The world economy cannot go back to where it was before the crisis, because that was demonstrably unsustainable

TO BE NOTED: From the FT:

"Why the ‘green shoots’ of recovery could yet wither

Published: April 21 2009 20:24 | Last updated: April 21 2009 20:24

Spring has arrived and policymakers see “green shoots”. Barack Obama’s economic adviser, Lawrence Summers, says the “sense of freefall” in the US economy should end in a few months. The president himself spies “glimmers of hope”. Ben Bernanke, chairman of the Federal Reserve, said last week “recently we have seen tentative signs that the sharp decline in economic activity may be slowing, for example, in data on home sales, homebuilding and consumer spending, including sales of new motor vehicles”.

Is the worst behind us? In a word, No. The rate of economic decline is decelerating. But it is too soon even to be sure of a turnround, let alone of a return to rapid growth. Yet more remote is elimination of excess capacity. Most remote of all is an end to deleveraging. Complacency is perilous. These are still early days.

As the Organisation for Economic Co-operation and Development noted in its recent Interim Economic Outlook, “the world economy is in the midst of its deepest and most synchronised recession in our lifetimes, caused by a global financial crisis and deepened by a collapse in world trade”. In the OECD area as a whole, output is forecast to contract by 4.3 per cent this year and 0.1 per cent in 2010, with unemployment rising to 9.9 per cent of the labour force next year. By the end of 2010, the “output gap” – a measure of excess capacity – is forecast to be 8 per cent, twice as large as in the recession of the early 1980s.

In the US, the rate of decline of manufactured output compares with that of the Great Depression. Japan’s output of manufactures has already fallen by almost as much as in the US during the 1930s (see chart). The disintegration of the financial system is, arguably, worse than it was then.

If the world experiences a “Great Recession”, rather than a Great Depression, the scale of policy support will be the explanation. Three of the world’s most important central banks – the Federal Reserve, the Bank of Japan and the Bank of England – have official rates close to zero and have adopted unconventional policies. The real OECD-wide fiscal deficit is forecast at 8.7 per cent of gross domestic product next year, with a structural deficit of 5.2 per cent. In the US, the corresponding figures are 11.9 and 8.2 per cent. Governments of wealthy countries have also put their healthy credit ratings at the disposal of their misbehaving financial systems in the most far-reaching socialisation of market risk in world history.

It would be impossible for such activism to have had no effect. We can indeed see partial normalisation of financial markets, with a marked reduction in spreads between riskier and less risky assets (see charts). The FTSE All-World index has jumped by 24 per cent and the S&P 500 by 23 per cent since March 9 2009. Purchasing managers’ indices are picking up (see chart). More broadly, the chances of a manufacturing turnround are high: big falls in demand generate inventory build-ups and collapses in output. The latter are sure to reverse. China’s growth is also rebounding.

We can say with some confidence that the financial system is stabilising and the rate of decline in demand is slowing. But this global recession is different from any other since the second world war. Its salient characteristic is uncertainty.

Consider obvious perils: given huge excess capacity, a risk of deflation remains, with potentially dire results for overindebted borrowers; given the rising unemployment and huge losses in wealth, indebted households in low-saving countries may raise their savings rates to exceptional levels; given the collapse in demand and profits, cutbacks in investment may be exceptionally prolonged and severe; given massive and persistent fiscal deficits and soaring debt, risk aversion may lead to higher interest rates on government borrowing; and given the flight from riskier borrowers, a number of emerging economies may find themselves in a vicious downward spiral of weakening capital inflow, falling output and reductions in the quality of assets.

In short, as Stephen King and Stuart Green of HSBC note in a recent report, the exceptional dynamics of this crisis suggest a healthy scepticism about the timing and speed of recovery. What is most disturbing, moreover, is the scale of the policy action required to halt this downward spiral. This raises the big question: how and when might the world return to normality, with sustainable fiscal positions, strongly positive short-term official interest rates and solvent financial systems? That Japan has failed to achieve this over 20 years is surely frightening.

What I find most disturbing of all is the reluctance to admit the nature of the challenge. In its policy advice, even the OECD seems to believe this is largely a financial crisis and one that may be overcome in quite short order. Even the latter looks ever more implausible: in its latest Global Financial Stability Report, the International Monetary Fund now estimates overall losses in the financial sector at $4,100bn (€3,200bn, £2,800bn). The next estimate will presumably be higher.

Above all, the financial crisis is itself a symptom of a balance-sheet disorder. That, in turn, is partly the consequence of structural current account imbalances. Thus, neither short-term macroeconomic stimulus nor restructuring of balance sheets of financial institutions will generate sustained and healthy global growth.

Consider the salient example of the US, on whose final demand so much has for so long depended. Total private sector debt rose from 112 per cent of GDP in 1976 to 295 per cent at the end of 2008. Financial sector debt alone jumped from 16 per cent to 121 per cent of GDP over this period. How much of a reduction in these measures of leverage occurred in the crisis year of 2008? None. On the contrary, leverage rose still further.

