Chapter 9. Uncertainty: How Bad Is It?

Ayhan Kose, and Marco Terrones
Published Date:
December 2015
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Chapter Epigraphs

Uncertainty is largely behind the dramatic collapse in demand. Given the uncertainty, why build a new plant, or introduce a new product now? Better to pause until the smoke clears.

Olivier Blanchard (2009c)

Participants noted that elevated uncertainty about employment prospects continued to weigh on consumption spending. A number of business contacts indicated that they were holding back on hiring and spending plans because of uncertainty about future fiscal and regulatory policies.

Federal Open Market Committee (2010)

This chapter explores the role of uncertainty in driving macroeconomic outcomes. It addresses three questions: How is uncertainty measured? How does it evolve over the business cycle? And what is the impact of uncertainty on growth and business cycles? We analyze the main features of various measures of uncertainty, examine the links between uncertainty and growth and business cycles in advanced economies, and interpret the evidence in light of findings from recent research.

Something of a Mystery

Some economists and politicians argue that the two years of harsh times visited on the United States and euro area during the Great Recession should have been followed by rapid recoveries. Milton Friedman, the late Nobel Prize–winning economist, called this the “guitar-string” theory of recessions. When a guitar string is pulled down and released, it bounces back—and the harder the string is pulled down, the faster it returns.1

The recent recovery in advanced economies has been accompanied by bouts of elevated uncertainty.

However, the economic performance in many advanced countries since the Great Recession has not followed that theory. Instead, the deep recessions were followed by recoveries that have been disappointingly weak and slow. To push Friedman’s metaphor further, the guitar string seems to have been pulled down so hard that it snapped.

These developments are something of a mystery. Why has the latest recovery been so slow? As we documented in the previous chapter, some argue that recoveries following financial crises tend to be slow because the legacy of the crisis—balance sheet repair, weak credit expansion, and lingering problems in housing markets—weighs on activity. Considering the evidence, this argument certainly has its merits.

However, the latest recovery in advanced economies has been different from the earlier ones in at least one important dimension—it has been accompanied by bouts of elevated uncertainty, whether associated with financial crises or not. This suggests a complementary explanation for the anemic recovery, one that emphasizes the roles played by macroeconomic and policy uncertainty in curtailing economic activity and is unrelated to the fact that the 2009 global recession was associated with a financial crisis.

Economic uncertainty refers to an environment in which little or nothing is known about the future state of the economy. There are many sources of economic uncertainty, including changes in economic and financial policies and regulations, differing views on growth prospects, and productivity movements, as well as potential wars, acts of terrorism, and natural disasters.

Lawrence Summers on “hysteresis” and why the long-term economic costs of the Great Recession will be so high.

How important is uncertainty in slowing the latest recovery? This question has led to intense debates. On one side, recent research shows that uncertainty has indeed risen in the United States and the euro area since 2007, and the increase in uncertainty appears to have negative effects on activity at both macro and micro levels.2 Businesses have been uncertain about the fiscal and regulatory environment in the United States and Europe, and this has probably been one factor causing them to postpone investment and hiring. For example, a 2014 survey by the National Association for Business Economics reported that the “vast majority” of a large panel of business economists “feels that uncertainty about fiscal policy is holding back the pace of economic recovery.”3 On the other side, some argue that the standard measures of macroeconomic and policy uncertainty suffer from various problems and that it is unclear whether uncertainty has a causal effect on activity.

Measuring Uncertainty

Quantifying uncertainty is a challenge because it is not an observable variable but is one that is deduced from other variables. In the language of statistics, uncertainty is a latent variable. However, it is possible to gauge uncertainty indirectly using a number of measures that emphasize distinct aspects of uncertainty that an economy faces over time.

Some of these measures focus on macroeconomic uncertainty, including the volatility of stock returns, dispersion in unemployment forecasts, and the prevalence of terms such as “economic uncertainty” in the media. Others consider uncertainty at the microeconomic level, using indicators that capture variation across sectoral output, firm sales, stock returns, and dispersion among forecasts by managers in manufacturing firms.

Because we are concerned primarily with macroeconomic uncertainty, we concentrate on four measures based on the volatility of stock returns and economic policy. The first is the monthly standard deviation of daily stock returns in each advanced economy in our sample of 21 countries. This measure captures uncertainty associated with firm profits and has also been shown to be a good proxy for aggregate uncertainty.

The second is the Chicago Board Options Exchange S&P 100 Volatility Index, which is an indicator of the implied volatility of equity prices calculated from prices of Standard & Poor’s (S&P) 100 options. The third gauges uncertainty over economic policies in the United States and the euro area and is a weighted average of the following indicators: the frequency with which terms like “economic policy” and “uncertainty” appear together in the media, the number of tax provisions that will expire in coming years, and the dispersion of forecasts of future government outlays and inflation. The fourth, which represents uncertainty at the global level, captures common movements in the first measure using data for some major advanced economies with the longest available series.

