Thursday, October 18, 2012

Uncertainty Undervalued

In all the number crunching and politicized statistics this election season, the human behavior behind the numbers is sometimes forgotten. Jeffrey Lacker, the current president of the Federal Reserve Bank of Richmond and "the Fed's Mister No," demonstrated in a recent Charlie Rose interview why he is one of (if not) the most restrained voter on the Federal Open Market Committee. His skepticism over more stimulus spending and increased regulation is, in my view, most welcome along with the implied understanding of incentives and human behavior. While his praise for 'living wills' is arguably overstated, his desire to see the business and political culture of “too-big-to-fail” eradicated is important. He rightly notes that government bailouts breed expectations of future bailouts. This type of expectation creates a moral hazard (often unknowingly) and incentivizes high-risk decisions that would possibly be tapered if the financial institutions were expected to shoulder the burden of their own decisions.

Furthermore, Lacker seems to understand that the economy is not an abstract entity living above and beyond U.S. citizens, but the citizens themselves. He recognizes that uncertainty has a perverse effect on entrepreneurship. Much of this uncertainty has been placed at the feet of Dodd-Frank, with almost 36% of its near 400 rules remaining unwritten.[1] Some of the more recent discoveries within the act have been compared with the lending activity that helped fuel the financial crisis, though on a smaller scale. One study, sampling 29 countries, found that “the size of government, the quality of the monetary policy and overall financial environment are strong determinants of entrepreneurship across the small sample…for which there are comparable data.”[2] Furthermore, government consumption is negatively correlated with entrepreneurial activity, both out of necessity and out of opportunity.[3] The effect on opportunity entrepreneurship is three times larger than that out of necessity. This is most likely related to what economist Robert Higgs calls "regime uncertainty." If Washington bureaucrats want the economy to pick up, they need to unleash the entrepreneurs

Business confidence was very low a couple years ago, causing Scott Shane of Case Western Reserve University to write, "If policymakers want small businesses to participate in the economic recovery, they need to revive the business owners' optimism…Make a credible commitment to reduce the uncertainty facing small businesses. Promise them that their taxes won't increase and that they won't face new regulations or major changes in how they operate until after the 2012 Presidential election, at the earliest." Unfortunately, his advice was not heeded and recent evidence paints yet another dismal picture. The National Federation of Independent Business released an August study demonstrating a dip in the Small Business Optimism Index. The recession-level optimism makes this the worst recovery period in NFIB survey history, beginning in 1973. The NFIB reported a slight bump in the Small Business Optimism Index the following month. Yet, 38% of owners said it was not a good time to expand due to economic uncertainty, while 22% (a record high for this business cycle) said it was not good due to political uncertainty. Similarly, “Uncertainty over Economic Conditions” was ranked the second greatest concern for owners (below “Cost of Health Insurance”) and “Uncertainty over Government Actions” was ranked fourth. The most recent survey found another drop in the Small Business Optimism Index, with job creation plans dropping 6 points, job openings falling 1 point, and further decreases in employment (despite the recent drop in unemployment).[4] This is the 56th time the Index has dipped below 93 (currently at 92.8) since 1986 (32 of these occurrences have been since June 2009). 

NFIB chief economist William Dunkelberg points out,

The election is just weeks away and essentially a horse-race, and its outcomes would have vastly divergent policy implications. Everyone is waiting to see what happens, especially small-business owners who have a lot at stake in the outcome—which could mean higher marginal tax rates and more deficits, OR lower marginal tax rates and less government. Small-business owners are reporting that the political climate is a reason not to expand—second only to the economy, which is only keeping up with population growth. And so, in the meantime, owners are in maintenance mode; spending only where necessary and not hiring, expanding or ordering more inventories until the future becomes more ‘certain.’

