By Rumplestatskin, a professional economist with a background in property development, environmental economics research and economic regulation. Follow him on Twitter @rumplestatskin. Cross posted from MacroBusiness
One strange claim in the economic debate that followed the financial crisis was the impact of uncertainty on the path of investment and subsequently the recovery in economic activity. Taking just one example, it was claimed here that “fiscal policy uncertainty has directly harmed the American economy by increasing the unemployment rate by 0.6%, or the equivalent of 900,000 jobs.”
Often the idea of uncertainty is captured in economic debates by labelling its inverse, a high degree of certainty, ‘confidence’, or when being a little more critical, the ‘confidence fairy’.
It was never particularly clear to me exactly what ‘high’ or ‘low’ uncertainty was supposed to mean, since the future is always uncertain and investment is always risky, and current policy decisions are not set for eternity. In this post I will dig down into the economic theory of real options that forms the basis for claims that uncertainty alone can greatly reduce investment activity. By doing so I hope the reader will develop a considered level of scepticism about such claims.
First, we should acknowledge just how widespread the idea that uncertainty hampers investment has become. There is a website devoted to providing national indices of policy uncertainty, which itself rests on two decades of effort in academic circles to endeavour to capture this mirage-like phenomena. Even now, India’s growth slowdown is being blamed on this mythical beast.
As a general observation, it seems there is no economic ill that cannot be blamed on government policy-induced high levels of uncertainty.
The economic origins of the idea start with Black-Scholes, and were more fully developed in the general sense in terms of capital investment by Dixit and Pindyck in what is generally known as real options theory. While I have concerns about how real options is applied (which I will get to in a moment), the fundamental principle embodied in real options theory is crucial to understanding economics.
The basic idea is this. If the future is uncertain, such that your future revenues and costs won’t be exactly what you expect, then you may choose to delay investment in order to get new information about the best investment choice.
Thus, when there is more uncertainty, or what would technically enter the real options model as a larger standard deviation on the expectations of price movements, then the value from delaying investment in order to better asses new information is greater.
Under these conditions firm value maximisation occurs not by profit maximising, but by maximising the rate of change of profit over time, or the rate of return on firm equity. The idea here is that investors choices based on expectation of both price levels and the rate of change in prices.
That’s whole idea right there. If you follow that through without thinking too much more about it, you can end up at the point of advising governments to ‘fix up certainty’ in order to bring forward investment decisions in order to reduce unemployment and increase economic growth.
But that ignores some very important points, which I haven’t seen properly addressed in the application of real options theory.
First, why is a perfectly known probability distribution in any way uncertain? We have done the old trick of calling the distribution of expectations (or for that matter simply the distribution of past price movements) uncertainty instead of its usual label, risk. Unquantifiable Knightian uncertainty remains ignored. Which means that even if the distribution of price expectations narrows, and real option theory says that such a thing will encourage investment, there remains a value to delay at all times if there is even a trace of unquantifiable uncertainty.
For me, this lack of distinction removes the possibility for real options theory as it stands to provide insights into the business cycle, particularly in relation to the type of herding behaviour we see both in financial and real resource investments. My personal view is that ubiquitous unquantifiable uncertainty is fundamental to understanding why investors can appear irrational, and why our innate herding behaviour is often a more useful and actionable decision rule for investment.
Second, even accepting that risk appropriately captures the rationale for delaying investment, changing the average expectation doesn’t change uncertainty. Most commentators who argue that their policy proposals reduce uncertainty are actually more concerned with shifting the average expectation of price movements upwards. But if the whole distribution shifts, but doesn’t narrow, then uncertainty is unchanged and it remains equally rational to delay investment in the face of increasing prices.
Third, it is not at all clear what the implication for real options is when rather than shrinking the spread of the distribution, the complete nature of the distribution changes. What I mean by this is that if risk appears normally distributed at some point in time, but events occur that change expectations of future price outcomes to be exponentially distributed. Moreover, there is no real understanding of the emergent properties of agents interacting with different risk expectations – are these interactions already captured in perceptions of risk, or do they add an additional dimension which take risk perceptions into the territory of pure uncertainty?
