Uncertainty and Economic Activity
Increases in business uncertainty are associated with prolonged declines in economic activity.
In Uncertainty and Economic Activity: Evidence from Business Survey Data (NBER Working Paper No. 16143), researchers Ruediger Bachmann, Steffen Elstner, and Eric Sims use micro data from the Federal Reserve Bank of Philadelphias Business Outlook Survey and Germanys IFO Business Climate Index to investigate how measures of business uncertainty, which are derived from managers business expectations, are related to economic activity. They find that increases in business uncertainty are associated with prolonged declines in economic activity. However, they find no evidence of the "wait-and-see" effect -- that is, a large decline in economic activity when uncertainty rises, followed by a rapid rebound in economic activity when uncertainty declines. Instead, increases in business uncertainty appear to have effects similar to declines in business confidence. Bachmann, Elstner, and Sims argue that periods of high uncertainty are a reflection of bad economic times or bad economic news.
Waiting for uncertain events to be resolved is more valuable when the level of uncertainty is high than when it is low, so when firms find themselves in a period of heightened uncertainty, they may stop investing and hiring, leading the economy to slip into a recession. Because these wait-and-see dynamics are likely to take place quickly, the researchers use partly confidential monthly data from business surveys to investigate the relationship between uncertainty and economic activity. They argue that these high-frequency business survey data are well suited to measuring the direct impact of uncertainty on economic decisionmaking. In particular, business survey data capture the mind set of actual decisionmakers, as opposed to the views of outside experts. Also, the confidential survey microdata allow comparison of expectations and realizations of economic variables.
Bachmann, Elstner, and Sims consistently find that increases in uncertainty are associated with protracted negative effects on economic activity. The short-run "impact effect" of an increase in uncertainty, however, is small. Negative long-run shocks appear to raise uncertainty, which leads the authors to conclude that higher reported uncertainty is a reflection of bad economic times.
Bachmann, Elstner, and Sims think of recessions as times of severed business and customer relationships and of failing business models. Business and customer relationships have to be reestablished and business models altered when the economy is at trough. This generates uncertainty. In booms, in contrast, businesses have little incentive to change their operating practices.
-- Matt NesviskyThe Digest is not copyrighted and may be reproduced freely with appropriate attribution of source.