State of Confusion: Economic Policy Uncertainty and International Trade and Investment

• Author: Stephen Kirchner
• DOI: http://doi.org/10.1111/1467-8462.12319
• Published date: 01 June 2019
• Date: 01 June 2019

State of Confusion: Economic Policy Uncertainty and

International Trade and Investment

Stephen Kirchner*

Abstract

Uncertainty about economic policy in

Australia and the United States has increased

episodically since the Global Financial Crisis.

Existing research focuses on the effects on

economic activity, employment and investment.

I extend this work to examine the effect of

policy uncertainty on global trade volumes,

industrial production and cross-border trade

and investment for Australia and the United

States. Australia’s relative resilience to policy

uncertainty shocks reflects a larger role for the

exchange rate in intermediating foreign shocks

and the absence of a recession in Australia

during the sample period considered.

1. Introduction

Uncertainty about the economy and economic

policy in Australia and the United States has

increased episodically since the Global Finan-

cial Crisis. Australia’s high turnover in prime

ministers and US congressional battles over the

budget and debt ceiling has resulted in episodes

of increased economic policy uncertainty. In

the United States, the election of President

Donald Trump has increased uncertainty,

particularly in relation to trade policy.

Uncertainty about economic policy can

reduce economic activity, quite apart from

the substance and direct effects of those

policies that are actually implemented. By

the same token, reducing uncertainty, for

example, by putting in place clear and

transparent policy rules and frameworks, can

have economic benefits that can be captured at

relatively little cost. Policymakers should aim

to reduce uncertainty where possible by

increasing the predictability of government

policy decisions for business, investors and

consumers.

Recent advances in the narrative identifica-

tion of economic policy uncertainty have

enabled researchers to quantify its economic

effect (Baker, Bloom and Davis 2016). Similar

methods have been applied to the measurement

of partisan political conflict, which is posi-

tively correlated with economic policy uncer-

tainty, although not necessarily in a causal

fashion (Azzimonti 2018).

Existing research largely focuses on the

effects of economic policy uncertainty and

partisan political conflict on economic activity,

employment and investment. Economic policy

uncertainty has also been shown to negatively

affect cross-border trade and investment for the

United States (Novy and Taylor 2014; Handley

* United States Studies Centre, University of Sydney,

NSW 2006 Australia. Email <stephen.kirchner@

sydney.edu.au>. The author would like to thank two

anonymous reviewers for comments on an earlier version

of this paper.

The Australian Economic Review DOI: 10.1111/1467-8462.12319

°

C2019 The University of Melbourne, Melbourne Institute: Applied Economic & Social Research,

Faculty of Business and Economics

Published by John Wiley & Sons Australia, Ltd

The Australian Economic Review, vol. 52, no. 2, pp. 178–199

179

Kirchner: State of Confusion 3

179

and Limao 2015, 2017; Krol 2018). Economic

policy uncertainty has a larger effect in the

context of recessions (Caggiano, Castelnuovo

and Groshenny 2014; Caggiano, Castelnuovo

and Figueres 2017), as well as significant

international spillovers (Caggiano and Castel-

nuovo 2017). I extend this work to examine the

effect of this uncertainty on cross-border trade

and investment, with a particular focus on

Australia and the United States. Trade and

investment have important implications for

economic growth.

The next section briefly looks at the nature of

economic policy uncertainty and partisan

political conflict, its measurement and the

existing literature on its economic effects. An

important finding of the existing literature is that

economic policy uncertainty explains business

cycles and some of the recent slowdown in

international trade in ways that other variables

and modelling approaches do not. Section 3

examines measures of economic policy uncer-

tainty for Australia, the United States and the

rest of the world and the relationship between

them. In Australia’s case, economic policy

uncertainty is highly correlated with global

and US uncertainty, but is also more volatile.

Section 4 examines the effects of global

economic policy uncertainty on global indus-

trial output and international trade using a

standard modelling approach from the literature

on uncertainty shocks. Global industrial pro-

duction and global trade volumes are shown to

decline in response to economic policy uncer-

tainty shocks. Section 5 examines the effects

of Australian economic policy uncertainty.

Shocks to policy uncertainty in Australia lower

the real effective exchange rate, real interest

rates and foreign portfolio investment, but

foreign direct investment, trade volumes and

gross national expenditure do not show statisti-

cally significant responses. Section 6 examines

the implications of economic policy uncertainty

in the United States. Shocks to policy uncer-

tainty in the United States are shown to lower

real interest rates, foreign investment, trade

volumes and real GDP. Shocks to partisan

political conflict lower the real effective

exchange rate. Finally, Section 7 concludes

with implications for policy.

2. Measuring Economic Policy

Uncertainty and Partisan Political

Conflict

Economists have long recognised uncertainty

as an important influence on economic activity.

Following Knight (1921), economists typically

distinguish between risks, which are quantifi-

able based on known probability distributions,

and uncertainty, which is generally unquantifi-

able. The actions of policymakers, because

they often reflect discretionary decisions rather

than following known rules, constitutional or

other legal constraints, are an important source

of economic uncertainty.

It is necessary to distinguish between

general economic uncertainty and economic

policy uncertainty. The economy will always

have an unpredictable or random component,

reflecting factors over which policymakers

have little direct control. For example, the

weather, natural disasters, technological inno-

vations and other unexpected events can

amplify cycles in economic activity. Real

business cycle (RBC) theory attempts to

explain fluctuations in the economy largely

in terms of these real as opposed to monetary or

other policy-related shocks.

Economic policy uncertainty concerns the

predictability of the actions of policymakers

and their policy instruments. Workers, employ-

ers, investors and financial market participants

try to anticipate how economic policy will

affect them and change their behaviour

accordingly. If the actions of policymakers

are unpredictable, this increases uncertainty

and leads the public to make different

economic decisions. In particular, consumers

may delay spending, or business may defer

making investments, waiting for a more certain

policy environment.

Baker, Bloom and Davis (2016) made a

significant advance in quantifying economic

policy uncertainty with an index that measures

this uncertainty over time. The index is based

on the appearance of keywords in major

newspapers relating to economic policy and

uncertainty. Their Economic Policy Uncer-

tainty (EPU) Index has been constructed for the

United States and a number of other countries,

°

C2019 The University of Melbourne, Melbourne Institute: Applied Economic & Social Research, Faculty of Business and

Economics