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Uncertainty as a Driver of Business Cycles: Evidence and Implications

This paper explores the role of uncertainty as a driving factor in business cycles. It provides empirical evidence that uncertainty is counter-cyclical and not primarily driven by first moment shocks. The paper also presents a DSGE model that incorporates time-varying uncertainty, heterogeneous firms, and non-convex adjustment costs. The model shows that uncertainty shocks lead to drops and rebounds in labor, capital, TFP, and output, and also change the impact of policies.

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Uncertainty as a Driver of Business Cycles: Evidence and Implications

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  1. Really Uncertain Business CyclesNick Bloom (Stanford & NBER)Max Floetotto (McKinsey (the dark-side))Nir Jaimovich (Duke & NBER)Itay Saporta-Eksten (Tel Aviv) Stephen J. Terry (Stanford)Hass University, 11/13/2014

  2. Uncertainty as another driver of business cycles Many business people and policymakers believed this was a key factor in driving recent recessions: “participants reported that uncertainty about the economic outlook was leading firms to defer spending projects until prospects for economic activity became clearer.” FOMC minutes, April 2008

  3. Uncertainty as another driver of business cycles Many economists have also a taken a similar view “the main contribution to the decline in output and employment during the 2007-2009 recession are estimated to come from financial and uncertainty shocks” Stock and Watson (2012, BPEA)

  4. Uncertainty has also been in the media a lot recently

  5. Although for some the best evidence is..…

  6. ….that Paul Krugman thinks it does not matter

  7. So we study second moment (uncertainty) shocks • Can generalize this to include idiosyncratic demand shocks (e.g. Hopenhayn and Rogerson, 1993)

  8. Summary of what this paper does • Provides empirics suggesting uncertainty is: • Counter-cyclical • Not primarily driven by first moment shocks • Builds a DSGE model generalized with time-varying uncertainty, heterogeneous firms and non-convex adjustment costs, finding: • Uncertainty shocks generate drops and rebounds in labor, capital, TFP & output • Uncertainty shocks change the impact of policies

  9. Disinvest (s) Invest (S) Density of units Productivity / Capital Intuition is adjustment costs for investment and hiring leads to Ss models (here for capitals) Innaction Disinvestment Investment

  10. Increased uncertainty makes the SS thresholds move outwards Disinvest (s) Invest (S) Density of units Innaction Productivity / Capital

  11. This leads net investment to fall, because investment drops more than disinvestment Disinvest (s) Invest (S) Density of units Productivity / Capital Drop in disinvestment Drop in investment

  12. This leads to the: “Delay effect”: higher uncertainty leads firms to postpone decisions. So net investment (and hiring) falls ∂I/∂σ<0 where I=investment or hiring, σ=uncertainty

  13. Higher uncertainty also reduces responsiveness to stimulus (like prices, taxes and interest rates) Disinvest (s) Invest (S) Density of units Marginal investing density at low uncertainty threshold Marginal investing density at high uncertainty threshold Productivity / Capital

  14. This leads to the : “Delay effect”: higher uncertainty leads firms to postpone decisions. So net investment and hiring falls ∂I/∂σ<0 where I=investment or hiring, σ=uncertainty “Caution effect”: higher uncertainty reduces firms response to other changes, like prices or TFP ∂2I/∂A∂σ<0 where I and σ as above, A=prices or TFP

  15. Since this model has 2-factors with adjustment costs it has a 2-dimensional response box High uncertainty Low uncertainty

  16. Measuring UncertaintyModelSimulation of an uncertainty shockPolicy experiment

  17. Macro and Micro Uncertainty appear countercyclical • Counter cyclical macro uncertainty is by now a stylized fact – so I will just show some summary graphs (from Bloom 2014, JEP) • Counter cyclical micro uncertainty is less clears

  18. Stock returns realized volatility (back to 1950) Volatility of the daily returns on the S&P 500 Source:Monthly volatility of the daily returns on the S&P500 at an annualized level. Grey bars are NBER recessions. Data spans 1950Q1-2013Q4.

  19. VIX, the 1-month ahead implied S&P500 volatility Source:VIX is the implied volatility on the S&P500, averaged to the quarterly level, provided by the Chicago Board of Options and Exchange. The VIX is the markets implied level of stock-market volatility over the next 30-days, where values are in standard-deviations on the S&P 500 at an annualized level. Grey bars are NBER recessions. Data spans 1990Q1-2013Q4.

  20. Stock-volatility and VIX lead and lag the cycle 0 -.1 -.2 Correlation of stock volatility (or VIX) andindustrial production growth -.3 vol correlation vix correlation -.4 -12 -11 -10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 Lead (lag if negative) months on volatility (or VIX) Source:Industrial production monthly data from Federal Reserve Board data from 1970 onwards (VIX from 1990 onwards)

  21. GDP GARCH(1,1) conditional vol. 37% higher in recessions Source: Bloom (2013), “Fluctuations in Uncertainty”, NBER WP 19714 (auxiliary data do-file)

  22. News-Based uncertainty indicators US Newspapers: • Boston Globe • Chicago Tribune • Dallas Morning News • Los Angeles Times • Miami Herald • New York Times • SF Chronicle • USA Today • Wall Street Journal • Washington Post Basic idea is to search for frequency of words like econom* and uncert* in newspapers

  23. US Economic policy uncertainty 250 200 150 100 50 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 Debt Ceiling; Euro Debt 9/11 Shutdown Fiscal Cliff Lehman and TARP Gulf War II Bush Election Gulf War I Black Monday Stimulus Debate Russian Crisis/LTCM Clinton-Election Euro Crisis and 2010 Midterms Source: “Measuring Economic Policy Uncertainty” by Scott R. Baker, Nicholas Bloom and Steven J. Davis, all data at www.policyuncertainty.com. Data normalized to 100 prior to 2010.