Back in 2010, three Chicago economists (including Nobel laureate Gary Becker) argued in The Wall Street Journal that shattered confidence and policy uncertainty in particular were slowing the recovery. Reforms and major adjustments to the health care system, antitrust policy, monetary policy and so forth created a business climate of uncertainty. "These facts suggest that it was a serious economic mistake to press for a hasty, major transformation of the U.S. economy on the heels of the worst financial crisis in decades," write the authors. "...By failing to adopt a measured approach to economic policy, Congress and the president may be slowing the economic recovery, and thereby prolonging the distress from the recession." A recent study found economic policy uncertainty in 2010 and 2011 to be four times higher than on average between 1985 and 2011. While this uncertainty revolved largely around taxes and monetary policy, the list included entitlement programs, health care, financial and labor regulation, and sovereign debt and currency issues. This uncertainty leads firms to delay investments and other costly decisions.[5]

Thankfully, consumer confidence is beginning to gain momentum, particularly in housing. Jeremy Siegel of the Wharton School of the University of Pennsylvania has been claiming for months that housing will drive the U.S. economy in 2013, including the Dow surging to 17,000. Purchases of new U.S. homes were almost at a two-year high toward the end of August. The National Association of Realtors reported that existing home sales exceeded forecasts, reaching a two-year high, 4.82 annual rate. July was the sixth month in a row to see a rise in home prices, with consumer confidence rising significantly from August to the highest level since February. The Thomson Reuters/University of Michigan September Survey of Consumers reported gains in consumer confidence (including positive home buying plans), but with a dose of reality regarding the "rocky road" ahead. The latest report placed consumer sentiment at a 5-year high. This may be due to the nearing election (Cornell's William Jacobson makes an interesting case for a positive correlation between Romney's spike in the polls and consumer sentiment).

The Chicago Booth/Kellogg School Financial Trust Index recently found that only 21% of Americans trust the financial system, which is the lowest since March 2009. Scholars Betsey Stevenson and Justin Wolfers have documented that trust in public institutions has declined in the United States, particularly since the financial crisis. A 2010 study found that increased regulation decreases social trust and vice versa.[6] As various research has shown, social trust is correlated with positive economic performance.[7] 

Uncertainty has been undervalued when discussing our economic troubles. The election outcome will provide an idea of what policies will be instituted. This will allow businesses and consumers to have a better grasp of the future economic direction. Ultimately, I think the market will pick up no matter who is elected. To what extent is another question.

1. See also Penny Crosman, "As Dodd-Frank Turns Two, Tech Solutions Lacking," American Banker (July 18, 2012); Peter J. Wallison, "Dodd-Frank: The Economic Case for Repeal," The American (June 27, 2012); Jim Turner, "Uncertainty in Dodd-Frank, Presidential Contest Clouds Florida's Economic Future," Sunshine State News (Sept. 8, 2012); Nicole Gelinas, "Dodd-Frank's Protection Racket," City Journal 22:3 (Summer 2012).

2. Christian Bjornskov, Nicolai J. Foss, "Economic Freedom and Entrepreneurial Activity: Some Cross-Country Evidence," Public Choice 134 (2008): 324. See also Christian Bjornskov, Nicolai J. Foss, "How Institutions of Liberty Promote Entrepreneurship and Growth," in James Gwartney, Robert Lawson, Joshua Hall, Economic Freedom Around the World: 2012 Annual Report (Fraser Institute, 2012).

3. Opportunity entrepreneurship is the state of those that "have engaged in an activity for the reason that they perceive that it represents an economic opportunity to them." Necessity entrepreneurship is the state of those "engaged in an activity for the reason that they perceived it "necessary," probably in order to uphold a decent standard of living or, in developing countries, to be able to support their family." (Ibid.: 315-316)

4. While I sympathize with Jack Welch's skepticism, I think it can be demonstrated that the books were not cooked. Both AEI's James Pethokoukis and David Altig of the Atlanta Fed provide useful commentary.

5. See also the Economic Policy Uncertainty Index. A new working paper out of the University of Washington found that a 1% increase in economic policy uncertainty is associated with a 1.495% decrease in the one-month unexpected return on the country-level market index (this continues for at least two years). Increases in economic policy uncertainty correlate with decreases in GDP for at least seven quarters, driven by a decrease in private investment and consumption.

6. Philippe Aghion, Yann Algan, Pierre Cahuc, Andrei Shleifer, “Regulation and Distrust,” The Quarterly Journal of Economics 125:3 (2010).

7. For example, see Francis Fukuyama, Trust: The Social Virtues and the Creation of Prosperity (New York: Free Press, 1995).

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