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Volatility and reforms: The overlooked virtues of economic uncertainty

The Great Recession highlighted the prominent role that economic uncertainty plays in hindering investment and growth. This column provides new evidence that economic uncertainty can actually play a positive role by promoting the implementation of structural reforms with long-run benefits. The effect appears to be strongest for countries with poorly informed voters. These findings suggest that times of uncertainty may present an opportunity to implement reforms that would otherwise not be passed.

Does economic uncertainty promote or impede the adoption of structural reforms? This question arises when jointly considering two issues that became particularly relevant during the Great Recession.  On the one hand, the rise in macroeconomic volatility in recent years has stimulated a new literature on how uncertainty impacts economic activities and private investment decisions (see Bloom 2009, 2011, 2011a, 2014). On the other hand, the Crisis has also revealed the need for structural reforms. Surprisingly, little effort has been devoted to studying the effect of uncertainty on public policy decisions such as reforms.  In a recent paper, we aim to fill this gap by empirically investigating whether and how economic uncertainty affects the implementation of structural reforms (Bonfiglioli and Gancia 2015).

What does the theory predict?

While the political economy literature has identified a series of factors fostering or hindering the adoption of reforms, little attention has been paid to the role of uncertainty.  Some theories suggest that uncertainty on the distributional effects of a reform may be an obstacle to its adoption, for instance because it may induce a status quo bias in voters (Fernandez and Rodrik 1991), or a war of attrition between parties resulting in inefficient delays (Alesina and Drazen 1991). Alternatively, as we have earlier suggested (Bonfiglioli and Gancia 2011, 2013), uncertainty on economic outcomes may promote the adoption of reforms by making re-election probability depend more on luck and less on policy action – thereby leaving governments more free to adopt reforms with short-run costs and long-run benefits.

Measuring reforms and economic uncertainty

For our empirical analysis, we rely on two recent datasets providing useful information for measuring structural reforms and economic uncertainty. For structural reforms, we borrow from the IMF (see Ostry et al 2009) a set of regulation indices covering six sectors – the domestic financial market and external capital account, trade and the current account, product markets and agriculture. We normalise all indices between 0 and 1, with a higher value corresponding to a greater degree of liberalisation, and measure structural reforms for each sector as the annual change in its index.

Our measure of economic uncertainty, drawn from a recent contribution by Baker and Bloom (2013), is the standard deviation of daily stock market returns, which reflects the variability in investors' expectations over the future sales of firms, computed from the Global Financial Database.

We conduct our analysis on a sample of 56 developed, emerging, and developing countries, with annual observations between 1973 and 2006, and data on structural reforms in six sectors, corresponding to about 6,400 sector-country-year observations.

Empirical strategy and results

We regress our measure of structural reforms on a set of variables including one-year lags of stock market volatility, the liberalisation index, and, progressively, political variables, real and financial crises, and development indicators. We also include country-sector and year fixed effects to account for omitted heterogeneity.

The OLS coefficient estimates suggest that structural reforms are strongly and positively correlated with economic uncertainty. However, although volatility enters in the regression with one lag, these estimates may not capture a causal link from uncertainty to reforms. For example, volatility in the year prior to the adoption of reforms may be affected by the political debate over the design and approval of the reform itself, which would induce reverse causality. To identify the causal effect of volatility, we instrument it in three alternative ways and estimate our specifications with two-stage least squares.

First, we argue that, given the degree of international integration of stock markets and the importance of world-level shocks, there are some common factors driving volatility in all countries. Such a world component of volatility seems a good instrument for country-specific volatility because it is likely to be independent of the political debate over reforms taking place in each single country. Hence, our first instrument is the lag of the average volatility in the other sample-countries, weighted by their real GDP per capita. The results prove our instrument to be strong and suggest that uncertainty indeed positively affects structural reforms.

As an alternative set of instruments for stock market volatility, we borrow from Baker and Bloom (2013) four indicators capturing exogenous events such as natural disasters, political shocks, and terroristic attacks. All indicators are constructed as dummies accounting for the occurrence of at least one shock in a given country and year, weighted by a measure of the attention devoted by world media to the country around the day of the shock.  Moreover, since political shocks and terroristic attacks may be endogenous to economic and political conditions (such as reforms) in a country, we also use, as a third set of instruments, the average shocks that occurred in other sample countries, weighted by real GDP per capita. The results show both sets of instruments to be strong and confirm that uncertainty promotes reforms. In particular, the IV coefficients suggest that a one-standard deviation increase in volatility has a positive effect corresponding to 16-30% of the average reform size.

As a further robustness check, we show that of our findings are preserved when replicating the analysis restricting the sample to some groups of reforms and countries.

Besides providing novel results on the effects of uncertainty, our estimates corroborate the existing evidence that reforms are also positively correlated with the degree of democracy, left-wing orientation of governments and presidential systems. Our analysis also suggest that both recessions and financial (banking, currency, and sovereign debt) crises are associated with a lower reform effort.

As a final exercise, we take a step towards understanding the mechanism linking uncertainty to reform intensity. Our starting point is the model in Bonfiglioli and Gancia (2013), where uncertainty can mitigate political myopia generated by electoral incentives and asymmetric information. The argument is that in times of turmoil re-election depends more on luck rather than political actions, thereby leaving the government freer to invest in reforms with short-run costs and future payoffs. We then test the prediction that uncertainty promotes reforms more where fewer voters are informed about policy choices. To do so, we estimate our main specifications on two groups of countries, characterised by high and low circulation of daily newspapers per thousand inhabitants in 1996. Consistent with the theory, the results point to larger effects in the latter group of countries.


Our analysis has unveiled a strong positive effect of uncertainty on the intensity of structural reforms, which seems to be more pronounced in countries with poorer information about policy action. These results are important in at least two respects. First, they suggest that times of market turmoil, which are characterised by a high degree of uncertainty, may provide an opportunity to implement reforms that would otherwise not pass. Second, if the myopic bias is indeed driven by poor information, as hinted by our last findings, it would imply that promoting transparency, guaranteeing media independence, and educating voters are important factors to make democracies work well.


Alesina, A and A Drazen (1991) "Why are stabilizations delayed?", American Economic Review, 81: 1170-1188.

Baker, S and N Bloom (2013) "Does uncertainty drive business cycles? Using disasters as natural experiments", NBER Working Paper 19475.

Bloom, N (2009) "The impact of uncertainty shocks", Econometrica, 77(3): 623--685.

Bloom, N (2011) "The uncertainty shock from the debt disaster will cause a double-dip recession" VoxEU.org, 22 August.

Bloom, N (2011a) "The price of market uncertainty is a double-dip recession," VoxEU.org, 26 August.

Bloom, N (2014) "Fluctuations in uncertainty", Journal of Economic Perspectives, 28(2): 153--176.

Bonfiglioli, A and G Gancia (2011) "Why are reforms so politically difficult?", VoxEU.org, 14 June.

Bonfiglioli, A and G Gancia (2013) "Uncertainty, electoral incentives and political myopia", The Economic Journal, 123(May): 373--400.

Bonfiglioli, A and G Gancia (2015) "Economic uncertainty and structural reforms”, CEPR, Discussion Paper 10937.

Fernandez, R and D Rodrik (1991) "Resistance to reform: Status quo bias in the presence of individual-specific uncertainty", American Economic Review, 81(5): 1146-1155.

Ostry, J D, A Prati, and A Spilimbergo (2009) Structural reforms and economic performance in advanced and developing countries, International Monetary Fund, Washington, DC.

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