Monday, October 3, 2011

Fear (of another recession), not uncertainty.

What is keeping growth in advanced economies from recovering at a speed similar from previous recessions? There are several explanations and which one you prefer might depend on your political taste (see an example of this debate in the US here).

There is one potential explanation that I find is being overemphasized: "it is all about uncertainty". And some make it more explicit and talk about regulatory uncertainty, uncertainty about taxes, about a sovereign default in Europe, etc.

No doubt that uncertainty plays a role in explaining macroeconomic fluctuations and I am a big fan of Nick Bloom's work, an economist at Stanford, who has provided strong evidence that uncertain raises around some of the most recent recessionary episodes.

But what do we mean when we use the word uncertainty to describe the current environment? I believe we are mixing two things: one is that the future is more difficult to predict (and this truly matches the notion of uncertainty) but the second one is that future scenarios are simply worse than what we thought before. This is not uncertainty, this is just bad news.

Here is an example: five years ago most investors would not consider the possibility of sovereign default in Europe. Today there is a chance that it might happen. Has uncertainty increased? Yes. There are now two scenarios (default and no default) and we are not certain about which one will happen. But the real problem is that on average the future looks much worse than it used to! So all the uncertainty comes from the left side of the distribution. This is mainly bad news combined with some increase in uncertainty.

Same applies to other issues where we currently use the word uncertainty: business face uncertain demand but the real problem is that in the scenarios they are considering, most look bad and they have recently gotten worse; there is increased uncertainty about public finances but the problem is not that we do not know how governments will resolve this challenge, the real problem is that governments have a challenge to resolve!

My preference would be to use the word fear rather that the word uncertainty to describe what we are seeing these days. What is really damaging is the possibility of a new recession, the possibility of sovereign default. These are all bad news. On average the future does not look great and this is the real problem.

Antonio Fatás