This article appears in the May 4, 2015 issue of National Review.
In my last column, I showed that policy uncertainty rises as presidential and midterm elections approach and cited research that documented a strong negative statistical link between economic-policy uncertainty and economic growth. I heard back from many National Review readers who wondered whether the apparent relationship between policy uncertainty and growth might be a simple coincidence. How can it be, a critic might say, that elections in this gridlocked world matter that much? The questions motivated a deeper dive into the data, a dive that uncovered some pearls that are the subject of this month’s chart.
Economists deploy theory as a defense against statistical coincidence. One should reason through a specific causal link before looking at the data, the thinking goes, and then turn to the data and see whether the data are consistent with the theory. In the best of all worlds, the theory motivates the investigator to look at something completely different, and then the data reveal a new pattern that confirms the theory.
Policy uncertainty should, in theory, affect the economy by increasing the risk that people perceive they face when making economic decisions. If you were going to lend money to a low-risk borrower—say, Bill Gates—then you might charge him a low interest rate. If you were going to lend money to a tremendously sketchy fellow—say, Jonah Goldberg—then you might charge a higher interest rate. If policy uncertainty has a big effect on the economy, it should be visible as generally heightened risk premia. These, in turn, would harm the economy because they would raise the cost of investing in anything that requires financing, be it a new machine, a house, or a new car.
The price-to-earnings ratio of the S&P 500 measures the price a firm can charge an investor in exchange for the claim on the firm’s earnings that a share of its stock represents. A relatively high P/E ratio serves as an indication that the firm can raise capital at a relatively low cost: When the P/E is higher, it means the market perceives the equity to be less risky. The spread between the yield on Moody’s BAArated debt and the ten-year Treasury yield is an alternative measure of the risk premium. It indicates how much market participants demand in exchange for holding bonds that, according to Moody’s, come with “moderate credit risk” and have “certain speculative characteristics.” A larger spread indicates that market participants are charging businesses more for buying their bonds instead of the “risk-free” bonds of the U.S. government.
The chart below plots these measures against the measure of policy uncertainty I discussed last time. As the chart shows, stock valuations and debt spreads both respond adversely to the increases in uncertainty that seem to come with the election cycle. The effects are large and so vivid that they are almost eerie.
So elections are times when politicians present wildly different views of what policy might be, and when investors dramatically increase their assessments of risk. The higher risk premia that result then dampen economic activity. The data continue to support the view that policy risk is a very big deal indeed.
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