The danger is that a turnround, however shallow, will convince the world things are soon going to be the way they were before. They will not be. It will merely show that collapse does not last for ever once substantial stimulus is applied. The brutal truth is that the financial system is still far from healthy, the deleveraging of the private sectors of highly indebted countries has not begun, the needed rebalancing of global demand has barely even started and, for all these reasons, a return to sustained, private-sector-led growth probably remains a long way in the future.

The world economy cannot go back to where it was before the crisis, because that was demonstrably unsustainable. It is at the early stages of a long and painful deleveraging and restructuring. Fortunately, policymakers have eliminated the worst possible outcomes. But there is much more yet to be done before fragile shoots become healthy plants.

martin.wolf@ft.com

More columns at www.ft.com/wolf

Read and post comments at Martin Wolf’s blog

Copyright The Financial Times Limited 2009"

This combined with a weak economy and an unresolved financial crisis could in theory lead to a deflationary spiral

TO BE NOTED: From Antonio Fatas and Ilian Mihov on the Global Economy"

"Uncertainty as defined by Larry Summers (or just another example of a two-handed economist?)

In an interview last week, Larry Summers said that "there are risks of both deflation and inflation", so anything is possible... In defense of Larry Summers' lack of commitment when it comes to forecasting inflation, there is indeed an outgoing debate between those who are afraid that advanced economies are heading into deflation and those who believe that the aggressiveness of monetary policy (and the expansion in the central banks' balance sheets) will soon produce a large and persistent increase in inflation rates.

To some this might sound like the standard two-handed approach of economists but I think that in this case the debate is also reflecting an unusual amount of uncertainty as we are dealing with an episode that is different from what we have seen before (of course, as an economist, I have to defend the profession...).

There are two reasons for why uncertainty can be so high. First, this is the deepest recession for many advanced economies after WWII. While there are some historical episodes of even deeper downturns (such as the Great Depression), they took place in a very different economic, political and institutional environment. In addition, some of the monetary policy actions that central banks around the world are taking can be seen as an experiment (out of desperation). Traditional monetary policy actions are not enough so they need to try unorthodox measures. Yes, we have a sense on the consequences that these actions will have but we do not have previous historical experiences to produce a good quantitative estimate. If you want to look at how this uncertainty is reflected in differences in inflation forecasts, here is an interesting entry from the macroblog at the Altlanta Fed on the current state of inflation expectations and uncertainty.

The deflation scenario is one that is supported by the data. Today, the U.S. Bureau of Economic Analysis released the CPI estimate for March and on an annual basis, inflation was -0.4%, the first time this measure is negative since 1955. This combined with a weak economy and an unresolved financial crisis could in theory lead to a deflationary spiral. However, one has to be careful reading too much into the figure that was released today. If one looks at the details, the only category where we had deflation was in "transportation", which is driven by the decrease in oil prices over the last 12 months. Falling oil prices is, if any, good news for the US economy. Other items display inflation rates that were clearly above zero on an annual basis (Food and Beverages at 4.3%, Education at 3.2% and Other Goods and Services at 5.7%). The trend looks somehow more worrisome as on a month to month basis we see negative inflation rates across more categories in some of the most recent months, but it is fair to conclude that we are still far from the type of persistent deflation that can cause major damage to the economy.

The inflation scenario is driven by the massive increase in the balance sheets of many central banks (including the Federal Reserve that has probably been the most aggressive of all). We know that this increase in the balance sheets has not translated into a one-to-one increase in the money supply (see earlier entry about the money multiplier), but there is still the risk of inflation if central banks do not react faster and withdraw the additional liquidity when the economy recovers. Simon Johnson has recently written an article in the Washington Post summarizing the inflationary risks of the current monetary policy "experiment". Theoretically, the Fed has the ability to do what it needs to be done to avoid inflation (see, for example, this article by Woodward and Hall on the potential use of the interest rate paid on reserves).

So what will it be, inflation or deflation? If central banks are good at what they do and they quickly react to the different potential scenarios ahead, we should not see any of the two (i.e. we should see an inflation rate that remains positive but around or below what is considered to be the -explicit or implicit- medium target for central banks).

Under which conditions can central banks fail? On the deflation scenario, the failure would be one of anticipation. As long as central bank are ahead of the curve and provide the necessary liquidity using whatever means are necessary (including the "helicopter money drop"), they should be able to keep their economies from falling into persistent deflation. On the other side (the inflation scenario), there are potentially two risks: a technical one and a political one. From a technical point of view, central banks also need to anticipate changes in inflation expectations and move as fast as they can to avoid any sustained increase in those expectations. The second risk is more of a political nature. One can envision scenarios where the central bank could be under enormous pressure to give up and let inflation increase above its normal level. If the economy recovery is slow but still fast enough to get inflation expectations increasing, undoing the monetary expansion could have a large impact on the interest rate. An increase in the interest rate will impose a serious cost to governments who are currently accumulating debt at a very fast pace because of large deficits. And if growth is not strong enough to bring the necessary tax revenues, governments will feel the need of either raising taxes or cutting spending, none of which are easy from a political point of view. No doubt that this will be an interesting test of the independence of central banks. We have already seen in recent months central banks deciding on actions that "they did not want to take" but it was necessary because of the "special circumstances". If inflation expectations come back too early, the trade off between inflation and growth (and interest rates) will be very strong. Would it also be considered a special circumstance that requires unusual actions by central banks? Let's hope we do not get there and we do not need to test the independence of central bankers.

