Download The permanently damaging impact of uncertainty on growth

THE PERMANENTLY DAMAGING IMPACT OF UNCERTAINTY ON GROWTH
Economic uncertainty and uncertainty about economic policy are generally bad for
economic growth. What’s more, the effects on national economic output of an increase
in uncertainty seem to be permanent: a fall in growth is not made up for by higher than
normal growth later on.
These are among the conclusions of new research by Massimo Giuliodori and
colleagues, to be presented at the Royal Economic Society’s 2012 annual conference.
Their study analyses more then 60 years of data on US economic growth and US stock
market volatility – an indicator of economic uncertainty – to show that:

An increase in stock market volatility is followed by a slowdown in economic
growth.

An increase in stock market volatility substantially above average leads to a drop
in GDP of 1%.

This is a rise in stock market volatility of one standard deviation from the mean.
To put this in context, the volatility of the stock market following the fall of
Lehman Brothers was almost nine standard deviations from the mean.

The same rise in volatility of one standard deviation results in a 6% slowdown in
investment growth and a 0.6% fall in consumption growth.
The authors conclude:
‘Our results show that economic uncertainty is generally bad for economic
growth.
To the extent that economic uncertainty is caused by policy uncertainty, our
results argue in favour of limiting policy changes.’
More…
The recent global economic and financial crisis has stimulated research on the
relationship between financial markets and the macroeconomy. In particular, several
economists have stressed that that higher volatility in the stock markets, which can be
used as a measure of general economic uncertainty, could be one of the driving factors
explaining the recent slowdown of economic activity.
A measure of volatility measure that is based on variance of the daily returns on the
Dow Jones index was particularly high in the last quarter of 1987, the period in which
Black Monday occurred, and at the end of 2008, the period after the collapse of
Lehman Brothers.
But how can higher uncertainty affect the economy? The existing literature identifies
several potential channels. First, higher uncertainty may lead to an increase in
precautionary savings, thereby depressing consumption.
Second, it may raise the required compensation for bearing systematic risk in financial
markets, thereby pushing up the cost of capital and, hence, depressing investment.
Higher uncertainty also raises the value of the option-to-wait in making irreversible
investment decisions, thereby slowing down investment expenditures. The same is true
for consumption of durable goods.
Finally, it is sometimes argued that higher stock market volatility reflects enhanced
uncertainty about future cash flows and discount rates that result from expected
resource-consuming structural changes that depress GDP growth.
These theoretical channels seem to be consistent with the existing empirical literature,
which finds a negative relationship between stock market volatility and output growth.
But this literature does not document whether this relationship is stable over time.
This new study analyses US data from the beginning of 1950 until mid-2011, and finds
that the macroeconomic response to stock market volatility changes rather markedly
over that period both in qualitative and quantitative terms.
Consistent with previous work, estimates for the entire period confirm that an increase
in stock market volatility is followed by a slowdown of real output growth. More
specifically an increase of stock market volatility by one standard deviation (the volatility
in the fourth quarter of 2008 was almost nine standard deviations) leads to a drop in
output growth of 1%. The main channel underlying this result is a 6% slowdown of
investment growth, although consumption growth also deteriorates by 0.6% after a
volatility shock.
But splitting the sample, there are remarkably different results between the pre- and
post-1984 period. The negative response of GDP growth is substantially smaller during
the second sub-period. Further, while in the first sub-period both a slowdown in
consumption and investment growth contribute to a drop in GDP growth, during the
second sub-period, only investment contributes to the GDP slowdown.
A variance decomposition analysis, which makes it possible to quantify the contribution
of stock market volatility to the movements of the variables in the model shows that,
going from the first to the second sub-period, the contribution of volatility becomes
negligible for consumption growth, while it increases substantially from around 10% to
almost 20% for investment growth.
These results show that economic uncertainty is generally bad for economic growth.
Moreover, the level effects on GDP of an increase in uncertainty seem to be
permanent: a fall in growth is not made up for by higher than normal growth later on.
To the extent that economic uncertainty is caused by policy uncertainty, an issue that
requires deeper investigation, the results of the paper argue in favour of limiting policy
changes. The variance decomposition analysis shows in particular that the benefit of
stability for investment has increased substantially over time.
ENDS
Contact:
Massimo Giuliodori
Amsterdam School of Economics,
Roetersstraat 11, 1018 WB Amsterdam, The Netherlands
+31.20.5254011.
Email: [email protected]