Fearing fear itself

By R.A. | WASHINGTON

A PIECE in the New York Times this morning reads:

Hesitation is weakening the American economy, as Monday's disastrous day on Wall Street reaffirmed what many companies and ordinary Americans have been fearing for weeks: this is too tumultuous a time for businesses or households to be contemplating expansion.

Just a few months ago, analysts were predicting that the economy would grow about 4 percent this year. The forecast is now closer to half that number as a wave of pessimism sweeps the country.

“Everybody gets into this hangdog demeanor with respect to economic expectations,” said Paul Laudicina, chairman of A. T. Kearney, a consulting firm. “People sit on their wallets because they feel like everything is going to get worse, and things get worse because people are sitting on their wallets.”

And at Vox, Nicholas Bloom says:

I have studied 16 previous uncertainty shocks – events like 9/11, the Cuban Missile Crisis, the assassination of JFK – and the only certain thing about these is they lead to large short-run recessions (Bloom 2009).

When people are uncertain about the future, they wait and do nothing.

• Firms do not to hire new employees, or invest in new equipment if they are uncertain about future demand.
• Consumers do not buy a new car, a new TV, or refurnish their house if they are uncertain about their next paycheck.

The economy grinds to a halt while everyone waits...

Based on my research, I predict another short, sharp contraction in late 2011 of about 1%, with a rebound in spring 2012. This research looks at the average impact of the previous 16 uncertainty shocks to predict the impact of future shocks. Typically these leads to reductions of growth of about 2% immediately after the shock, with a recovery about six months later once uncertainty subsides.

Mr Bloom notes that his work builds on others' research, including the paper, "Irreversibility, uncertainty, and cyclical investment", by one Ben Bernanke. Its abstract reads:

This paper builds on the theory of irreversible choice under uncertainty to give an explanation of cyclical investment fluctuations. The key observation is that, when individual projects are irreversible, agents must make investment timing decisions that trade off the extra returns from early commitment against the benefits of increased information gained by waiting. In an environment in which the underlying stochastic structure is itself subject to random change, events whose long-run implications are uncertain can create an investment cycle by temporarily increasing the returns to waiting for information.

This is the kind of dynamic I had in mind yesterday when I wrote:

I've been thinking, today, of the investors and entrepreneurs who bought the talk about sustained recovery and put money on the line during the eight quarters since the recession's official end. They will be punished for their daring if the economy falls back into recession, and the firms that built up ever larger cash piles will be vindicated. It will be harder than ever to pry firms and households away from a deflationary mindset. That's an extremely troubling thought. Risks are pointing overwhelmingly to the downside here, and if major central banks fail to react, the carnage will only grow.

As uncertainty about the path of growth increases, the return to delaying spending and investment while new information arrives exceeds the return to spending and investing now. As firms and households pull back, fear of a return to recession becomes self-fulfilling. The Fed can and should play a stabilising role against these shifts. Interestingly, Mr Bernanke specifically cites the occurence of unexpectedly low money-growth rates as an example of an anomaly that can lead firms and households to pause while waiting to observe whether the central bank has altered its policy rule.

The case seems strong for a Fed statement that it will not allow nominal growth or inflation to surprise to the downside. Indeed, Mr Bernanke's research suggests it would probably be a good idea for the central bank to target a constant rate of nominal GDP growth and take whatever action is necessary to hit that target.

Instead, the Fed seems remarkably willing to leave the economy hanging, wondering if, when, and how the Fed might react to massive swings in markets and a deteriorating economic picture. As bad or worse, the Fed, like many central banks, seems all too willing to prevent any upside surprise in growth or inflation while frequently tolerating downside surprises.

Mr Bernanke knows this is harmful to an economy; his past research is testament to this. The only question is whether he has the confidence to do anything about it.