Uncertainty: Here, There, and Everywhere

Regardless of which measures are used, both macroeconomic and policy uncertainty tend to rise during global recessions (Figure 9.1). Policy uncertainty in the United States and the euro area has remained relatively high since the 2007–09 global financial crisis. The euro area experienced significantly higher uncertainty because of severe sovereign debt problems in some member states. In the United States, uncertainty was driven primarily by wrangling over fiscal policy (including taxes and government spending), long-term structural issues (such as health care and regulatory policies), and entitlement programs (such as the government-sponsored retirement plan Social Security and the old-age health plan Medicare) during 2010–12 (Figure 9.2).4

Figure 9.1Evolution of Uncertainty

Note: Uncertainty in the United States refers to the Chicago Board Options Exchange S&P 100 Volatility Index (VXO), which is calculated from S&P 100 calls and puts. Global uncertainty is the estimated dynamic common factor of the country-specific uncertainty measure using the series for Italy, Japan, and the United States (these countries have had series of stock market indices since 1960), and country-specific uncertainty refers to the monthly standard deviation of daily stock returns in each country. Daily returns are calculated using each country’s stock price index; time coverage varies across economies. Economic policy uncertainty is an index of policy uncertainty for the United States and the euro area.

Figure 9.2Sources of Policy Uncertainty

(in percent of total, January 2010–October 2012)

Note: Each bar shows the proportion of policy uncertainty accounted for by the respective policy variable. Fiscal policy refers to uncertainty associated with taxes and government expenditures, whereas “Other policies” refers to uncertainty associated with national security, trade, sovereign debt, and currency.

Interestingly, monetary policy uncertainty does not appear to be a major factor behind the rise in policy uncertainty, possibly because of low and stable inflation and interest rates. Moreover, uncertainty has been unusually high and volatile throughout the lethargic global recovery, which contrasts with the recoveries following the other three global recessions (Figure 9.3), which were all accompanied by steady declines in uncertainty.

Figure 9.3Uncertainty during Global Recoveries


Note: Uncertainty refers to the monthly standard deviation of daily stock returns in the United States. Each line represents the evolution of uncertainty starting three quarters after uncertainty reached its peak during the respective global recession. The uncertainty measure is equal to 100 three quarters after uncertainty reached its peak during the respective global recession. Time 0 refers to February 1975, March 1983, March 1991, and March 2009.

At the national level, uncertainty about the economy runs contrary to the business cycle. During expansions, macroeconomic uncertainty is generally much lower than during recessions, regardless of the measure used (Figure 9.4). Likewise, microeconomic uncertainty about specific industries or companies, measured by the volatility of movements in plant-level productivity in the United States, also behaves countercyclically and reached a post-1970 high during the Great Recession.5

Figure 9.4Uncertainty over the Business Cycle

(in percent)

Note: This figure shows the average country-specific and global uncertainty levels during expansions and recessions. Country-specific uncertainty refers to the monthly standard deviation of daily stock returns in each advanced economy. Global uncertainty is the common factor of the country-specific uncertainty for three advanced economies (Italy, Japan, United States) for which data are available for 1960–2012.

Uncertainty and Activity: Understanding the Linkages

It is difficult to establish a causal link between uncertainty and the business cycle. Does uncertainty drive recessions, or do recessions lead to uncertainty? Empirical findings on this question have been mixed.6 However, economic theory points to clear channels through which uncertainty can negatively affect growth. Some uncertainty is intrinsic to the business cycle: firms and households will learn only over time which sectors fare better or worse—and for how long—in response to the shocks that cause recessions. On the demand side, for example, when faced with high uncertainty, firms reduce investment and delay projects as they gather new information, because investment is often costly to reverse.7 The response of households to high uncertainty is similar: they reduce their consumption of durable goods as they wait for less uncertain times. On the supply side, firms’ hiring plans are also hurt by higher uncertainty, reflecting the high costs of adjusting personnel.

When faced with high uncertainty, firms reduce investment and delay projects as they gather new information.

Financial market problems, such as those since 2007, can amplify the negative impact of uncertainty on growth. For example, uncertainty leads to a decline in expected returns on projects financed with debt and makes it harder to assess the value of collateral. As a result, creditors charge higher interest rates and limit lending during uncertain times, which reduces firms’ ability to borrow. The decline in borrowing causes investment to contract, especially for credit-constrained firms, and slows productivity growth because of reduced spending on research and development. These factors together can translate into a significant reduction in output growth.8

The impact of uncertainty differs across sectors and countries. Sectors producing durable goods, including machinery and equipment, automobiles, houses, and furniture, are often most affected by increased uncertainty. The impact of uncertainty on consumption and investment is larger in emerging market economies than in advanced economies, possibly because financial markets and institutions are less developed.9

What Is the Impact of Uncertainty on Growth?