Finally, it is well known that even in the absence of uncertainty there can still be a value to waiting to invest for current asset owners. For example, if I own a piece of land with scope for development, in the case where there is uncertainty about future prices it may be optimal to wait to see which direction prices move in order to determine the optimal building type and size to construct to maximise my land value. But even if I know exactly what prices and construction costs will be over the course of the next few years, I may still choose to delay if I expect (perfectly, with no uncertainty) the value of the land in its undeveloped state to increase at a faster rate than when it is developed. Or indeed, to not lose value as quickly if it were the case that prices are falling.
So while claims of policy uncertainty having large real impacts in investment may appear well-grounded in economic theory, the theory still has many problems when applied to real policy, real investment and a real world of fundamental Knightian uncertainty. However I do hold out some hope that the core elements of real options theory, which are substantial improvements on the usual equilibrium theory of mainstream economics, can be more successfully incorporated into our understanding of investment and the business cycle.
Yes, the problem is a psychological / behavioral / cultrual one. It has nothing to do with theoretical economics (very little of any substace actually does).
Specifically, everyone — that includes me, “investors” of every ilk e.g. hedge funds, pension fund managers, private equity, my mother-in-law — wants risk free returns. There is now such a pervading sense of entitlement that it requires having another actor — and the only one big enough to fulfil that role realistically is the government — on hand to step in to save people from their (with hindsight) unsuccessful investment choices that the absence or perceived unwillingness of that actor to “do what they have to do” is seen as some sort of flaw.
The Emperor’s New Clothes in the living room stuck up a gumtree here is the multi million dollar comp packaged CEO and the fee extracting private equity manager. If they’re so clever, and their abilities so stellar, then they should not be acting like hapless girls tied to the railway track needing other agencies to rescue them from the oncoming train while the lack of confidence villain of the piece twirls his moustache. But the fact that these parties so often besiege governments to guarantee how the future will turn out for their plans makes me wonder if, in fact, they might just be like the rest of us, making it up as we go along and hoping for the best. They’re just better at whining.
And better at the looting.
Great and colorful comment!
I wonder if there is more too this. If we really are going toward the Herman Daly Steady-State Economy and this is partially cover and partially the have-a-hammer-everything-looks-like-a-nail problem. You can’t say that organic growth is slowing, that we are hitting diminishing returns – so you come up with this. It fits the framework.
Mix me a metaphor Clive, shaken not stirred. MSM in the UK today is telling us our government sold off our Post Office cheap and a bunch of speculators turn out not to be speculators but preferred investors brought in to keep shares for a long time. They nearly all dumped the shares asap to take big profits. My definition of uncertainty would have to include ‘something certain pretended not to be that excuses fraud’. UK public loses billions, but hey, it was a successful sale! Further in the definition we need, ‘what I mean by uncertainty is something I know for sure at the same time knowing others are uncertain about it’. And eventually we need, ‘leave no paper of email trails’ because that way we can keep other people uncertain about what we did.
We may have the wrong stats on uncertainty. A simple historical record and a look at who keeps winning against the odds should be enough to work out just how little unceertainty there was.
That our TBTF banks regularly brag about long strings of trading days without a loss tells me what kind of risk is in the markets right now,
Ahhh, yes. I have thought about this one myself. I didn’t read it all, but if you can make the central bank or government have a policy that effectively rigs the game, or changes the odds in favor of you of course you will lobby for it.
It’s an “economic” justification for rigging the playing field.
and fake economic reasoning with no data that backs the interests of the wealthy is not in short supply in economics.
Think about forward guidance for a second. All it really is is a heads up for speculators/ the markets of when to jump ship. Honestly, how many real world decisions are based on the central bank interst rate policy and announcements? What % of real people actually follow this stuff? it’s all based on nonsense assumptions. The emperor has no clothes. They will never admit it, but that is besides the point.
I was laughing at the Yellen statements of this morning about how the federal reserve has all this room to help the labor markets. Which really means more zero interest rate policy, a signal for speculators to lever up. It doesn’t mean: “we will actively work to break up too big to fail and increase transmission of monetary policy objectives” , or “We really fucked up and over leveraged the system, so we have to make sure all this borrowed credit never goes bad, hence we will never raise interest rates, and will inflate out the bad debt” or “Our entire belief system rests on shakey foundations, so we have to appear to at least be doing something, or people will catch on” , You get the idea I’m sure
Wrt Yellen: the only theory the Fed knows is “trickle-down”. That’s it. Period.
