When gridlock and political uncertainty rise, US economy takes a hit

One new study finds that when political conflict spikes upward, it makes foreign CEOs less likely to make investments that can create jobs in the US.

This year’s rancorous, winner-takes-all politics is not only dividing America, it’s hurting the economy, according to new research.

Two indexes of politics – one measuring political conflict, the other policy uncertainty – rose this year with the start of the presidential primaries. Both have since leveled off, a reflection perhaps of how the campaigns have turned to other issues than economics. But they are expected to rise even more if the presidential race tightens.

And that’s a problem for the economy.

When political risk rises, “there’s a temporary decline in investment, especially in industrial firms with very large investments that cannot be undone easily,” says Scott Baker, a finance professor at Northwestern University’s Kellogg School of Management, who helped create the policy uncertainty index.

Business executives don’t like uncertainty.

For example: Increasing political conflict is associated with a significant slowdown in investments foreign companies make in the United States, says economist Marina Azzimonti, who developed a monthly partisan conflict index for the Federal Reserve Bank of Philadelphia. She found that a 10 percent rise in the Partisan Conflict Index was followed by a quarterly decline equivalent to an estimated $15.7 billion loss in such foreign direct investments.

Political rancor appears to keep getting worse. The partisan index, which measures the frequency of keywords in newspaper articles back to 1981, has trended sharply higher since 2010, according to Professor Azzimonti, of Stony Brook University. It hit its peak in October 2013 when the federal government was shut down by Congress’s failure to pass a budget.  “The uncertainties associated with political discord make the US market less attractive to invest into,” she says via e-mail.

Ditto for US companies, who reduce investment and hiring in the face of policy uncertainty, according to Professor Baker and two colleagues, who developed another newspaper-keyword index of economic policy uncertainty.

Gridlock can also lead to policy risk in the form of executive actions that could be reversed by the next president, according to Baker. “There can be a lot of partisanship but if nothing gets done that’s not so much uncertainty as inaction. But the ability to get a lot of these actions through executive order provokes more uncertainty,” he says.  

The leveling off of the index in recent months may reflect that press coverage has moved to the personalities and issues like immigration rather than specific economic policies, he adds.

The index itself looks back more than a century. Policy uncertainty has been growing since 1960, the economists find.

This half-century rise is associated with two parallel trends: A larger government role in the economy and rising political polarization, says University of Chicago professor Steve Davis, who collaborated with Baker and Stanford professor Nicholas Bloom. “There are sources of partisan conflict that are not primarily economic ... but that can lead to dysfunction in the overall policymaking process,” he says.

Policy uncertainty is rising elsewhere, too, say the economists, who have created indexes for several countries. Their UK index, which goes back to 1997, recently hit an all-time peak ahead of the June 23 referendum on European Union membership; much of the debate reflected in UK press coverage has turned on economic and trade policies, in contrast with the US presidential primaries.

In the US, the challenge of partisan rancor and uncertainty doesn't mean that foreign investment is falling off a cliff. It notched a new record in 2015.

The two indexes sometimes diverge. One reason is that Azzimonti’s Partisan Conflict Index doesn’t distinguish between wrangling in Washington over social or cultural issues and tax-and-spend policymaking. Also, uncertainty and conflict aren’t always synonymous. The 9/11 attacks led to great uncertainty over US economic policy but curbed partisan conflict.

Azzimonti’s finding that partisanship impacts foreign investment “is broadly true,” even if trying to capture political volatility in a single number seems implausible, says Michael Moran, managing director of global risk analysis at Control Risks, a consulting firm. “This is another useful way to make the argument that needs to be made: We live in volatile times.”

Still, not all conflict is bad for business since gridlock can stay the hand of politicians who might damage the economy with their meddling, adds Mr. Moran, who is based in New York. “One of the very few benefits of our dysfunctional political debate is that neither side has been able to do anything stupid.”