Empirical evidence suggests that uncertainty tends to be detrimental to economic growth.10 For example, a 1 standard deviation increase in uncertainty is associated with a decline in output growth of between 0.4 and 1.25 percentage points depending on the measure used for macroeconomic uncertainty. There have indeed been multiple episodes during which uncertainty rose by 1 standard deviation or more, including at the onset of the 2009 global recession and during the recent debt crisis in the euro area. High uncertainty tends to be associated with a larger drop in investment than in output and consumption growth. These findings lend support to the validity of different channels through which uncertainty hurts economic activity. They are also consistent with recent studies that document a negative relationship between growth and uncertainty.11

Uncertainty tends to be detrimental to economic growth.

Policy-induced uncertainty, which is also negatively associated with growth, has increased to record levels since the 2009 global recession. Specifically, the sharp increase in policy uncertainty between 2006 and 2011 may have stymied growth in advanced economies. Empirical evidence indicates that such a large increase in policy uncertainty is associated with a highly persistent and significant decline in output (Figure 9.5).12 The adverse impact of uncertainty on economic growth works mainly through two channels. First, it directly affects the behavior of households and firms, which postpone investment and consumption decisions when uncertainty about future policies is elevated. Second, it breeds macroeconomic uncertainty, which in turn tends to reduce growth.

Figure 9.5Impact of Policy Uncertainty on Growth

(in percent)

Note: This figure shows that gross domestic product (GDP) declines 2.2 percent in the second quarter in response to an increase in policy uncertainty in the first quarter, 2.4 percent in the fourth quarter, and so on. The increase in uncertainty is assumed to be equal to the change from 2006 until 2011. These results are based on a vector autoregression model, which is estimated using quarterly data from 1985 to 2011, including policy uncertainty, GDP, the S&P 500 Index, the federal funds rate, employment, investment, and consumption.

Uncertainty, Recessions, and Recoveries

The degree of economic uncertainty also appears to be related to the depth of recessions and the strength of recoveries. Recessions accompanied by high uncertainty are often deeper than other recessions (Figure 9.6). Similarly, recoveries that coincide with periods of elevated uncertainty are weaker than other recoveries. The unusually high levels of uncertainty since the latest financial crisis and the associated episodes of deep recessions and weak recoveries play an important role in explaining these findings. Moreover, the latest recovery in advanced economies has coincided with lower cumulative growth in consumption and investment, along with a sharp and sustained contraction in investment in structures, as uncertainty has remained high.

Figure 9.6Role of Uncertainty: Recessions and Recoveries

(in percent)

Note: This figure shows the amplitude of recessions and recoveries associated with and not associated with high uncertainty. A recession is associated with high uncertainty if the level of uncertainty falls in the top quartile of uncertainty measured at the trough of all recessions. A recovery is associated with high uncertainty if the level of uncertainty during the recovery is in the top quartile of the average uncertainty of all recovery episodes. The amplitude of a recession is the percent decline in output from peak to trough. The amplitude of a recovery is the one-year change in output from the trough of the recession. The statistics refer to the median of all episodes. Uncertainty refers to country-specific uncertainty, which is the monthly standard deviation of daily stock returns in each country. Daily returns are calculated using each country's stock price index; time coverage varies across economies.

Recessions accompanied by high uncertainty are often deeper than other recessions.

Uncertainty shocks account for about one-third of business cycle variation in advanced economies and up to half of cyclical volatility in emerging market and other developing economies, implying that these shocks play a sizable role in driving the dynamics of recessions and expansions. Other relevant research concludes that shocks associated with uncertainty and financial disruptions were the primary factors that led to the 2009 global recession.13

This chapter documents that high uncertainty historically coincides with periods of lower growth and that a pickup in uncertainty appears to increase the likelihood of a global recession. It is difficult for policymakers to overcome the intrinsic uncertainty economies typically face over the business cycle. However, uncertainty about economic policy was unusually high during the latest recovery, and it appears to have contributed significantly to macroeconomic uncertainty.

On the Horizon: Policies

Policymakers can reduce policy-induced uncertainty by implementing bold and timely measures. Have the policy measures been sufficient to mitigate the severe impact of the 2009 global recession? In the next chapter, we trace the evolution of policies during global recessions and recoveries and document another unusual feature of the latest global recovery: the great divergence between fiscal and monetary policies in advanced economies.


Mario Draghi, president of the European Central Bank, pledges to preserve the euro.

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