Blog Post

The uncertainty hypothesis

What’s at stake: Uncertainty is frequently blamed for the sorry state of the economy. In the US, the Speaker of the House John Boehner, for example, recently declared that regulatory, tax, and trade uncertainties are playing a hampering role on the recovery from the Lesser Depression by straining the incentives for companies to invest. After […]

By: and Date: October 6, 2011 Topic: Global Economics & Governance

What’s at stake: Uncertainty is frequently blamed for the sorry state of the economy. In the US, the Speaker of the House John Boehner, for example, recently declared that regulatory, tax, and trade uncertainties are playing a hampering role on the recovery from the Lesser Depression by straining the incentives for companies to invest. After reviewing conditions under which an increase in uncertainty (second moment) – as opposed to a decrease in prospects (first moment) – can have a detrimental impact on the economy, we review the empirical evidence on the topic. We start by the specific type of uncertainty outlined by Boehner and then turn to another kind of uncertainty: our lack of knowledge about the shape of post-financial crisis recoveries.

Is uncertainty necessarily bad?

Antonio Fatas points to the importance of differentiating between uncertainty and bad news. One is that the future is more difficult to predict (and this truly matches the notion of uncertainty) but the second one is that future scenarios are simply worse than what we thought before.

David Romer furthermore argues that uncertainty does not necessarily reduce spending. What is key in terms of impact on aggregate spending is the asymmetry of the costs of doing more or less than you would have done had you known for sure. To build an argument based on uncertainty, it is therefore necessary to either assume an asymmetric objective function, or be in a situation where the value of waiting is increasing as uncertainty grows. In a set-up where durables purchases are irreversible and consumers choose not only the quantity but also the quality of durable goods they purchase, a temporary increase in uncertainty would reduce spending.

Nick Bloom of Stanford University reviews research on 16 previous shocks – such as September 11 and the Enron scandal – and concludes that today’s uncertainty shock will create a short, sharp contraction in late 2011 of about 1% with a rebound coming in spring 2012. Following disruptive events, he observes a sharp rise in the VIX index, followed by a large short run recession. In the end of August, the level of uncertainty had reached the same levels as during the post September 11 weeks.

In a recent NBER working paper, Ruediger Bachmann, Eric Sims, and Steffen Elstner found no evidence that changes in uncertainty cause a wait-and-see effect, defined as a large decline in economic activity when uncertainty hits followed later by fast rebounds. The economists used the Philadelphia Fed’s manufacturing survey since 1968 and the German Ifo business sentiment survey since 1980 and calculated uncertainty in various ways. Using as an indicator the divergence between prediction and real conjuncture, they conclude that uncertainty does not cause a wait-and-see impact on production and employment.

Policy and regulatory uncertainty

John Taylor makes the case against active interventionist policies. Stop all the interventions — the short-term discretionary fiscal stimulus packages and the massive quantitative easings and the operation twists of monetary policy. The unpredictability caused by these policies is causing uncertainty and holding the recovery back. Instead put in place more permanent reforms which will create economic recovery and return the economy to the kind of performance we saw in the 1980s and 1990s when rules-based, less interventionist policies were followed.

Robert Barro
and Greg Mankiw argue that uncertainties on taxes and regulation reduce the returns of current investments. Mankiw points to the counterexample of the Reagan recovery in 1982, where non-residual fixed investment grew by 27% two years after the trough. As investment leads recoveries, taxes should be shifted to other bases to lower its cost. In a similar vein, Barro suggests establishing a VAT to lower the cost of capital.

Menzie Chinn
, however, points that the “jobless recovery” does not seem to be an “investment-less recovery”: non-residential investment has rebounded faster than on average in other recessions (the Reagan recovery should be treated as a special case, precisely because of the particular macro and monetary environment at the time), whatever the metric used (from peak or from trough). The econometric relation between output and business investment is, if anything, more stable than in previous years.

Bruce Bartlett
reports that, according to a BLS survey, the number of jobs involved mass lay-offs by companies citing new government regulations as a reason for is a mere 1% of the ones citing “lack of demand”. The number of small businesses reporting the regulatory environment as a problem is higher, but still accounts for less than half of the demand factor. Lawrence Michel, of the think tank EPI, adds that those concerns have always been high and roughly constant for small businesses, but that the lack of demand has suddenly risen as the main hurdle. Challenged by James Pethokoukis of the American Enterprise Institute, Michel further notes that investment in equipment and software during the 2009-2011 recovery has been more dynamic than in any of the four preceding ones.

Greg Ip
argues regulations are sector-specific, and if they have an impact, it might be non-perceived at the macroeconomic level. They could also have a cost as part of a trade off (for example, in the case of the financial industry, a higher cost of capital against more financial stability).

Non-policy uncertainty

One particular type of non-policy uncertainty is due to our limited knowledge about the shape of recoveries following a financial crisis.

