The Uncertain Economy

These are highly uncertain times. In a matter of weeks, the longest economic expansion in U.S. history has become the sharpest recession on record with the first true pandemic recession. Mass death, record declines in GDP, and job losses are foregrounded against the confusing backdrop of a messy presidential election and a resurging stock market. As the pandemic evolves, policymakers, researchers, and the public attempt to respond with unprecedented speed and untested tools. The effects of economic uncertainty have long been theorized but are difficult to measure. Now, new empirical tools hold promise to quantify uncertainty – and in doing so reveal just how concerning the state of the economy actually is.

Within the economics field, uncertainty is more than just a stand-in term for “unexpected.” Uncertainty is a foundational concept, much like risk. However, unlike risk — which can be estimated, managed, and insured against — uncertainty refers to risks that are unknown. When risks are known, consumers and firms can adjust, even if the risk is high. However, when the level of risk is uncertain, consumers and firms cannot respond efficiently. The result: economic immobilization and destruction.

A little uncertainty can impair the most fundamental theoretical models and make policy less efficient. But large amounts of uncertainty can have tragic consequences. These include deferred spending, lower investment, decreased economic activity, and so on. Collectively, the consequences can slow an economy or deepen a recession.

The distinction between risk and uncertainty was discussed over 100 years ago by economists such as Frank Knight. However, it was difficult to measure and quantify, and the field remained fairly dormant for almost a century. Former Federal Reserve Chairman Ben Bernanke reintroduced the concept of uncertainty in a 1983 paper while a professor at Stanford University (Bernanke, 1983). His innovative work in the field made him a fitting choice to preside over the Federal Reserve during its response to the uncertainty of the 2009 financial crisis.

The 2009 collapse and subsequent slow recovery reawakened interest in uncertainty among economists. In 2015, empirical work by researchers Scott Baker, Nicholas Bloom, and Steven Davis revolutionized the field with a groundbreaking metric, often referred to as simply the Economic Policy Uncertainty index (Baker et al., 2015). The index, which has since been adopted by the Federal Reserve, is a fundamentals model, which means it combines several quantitative indicators into a single forecast. The initial model emphasized data such as GDP, income data, and others with estimates dating back to the 1980’s. Over time, additional indices have been added and the main index has been updated to include other relevant metrics, including qualitative data that helps capture market sentiment.

Now, the index has been updated yet again in a new working paper coauthored by David Altig and a team of 14 other researchers (including Baker, Bloom, and Davis). In fact, the new paper includes not just one version of the index, but several. The most complex index includes implied stock market volatility, qualitative analysis of newspaper articles, Twitter chatter, survey data regarding future business projections, and even empirical disagreements between forecasters.

Unlike earlier versions, the updated index is designed specifically as a forward-looking tool. Previous versions of the index, and by extension most economic forecasts and recession indicators, relied on fairly slow data that lags the policy response. The latest index includes real time data and constantly updates, all in an effort to provide a more accurate measure on which to base economic policy. Regardless of the index, the research concludes that the economy is not just historically bad, but also historically uncertain.

Uncertainty is not just a consequence of previous events; it is a problem in itself. High degrees of uncertainty can drastically slow a recovery, potentially bogging down the economy in an extended downturn. In the absence of a vaccine, limiting uncertainty will be difficult, though a clear and consistent economic policy message would help considerably. Unfortunately, even that is unlikely in the short term.

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Altig, David, Scott R. Baker, Jose Maria Barrero, Nicholas Bloom, Philip Bunn, Scarlet Chen, and Steven J. Davis, et al. 2020. “Economic Uncertainty Before and During the COVID-19 Pandemic.” National Bureau of Economic Research 27418 (June). https://doi.org/10.3386/w27418.

Baker, Scott R., Nicholas Bloom, and Steven J. Davis. 2016. “Measuring Economic Policy Uncertainty.” The Quarterly Journal of Economics 131, no. 4 (November): 1593-1636. https://doi.org/10.1093/qje/qjw024.

Bernanke, Ben S. 1983. “Irreversibility, Uncertainty, and Cyclical Investment.” The Quarterly Journal of Economics 98, no. 1 (February): 85-106. https://doi.org/10.2307/1885568.