I can’t stand anymore to listen to any of their pseudo-scientific claptrap, or their deluded / disingenuous concern for the labor markets. Watch what they do, not what they say: they are bootlickers of the plutocracy. They are functionally reactionary kleptocrat tools. They are very much part of the problem.
The basic idea is this. If the future is uncertain, such that your future revenues and costs won’t be exactly what you expect, then you may choose to delay investment in order to get new information about the best investment choice.i
Or simply not invest much at all. Why must a business expand in the absence of viable competition? It can just hold steady with its current market shares and let its shareholders and execs continue to pocket their rents.
But to me, the issue about confidence has nothing to do with the distinction between so-called Knightian uncertainty and quantifiable risk. Leaving Knightian uncertainty aside and viewing things purely within the framework of standard expected utility theory, the problem is just this: whether or not it a business judges it profitable to invest in expanding its output depends on the probability it assigns to the circumstance that other businesses will expand their output, because only if others are producing more output will one’s own new output get sold at a price that justifies the added cost in producing it. If all businesses concurrently assign a low probability to the proposition that other businesses will expand, then the whole economy can remain stuck in a Nash equilibrium of low employment and under-capacity production, and can stay there for a long time. Low business confidence in general economic expansion is rationally self-perpetuating; expectations of stagnation sustain themselves and themselves help constitute the stagnation.
Notice this problem is purely a matter of business confidence about the general business environment, and has nothing to do with any further issues about the probabilities assigned to government policies. It also has nothing to do with the presence of some fuzzy and non-quantifiable Knightian uncertainty. Even if all business people were idealized Bayesian agents, this phenomenon could happen.
“the problem is just this: whether or not it a business judges it profitable to invest in expanding its output depends on the probability it assigns to the circumstance that other businesses will expand their output, because only if others are producing more output will one’s own new output get sold at a price that justifies the added cost in producing it.”
This seems counter-intuitive to me. Is this perhaps academic/consultant wisdom? I am a (very) small business, in a niche market catering to less than .00001% (unf not *that* 000001%; my sliver, musicians, is pretty well broke). I would only consider expanding if I could expand my *market*, and perhaps not even then (if I have enough work, I am happy). Not only would other businesses expanding not encourage m’e to expand, that might even cause me to *not* expand put me off expanding — there are only so many customers to go around and fighting over them will divert time and money making my product more expensive and, arguably, not as good.
I am mulling this over. Perhaps I should be reading ‘capitalist’ rather than ‘business’ in this context?
When I say “other businesses” in the passage you quoted, I’m talking not about your competitors, but other businesses in general. The intuition is that a business will only expand if, as you say, they think there is a market for the additional goods. But if the whole economy is stagnant, then consumer incomes are not going up and so many businesses will conclude that such a market doesn’t exist.
If households have been steadily spending $3 billion/year on kitchen widgets, without much evidence of unmet consumer demand, what will make WidgetCorp think they can be induced to spend $4 billion, and so invest in the increased equipment and workforce needed to increase their output by 33%? They will only think this is likely if they project the whole economy to grow and raise household incomes. If they don’t think this is likely, then their best strategy is just to stand pat, investing only so much as is needed to replace decaying equipment, and making new hires only to replace losses from attrition.
I think you have a good point. I think expectations are more specific and not necessarily related to the economy as a whole. It’s possible to lift up the 80% of the ships that are sinking. An example would be a job guarantee program that targeted social issues, elder care etc which could also include better funding the arts. If we started seeing more musicians with guaranteed income this would give confidence (real not fairy) to the stores that cater to these people to increase their investment.
Knight had uncertainty as risk you couldn’t measure. Fortunately I was at the back of the lecture theatre and was able to leave for a couple of pints before I had to put up with any more. I don’t suck eggs well. So uncertainty cosy 900,000 jobs. We’re already in the realm of using figures in peculiar ways to cover up 900,000 likely stories of misery. We never think to do something like prevent the certainty of uncertainty causing the misery. Who would give a damn about intercoursing the stochastic pink penguin of what you can’t measure anyway if we buffered people better from lousy treatment?