Antonio Fatás"

This big spike in uncertainty in the fall of 2008 was a major factor behind the recent rapid slowdown

TO BE NOTED: From Vox:

Halfway to recovery

Nicholas Bloom 17 April 2009

Print Email Comment Republish

This column says that the policy response to the financial crisis seems to have been adequate – we will not slip into another Great Depression. It argues that growth will resume by late 2009, as uncertainty is subsiding due to global cooperation.

Last year I wrote a piece forecasting a severe recession in 2009. Based on my analysis of 16 previous economic shocks, I predicted a 3% drop in GDP and a 3 million increase in unemployment in Europe and the US. Unfortunately, this looks to have been reasonably accurate. But I also worried about a far worse outcome – the world slipping into another Great Depression due to a damaging policy response to the crisis. Fortunately, that has not come to pass.

I now think that the broadly pro-market consensus of the G20 governments means that this worst case scenario has been avoided. Tariffs are not going to be dramatically raised in global trade wars. Governments are not regulating away free markets, and wholesale nationalisations of banks seem to have been avoided as well.
Avoiding the terrible policy mistakes of the 1930s that led to the Great Depression has averted fears of economic armageddon. As a result, uncertainty measured by implied volatility on the S&P 100 – commonly known at the financial “fear factor” – has fallen back by 50%, and the stock market has begun to rise. I believe growth will resume by late 2009, and the halfway point of the credit crunch may have passed.

Another Great Depression has been avoided

Much like today, the Great Depression began with a stock market crash and a meltdown of the financial system. Banks withdrew credit lines and the interbank lending market froze up. What transformed the financial crisis into an economic disaster, however, was the compounding effect of terrible policy. The infamous Smoot-Hawley Tariff Act of 1930 was introduced by desperate US policymakers as a way of blocking imports to protect domestic jobs. Instead of helping workers, this worsened the situation by freezing world trade. At the same time, policymakers were encouraging firms to collude to keep prices up and encouraging workers to unionise to protect wages, exacerbating the situation by strangling free markets.

Uncertainty is now falling

Figure 1 shows the implied volatility on the S&P 100 as a measure of uncertainty. This jumped over threefold after the dramatic collapse of Lehman Brothers in September 2008. But it has fallen back by half as political uncertainty has receded. Events like the G20 meetings showed how international leaders have agreed to maintain free markets, albeit with sensible increases in financial regulation. But this agreement on a common global policy response is radical stuff. Having the Americans and the British agree with the French on anything is an achievement, and an agreement on a global plan for economic growth is more or less unprecedented.

Figure 1 The financial 'fear factor': daily US implied stock market volatility on the S&P 100 (%)

But we are only halfway there, as the extent of the damage to the economy is still very much uncertain. There is a sea of toxic assets whose value is unknown and whose eventual victims remain unclear. As a result uncertainty has fallen, but to a level that before the Credit Crunch occurred only after extreme events like the 9/11 terrorist attacks.

The fall in uncertainty will help spur the recovery

The heightened uncertainty after the credit crunch led firms to postpone investment and hiring decisions. Mistakes can be costly, so if conditions are unpredictable, the best course of action is often to wait. Of course, if every firm in the economy waits, economic activity slows down (Bloom, Floetotto and Jaimovich 2009). This big spike in uncertainty in the fall of 2008 was a major factor behind the recent rapid slowdown. But now that uncertainty is falling back, growth should start to rebound. Firms will start to invest and hire again to make up for lost time.

So the good news is that no government is advocating abandoning capitalism altogether. Instead, they are applying the short-run therapy of massive tax and interest rate cuts and the long-run therapy of stricter financial regulation. The patient sitting in the recovery ward now just has to pray that this treatment has no nasty side effects.

References

Nicholas Bloom, Max Floetotto and Nir Jaimovich (2009) “Really Uncertain Business Cycles” Stanford University mimeograph.

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1 The predictions are made from VAR forecasts. This VAR methodology is described in “The impact of uncertainty shocks”, forthcoming in Econometrica, My predictions use this methodology with a 3x uncertainty shock and a 30% stock-market fall."

I would put more trust in computational decision aids if they included this same kind of machinery

TO BE NOTED: From Marginal Revolution:

"Letter from the chair

Mon December 15, 2008

Andrew Barto, Professor and Chair

Letters from the chair are not usually about technical subjects, but as I write this I am having trouble ignoring the uncertainty we are facing both locally and around the globe. With so many researchers in Computer Science and other disciplines studying decision making under uncertainty, one might think that we would be able to turn the crank on any number of sophisticated algorithms to figure out what is the best course of action for maximizing our ‘expected utility' even while lacking complete information about the state of the world, about how our decisions might change things, and about what the unfolding future will mean for our measures of utility.

