Uncertainty and Economic Fluctuations

Economist Nicholas Bloom (Stanford) has produced a nice summary of his work on uncertainty and economic fluctuations:

This review article tries to answer four questions: (i) what are the stylized facts about uncertainty over time; (ii) why does uncertainty vary; (iii) do fluctuations in uncertainty matter; and (iv) did higher uncertainty worsen the Great Recession of 2007-2009? On the first question both macro and micro uncertainty appears to rise sharply in recessions. On the second question the types of exogenous shocks like wars, financial panics and oil price jumps that cause recessions appear to directly increase uncertainty, and uncertainty also appears to endogenously rise further during recessions. On the third question, the evidence suggests uncertainty is damaging for short-run investment and hiring, but there is some evidence it may stimulate longer-run innovation. Finally, in terms of the Great Recession, the large jump in uncertainty in 2008 potentially accounted for about one third of the drop in GDP.

The crucial unanswered question is why uncertainty increased in 2008.

One possibility is that consumers and firms could not readily judge the severity of the financial crisis.

A different possibility is that consumers and firms were confused by the federal government’s aggressive new policies (e.g., bailouts) and uncertain about whether the incoming Obama administration would emphasize fiscal responsibility (e.g., scaling back entitlements) or expanded redistribution (e.g., Obamacare and higher tax rates).

The two possibilities are not mutually exclusive. But it matters a great deal which is quantitatively more important.  With luck, Bloom’s future work will address this issue.