Wednesday, October 8, 2008

Update on the role of aggregate uncertainty

VoxEU provides some data on aggregate uncertainty and recessions as an update to my post on how the Fed needs to reduce volatility. (Some nice charts within the link. Emphasis mine.)

One of the most striking effects of the recent credit crunch is the huge surge in stock market volatility this has generated. The uncertainty over the extent of financial damage, the identities of the next banking casualty and the unpredictability of the policy response have all led to tremendous instability. As a result the implied volatility of the S&P100 – commonly known as the index of “financial fear” - has more increased almost six-fold since August 2007. In fact since the outbreak of the Credit Crunch it has jumped to levels even greater than those witnesses after the events of the 9/11 Terrorist attacks, the Gulf Wars, the Asian Crisis of 1997 and the Russian default of 1998. ...

So why is this banking collapse and rise in uncertainty likely to be so damaging for the economy? First, the lack of credit is strangling firm’s abilities to make investments, hire workers and start R&D projects. Since these typically take several months to initiate the full force of this will only be fully felt by the beginning of 2009. Second, for the lucky few firms with access to credit the heightened uncertainty will lead them to postpone making investment and hiring decisions. It is expensive to make a hiring or investment mistake, so if conditions are unpredictable the best course of action is often to wait. Of course if every firm in the economy waits then economic activity slows down. This directly cuts back on investment and employment, two of the main drivers of economic growth. But this also has knock-on effects in depressing productivity growth. Most productivity growth comes from creative destruction – productive firms expanding and unproductive firms shrinking. Of course if every firm in the economy pauses this creative destruction temporarily freezes – productive firms do not grow and unproductive firms do not contract. This leads to a stalling productivity growth. ...

So the current situation is a perfect storm – a huge surge in uncertainty that is generating a rapid slow-down in activity, a collapse of banking preventing many of the few remaining firms and consumers that want to invest from doing so, and a shift in the political landscape locking in the damage through protectionism and anti-competitive policies.

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