Why aren't decision theorists saving the day? Indeed, why has some of the blame for the current financial crisis been attributed to new financial instruments that owe their existence to complex theories and algorithms? There are many answers to these questions, but putting aside the big issue of how we assign utility to possible futures, the main answer is that these methods need either accurate probabilistic models or immense amounts of data, not to mention a lot of regularity in what is happening in the world. Lacking these, we can argue about whose probability estimates are the best, with our inference algorithms waiting in the wings to grind out recommendations, all the while knowing that there is no infallible way to predict the future.

But evolution has given us skills for dealing with uncertainty—not skills that necessarily help us manage our finances, but skills that have kept our ancestors alive through the millennia. It is not known exactly how we are wired to act in the face of uncertainty, but a few theories—even if false—are thought provoking. One is that the brain has different systems, mediated by different neurotransmitters, for dealing with expected uncertainty and unexpected uncertainty (A. J. Yu and P. Dayan, "Uncertainty, Neuromodulation, and Attention," Neuron, 46, 681-692, 2005). Expected uncertainty occurs when we are in a familiar environment and have had a lot of experience with its unreliable predictive relationships. We have pretty good probability estimates and strong top-down expectations. Unexpected uncertainty, on the other hand, occurs when there is a major shift in context causing our top-down expectations to be grossly wrong. According to this theory, the degree of expected uncertainty is signaled by the amount of one neurotransmitter (acetylcholine) that causes us to pay less attention to our models—our preconceptions—and more to what we are actually experiencing. The neurotransmitter that signals unexpected uncertainty (norepinephrine), on the other hand, has the additional effect of causing us to shift attention in order to search for new cues that might be predictive in the new context, thus helping us to form new models rather than just tune the old ones. Increased levels of norepinephrine are also associated with increased anxiety.

If something like this theory is correct, then what is responsible for the anxiety we are feeling is not just uncertainty; it is unexpected uncertainty. Maybe a measure of comfort can be taken from the possibility that the brain machinery causing our anxiety is also encouraging us to look beyond the information streams we have been relying on up to now as we try to form new models that can guide us as we move forward. I would put more trust in computational decision aids if they included this same kind of machinery."

"Luckily, using the latest data on uncertainty measures, our model predicts that the worst has been avoided."

A post on Vox by Bloom and Floetotto with a view like mine:

"A key source of the today’s economic weakness is uncertainty( FEAR AND AVERSION TO RISK ) that led firms to postpone investment and hiring decisions( A PROACTIVITY RUN ). This column, by the authors whose model forecast the recession as far back as June 2008, report that the key measures of uncertainty have dropped so rapidly that they believe growth will resume by mid-2009( I AGREE ). This means any additional economic stimulus has to be enacted quickly. Delaying to the summer may mean the economic medicine is administered just as the patient is leave the hospital. ( GOOD IDEA )

Many pundits (e.g. Krugman) are warning that a dire recession is in the offing. We would have agreed with them three months ago; indeed, we wrote a VoxEU column predicting a severe recession in 2009; based on the analysis of 16 previous economic shocks, we forecasted a 3% drop in GDP and a 3 million increase in unemployment in each of Europe and the US with these predictions made from VAR forecasts (see Bloom 2008 for details).

We also worried about a far worse outcome – Europe and the US slipping into another Great Depression due to damaging policy responses( THAT COULD DO IT ). Luckily, using the latest data on uncertainty measures, our model predicts that the worst has been avoided.( I AGREE )

Good news: Great Depression II avoided and growth resumes mid-2009

Much like today, the Great Depression began with a stock-market crash and a melt-down of the financial system. Banks withdrew credit lines and the inter bank lending market froze-up. What turned this from a financial crisis into an economic disaster, however, was the compounding effect of terrible policy. The infamous Smoot-Hawley Tariff Act of 1930 was introduced by desperate US policymakers as a way of blocking imports to protect domestic jobs. Instead of helping workers, this worsened the situation by freezing world trade( YES ). At the same time policymakers were encouraging firms to collude to keep prices up and encouraging workers to unionize to protect wages, exacerbating the situation by strangling free markets.

In fact economic uncertainty is now dropping so rapidly that we believe growth will resume by mid-2009.( I AGREE )

Uncertainty is now falling

It now appears that the global policy response to the credit crunch has avoided repeating those mistakes. Instead, it has focused on delivering a massive dose of tax and interest rate cuts, and spending increases. Policies restricting free-markets have largely been avoided. This has calmed stock markets as the fears of an economic Armageddon have subsided. At the same time political uncertainty has dropped as world leaders have clarified their stimulus plans.

