State of confusion: how policy uncertainty harms international trade and investment

Economics International relations International trade Foreign investment Australia United States of America

Australia and the United States have experienced above average levels of economic policy uncertainty in the years since the global financial crisis.

Increased economic policy uncertainty has been shown to have negative effects on economic activity, employment, trade and investment, while partisan political conflict in the United States has been shown to have negative effects on economy-wide and firm-level investment spending.

Australian economic policy uncertainty is more strongly correlated with policy uncertainty in the United States than in China or the rest of the world.

The strong correlation between the Australian, US and global measures of policy uncertainty suggests that uncertainty in the United States has significant international spillover.

Australian policy uncertainty is more volatile (has a larger standard deviation) than for the United States and globally. This is consistent with Australia’s status as a small, open economy more exposed to foreign shocks than a large and relatively closed economy like the United States.

Global industrial output declines around 0.5 per cent after six months in response to a one standard deviation increase in global economic policy uncertainty. Global trade volumes decline around 0.8 per cent over the same six months.

Increased policy uncertainty accounts for some of the slowdown in global trade since the 2008 financial crisis.

The Australian dollar real exchange rate and real interest rates decline in response to an increase in Australian economic policy uncertainty. However, trade volumes, foreign investment and economic activity do not show statistically significant responses to an economic policy uncertainty shock.

The Australian economy seems more robust to policy uncertainty than the global or US economy. This has several possible explanations:
- Australia has not experienced a recession during the sample period examined in this report. Uncertainty shocks have been shown to have a bigger impact during recessions in the United States and elsewhere.
- The shock absorbing role played by the Australian dollar foreign exchange rate. 
- International influences on the Australian measure of policy uncertainty.
- The Australian media over-stating the implications of foreign economic policy uncertainty for Australia.

In the United States, real interest rates decline, but the exchange rate does not show a statistically significant response to US policy uncertainty shocks. Trade volumes, foreign investment and economic activity all decline in response to an increase in uncertainty.

The US dollar benefits from safe-haven flows, while US trade and foreign investment is largely denominated in US dollars, reducing the scope for exchange rate adjustments to offset uncertainty or other shocks.

Increases in partisan political conflict in the United States cause the US dollar real exchange rate to fall, although do not seem to affect foreign trade, foreign investment or economic activity. Other studies have shown a negative effect on US domestic investment spending.

Given the elevated levels of US economic policy uncertainty, including trade policy uncertainty, and increased partisan political conflict associated with the Trump administration, US and global trade and investment can be expected to be weaker than if the administration followed a more predictable economic policy path at home and abroad.

An important implication for policy is that reducing policy uncertainty can be expected to benefit cross-border trade and investment, as well as domestic economic activity. Reducing uncertainty requires only that policymakers adhere to well-defined, transparent and rules-based policy frameworks, both domestically and internationally. This can be done at relatively little fiscal cost.

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