Does economic uncertainty matter? Yes, says Stanford professor Nicholas Bloom, University of Chicago professor Steven Davis, and Stanford grad student Scott Baker in a new paper titled Measuring Economic Uncertainty. They find that economic uncertainty caused real GDP to decline 3.2% over the past few years. This paper has stirred controversy because it has been used by conservatives to show that uncertainty created by President Obama is the main reason for the ongoing slump. Some observers like Mike Konczal, Dylan Matthews, and Matt O'Brien have questioned the use of this index on methodological grounds as well as on its proper interpretation. The latter point is really important. While there can be exogenous shocks to uncertainty such as the debt ceiling talks last year, uncertainty is always with us and is endogenous to the the state of the economy.1 That is, people get more uncertain the weaker the economy becomes and vice versa.
Here are some figures that illustrate this point. The first one shows a 3-quarter centered moving average of the paper's uncertainty index along with the nominal GDP (NGDP) gap. This gap measures aggregate demand deficiency and is calculated as the percent difference between potential and actual NGDP:
The two series are clearly related. The next figure shows the strength of this relationship:
This scatterplot does not establish causality, but it does suggest that about two thirds of economic uncertainty can be traced to a shortage of aggregate demand. Mike Konzcal might argue the relationship would be even stronger if not for the measurement problems. Even so, this is still a strong relationship and implies that Fed could do far more to spur a recovery by closing the NGDP gap.
Even if one believes causality runs form greater uncertainty to lower NGDP, the Fed still should respond. For the reason greater uncertainty matters is that is raises money demand which, for a given stock of money assets, causes a slump in nominal spending. The Fed could ease uncertainty and the resulting money demand by committing to a NGDP level target. This would close the NGDP gap and add certainty to the future path of nominal incomes. The failure of the Fed to do this means the economic uncertainty is as much a byproduct of the Fed's inaction (i.e. passive tightening) as it is anything else.
Here are some figures that illustrate this point. The first one shows a 3-quarter centered moving average of the paper's uncertainty index along with the nominal GDP (NGDP) gap. This gap measures aggregate demand deficiency and is calculated as the percent difference between potential and actual NGDP:
The two series are clearly related. The next figure shows the strength of this relationship:
This scatterplot does not establish causality, but it does suggest that about two thirds of economic uncertainty can be traced to a shortage of aggregate demand. Mike Konzcal might argue the relationship would be even stronger if not for the measurement problems. Even so, this is still a strong relationship and implies that Fed could do far more to spur a recovery by closing the NGDP gap.
Even if one believes causality runs form greater uncertainty to lower NGDP, the Fed still should respond. For the reason greater uncertainty matters is that is raises money demand which, for a given stock of money assets, causes a slump in nominal spending. The Fed could ease uncertainty and the resulting money demand by committing to a NGDP level target. This would close the NGDP gap and add certainty to the future path of nominal incomes. The failure of the Fed to do this means the economic uncertainty is as much a byproduct of the Fed's inaction (i.e. passive tightening) as it is anything else.
1Even the debt ceiling crisis to some extent was endogenous. For had there been no Great Recession, both cyclical and structural budget deficits would have been much smaller.
Update: For those wanting more evidence of an AD shortfall see here.
Update: For those wanting more evidence of an AD shortfall see here.
Arguments that our ongoing economic woes are the result of uncertainty are transparently reducible to an excess demand for money.
ReplyDeleteOnly when the increased uncertainty manifests itself as an excess demand for money do the recessionary implications follow.
But should we expect uncertainty to increase money demand? Shouldn't increased uncertainty about the future cause increased spending on consumption in the present?
What happened to Say's law? Oh, right, an excess demand for money happened to it, that's what!
Increasing uncertainty is bad (at least when a consequence of an increasingly capricious government). It tends to retard investment and growth, but it should have nothing to do with nominal spending and, in the long-term, not much to do with the rate of employment either.
The only reason increasing uncertainty might cause an excess demand for money is because the central bank fell asleep at the wheel, or perhaps was it too concerned with the happiness of its passengers (banks) to notice all the pedestrians it was running down.
Excellent blogs of late, per usual.
ReplyDeleteYes, there is regime uncertainty with this Fed, and its peek-a-boo, hide-and-seek policies.
I have no clue as to what the Fed will do, and I am obsessed with the Fed. I assume most businesspeople are similarly vexed.
Obviously, the Fed should be transparent, and have transparent macroeconomic goals, obtained by methods it announces well in advance. Market Monetarism.
It seems to me that uncertainty would be more effectively attacked by a spending commitment from the federal government rather than the central bank.
ReplyDeleteFor example, the business I work for sells books to public libraries. As you know, the budgets of public libraries - and many other government operations and enterprises - have been hammered during the recession. The response of the federal government has been to allow this kind of state and local austerity to happen, and sometimes even to encourage it and revel in it. After a promising early commitment by the federal government to expanded spending, and a nice bit of recovery, the government then retreated back into debt hysteria and the bogus "out of money" theme.
The Fed should avoid making commitments to goals it can't achieve, and a Fed commitment to a total level or growth rate of nominal spending doesn't seem all that much different from a Fed commitment to a birth rate. It's a target that the Fed has no reliable mechanism for achieving, and that it will just have to walk back in a few years anyway.