Figure 1 shows one measure of uncertainty – the implied volatility on the S&P 100 – commonly known as the financial “fear factor”. This jumped over three fold after the dramatic collapse of Lehman’s in September 2008 ( I AGREE ). But it has fallen back by 50% over the last three weeks as both economic and political uncertainty has receded. Other measures of uncertainty have also fallen; this is even true for the frequency of the word “uncertain” in the press!

As uncertainty falls the economy will rebound( I AGREE )

The heightened uncertainty after the credit crunch led firms to postpone investment and hiring decisions. Mistakes can be costly, so if conditions are unpredictable the best course of action is often to wait. Of course, if every firm in the economy waits, economic activity slows down( A PROACTIVITY RUN ).¹

But now that uncertainty is falling back growth should start to rebound. Firms will start to invest and hire again to make up for lost time. Figure 2 shows our predicted impact of the spike in uncertainty following the credit crunch. This is based on our detailed analysis of 16 previous financial, economic and politically driven uncertainty shocks. After falling by 3% between October 2008 and June 2009, we forecast GDP will rapidly rebound from July 2009 onwards.

So it’s now or never for expansionary policy

Many economists make the case for a stronger policy response. That might be right, but policy makers need to act fast. Any additional economic stimulus – be it a spending package, quantitative easing or a couple of rounds of liquidity injections – has to be enacted quickly. Dithering over different courses of policy will actually make things worse by adding uncertainty( I AGREE ) (see Caballero 2008). This is exactly what happened after 9/11 when the Federal Reserve Board criticized Congress for creating unnecessary uncertainty with its lengthy debates on investment tax credits.

Delaying the stimulus package until the summer may mean that it is too late. The economic medicine will be administered just as the patient is trying to leave the hospital!

References

Caballero, Ricardo (2008). “Normalcy is Just a Few Bold Policy Steps Away,” December 17, 2008.

Bloom, Nick, Max Floetotto and Nir Jaimovich (2008). “Really Uncertain Business Cycles.”

Bloom, Nick (2008). “The Impact of Uncertainty Shocks,” Stanford mimeo, forthcoming Econometrica.

Krugman, Paul (2009). “Ideas for Obama,” New York Times column, 11 January 2009.

Footnotes

1 See “Really Uncertain Business Cycles” by Bloom, Floetotto and Jaimovich for a more detailed discussion ; here is the abstract from that paper: “This paper proposes uncertainty shocks as a new impulse driving business cycles( I AGREE ). We first demonstrate that uncertainty, measured by a number of proxies, appears to be strongly countercyclical. When uncertainty is included in a standard vector-auto-regression, uncertainty shocks lead to a large drop and rebound in economic activity. Guided by this we build a stochastic dynamic general equilibrium model that extends the benchmark neoclassical growth model along two dimensions. It allows for heterogeneous firms with non-convex adjustment costs for both capital and labor, and time varying uncertainty defined as fluctuations in the variance of technology shocks. Increases in uncertainty lead to large drops in employment and investment. This occurs because uncertainty makes firms cautious, leading them to pausing hiring and investment( FEAR AND AVERSION TO RISK ). This freeze in activity also reduces the reallocation of capital and labor across firms( THAT'S WHY THE DROP WAS ACROSS THE BOARD ), leading to a large fall in productivity growth( NOT IMMEDIATELY IN A PROACTIVITY RUN ). Taken together, the freeze in the hiring and investment, and the drop in relocation, lead to a business cycle sized drop and rebound in output, investment and productivity growth after a rise in uncertainty( I AGREE ).”

This is my view, more or less.

"it indicates a modest decline of uncertainty since October 2008, suggesting that the worst may be behind us. "

I tend to agree with this post on Vox by Michelle Alexopoulos Jon Cohen:

"This column claims that uncertainty shocks affect on economic activity with remarkable swiftness, strength, and durability. Capturing expectations of average citizens in Main Street through the use of keywords in main newspapers, it indicates a modest decline of uncertainty since October 2008, suggesting that the worst may be behind us.( I AGREE )

It’s official. As everyone now knows, the US economy is in recession and has been since December 2007. If the contraction continues for another four months, which at this point seems inevitable, this downturn will match the two longest peak to trough slides in the Post-WWII period, the first from November 1973 to March 1975, the second from July 1981 to November 1982. Whether the current recession achieves the dubious distinction of matching unemployment rates of the earlier ones (9% in May 1975 and 10.2% in November 1982) remains to be seen, but the dramatic rise in unemployment announced on 5 December 2008 is worrisome. As for the stock market, the decline of the Dow Jones Industrial Average from its peak in July 2007 to its low point on 20 November 2008 actually exceeds by a few percentage points the 40% drop between October 1972 and October 1974. And, of course, the catastrophic fall in house prices continues unabated. In short, the economy is in serious trouble and it is likely to get worse before it gets better.( TRUE )

