Scott Sumner  

Uncertain about uncertainty

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I've always been a bit skeptical when people point to "uncertainty" as the cause of economic distress. High unemployment? Uncertainty about ObamaCare! More often, the problem is bad monetary policy, and the only "uncertainty" is just how much NGDP instability the central bank will tolerate.

And yet I don't want to be dogmatic, it seems plausible that uncertainty would create at least some distress, as investors held off on new projects. Even if the central bank maintained stable NGDP growth (as it should) there might be a decline in RGDP due to the sort of "re-allocation" that Arnold Kling often discusses.

The recent Brexit shock is by far the biggest uncertainty shock that I've ever seen hit a major economy (apart from monetary/uncertainty shocks, such as 2008). There are many reports that investment projects in the UK are being put on hold. So I'm going to keep an open mind, and revise my views as the data comes in.

In a recent post, I made the following comment (italics), and commenter Tom Brown responded with a question:

Not a definitive test (which would require observations with and without NGDP targeting, to tease out AD vs. AS channels), but certainly a suggestive test. I have an open mind at this point, and am eager to learn.

Can you describe which outcome(s) would most strongly suggest that your current beliefs are wrong? I'm not hoping that they are, I'm just wondering if we can somehow put a marker down now to compare with the future.

Here are three plausible outcomes:

1. Very little change in NGDP, and unemployment is fairly stable, rising by less than 100 basis points.

2. Very little change in NGDP, and unemployment rises sharply, as the UK slides into recession.

3. NGDP slows sharply, and unemployment rises sharply.

In cases #1 and #2, monetary policy stays neutral, and we get a test of the aggregate supply effects of reallocation. In that case, I think #1 is more likely. I'll say the unemployment rate rises by 50 basis points within a year, if you want a point estimate to judge me by.

In case #3, we don't really have a clean test. Nonetheless, I think those who disagree with me would be at least somewhat justified in claiming that uncertainty was really important, if only because central banks weren't very good at offsetting it. So case #3 would not be a slam-dunk victory for those who disagree with me, but it would be a qualified win, and a modest loss for me. Case #2 would mean I was even further off base in my estimate of the impact of uncertainty.

PS. Just to reassure readers, I do not forget these tests. A few days ago I revisited a raging debate from a year ago, when the Chinese stock market crashed. Many said China faced a hard landing, whereas I predicted 6% growth. I also revisit other "tests", such as Krugman's famous 2013 test of market monetarism, or his 2014 test of ending extended unemployment benefits, or Tyler Cowen's less famous observation that Denmark would provide a test of whether the Swiss actually had to devalue in early 2015 (we now know they did not.) Or pundit predictions that Bitcoin was a bubble. And many others. So have no fear, I'll revisit this even if I am wrong, which is very possible.

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COMMENTS (5 to date)

Brexit uncertainty is a real shock, I expect lower RGDP. Whether it translates into unused resources (unemployment) is probably a matter of central bank policy. If the BoE keeps NGDP growing, then I expect we'll see higher inflation and only a little extra unemployment (some is inevitable as the economy transitions to a lower productivity regime with fewer international projects and more low-wage local services).

So, #1 could be true and uncertainty would still be an important issue as it affects real incomes.

I think the uncertainty fans cry wolf a lot, but in the case of brexit, it seems to be a real wolf.

(my expectation is a mix of 1 in the UK and 2 in the euro zone).

bill writes:

Nice post.
I think the uncertainty element makes it harder for central bank to know how it's doing with respect to keeping NGDP growth on track, thus increasing the probability of #3. If it succeeds in keeping NGDP on track, then I believe your prediction of #1 is indeed the more likely one.
That said, since I believe that less trade and less open markets will reduce RGDP over some time frame, I wonder how that transition occurs? Is it a gradual process or a quick drop then a return to a normal % growth from the lower base?

James Alexander writes:

Good post.
But you might have to be more specific about numbers, at least historic ones. UK NGDP has averaged YoY growth at a 2.4% per quarter for the last 12m.

The consequences of this low level could be bad, already.

What number would you call a sharp slowdown?

Lorenzo from Oz writes:

If we mean Knightian uncertainty -- do not have enough information to calculate probabilities with reasonable confidence -- then it is likely that an increase in uncertainty alone is not enough to determine the direction of the effect. After all, if we get a shock where we lack such information in specifics but (1) the expectations are that effect will be positive (e.g. new technology), that is different from a shock where we lack such information in specifics but the expectations are either that (2) it will be negative or (3) the uncertainty is so complete we have no expectations at all about the net effect.

In the first case, one would expect a surge in hopeful asset purchases. In case (2) we would expect a flight to safe assets. In case (3) we might expect some move to safe assets, though inertia would seem to be more likely (keep doing what you are doing, since there is not enough information to motivate a change).

I have toyed with the idea that "animal spirits" is really about how folk are currently reading whatever uncertainty is about.

James Alexander writes:

Here's a link to the UK NGDP data by quarter:

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