In autoepistemic reasoning we sometimes infer things on the basis of our not knowing certain things. I might infer I don’t have a sister because if I had I would surely have met her. Yet I might have a sister as in those dreadful separated at birth novels. I’m not able to do a defeasible logic calculation here, but we can at least wonder quite what uncertainty confidence fairies experience. In brevity I will say we could better call them panicking pixies. And ask why we give them any power over real people’s lives. The certainty in this uncertainty is we should not let the idiots make decisions. None of this is about probability theory. This is all to do with a rigged world that allows pampered dolts to take decisions tough on others.
What I see all around me is a loss of nerve. We want everything but we don’t want to risk anything to get it. Thus the endless cheating and subterfuge of our times. It’s drone strikes, copyright forever, TBTF, LIBOR, ZIRP, “dark sites”, “special rendition”, TPP, and a hundred other scams and dirty deeds writ large. We’re existing as a civilization on the raw desire for wealth and power. It’s the only energy left in the system. The quest for excellence, for transcendence, for artistic achievement (rather than just self-expression), for human betterment, seem to be largely enervated, moribund.
Rome survived for a long time on little more than greed and bloodlust. But it had a huge cushion of wealth and power and existed in a largely uncompetitive geostrategic environment (many threats, but no existential ones until very late, and then more because of Roman weakness than enemy strength). I fear that if things get rough we have a Diocletian waiting in the wings to stabilize the hulking, degraded mess for another century, but cultural and civic renewal seem beyond us.
Watching General Clapper speak to Congress lst year I realized that his obsession with knowing *everything* about *everyone* comes from his personal deep insecurity. I mean, here is a guy who cannot even dress himself (I refer to his uniform, regulation haircut and shoeshine, etc.) Just watching him I could feel that he was frightened to his core. I wonder if that doesn’t drive a lot of those people who amass ‘wealth and power’, because they are mortally terrified by uncertainty.
I think you’re right. I just posted something that showed mathematically you’re right — which makes it an objective fact — with an equation I discovered through research, where I discovered a Lambda factor that represents sensitivity to uncertainty and how that decreases the Job Offering Rate (JOR) where the JOR = L*U*C*K where U = uncertainty, C = Capital, K = a constant you can estimate by yourself without a calculator, but the comment got eaten. This was horrible. As L declines, JOR declines. L declines for the reasons you said. And it declines in proportion to their share of C. U is relatively constant most of the time. this one was a winner. It should be in the text books
Q, I say.
We’re existing as a civilization on the raw desire for wealth and power. It’s the only energy left in the system. The quest for excellence, for transcendence, for artistic achievement (rather than just self-expression), for human betterment, seem to be largely enervated, moribund.
This seems right to me too. But I wonder how it got that way. The neoliberal revolution seems to coincide with a cultural revolution that extolled all of the most greedy and shallow of human impulses, and both reactionary and countercultural repudiations of centuries of moral and epistemic culture. But what is cause and what is effect, I don’t know.
Americans seem to have swallowed the idea that a successful society and culture can just “emerge” naturally out of the fully liberated energy of hungry, consuming nerve endings.
Because markets. It really is a secular religion…
Perhaps many or most deludedly believe that this was true of the past (what made the US a successful society) but I think most ordinary Americans now see that period as over, understand that the game is now rigged against them, and refuse to support more “intrusive” government because they see it, correctly, as captured by special interests who either do not care about them or are out to actively screw them. The fact that there is confusion about which special interests are the problem is entirely understandable.
Great comments. I thought the post was vacuous considering just what nonsense we have made of the economy, but I told myself I was probably missing a profound point. The profound point was made by allcoppedout: “We never think to do something like prevent the certainty of uncertainty causing misery.” That’s a keeper.
“the theory still has many problems when applied to real policy, real investment and a real world of fundamental Knightian uncertainty”
If a true “real” is only formed through “testing of the real” then how should we treat a theory that fails when tested in a “real” application?
I ask myself this question constantly when it comes to political and economic theory. It often helps me separate the abstract from the concrete. In this case it makes me suspect that “market uncertainty” is simply a euphemism/abstraction for “lack of demand”.
