The Relationship Between Uncertainty, The Irish Economy and Its Financial.

The relationship between Uncertainty, the Irish Economy and its Financial

Authors: Dr. Sean Kenny, Dr. Fergal O’ Connor, Emma Horgan PhD Keywords: Uncertainty, Ireland, Irish Economy Introduction: In essence, this paper attempts to quantify the relationship between uncertainty shocks and both the real economy and financial system. Uncertainty is defined as ‘people’s inability to forecast the likelihood of an event happening’ and it is typically proxied using metrics such as stock market or GDP volatility, forecaster disagreement, or the volatility of productivity shocks to firms (Bloom 2014). In the previous decade, an innovative research approach has emerged, placing the construction of Economic Policy Uncertainty (EPU) indices centre stage. The longest available historical series of economic policy uncertainty (EPU) are for the U.S. and the U.K. extending back to 1900 (Baker et al. 2016). Furthermore, unlike the case of many other high-income economies (Baker et al. 2016), we have only a limited understanding of the role that uncertainty has played in influencing Irish macroeconomic variables, such as unemployment, inflation and GDP. In sum, we cannot yet know what the occurrence of these shocks will imply for economic performance, future debt to GDP ratios, debt servicing capability and future fiscal policy. The paper contains a new database containing an original long run series for uncertainty. We also introduce further long run economic variables at monthly frequency not previously publicly available, including but not limited to, imports, exports, fiscal receipts and expenditure and stock and bond market data. These series are then tested for their sensitivity to external shocks. Uniquely, we then model the effects of uncertainty not only upon the economy, but also upon the cost and sustainability of government financing. This historical approach has the advantage of allowing us to observe how the government’s ability to finance activity before, during and after previous external emergencies was affected. Literature: There has been a vastly growing literature on the macroeconomic effects of uncertainty shocks, initiated by Bloom (2009), however, there has been limited investigation in an Irish context. Two studies on uncertainty in Ireland have so far been produced Zalla (2016) compiles an EPU index following the methodology of Bloom (2016) beginning in 1985 and Rice (2020) expands upon this by including a wider dataset. Zalla (2016) finds EPU shocks to suggest consequences on the Irish Stock Exchange (ISEQ), the interest rate, employment, and industrial production. Methodology: The construction of this long run (1920-2020) EPU series is based on the frequency of key terms, which characterise uncertainty in policy, in newspaper reporting and represent an attempt to quantify its extent over time (Baker et al. 2016). An article is identified as relating to economic policy uncertainty if it contains an economic, policy, and uncertainty related term (Lennard, 2020). The economic terms are ‘business’, ‘commerce’, ‘commercial’, ‘economic’, ‘economy’, and ‘industry’. The policy terms include ‘Currency board’, ‘Central Bank, ‘Bank Rate’, ‘budget’, ‘deficit’, ‘duty’, ‘policy’, ‘regulation’, ‘spending’, ‘tariff’, ‘tax’, and ‘war’. The uncertainty terms are ‘uncertain’ and ‘uncertainty’. There is only one national newspaper which is published daily, nationally circulated and with archival access back to 1920. Thus, we use the Irish Times as our sole source of EPU data. However, when compared with Zalla (2016) and Rice (2020) we find our Index is more consistent with Rice (2020) who uses multiple newspapers. We therefore conclude that by following Lennard’s (2020) keywords, the reliance on a single newspaper source is more effective than that of Zalla (2016). The index is then constructed by first, counting the number of articles about economic policy uncertainty i in month t, second, by counting the total number of articles N in month t. Third, by calculating the ratio of uncertainty articles to total articles in month t, Y_t=i_t/Nt . Fourth, by averaging the normalized newspaper-specific ratios to form a basic index and finally, dividing the basic index by its mean Z and multiplying by 100 to construct the final index. We also follow Vector Auto Regressions (VAR) to test the relationship between EPU and Irish economic variables. Results: We show that uncertainty has an immediate impact on both stock and bond markets, though the relationship s bi-directional between bonds and Uncertainty. Uncertainty shocks are shown to have a negative impact on the real economy and to precede these by around one quarter.