Does Uncertainty Matter?

Since the recovery began last year, economists and pundits have been complaining that uncertainty is slowing it down. The logic is pretty easy: when businesses are less sure about the future, they're going to be more cautious with their hiring. Yet, a new economic analysis casts doubt on this theory.

A new paper written by a trio of economists, Ruediger Bachmann of the University of Michigan, Eric Sims of the University of Notre Dame, and Steffen Elstner of the University of Munich, explores whether there's a causal chain between business uncertainty and lower growth. They examined Philadelphia Federal Reserve manufacturing data since 1968, and German Ifo business sentiment since 1980 to determine whether or not uncertainty causes a "wait-and-see" effect. They found no such correlation.

Although the paper is behind a pay wall, Real Time Economics provides a nice summarizing analysis. Here's a key excerpt explaining the paper's conclusions:

"Changes in uncertainty may themselves be the result of the business cycle and not the cause of recession," says Bachmann. As the paper says, "There is an intrinsic uncertainty due to recessions, because business structures and practices have to be rearranged."

One conclusion from the paper is that policy makers can talk about the need to end uncertainty all they want, but jaw-boning won't make much difference. Only increased demand will make business executives feel more confident.

In other words, recessions breed uncertainty, and not vice-versa. It's hard to argue with the first part of that, and the data they analyze shows the second. But RTE continues:

In addition, Bachmann cautions that uncertainty in this business cycle may be more acute because of the recession's unique properties, such as the housing collapse and financial meltdown. It is too early in the recovery to tell, he says.

This raises a question. While business uncertainty may not ultimately be a cause for a deepening recession, what about consumer uncertainty? Couldn't that drive demand lower, where uncertaintly indirectly affects business decisions? The analysis didn't really approach this question.

And this recession is pretty historically unprecedented in terms of the uncertainty that Americans face. Consider the other recessions included in U.S. data set used by the economists. The highest unemployment rate over the time period was during the early 1980s, where it rose above 10% for a several months before quickly falling. And that recession was intentionally made worse by the Fed specifically to create more economic certainty, as the central bank fought inflation. Other than that, no recession in the U.S. data analyzed included unemployment rising above 9%. Aggregate home prices also didn't decline during those recessions.

While there's little doubt that demand ultimately drives business decisions, it's hard to escape the possibility that severe, prolonged unemployment paired with falling housing prices could cause greater economic uncertainty for consumers further impairing their demand.

Moreover, Bachmann cites (and Real Times Economics mentions) a shortcoming of the paper: it only considers economic uncertainty faced by businesses -- not political or regulatory uncertainty. In particular, RTE notes that health care reform, potential tax changes, and fear of carbon emission limits could be restraining corporate investment right now. Although RTE doesn't mention it, you could certainly add financial regulation to that list of Washington-driven uncertainty. So even if economic uncertainty isn't preventing business from hiring, political and regulatory uncertainty could still be playing a part, particularly with an ambitious administration at the helm.