Nick Bloom, in a recent Vox column, uses links he has identified in his academic research between uncertainty shocks as measured by changes in expected volatility of the S&P 100 – the so-called investor fear index – and GDP growth to predict the length and depth of the current downturn. He predicts, on the basis of a dramatic jump in expected volatility caused by the credit crunch, a GDP decline of 3 percentage points in 2009 with recovery starting at the very end of year, assuming favourable government policies and a drop in volatility. Fear and uncertainty with all its associated collateral damage – postponed investment, limited structural change, and delayed consumption – indeed would seem to stalk the land.( I BELIEVE THAT THE FEAR AND AVERSION TO RISK IS THE MAIN CAUSE OF OUR CURRENT SITUATION )

From Wall Street to Main Street

Bloom’s argument depends heavily on the reliability of the expected volatility index( I BELIEVE THAT IT IS GOING DOWN ) as an indicator of uncertainty. Although his research results are compelling, it is still reasonable to wonder if his results are sensitive to his uncertainty measure. Or, to put it another way, are the forces that shape expectations among the Wall Street crowd the same as those that affect the folks on Main Street? In short, would the use of a more broad-based indicator of uncertainty alter the observed link between uncertainty shocks, output, and productivity? This is the question we are addressing in our current research. In brief, here’s what our preliminary results tell us.

Uncertain times, uncertain measures

We base our index of economic uncertainty on the number of articles that appear in the New York Times which use the terms uncertain and/or uncertainty and economic and/or economy( I'VE NO IDEA HOW RELIABLE THIS IS ). The beauty of the measure is that it is consistent over a very long time span (the New York Times searchable data base extends back into the nineteenth century), it is transparent and unfiltered (as they say, all the news that’s fit to print), and it approximates what the average Main Street resident knew about current events. In Figure 1, we present our monthly uncertainty index (adjusted for the days of each month) with NBER business cycle reference dates in the background, to show it adheres closely to business cycle dates. Moreover, as Figure 2 illustrates, the timing of the uncertainty shocks identified by Bloom’s uncertainty index (based on S&P volatility) and ours are quite similar.

Our statistical results suggest that uncertainty shocks act on economic activity with remarkable swiftness (the shock has an almost immediate negative impact on growth and productivity), strength (they explain over 25% of the variance of output and productivity within two years), and durability (the effects linger for a number of quarters). Moreover, the current uncertainty shock - that effectively dates from the Bear Stearns bailout( THIS INTERESTS ME ) - is the largest of the twentieth century, greater even than that associated with the October 1929 stock market crash.

The dreaded D-word

Of course, the obvious question is what does all of this mean for Main Street and its inhabitants? Many are now prepared to put the current crisis in the same league as the dreaded Great Depression. They point out that in both periods there were significant bank failures, sharp declines in equity and housing prices, and a severe credit crunch. However, the current policy responses have been vastly different, in large part because Federal Reserve Chairman Bernanke, an expert on the Great Depression, has used his deep knowledge of that event to avoid the errors of the past. Unlike in the 1930s, the monetary authorities have moved swiftly to increase liquidity, push down interest rates, and bolster the stability of the financial system. As it happens, our regression results suggest that these policy responses make a big difference. That is, when we introduce interest rates (the policy variable) into our regressions, we find that the economic contraction is likely to be closer to the 1%( I TEND TO AGREE ) predicted by the OECD than to the 3% predicted by Bloom.¹

Could the worst be over soon?

In spite of the very real threats to the US (and world) economy, a little perspective is in order. First, we have survived sharp jumps in uncertainty in the past – July 1971, January 1991, September 2001 (see Figures 1) – and will do so again( TRUE ). In this respect, it is also worth noting that the pattern displayed by our uncertainty index for the current crisis resembles more the sharp, short-lived ups and downs of the 1970s and early 2000s than it does the long drawn out rise and sluggish fall of the Depression years. This would seem to suggest that the current crisis, despite its gravity, does not mark the end of the world as we know it( I AGREE ). Second, in keeping with the old adage that it is often darkest just before the dawn, the numbers in Table 1 indicate that the light of a new day may just be visible on the horizon. Our uncertainty index, in this case based on data from six major US newspapers, shows a sharp run-up in uncertainty through October 2008 and a modest decline since. Two months do not make a trend but the drop is definitely encouraging( IT IS ). Although the negative economic consequences of the severe shock are likely to dog the economy for some time, we would guess that the worst is, indeed, behind us. Or, to employ Bloom’s horror film metaphor, the credit crisis has us (with good reason) perched on the edge of our seats, white-knuckled and wide-eyed. But, it is well to remember that the heroine while a little worse for wear, usually lives to welcome the dawn of a new day.

Newspaper	Average daily number of articles with keywords ("uncertainty” or “uncertain” & “economic” or “economy”)					Average week-day circulation
	2007	2008a	Selected months			30 Sept. 2008
			October	November	Decembera
New York Times	1.09	2.33	4.13	3.87	3.11	1,000,665
LA Times	0.65	1.07	2.00	1.27	1.44	739,147
USA Today	0.23	0.47	0.68	0.60	0.75	2,293,310
Wall Street Journal	1.98	3.38	5.29	3.43	2.56	2,011,999
Washington Post	0.76	1.58	3.48	1.90	2.22	622,714
Chicago Tribune	0.56	1.07	1.32	1.60	1.67	516,032
Circulation-weighted average	0.95	1.75	2.88	2.10	1.85	na

a. Values reported for 2008 are through 9 December 2008.

