the “option value” of not committing increases. Similarly, firms can minimize the risk of holding unsold goods by reducing inventories.

 The same argument applies to households’ decisions about purchases of durable goods, especially large financial

commitments, such as cars and houses. Even for nondurable goods, households might increase precautionary savings.

 Asset prices would be expected to fall, not just because falling demand would be associated with reduced yields (such as from dividends, in the case of equities), but also because risk premia would be expected to rise in response

to higher uncertainty. 1

Estimating the effects of changes in uncertainty is difficult. Nonetheless, a range of studies of the effects of changes in uncertainty support the notion that an increase in uncertainty is likely to result in reduced private demand and falling asset prices.

 Output : Denis and Kannan (2013) found that uncertainty played a significant role in depressing output in the UK in the aftermath of the global financial crisis, accounting for about a quarter of the decline.

 Investment: Bloom et al. (2013) find that increases in uncertainty about economic policy foreshadow declines in investment and employment. Using the same approach, Gulen and Ion (2016) find that a doubling of policy uncertainty is associated with an average decrease in quarterly investment rates of approximately 9 percent relative to the average investment rate in the sample. The authors estimate that one third of the downturn of US capital investment during the financial crisis can be attributed to policy uncertainty, a result corroborated independently by Stein and Stone (2012). Of particular relevance to thinking about the effects of the EU referendum is the literature on the effects of electoral uncertainty. Julio and Yook (2012) find that investment declines during election years, and particularly so when the election result is uncertain and the impact of the election in terms of policies could be large —average investment rates drop by 12 percent in such cases. Similarly, Handley and Limao (2012) find that uncertainty around Portugal’s accession to the European Community in 1986 caused firms to put off entering markets.

 Consumption : Giavazzi and McMahon (2012) estimate that the 1998 German election induced households to

increase savings rates by 3 percentage points of household disposable income. Leduc and Liu (2015) find that uncertainty tends to increase unemployment, fears of which could further depress consumption —Benito (2006) finds that increased job insecurity in the UK has been associated with lower consumption, especially of young and less skilled workers.

 Asset prices : Pastor and Veronesi (2013) find that political uncertainty increases the equity risk premium, the more so

when the economy is weak. Kelly et al. (2015) look at options prices around elections and political summits in 20 countries and find that the cost of financial insurance against uncertainty soars as political uncertainty increases.

On this basis, the effects of uncertainty seem to be universally negative, and potentially quite strong and persistent, even if ultimately temporary.

1 An increase in uncertainty does not per se make assets risky; rather, investors will demand higher compensation —lower prices—to hold those assets that could deliver low returns at the time when the ability to increase consumption is most valuable (i.e., during a

downturn).

INTERNATIONAL MONETARY FUND 41