During 2009 and 2010 Paul Krugman did a lot of complaining about the “uncertainty fairy”—criticizing the idea that uncertainty played a role in the slow recovery of the economy after the Great Recession. As it turns out he was both right and wrong, depending on what is meant by “uncertainty”, as this column at Bloomberg by Noah Smith points out:
A team of empirical macroeconomists recently set out to investigate the uncertainty issue more deeply. Sydney Ludvigson and Sai Ma of New York University and Serena Ng of Columbia University have a new paper in which they investigate whether uncertainty is exogenous or endogenous — that is, whether it is the cause of economic disruption, or the effect. Their statistical technique requires some bold assumptions, but allows for interpretation of cause and effect.
Ludvigson, Ma and Ng find that financial uncertainty seems to cause every other type of economic uncertainty — in other words, that financial uncertainty looks exogenous while other types of uncertainty seem to be endogenous. This reinforces what many other macroeconomists have found since the crisis — finance often seems to drive the real economy.
So what does this result mean for the policy uncertainty hypothesis? On one hand, it reinforces the notion that uncertainty, in the general sense, is very bad for the economy. But it implies that for policy to be the cause of this uncertainty, it would have to do so through its impact on financial markets. Legal challenges to Obamacare or increased regulation of aircraft manufacturing would be unlikely causes of recessions.
In summary uncertainty is bad for the economy but uncertainty in the financial markets induces other forms of uncertainty rather than the other way around. Or, said another way, the Masters of the Universe screwed up big time.
One hardly knows where to start with it.
By definition financial uncertainty, more properly risk, is literally the statistical distribution of return around an expected value. Every single factor impacting that distribution of returns is a real, or operating, variable. Demand, tax changes, regulatory and political changes, technology advancements, movements in asset prices……. Financial uncertainty can’t cause itself, it’s simply the measurement of the effects of real economy variables on cash flows.
In corporate finance the term “financial risk” gets bandied about, but is really a colloquialism. Closest to a useful concept is it’s use in the context of financial leverage. Taking on “financial risk” is really a way of saying the debt service requirements associated with taking on (a high level of) leverage leaves no guard band for unexpected real economy events that diminish cash flow. More common useage is simply the notion that, yes, financial returns are not certain, so financial market valuations fluctuate. A residual, and not much information there.
It sounds like the professors, since I doubt they are stupid, have produced an agenda driven piece. In particular I infer they are talking about the 2008 financial crisis. But the fact of the matter is that the real economy drove the financial crisis: credit standards and regulatory posture that inflated asset values, drove the construction sector, and created de facto household ATM machines driving economic performance……until they didn’t.
I would note that equity market values have been re-inflated to pre-2008 levels. Yet, if GDP was measured on the same basis as pre-2008, it would be essentially zero.
Meh, I don’t think this report undermines a “policy uncertainty” proposition. As Smith states: “Their statistical technique requires some bold assumptions.”
I don’t think anybody could dispute that there are numerous policies and policy proposals that are intended to encourage or discourage investment. Proposed regulations and legislation are often accompanied by economic analysis of their potential effect on jobs and the economy. In making business decisions in areas where public policy is active, businesses have to take into consideration future policies, what new ones may come into place or what existing ones will be repealed. The effect will be different between new startups and existing businesses. The effect will be less with respect to multinationals that can move operations outside the public policy orbit of the U.S.
How to measure this? I don’t know. I would probably look to the number of regulatory attorneys/consultants and lobbyists.