References

Alexopoulos, M. and Cohen, J. 2008. Uncertain Times, Uncertain Measures. Manuscript. University of Toronto, 2008.
Bloom, N. 2007. The impact of uncertainty shocks. National Bureau of Economic Research, Working Paper W13385. Issued in September 2007.
Bloom, N. 2008. The credit crunch may cause another great depression. VoxEU, 8 October 2008.
Bloom, N. 2009 will be the Nightmare on Main Street. VoxEU, 18 November 2008.
OECD. 2008. Economic Projections for the US, Japan & Euro area. Press Conference 11 November 2008.

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1. Our predictions are made from standard Vector Autogression (VAR) forecasts. While our bivariate analysis suggests a decline of approximately 3%, the addition of interest rates into the system cut the forecasted decrease to 1%."

My own opinion comports with this. As the level and breadth of the government guarantees are absorbed, and the government reacts with various incentives against the fear and aversion to risk, and as the Bush Administration departs, it's possible that uncertainty and fear will start declining in earnest. I'm leaving it at this just in case this opinion turns out to be idiotic.

"Knight argued that making such decisions was the job of an entrepreneur"

One thing to like about Justin Fox is that he tackles big ideas. Here he takes on Uncertainty:

"The future seems especially uncertain at the moment. There are those who would object that the future is always uncertain, and that it is when we think we've captured it in our forecasting models that we've invariably gotten things terribly wrong. But still, it is possible most of the time to be reasonably confident that one knows the range within which growth, inflation, and other important economic variables will fall for at least the next year or two. It's that confidence that allows business executives and investors and consumers to make decisions."

First of all, he links to Taleb who I basically agree with, and I take it that he doesn't. But that's fine. Thinking that you're reasonably confident about the future can get you in trouble, but so can being terrified of it.

"Right now that kind of confidence is in extremely short supply. The economy is shrinking at a rapid pace. That won't go on forever, but when it will end, and what the recovery will look like, is anybody's guess. Are we about to get sucked down into a deflationary spiral, or are the Fed's aggressive actions eventually going to make inflation the real threat? Is the global economic clout of the U.S. going to be permanently diminished by the current crisis, or does this represent a second chance to get things right? Are we really about to enter a new age of thrift, or just take a time out before returning to borrowing and spending? Are we looking at a long-term malaise, or a sharp-but-short shock?"

See, there's a difference between uncertainty and fear and aversion to risk. One way to read the current market, for example, is that people know that deflation and bad times are ahead, and they're investing accordingly. It's not uncertainty that's causing panic, but rather the certainty of bad times ahead. By the way, some people do better in a downturn, just as some people will do better in deflation. I don't see that confidence distinguishes among particular choices at all, as to where the economy is going. I think that real investing means trying to overcome both confidence and fear, at least as best a human being can, and make competent decisions based on what you then see. It won't be perfect, but it's the best you can do. Attributing an advancing economy and business growth to confidence doesn't describe the complexity of human decision making and behavior.

"When one is not confident about the answers to such questions, the natural tendency is to hold off on making decisions, especially decisions that involve any kind of long-term commitment. When lots of people postpone decisions, economic activity slumps. Uncertainty is a cause of recessions. And there's so much uncertainty now that this recession could really be doozy."

There is no a priori reason to believe this. People might well hold off decisions because they are certain they'll make better ones when the economy turns, or that they are deferring their decisions until a more opportune time, which isn't quite the same thing as uncertainty. It's more like prudence.

"But at the same time, uncertainty is what makes capitalism go. This was the theme of University of Chicago economist Frank Knight's Risk, Uncertainty and Profit, a 1921 book that's overdue for a comeback. Wrote Knight:

With uncertainty absent, man's energies are devoted altogether to doing things; it is doubtful whether intelligence itself would exist in such a situation; in a world so built that perfect knowledge was theoretically possible, it seems likely that all organic readjustments would become mechanical, all organisms automata. With uncertainty present, doing things, the actual execution of activity, becomes in a real sense a secondary part of life; the primary problem or function is deciding what to do and how to do it.

Knight argued that making such decisions was the job of an entrepreneur, and that business profit was the reward for for being willing to act in the face of uncertainty. This means, I think, that some people who aren't sticking all their money into mattresses (or the modern equivalent, U.S. Treasuries) right now are going to make an awful lot of money over the next few years. Which people? I'm afraid I'm too uncertain to offer an answer to that."

Since you read this blog, you've probably read my link to Wittgenstein's "On Certainty", and feel, that, since you don't want to come within a million miles of dissecting certainty, you don't want to come within a billion miles of uncertainty. Well, I don't blame you. Let's look at Knight's statement anyway. Does it make any sense?

