It has soared above 200 twice: for two months in 2011, coincident with that year’s debt-ceiling debate, and in December 2012, when a compromise implementation of sequestration was being hammered out. It’ll be interesting to see what happens with the index in the wake of the past week’s developments (or lack thereof) in Washington. The point is that starting with the collapse of Lehman Brothers in September 2008, economic policy uncertainty has been consistently high, and half the time it has been extraordinarily high. It’s difficult to prove “beyond a reasonable doubt” that this elevated uncertainty is causally related to the weak recovery we’ve experienced. But the hypothesis is surely sensible, the timing is certainly auspicious, and enough careful confirming analysis has been done to say that the preponderance of evidence favors the proposition that not just recent policy decisions, but also the manner in which those decisions were arrived at, have been a significant hindrance to economic expansion. The Kinky Stuff: monetary policy As to monetary policy, I would submit there are several links between monetary policy and economic uncertainty. First, though, some background. Ordinarily, monetary policy works by influencing the current and expected near-term levels of short-term interest rates. Once short-term interest rates hit zero, however, the Fed turned to unconventional policies. By using massive purchases of longer-term Treasuries and agency mortgage-backed securities, these policies helped hold down term premia and support the housing recovery.

Such an occurrence can affect other economic agents. They may face illiquidity and even insolvency, affecting market interest rates, in turn leading to changes in trading activities and a disruption in market confidence Payment systems are an essential component in preventing such occurrences and a technical mechanism for the central bank to step in order to challenge contagion or potential contagion. The interest of central banks in financial stability was largely triggered by the Herstatt incident of June 26, 1974. German banks processed Deutsche Mark payments to Herstatt bank in exchange for US Dollars, to be delivered through Herstatt correspondent account in New York. Regulators, deciding to close the bank for lack of solvency immediately, failed to appreciate the time-zone difference between Frankfurt and New York, leaving transactions half-completed. German banks did not receive their US Dollar payments. Although the Herstatt incident did not lead to a financial-stability crisis, it made central banks aware of the risk and they started developing a continuous linked settlement platform, whereby commercial banks manage settlement of foreign exchange amongst themselves on a payment versus payment basis. Cooperation in this area led central banks to share experiences covering other areas of payment systems and financial stability. Well-functioning markets depend on the willingness to develop adequate solutions to ensure smooth functioning of payment systems. Ironically, part of the problem stems from the very fact that technological advances speed up the payment systems and make them more reliable. This in turn enables banks to economise on liquid balances.