Frank Knight’s uncertainty is really just another set of sums up the the immeasurable. Doing the stuff is like trying to put Clive’s great opener to numbers. We might get a handle on policy uncertainty by thinking what would happen if, say, we announced Mugabe was going to be drafted in as a technocrat to run the US economy. I mean “policy” would have almost no bearing on the panicking pixies. And what uncertainty would there be for that matter.
And what if we want a policy like a trading-block wide job/income guarantee? What role does this “uncertainty” play other than in trying to prevent such sense by saying the pixies will panic and run off to invest somewhere else so don’t breathe a word? In other words the corruption of politics and free speech – who’s modelling that? We can’t vote for anything socialist because the Bliars have already promised the panic pixies there will be no socialist policies.
Confidence fairies my arse. This is a tool of political repression. And even on the when to invest side I’m pretty sure markets don’t work on confidence any more. – and hasn’t Yves been telling us stock exchanges hardly raise money for investment anyway. I suspect something like one of the measurement problems in science might apply to the maths.
I’ll think about it as I walk Max to the bookie’s for a punt on uncertainty. I have a tip. Am I betting on the 4.15 pm in the same uncertainty as others? Harry the Horse’s tips have a 5:3 win ratio..
The evidence of the way real options theory is actually implemented seems to show that it isn’t the absence of the confidence fairy but the realization that investments in members of Congress and legislatures produce a higher return with less uncertainty than other investments. And stories about confidence fairies seem to move ignorant members of Congress with high levels of gullible belief. And positively thrill most business journalists with their “Politicians are killing Tinkerbell” narrative.
It had seemed to me that if an investment is riskier, more uncertain, you want a higher rate of return so that your gain in the decreased chance of success exceeds your loss in the increased chance of failure. For a purely financial investment the buyer can negotiate with the seller to set the rate of return and the deal can be done somehow. For a non-financial investment, like an apricot orchard or a railroad in Peru, like they had in Charles Dickens’ time, it’s different. You can’t negotiate with a non-existent railroad to get the level of business, or expenses, or profit and ROI that you must have. So you do the deal or you don’t. In a financialized economy this all looks pretty quaint because everything is fundamentally a poker game, and the only reason for holding out is that you believe the other guy will cave.
Risk means very different things to people with considerable financial resources and those with relatively modest resources. Someone with a billion dollars in the kitty can afford to risk millions. Even if he loses his entire investment, he’ll still be in fine shape. Someone with 100 thousand in the bank is in a very different position, as he could lose everything. Yet as far as economic theory is concerned, risk is risk, with little or no regard to the circumstances under which risk is taken.
My decision to get out of the stock market entirely was prompted by the following reasoning, which I defy any economist to challenge: it’s possible to envision a situation in which the market suddenly and without warning tanks drastically, losing a considerable percentage of its current value; yet it’s far more difficult to envision the opposite situation, where the market suddenly rises by a comparable amount. Since there is always some risk of the former, and very little likelihood of the latter, then, regardless of how much “confidence” one might have in the market, the risk of losing everything overnight, in one fell swoop, no matter how “unlikely,” is far too much risk for the ordinary individual (or business) to undertake, regardless of ANY other factors to be considered. Of course, as I said, if you are a billionaire in a position to risk only a small portion of your total capital, that’s a different story. As for me, if I were a gambling man, which I am not, I’d prefer the casinos, where you know exactly how much you are risking and what the odds are.
that’s what I thought last year and it went up 40%. Now what? Now I still think the same thing. We’ll be right eventually, but it’ll be too late to have any fun. So what good does it do? It doesn’t do any good.
Back when I had no money I didn’t care about spending it. Now that I have some, it hurts to spend it. Because then I didn’t know how hard it would be to get it and how easy it would be to lose it. I’d look at the hard cynical faces of old tired men and I’d wonder what blight had cursed them. What force had hunted them down and turned them into something savage and pathetic, lifeless, joyless, dry and wasted like a burned out pile of garbage in the sun. Now. Now I know.
Now what? It’s time to go short, but it was time last year too. Maybe gold. Maybe silver. Maybe it’s best just to forget about getting rich quick, or about money at all except what it takes to eat and ride the bus. You can live in your mind. But you have to live there by yourself. Let’s not be sentimental about it. If you want company, it usually takes money or the sh*t hits the fan and when it does it’s worse than being alone on a bus looking out the window up at the sky So much worse.