Life is inherently uncertain. Both the future and the past are uncertain. We've no choice but to act under conditions of uncertainty. What Knight really seems to be saying is that Entrepreneurs take chances that others do not, and that's how Capitalism works. Is that true?

Maybe. But it hardly distinguishes entrepreneurs from the anyone who rebelled against Rome, or went to live alone in the desert in order to find God. The fact that there risk is for profit, a better house, having no boss, etc., is just a way of saying that these individuals have chosen to face uncertainty in this particular way. Maybe we need them for capitalism, but maybe we need the people who choose another path also for capitalism, and other human desires and needs as well.

"When no one knows how the rules of the game are going to change — and they seem to change from week to week — who wants to take a risk?"

Here's a good post by Russell Roberts of Cafe Hayek:

"But we're also going to wait and see what the government's going to do next. Nobody knows, and that evidently includes the secretary of the treasury.

When no one knows how the rules of the game are going to change — and they seem to change from week to week — who wants to take a risk? Who wants to borrow money? Who wants to invest? Business and consumers are hunkering down, waiting for the storm of change to pass.

The problem isn't liquidity.

It's uncertainty.

Paulson doesn't realize that his erratic attempts at creating liquidity are creating the uncertainty that makes liquidity meaningless.

And his erratic moves elsewhere just add to the uncertainty. A few days ago, he announced that he was "exploring strategies" to use the TARP (the Troubled Asset Relief Program) for "foreclosure mitigation." Then came the news that, no, the FDIC would have to go it alone in helping mortgage workouts. No TARP for them.

I guess he's done exploring. At least until tomorrow.

As the TARP spreads, the cost will keep rising. Remember the talk about how the government might even profit from its $700 billion "investment?" (Insert hollow laugh here.)

I'd feel better if the money spent so far was helping. But there's no evidence that it is achieving what Paulson intends."

I certainly agree that uncertainty is a huge problem. For one thing, it has a political logic of its own, as I've argued about the consequences of seemingly arbitrary actions.

Here's an older post of some relevance:

"Monday, November 3, 2008

"The government’s mixed signals about rescuing financial institutions may have added to market turmoil in recent months"

Interesting post on the WSJ :

"The government’s mixed signals about rescuing financial institutions may have added to market turmoil in recent months, a Federal Reserve policy maker said Monday.

In remarks to a conference in Israel, Federal Reserve Bank of Richmond President Jeffrey Lacker said the “disparate” government responses to potential failures at major firms created uncertainty and “may have made it difficult for market participants to forecast whether and in what form official support would be forthcoming for a given counterparty.”

“Shifts in expectations regarding official intervention may have added volatility to financial asset markets that were already roiled by an increasingly uncertain growth outlook,” Mr. Lacker said at a conference at Hebrew University of Jerusalem, according to his prepared text released by the Richmond Fed...

Many investors and Wall Street executives have sharply criticized the U.S. response — spearheaded by Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke — for sending mixed signals during the crisis about which firms might get taxpayer support to prevent their failure. The Fed stepped forward with $30 billion in March to prevent the bankruptcy of Bear Stearns Cos. and facilitate its sale to J.P. Morgan Chase & Co. Six months later in September, however, it declined to offer support to prevent the failure of Lehman Brothers Holdings Inc. Fed officials believe Lehman’s circumstances wouldn’t have allowed for a similar rescue.

The rescue of insurer American International Group Inc. just after Lehman’s failure added to criticism. Now, after Congress passed a $700 billion financial-sector bailout last month, banks are lining up to receive capital infusions from the Treasury."

Here's my comment:

” for sending mixed signals during the crisis about which firms might get taxpayer support to prevent their failure.”

This is the truth. Investors were counting on government intervention in this crisis. Any signal that this might not be forthcoming was seen as a looming disaster.

The government should have acted immediately and decisively, since it had given implicit and explicit guarantees that it would intervene in a crisis. The failure was also one of not having clear policies and guidelines of what would trigger intervention. Consequently, all moral hazard arguments have been fruitless.

In future, we need clear guidelines of government intervention, and moral hazard needs to be clear

Comment by Don the libertarian Democrat - November 3, 2008 at 10:06 am

Lacker does give a positive view of sorts:

“We have to give serious consideration to the idea that this episode of credit and financial market turmoil is part of the economy’s natural response to the sharp decline in the underlying fundamentals in housing finance,” Mr. Lacker said. “My sense is that the deterioration of economic conditions is playing a more prominent role in the tightening of credit terms right now than the direct effects of financial market turbulence.”

But Mr. Lacker said an economic recovery sometime in 2009 is a “reasonable expectation” because the Fed’s interest-rate target has come down to 1%; the major shocks that dampened economic activity — such as high energy prices — are subsiding; and the drag from the housing sector “seems likely to lessen in the next year.”

Call me a cock-eyed optimist, but I agree that we're moving past the crisis stage into the recession stage, and that is actually progress. Also, maybe it's the influence of Casey Mulligan, but I believe that things will begin to improve faster than many think possible.

The long term problems will still be there, but we will have an opportunity to right this ship.