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Policy uncertainty in the U.S. is constraining Canadian prosperity

U.S. President Barack Obama, centre, flanked by Vice-President Joe Biden, left, and House Speaker John Boehner, delivers his State of the Union speech on Capitol Hill in Washington, Feb. 12, 2013.

Charles Dharapak/Reuters

With President Obama's first State of the Union speech in his second term now complete, Canadians should rightfully be worried about the implications of the President's policy agenda on the Canadian economy. After all, our economic fortunes are inextricably linked to those of the United States and unfortunately, the economic uncertainty being created by President Obama's policies and the increasing polarization of the U.S. political system is impeding genuine recovery in the U.S. and constraining our own prosperity.

The normal course of economic recovery after a recession is to mirror the severity of the contraction. In other words, a sharp decline is normally followed by a sharp recovery. For example, the U.S. economy contracted sharply in 1980 for two quarters (an 8.6-per-cent annualized rate of contraction over six months). The following two quarters were characterized by sharp expansion: 7.6 per cent and 8.6 per cent, annualized.

Similarly, moderate recessions are normally followed by moderate recoveries. In the final six months of George Bush Sr.'s final year in office, the U.S. economy contracted at annualized rates of 3.5 and 1.9 per cent, respectively. It then expanded 2.7 and 1.7 per cent, annualized, in the first two quarters of Bill Clinton's administration.

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This is what Nobel economist Milton Friedman called the guitar-string theory of economic recoveries. If you strum a guitar string it rebounds; the harder you strum, the faster its rebounds.

Unfortunately, the deep U.S. recession in 2007-09 did not follow this trend. After a recession that lasted a full year and included one quarter in 2008 where economic activity contracted by almost 9 per cent, the recovery has been sluggish at best, even anemic at times.

The most often heard explanation is that recoveries from recessions with financial crises are normally slower than other recoveries. However, a careful analysis of recessions and recoveries in the U.S. does not support this view. The average annualized growth rate following the previous eight recessions with financial crises was 6.2 per cent, versus the current average growth rate of only 2.1 per cent.

A key part of the answer explaining the slow recovery is the role of uncertainty, which is gaining increasing attention.

At its core, the idea is that uncertainty impedes or at least delays businesses, investors and entrepreneurs from acting, because they simply can't make adequate economic calculations about the future. In other words, there is too much "unknown" about the future that can't be reasonably managed, so firms and individuals delay making decisions.

To date it's been difficult to actually measure uncertainty. Scott Baker and Nicholas Bloom of Stanford University and Steven Davis of the University of Chicago (along with several collaborators) have created an innovative approach to measure policy uncertainty. They quantify uncertainty by measuring the discussion of uncertainty in the popular press. This measure is then buttressed by information regarding tax policies expiring in the future (tax uncertainty) and the degree of divergence among economic forecasts.

Their work has led to some important conclusions about the economic effects of policy uncertainty. For example, their recent statistical work concluded that "following an increase in policy uncertainty of the size seen on average between 2006 and 2011, industrial production in the U.S. dropped by 2.5 per cent and employment by 2.4 million." The magnitude of the contraction in the economy, coupled with the loss of employment, indicates sizable effects from policy-imposed uncertainty.

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Their work has been extended to Canada, and again illustrates how our economy is linked with that of our southern neighbour. A recent essay published by the Fraser Institute on the impact of policy uncertainty in the U.S. and Canada concluded that "much of Canada's current economic policy uncertainty is due to contagion from the U.S."

Policy certainty and uncertainty matters. Thankfully, Canada has a fairly decent record of minimizing policy uncertainty. Unfortunately, we are suffering from the lack of certainty south of the border, and will likely continue to do so as uncertainty reigns supreme in the United States.

Jason Clemens and Niels Veldhuis are economists with the Fraser Institute, a Canadian economic and policy research think-tank.

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