When Uncertainty Lingers, Growth Lags
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Finance & Accounting Jan 30, 2015

When Uncer­tain­ty Lingers, Growth Lags

Com­pa­nies’ reluc­tance to act in the wake of a country’s eco­nom­ic shock can inhib­it growth as much as the orig­i­nal shock itself.

Yevgenia Nayberg

Based on the research of

Scott R. Baker

Nicholas Bloom

Steven J. Davis

To most peo­ple, uncer­tain­ty sim­ply means not know­ing: not know­ing what next year’s vaca­tion plans are, who their next client will be, or how long their sav­ings will last.

But to econ­o­mists, uncer­tain­ty is para­dox­i­cal­ly know­able. It can be mea­sured, indexed, mod­eled, and cor­re­lat­ed with oth­er ele­ments in the busi­ness cycle. One such ele­ment is eco­nom­ic growth — uncer­tain­ty is low­er dur­ing booms and high­er dur­ing busts.

The asso­ci­a­tion makes intu­itive sense. But econ­o­mists have strug­gled to define a cause-and-effect link between uncer­tain­ty and growth. Which direc­tion is this rela­tion­ship going?” says Scott R. Bak­er, an assis­tant pro­fes­sor of finance at the Kel­logg School of Management.

In two recent research stud­ies, Bak­er and his col­lab­o­ra­tors exam­ined how uncer­tain­ty at the macro­eco­nom­ic and gov­ern­ment-pol­i­cy lev­els is not mere­ly a reac­tion to slug­gish growth, but can also act as an inhibit­ing influ­ence on growth itself.

The gov­ern­ment needs to be cog­nizant of action that they take or state­ments they make about uncertainty.”

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In oth­er words, eco­nom­ic uncer­tain­ty is not just a reac­tion to mar­ket forces — it appears to be a force unto itself. And it is a force that should be under­stood by econ­o­mists and hope­ful­ly mit­i­gat­ed by pol­i­cy­mak­ers so that it caus­es less eco­nom­ic stress.

Know­ing What We Do Not Know

Bak­er defines uncer­tain­ty not as an inabil­i­ty to fore­cast the out­come of events, but as a mea­sure of the vari­ance between many such fore­casts. Specif­i­cal­ly, he wants to know how large a spread there is around a mean.

For exam­ple, he says, If you ask ten econ­o­mists what GDP growth is going to be next year, and five say it’s going to be 1% and five say it’s going to be 2%, that’s a mean of 1.5%, and everybody’s with­in a half point of each oth­er. But if five peo­ple say 0% and five say 3%, there’s more uncer­tain­ty around that same mean val­ue of 1.5% because the range of poten­tial out­comes has increased.”

When the mean of these fore­casts is low, mean­ing peo­ple are more pes­simistic about eco­nom­ic fun­da­men­tals or busi­ness con­di­tions in the next year,” the spread between indi­vid­ual fore­cast­ed val­ues tends to be greater, Bak­er says.

To deter­mine whether this uncer­tain­ty was a cause or effect of the ini­tial pes­simism, Bak­er stud­ied the GDP growth of six­ty coun­tries that endured either a large-scale nat­ur­al dis­as­ter, ter­ror­ist attack, or peri­od of polit­i­cal strife between 1970 and the present day. These shocks to var­i­ous nations’ eco­nom­ic growth allowed Bak­er and coau­thor Nicholas Bloom of Stan­ford Uni­ver­si­ty to dis­en­tan­gle” the effects of eco­nom­ic uncer­tain­ty from those of the shocks that pre­cip­i­tat­ed them.

If an earth­quake occurs, it caus­es eco­nom­ic loss­es, so it has a neg­a­tive effect on mean stock returns in the next quar­ter. But it doesn’t have as large of an effect in terms of uncer­tain­ty about future pro­duc­tiv­i­ty,” Bak­er explains. In con­trast, some­thing like a polit­i­cal rev­o­lu­tion can also low­er the fore­cast mean of busi­ness con­di­tions for the next year, but there’s also a lot more uncer­tain­ty about what’s going to hap­pen. Maybe the new leader isn’t a known quan­ti­ty so nobody knows what eco­nom­ic poli­cies he’s going to take; maybe there’s going to be a reverse coup.”

When Bad Things Hap­pen to Good Markets

Bak­er used both first moment” eco­nom­ic shocks (the short-term effects on the lev­el of pro­duc­tiv­i­ty or on busi­ness con­di­tions) and sec­ond moment” shocks (things affect­ing the uncer­tain­ty and volatil­i­ty of fore­cast­ed busi­ness con­di­tions, as mea­sured by stock mar­ket volatil­i­ty) to neat­ly sep­a­rate the ensu­ing effects on eco­nom­ic growth.

We used nat­ur­al dis­as­ters and polit­i­cal con­flicts in our mod­el because these are nation­al-scale events that affect macro­eco­nom­ic growth in a way that is actu­al­ly mea­sur­able,” he says. They’re also very con­crete and fair­ly ran­dom at a high fre­quen­cy level.”

This allows Bak­er and Bloom to iso­late changes in uncer­tain­ty that stem from exter­nal forces, not from macro­eco­nom­ic growth itself, lead­ing to a clear­er analy­sis of whether uncer­tain­ty impacts growth or only the oth­er way around.

