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Why Regime Uncertainty Will Eventually Sink Trump and the Markets

Authored by Steve H. Hanke of the Johns Hopkins University. Follow him on Twitter @Steve_Hanke.

In the months since President Trump was elected consumer and
business confidence have soared, and the stock markets have, too. Many are
betting that much-needed supply-side tax reforms and deregulation would be
rabbits that Trump would pull out of his hat. But, economic growth remains
tepid, and political storm clouds are gathering in Washington, D.C.

To date, there is so much noise and so little signal from
Washington that stock prices have not been knocked off course. But, this will
not last. Regime uncertainty is a bad omen for trust, confidence and markets.
The course of economic activity depends in part on the level of trust and
confidence the public has in its elected officials and policy makers. Indeed,
members of the Cambridge School of Economics, which was founded by Alfred
Marshall (1842-1924), all concluded the fluctuations in business confidence are
the essence of the business cycle. As John Maynard Keynes argued in The General Theory:

The state of confidence, as they term it, is a matter to which
practical men always pay the closest and most anxious attention. But economists
have not analyzed it carefully and have been content, as a rule, to discuss it
in general terms. In particular it has not been made clear that its relevance
to economic problems comes in through its important influence on the schedule
of the marginal efficiency of capital. There are now two separate factors
affecting the rate of investment, namely, the schedule of the marginal
efficiency of capital and the state of confidence. The state of confidence is
relevant because it is one of the major factors determining the former, which
is the same thing as investment demand schedule.

Frederick Lavington (1881-1927), a Fellow of Emmanuel
College and the most orthodox of the Cambridge economists, went even further in
his 1922 book, The Trade Cycle.
Lavington concluded that, without a “tendency for confidence to pass into errors
of optimism or pessimism,” there would not be a business cycle.

The war being waged in Washington will eventually take its
toll on the public’s level of trust and confidence in the political elites.
This toll will result from what is called “regime uncertainty.” Regime
uncertainty relates to the likelihood that investor’s private property in their
capital and the flows of income and services it yields will be attenuated by
government action. As regime uncertainty is elevated, private investment is
notched down from where it would have been. This can result in a business-cycle
bust and even economic stagnation.

Robert Higgs, in a series of careful studies, was able to
identify why private investment was kept underwater during the Great
Depression. The source of the problem, according to Higgs, was regime
uncertainty. Higgs’s diagnosis is best summarized in his own words from Against Leviathan: Government Power and a
Free Society
(2004).

Roosevelt and Congress, especially
during the congressional sessions of 1933 and 1935, embraced interventionist
policies on a wide front. With its bewildering, incoherent mass of new
expenditures taxes, subsidies, regulations, and direct government participation
in productive activities, the New Deal created so much confusion, fear,
uncertainty, and hostility among businessmen and investors that private
investment and hence overall private economic activity never recovered enough
to restore the high levels of production and employment enjoyed during the
1920s.

In the face of the interventionist
onslaught, the U.S. economy between 1930 and 1940 failed to add anything to its
capital stock: net private investment for that eleven-year period totaled minus
$3.1 billion. Without ongoing capital accumulation, no economy can grow....

The government’s own greatly
enlarged economic activity did not compensate for the private shortfall. Apart
from the mere insufficiency of dollars spent, the government’s spending tended,
as contemporary critics aptly noted, to purchase a high proportion of sheer
boondoggle.

Thanks to Scott R. Baker of Northwestern University,
Nicholas Bloom of Stanford University and Steven J. Davis of the University of
Chicago we have a measure or proxy for Higgs’s regime uncertainty. The chart
below shows that, with the election of Donald Trump, the U.S. Policy
Uncertainty Index surged. It then backed off a bit, but remains elevated. This
will eventually take its toll on confidence and the markets. Use the calm
before the storm prudently. 

This piece was originally posted on Forbes.