What exactly is so bad about uncertainty, anyway?

21st November, 2019

The one certainty in politics at the moment is that it is uncertain. From a British point of view, there is the apparently endless game-playing over Brexit — coupled with the looming prospect of an unpredictable and highly consequential general election. I’m sure I don’t need to elaborate on the situation in the US.

The received wisdom is that political uncertainty is bad news, at least for the economy. Is that really true? And, if so, why? If we understand the problem a little better we may also have a sense of whether there is any chance of improvement.

The evidence from the research of various economists suggests that uncertainty is indeed a brake on economic activity. Nuno Limão and colleagues have shown that uncertainty over trade policy is itself a kind of barrier to trade. Meredith Crowley and colleagues have found that UK companies were less likely to enter EU markets, and more likely to exit, if those markets were more exposed to the risk of a breakdown in Brexit negotiations. And Nicholas Bloom has found that uncertainty — measured in various ways — tends to be a cause of recessions as well as a consequence. So the problem is real, but what exactly is causing it?

One theory is that there is something deeply unsettling about ambiguity. Back in 1961, a promising young economist named Daniel Ellsberg explored this issue in the Quarterly Journal of Economics. (Mr Ellsberg later became far better known as the whistleblower who leaked the Pentagon Papers.)

Mr Ellsberg imagined a gamble involving two urns, each known to contain a hundred red or black balls in total. The first urn contains 50 red and 50 black balls. The second has an unknown mix. Let’s say I offer to pay you $100 if the ball you draw out of an urn is red. From which urn would you prefer to pick — the first or the second? Most people prefer the first. But people also prefer the first urn if they are paid $100 for a black ball instead. It’s not that they feel their chances are better — logically, the first urn cannot possibly be a better choice for both red and black. It’s just that . . . well, the known risk feels less uncomfortable than the ambiguous risk.

That aversion to the unknown may explain part of why uncertainty seems to corrode the foundations of the economy. But I suspect that the main problem is something far less ethereal.

Imagine you are an entrepreneur with plans and permits to build, say, a cardboard recycling facility in Peterborough. If there is a fairly soft Brexit, or no Brexit at all, you think that a large plant would be profitable. If there is a hard Brexit, or even no deal, you still think you can make money with a smaller installation. What do you do?

Simple: you wait. You wait even though you would want to build some kind of factory under any circumstances. You wait because you will make a better decision if the Brexit uncertainty resolves itself. The uncertainty makes it more profitable to delay.

That’s the theory. What do the data suggest? In the UK, private sector investment is remarkably weak, given that the UK has not been in a recession. In fact, it is hard to find a parallel where a growing UK economy has been accompanied by such feeble investment. This weakness has persisted since about the time of the 2016 referendum. It is weak both historically and compared with the situation in the US and Germany. Perhaps that is all a coincidence, but I rather doubt it.

In the face of uncertainty, companies will value flexibility. The economists Benjamin Nabarro and Christian Schulz, contributing to the Green Budget of the Institute for Fiscal Studies, make an intriguing argument. They speculate that given persistent Brexit uncertainty, this desire for flexibility is being satisfied by hiring workers instead of making large investments in capital. That is a way to expand output without doing anything irreversible. It’s good news for jobs, and bad news for investment and productivity.

My example of the cardboard recycling plant implied that uncertainty will tend to depress investment, but uncertainty is not always an obstacle in that way. If the building permit for that recycling facility was about to expire, making this a now-or-never decision, you would find yourself making your best guess and building something. If the uncertainty would not be resolved until 2025, you might also decide the costs of delay were too great, and build immediately.

There are even cases where uncertainty encourages exploratory investments: not knowing what will happen, you try to ensure that you have a toehold in every possible future. For example, the mere possibility that a large country’s government might get serious about climate change encourages research into low-carbon technologies.

Not all uncertainty depresses investment, then. But if there is a scenario guaranteed to put everyone’s plans on ice, it is this: a major decision with weighty consequences that is forever being postponed. If that reminds you of anything, you are not alone.

Written for and first published in the Financial Times on 25 October 2019.

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