The results of the exper­i­ment were defin­i­tive,” Bak­er says.

GDP growth was reduced by up to 1.6% in the first finan­cial quar­ter fol­low­ing one of these major events, and up to 7% the fol­low­ing year — and the uncer­tain­ty the event caused was respon­si­ble for at least half of that change in growth.

The rea­son, Bak­er says, is because adjust­ing to chang­ing busi­ness con­di­tions incurs costs that can­not eas­i­ly be recouped. If firms can­not rea­son­ably pre­dict what those changes are like­ly to look like, they just tend to sit still for as long as pos­si­ble to wait for the uncer­tain­ty to resolve.” When busi­ness­es sit still — freez­ing their hir­ing and cur­tail­ing their cap­i­tal invest­ments — eco­nom­ic growth stalls.

Shaky Steps

Gov­ern­ments can mount a pow­er­ful pol­i­cy response to such slow­downs in growth. But uncer­tain­ty around these poli­cies can itself be a drag on the very growth they are designed to stimulate.

From 2010 to 2012, there was a lot of dis­cus­sion about whether the amount of uncer­tain­ty about [U.S.] gov­ern­ment pol­i­cy was one of the things that had been dri­ving the depth of the Great Reces­sion and the slug­gish­ness of the recov­ery,” Bak­er says. The gov­ern­ment was tak­ing all kinds of unprece­dent­ed action, so there was uncer­tain­ty about new reg­u­la­tions, new tax­es, new Fed­er­al Reserve pol­i­cy. Peo­ple won­dered whether that was hav­ing some neg­a­tive effects on con­sumers, house­holds, or businesses.”

In a sec­ond research study, Bak­er, Bloom, and Steven J. Davis of the Uni­ver­si­ty of Chica­go devised an eco­nom­ic pol­i­cy uncer­tain­ty index” to track and mod­el this effect. Bak­er acknowl­edges that uncer­tain­ty in gov­ern­ment pol­i­cy is a some­what neb­u­lous con­cept,” but his team quan­ti­fied it in much the same way as they did with macro­eco­nom­ic uncer­tain­ty in their oth­er work.

Between 1985 and 2014, the more vari­ance that the researchers could gath­er in pre­dic­tions about U.S. eco­nom­ic pol­i­cy — from news­pa­per arti­cles and gov­ern­ment spend­ing fore­casts to tax code changes and elec­tion results — the high­er was the uncer­tain­ty, as mea­sured on the index they created.

Bak­er found that while pol­i­cy uncer­tain­ty gen­er­al­ly increased in the wake of the 2008 reces­sion, deter­min­ing its effect on the econ­o­my was a chal­lenge. Still, the researchers found a tight link­age” between increased lev­els of pol­i­cy uncer­tain­ty and decreased invest­ment in firms that are high­ly depen­dent on gov­ern­ment spend­ing, such as defense con­trac­tors, health­care com­pa­nies, and hospitals.

Uncer­tain­ty as a Mar­ket Force

Both research projects, Bak­er says, strong­ly sug­gest that uncer­tain­ty is a macro­eco­nom­ic force to be reck­oned with in its own right — both by the econ­o­mists who mod­el and fore­cast busi­ness con­di­tions and the pol­i­cy­mak­ers who influ­ence and respond to those con­di­tions. Cer­tain first-moment eco­nom­ic shocks are inher­ent­ly unpre­dictable, but by under­stand­ing the sec­ond-moment effects that uncer­tain­ty can have, addi­tion­al reduc­tions in growth can be mitigated.

The gov­ern­ment needs to be cog­nizant of action that they take or state­ments they make about uncer­tain­ty,” Bak­er explains. For exam­ple, there are lots of tax­es now that are on per­pet­u­al one-year renew­al cycles. Our research sug­gests that things like that tend to depress invest­ment because firms are going to wait and see what the gov­ern­ment does, rather than main­tain some steady lev­el of invest­ment over time.”Baker main­tains that uncer­tain­ty analy­sis is also a cru­cial method for econ­o­mists’ own basic under­stand­ing of the busi­ness cycle.

Busi­ness­es are already tak­ing uncer­tain­ty and its poten­tial effects into account,” he says. That’s why we can see these sec­ond moment’ effects on growth. When we’re build­ing mod­els of macro­eco­nom­ic behav­ior, it’s very impor­tant not to assume that busi­ness­es are mak­ing deci­sions based on the mean of what they expect to hap­pen next year, but also in terms of the uncer­tain­ty around that mean. We think this is not just a char­ac­ter­is­tic of these very con­crete shocks, like earth­quakes and polit­i­cal rev­o­lu­tions, but of the evo­lu­tion of busi­ness con­di­tions in general.”

In oth­er words, a lit­tle knowl­edge — even if it is about what we do not know — can go a long way.

About the Writer

John Pavlus is a writer and filmmaker focusing on science, technology, and design topics. He lives in Portland, Oregon.

About the Research

Baker, Scott R., Nicholas Bloom. “Does Uncertainty Reduce Growth? Using Disasters as Natural Experiments.” Working paper.
Scott R. Baker, Nicholas Bloom, and Steven J. Davis’ “Economic Policy Uncertainty Index,” accessed January 29, 2015, http://policyuncertainty.com/index.html.

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