Fluctuations in Uncertainty (Digest Summary)

Providing analytical concreteness to the expansive concept of economic uncertainty, the author describes its patterns across countries and over time, explains its variance over the business cycle, traces its behavioral effects, and speculates on its continuing influence since the Great Recession. Although he acknowledges uncertainty’s detrimental impact on growth (especially in the short run), he also finds that it can be more benign over a longer investment horizon. Finally, he provides guidance on uncertainty’s policy implications, suggesting short and sharp stimulus programs for productive macroeconomic stabilization. He recognizes that handling root causes versus treating the symptoms (i.e., falling output) is the best path to effectiveness.

The author’s macro- and microlevel elaboration of uncertainty’s countercyclical nature provides potential forecasting tools. Investors can apply several types of evidence—the Chicago Board Options Exchange Volatility Index, degree of forecasting consensus, or content analysis of published references to uncertainty—to estimate the stage of the business cycle, the associated trends in capital investment and pricing, and uncertainty’s geographic impact, which is pronounced in developing countries. The behavioral mechanisms through which recessions increase uncertainty are also identified, allowing analysts to assess which firms are most likely to cope effectively through adoption of suitably targeted countermeasures.

The discussion of the “real options” theory highlights a key distinction between stock and flow—namely, the different consequences for a firm pertaining to the level of an activity versus a firm’s sensitivity to changes in that activity. A weakening in the elasticity of uncertainty can result in outcomes below original expectations. But initially shallower stimulus effects can also presage a boost to the delayed recoveries because of the release of pent-up productivity effects.

In describing the interaction between risk aversion and risk premiums given rising uncertainty, the author warns readers about the need to anticipate adverse financing consequences. Finally, there is counterintuitive support for uncertainty’s virtues via the “growth options” channel. An upside is possible as a result of either an increase in the availability of potential gains (e.g., the dot-com boom) or appropriate hedging strategies (e.g., flexibility in adjusting production to demand).

Because this is a review examining state-of-the-art understanding of uncertainty, original empirical investigation is not featured. Nonetheless, attention is given to methodological issues, including suggestions about the potentially fruitful ways to address key research issues. For example, in gauging the direction of causality of uncertainty’s effects, three alternative strategies are listed to examine timing effects (i.e., the reaction to economic shocks), to develop structural models calibrated to the economy as a whole or to individual firms, or to generalize from “natural experiments” (i.e., disasters, political upheavals, and volatility in energy or currency prices). So, empirical ground is sought for theoretical speculations.

This sense of relevancy is reinforced with concluding attention to the track of recovery after the recent Great Recession. The author makes a rough estimation that increased uncertainty is responsible for close to a 3% drop in GDP, amounting to about a third of the total loss of output. And as is to be expected in the writings of a leading academic, there is a call for improved measures of the subject at hand to better gauge the time horizon and types of uncertainty and a warning to policymakers not to ignore possible outcomes. That is, rules-based monetary policy may either reduce uncertainty through greater transparency or increase uncertainty by limiting the flexibility of interventions that could counteract incipient adverse reactions.

Economic uncertainty is a subject for investors that is both timely and perennial, having occupied leading thinkers since the University of Chicago’s Frank Knight pioneered its investigation nearly a century ago. The author, a demonstrable expert in the subject, offers a sound assessment of contemporary perspectives. This is particularly useful with the substantial expansion of academic interest given recent economic history and the expanded research toolkit of sophisticated modeling and related datasets. Undoubtedly, the topic will merit continuing scrutiny, with this research a handy road map for the potential tracks of new knowledge.