Policy uncertainty creates an invisible ‘tax’ on capital formation

• Key insight: Banks can price in risk and manage their way around both left-wing and right-wing administrations. But the kind of uncertainty that arises from today’s brand of politics is impossible to model.
• What’s at stake: The degree of uncertainty about the direction of future government policies today is far worse than what can be expected to result from typical political disagreements over left-wing or right-wing ideals.
• Forward look: For banks, predictability is key. Stability is not the same as ideology.

Banks and capital markets need policy clarity to inform their decisions. Unfortunately, the degree of uncertainty about the direction of future government policies today is far worse than what can be expected to result from typical political disagreements over left-wing or right-wing ideals.

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Under administrations of the left, right and center, financial institutions have carried on their businesses for generations. For centuries, money lending has continued in the face of political turmoil, inflation, pandemics, environmental catastrophes, wars and recessions. Policies that promise either lower taxes or higher taxes, de-regulation or simplification as well as greater public spending have not been a major issue to banks. Indeed, markets can adjust to almost any economic agenda so long as it is consistent, credible and capable of being translated into expectations. For these reasons, the most important challenge is our inability to price in political uncertainty.

This is an essential distinction. Bankers are used to price risk and deal with the laws of probabilities and statistics: liquidity risk, market risk with its specification of interest-rate risk, collateral values and macro-economic decisions. Contemporary banking assumes that risk can be measured and controlled through risk management systems. However, risk is only one part of the equation.

In the 1920s, Frank Knight brilliantly distinguished risk from true uncertainty by claiming that the latter cannot be anticipated and/or measured. John Maynard Keynes shortly afterward endorsed such understanding by pointing out that confidence in the future is the main step into taking reasonable risks. When the future is uncertain and cannot be simplified into a range of expectations, then the allocation of capital stalls.

This is the main new emerging problem of modern economics and democracies, and the United Kingdom offers an interesting case study. The U.K. shows that when there is not a clear direction from the political establishment of the day, then investors become confused. As a result, the persistent level of uncertainty in policymaking cannot be reduced into measurable risk-taking expectations, and markets as well as society at large suffer from political indecision and the lack of consistent direction. Indeed, the U.K. has seen sudden changes in leadership, fiscal experiments, regulatory uncertainty and inconsistency between political promises and market credibility. Investors can price higher or lower taxes in Britain as well as deregulation approaches, but what they cannot easily price is a framework in which the governing signal changes too quickly. That is when risk becomes true uncertainty.

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This is not only a British story, and concerns are visible on the other side of the Atlantic too, affecting U.S.-based banks and investors. Debt-ceiling standoffs, sudden tariff shifts, regulatory reversal between administrations, uncertainty over energy policy, capital and liquidity rules, industrial policy, and future direction of fiscal policy all combine to create similar uncertainty. And the problem is cumulative. When politics is unable to provide citizens and markets with collective answers, then models begin to lose authority.

This does not make it impossible for banks to lend or investors to stop investing. However, it means that they demand a higher premium for uncertainty. They delay long-term capital allocation or shorten time horizons by favoring liquidity. In other words, they become less confident in sectors affected by policy uncertainty. To this end, political unpredictability acts like an invisible tax on capital formation.

This is completely separate from debates about left-wing versus right-wing policies. For instance, a clear left government might be easier for markets to price than an erratic pro-market government of right-wing inspiration. Inconsistent fiscal signals may generate more anxiety than a new government with credible rules. For banks, predictability is key. Stability is not the same as ideology.

The lesson is that a government’s credibility is itself a sort of financial asset. Fiscal discipline, regulatory clarity, institutional coherence all shape the cost of capital. When governments protect those assets, markets can function properly by doing what they have always done: measuring risk and allocating capital. When governments erode them, they generate a form of uncertainty that no statistical model or risk management system can fully absorb.

Nowadays, for banks and investors the main question is no longer whether policy is pro-business or anti-business. Capital can cope with political agreement or disagreement, but it loses its purpose with incoherence in policymaking. In an era of perpetual inconsistency in political decisions, the most important economic policy is not left or right, but reliability itself to absorb uncertainty and allow efficient capital allocation.