The U.S. economy has experienced a slow recovery from the 2007-09 recession. Economic growth remains below its historical average. One possible contributor to the poor economic performance is economic policy uncertainty. For example, the future course of monetary policy has been unclear over the recovery time period. Given the important role of small businesses in job creation, this article examines the impact of economic policy uncertainty on small-business decisions. (1)
A number of economists have examined the impact of general economic uncertainty on business decisions. Bernanke (1983); Dixit and Pindyck (1994); Bloom, Bond, and Reenen (2007); and Bloom (2009, 2014) have shown the adverse impact of general economic uncertainty on business investment decisions. Bloom, Bond, and Reenen (2007) speculate that general economic uncertainty will also adversely impact hiring decisions. Ghosal and Ye (2015) find this to be the case. Lower investment and employment occur because uncertainty makes firms less sure about the returns associated with capital expenditures or hiring. Since there are nonrecoverable costs associated with a decision to invest in capital or hire and train workers, uncertainty makes it prudent to delay capital expenditures or hiring. Uncertainty also worsens information asymmetries between lenders and borrowers. With greater uncertainty, the chances of bankruptcy increase. As a result, banks tend to delay lending to firms, slowing business expansion (Greenwald and Stiglitz 1990).
Baker, Bloom, and Davis (2016) extend the notion of uncertainty to include economic policy uncertainty (EPU). They construct an index to measure EPU using a computer-based search that quantifies the frequency of articles dealing with uncertain policy issues in leading U.S. newspapers. Their study provides evidence at the firm and aggregate levels that EPU has a significant impact on economic activity. In sectors of the economy that do a substantial portion of business with the government, Baker, Bloom, and Davis find higher EPU increases stock price volatility and lowers investment and employment at the firm level. An example of this would be firms in the defense industry. At the macroeconomic level, they estimate a vector auto-regression and find a 90 basis point increase in the EPU index decreases aggregate industrial production by 1.2 percent and employment by 0.35 percent.
In this article, I examine the impact of EPU on small business decisions using the National Federation of Independent Business survey on economic trends. This survey asks questions that quantify small business expansion plans and their economic outlook. Schweitzer and Shane (2011) also use this data to examine the impact of EPU on small business decisions, but my analysis differs from Schweitzer and Shane in a number of ways. In assessing small business response to EPU, Schweitzer and Shane focus only on what firms said about their plans for employment and capital investments. I examine a broader set of survey responses, adding plans to increase worker compensation, plans for general expansion, and the degree of business optimism among small business respondents.
Schweitzer and Shane control for general economic and credit market conditions, but not supply shocks and general economic uncertainty. Supply shocks can influence small business expansion plans by changing production costs. I take supply shocks into account. In order to identify the impact of EPU on small business decisions, general economic uncertainty must be controlled. I use the Chicago Board of Options 30-day volatility index for S&P 500 options to measure general economic uncertainty.
Another issue is whether business responses to changes in economic policy persist over time. Schweitzer and Shane do not address that question. I add a lagged dependent variable to the regressions to see if business responses to changes in economic policy persist over time. Finally, the sample period I use is longer than that used by Schweitzer and Shane: it covers an additional four-and-a-half years of data following the 2007-09 recession.