Has Policy Stability Ended the “Bathtub” Recession?

By Nicholas Bloom

Posted on February 9, 2012


The US economy collapsed in 2008 and 2009. Millions of people lost their jobs in the worst recession since the Great Depression of 1929-1932. But we have yet to see a recovery. Throughout 2010 and 2011 growth was anemic and unemployment stayed high. Finally in early 2012 it looks like the recovery might be beginning.

The question is why has the recovery taken so long?

Recessions of old had a family pattern. Some horrible shock - like a war or oil price spike – would send the economy into a tail-spin. Once the shock was over growth would bounce back. This generated the “v-shape” recession – a sharp drop and recovery. But the current recession has broken with this tradition. We have seen a drop in output and then a flat-line. This is the “bathtub” recession.

Based on research with Scott Baker (Stanford) and Steve Davis (Chicago) I argue this bathtub recession is due to massive policy uncertainty. Uncertainty leads firms to delay hiring and investment decisions, choking the recovery. And the last two years has seen a truly volcanic policy landscape. Tax changes, regulatory fights, budget battles and debt crisis have erupted on a regular basis. Figure 1 shows our index of economic policy uncertainty from January 1985 until January 2012. This spikes sharply up after the 2008 Troubled Asset Relief Program (TARP) initiative and has remained high all the way through to the 2011 Budget battle. Only now has policy uncertainty fallen, dropping by 40% from its August 2011 peak to its January 2012 value.

Index of Economic Policy UncertaintyWe construct this index of policy uncertainty by combining three types of information: the frequency of newspaper articles that reference economic policy uncertainty; the number of federal tax code provisions that are set to expire in coming years; and the extent of disagreement among economic forecasters about future inflation and government spending.

High policy uncertainty from 2008 to 2011 has been a key factor stalling the recovery. When businesses are uncertain about taxes, healthcare costs and regulatory initiatives, they adopt a cautious stance. Because it is costly to make a hiring or investment mistake, many businesses naturally wait for calmer times to expand. If too many businesses wait to expand, the recovery never takes off. Weak investments in capital goods, product development and worker training also undermine longer-run growth.

But now, with the drop in policy uncertainty economic prospects in the US appear to have finally improved. Last Friday’s announcement of a 250,000 drop in unemployment led to a surging stock-market as investors began to believe the recovery had finally begun. The future looks good. The only ominous rumbling is the Presidential election and the 2012 budget battle that threatens a return of more policy uncertainty and the end of the recovery. Let’s hope not.

Note: the full dataset and methodology underlying Figure 1 is available at www.policyuncertainty.com.