Christina Romer argues that the sources of uncertainty holding the recovery are far more fundamental than the tax and environmental issues that typically top the list of complaints. The deepest and most destructive uncertainty we face centers on the overall health of the economy. Unlike other postwar recessions that were caused by tight monetary policy and high interest rates, the recent downturn resulted from the bursting of a housing bubble and a financial crisis. Because we are in largely uncharted territory, figuring out how and when the economy will recover is much harder than usual. One sign of heightened macroeconomic uncertainty is that the forecasts of respected analysts are all over the map. The difference between the highest and the lowest forecasts of unemployment a year from now is about twice as large as it was before the crisis. And forecasters’ reported uncertainty about their longer-run forecasts has shown no sign of improving over the last year.

Studying the 1825-1929 period in the US, Andrew Jalil argues that the sluggish output growth the U.S. economy has experienced in the aftermath of the Great Recession is consistent with the U.S. historical experience following major banking panics. Although policymakers often see Reinhart and Rogoff as the best work on recoveries following financial crises, Jalilforcefully reveals in the first part of his paper the major inconsistencies that the RR series on financial crises contain – sometimes even incorrectly identifying foreign banking panics as domestic ones. Armed with a better-identified series, Jalil investigates the shape of recoveries following banking crises in the US over the 1825-1929 period. Following three of the four major banking panics of the post-Jacksonian period, output did not rapidly revert back to its pre-panic trend. Moreover, following two of these panics, trend output growth declined substantially.

*Bruegel Economic Blogs Review is an information service that surveys external blogs. It does not survey Bruegel’s own publications, nor does it include comments by Bruegel authors.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Blog Post

Reforming the EU fiscal framework

Researchers have often highlighted the problematic nature of the currently very complex EU fiscal framework. Here we review economists’ views on how it should be changed.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: September 17, 2018
Read article More on this topic More by this author

Blog Post

Lehman Brothers: 10 Years After

Ten years after the bankruptcy that shook the world, we review economists’ take on the lessons learned from the global financial crisis.

By: Silvia Merler Topic: Finance & Financial Regulation Date: September 10, 2018
Read article More on this topic More by this author

Blog Post

Monetary policy and superstar firms

The yearly Jackson Hole gathering of central bankers has focused this year on the topic of changing market structure, the rise of superstar firms, and the implications of the way they compete for central banks.

By: Silvia Merler Topic: Global Economics & Governance Date: September 4, 2018
Read article More on this topic More by this author

Blog Post

The Turkish Crisis

Financial markets have been very nervous about Turkey for the past few weeks. We review economists’ opinions about the economic, political and geopolitical risks and opportunities of this situation.

By: Silvia Merler Topic: Global Economics & Governance Date: August 27, 2018
Read article More on this topic More by this author

Blog Post

Italy's "Dignity Decree"

The new Italian government pushed through its first legislative act including elements of labour market reform. Presented as an overturn of the previous government’s “Jobs Act”, the estimated effects of the decree are controversial. We review Italian economists’ view on the matter.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: July 23, 2018
Read article More on this topic More by this author

Blog Post

Economy of Intangibles

Economists have been discussing the implications of the rise of the intangible economy in relation to the secular stagnation hypothesis, and looking more generally into the policy implications it has for taxation. We review some recent contributions.

By: Silvia Merler Topic: Finance & Financial Regulation Date: July 16, 2018
Read article More on this topic More by this author

Blog Post

World Cup Economics

As we approach the final rounds of the tournament, here are some recent contributions about the economics and economic impact of the World Cup.

By: Silvia Merler Topic: Global Economics & Governance Date: July 9, 2018
Read article More on this topic More by this author

Blog Post

US tariffs and China's holding of Treasuries

China has the biggest bilateral trade surplus vis-à-vis the US but is also a top holder of US government bonds. While China has started to counteract US trade tariffs, economists have been discussing the case of China acting on its holdings of US Treasuries. We review recent contributions.

By: Silvia Merler Topic: Global Economics & Governance Date: July 2, 2018
Read article More on this topic More by this author

Blog Post

The Meseberg declaration and euro-zone reform

The recent Franco-German Meseberg declaration will set the scene for next week’s summit. We review opinions on this important agreement.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: June 25, 2018
Read article More on this topic More by this author

Blog Post

Demographics and Long Run Growth

Scholars have been investigating the relationship between demographics and long term growth, in the context of the secular stagnation hypothesis. We review recent contributions.

By: Silvia Merler Topic: Global Economics & Governance Date: June 18, 2018
Read article More on this topic More by this author

Blog Post

The Italian mini-BOT debate

Talks of parallel currency are not new in Italy. But one of the proposals – the so called mini-BOT – has made it into the government contract that underpins the current League-M5S coalition. We review what has been said about these proposals.

By: Silvia Merler Topic: Finance & Financial Regulation Date: June 11, 2018
Read article More on this topic More by this author

Blog Post

The Italian Crisis

While Italy has been through one of the gravest institutional crises in its history, we review recent opinions on the topic.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: June 4, 2018
Load more posts