  24. Policy Uncertainty also leads and lags the cycle 0 -.05 -.1 Correlation EPU & industrial production growth -.15 -.2 -.25 -12 -11 -10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 Lead (lag if negative) months on policy uncertainty news index Source:Economic Policy Uncertainty Index from www.policyuncertainty.com. Industrial production monthly data from Federal Reserve Board. Data from 1985 onwards.

  25. 300 200 100 0 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 News based measures are useful back in time Debt Ceiling Lehman and TARP Great Depression Relapse Great Depression, New Deal and FDR 9/11 and Gulf War II Gulf War I Black Monday Gold Standard Act Asian Fin. Crisis Assassination of McKinley Post-War Strikes, Truman-Dewey OPEC II OPEC I Versailles conference Watergate Start of WW I McNaryHaughen farm bill Policy Uncertainty Index Berlin Conference Notes: Index of Policy-Related Economic Uncertainty composed of quarterly news articles containing uncertain or uncertainty, economic or economy, and policy relevant terms (scaled by the smoothed total number of articles) in 5 newspapers (WP, BG, LAT, WSJ and CHT). Data normalized to 100 from 1900-2011.

  26. European Economic Policy Uncertainty Index 200 150 100 50 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Papandreou calls for referendum, then resigns Italy Rating Cut Greek Bailout Request, Rating Cuts Nice Treaty Referendum Lehman Bros. Treaty of Accession/ Gulf War II 9/11 Policy Uncertainty Index Russian Crisis/LTCM Northern Rock & Ensuing Financial Turmoil Ongoing Eurozone Stresses Asian Crisis German Elections French and Dutch Voters Reject European Constitution Source: www.policyuncertainty.com. Based on 10 paper (El Pais, El Mundo, Corriere della Sera, La Repubblica, Le Monde, Le Figaro, the Financial Times, Times, Handelsblatt, FAZ.)

  27. India Economic Policy Uncertainty Index 250 200 150 100 50 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Exchange Rate Fluctuations and Worry Lokpal Bill Congress Party wins National Election Lehman Bros Price Hikes India-US Nuclear Deal Bear Sterns India Based Policy Uncertainty Index Source: www.policyuncertainty.com. Data from 7 Indian newspapers (Economic Times, Times of India, Hindustan Times, Hindu, Statesman, Indian Express, and Financial Express)

  28. China Economic Policy Uncertainty Index Political Transition and new National Congress 400 300 200 100 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Eurozone Fears and Protectionism Inflation and Export Pressure 9/11 China Deflation and Deficit China Based Policy Uncertainty Index Rising Interest Rates China Stimulus Source: www.policyuncertainty.com. Data until February 2014. Based on newspaper articles from the South China Morning Post.

  29. Orange Revolution in Ukraine Russian Economic Policy Uncertainty Index (beta) Kiev Euromaidan; Crimea annexation Duma elections and protests against election fraud Second Chechen War Russian military exits Chechnya Lehman Brothers Failure Timoshenko resigns; Terror attack in Nalchik Kizlyar hostage crisis;PM Chubais resigns Acting PM Gaidar resigns Parliament dismissed In Ukraine Taper Tantrum Constitutional Crisis Putin election Russian financial crisis Medveded election Putin becomes PM Terror attacks in Nalchik & Stavropol Ukraine Conflict First Chechen War Source: Data from Kommersant daily newspaper (1992-2014)

  30. North Korean Economic Policy Uncertainty Index 250 200 Policy Uncertainty Index 150 100 50 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Source: www.policyuncertainty.com. Data from 0 North Korean newspapers

  31. Forecaster disagreement and uncertainty: GDP Mean Forecast GDP growth uncertainty and disagreement (same scale) GDP growth (mean forecast ) Forecaster disagreement Forecaster uncertainty Notes:Data from the probability changes of GDP annual growth rates from the Philadelphia Survey of Professional Forecasters. Mean forecast is the average forecasters expected GDP growth rate, forecaster disagreement is the cross-sectional standard-deviation of forecasts, and forecaster uncertainty is the median within forecaster subjective variance. Data only available on a consistent basis since 1992 Q1, with an average of 48 forecasters per quarter. Data spans 1992-20013.

  32. Macro and Micro Uncertainty appear countercyclical • Counter cyclical macro uncertainty is by now a stylized fact – so I will just show some summary graphs (from Bloom 2013) • Counter cyclical micro uncertainty is less clears

  33. We use census data to measure micro uncertainty • (Micro) uncertainty is hard to measure • We use Census ASM manufacturing data on about 50,000 plants per year from 1972-2010 • Primary sample: plants with 25+ years of data • Secondary samples: plants 2+ and 39 years of data • Also show Census based uncertainty measures very correlated with other popular uncertainty measures

  34. Define uncertainty as the variance of TFP ‘shocks’ Shocks are the forecast error in TFP, where TFP measured using standard SIC 4-digit factor share approach log(TFP) Plant fixed effect Year fixed effects Lagged log(TFP) TFP ‘shock’ Is this a shock? At least partially as this residual (ei,t) is correlated with parents’ stock returns (for plants with a publicly listed parent firm) over the same period (so contains news) Also looks very similar if condition on multiple lags of investment, employment, materials, sales, TFP expansions etc

  35. Counter-cyclical: micro-uncertainty, the variance of plant TFP shocks, increased by 76% in the Great Recession Density TFP shock Notes: Constructed from the Census of Manufactures and the Annual Survey of Manufactures using the balanced panel of all 15,752 establishments active in 2005-06 and 2008-09. Moments of the distribution for non-recession (recession) years are: mean 0 (-0.166), variance 0.198 (0.349), coefficient of skewness -1.060 (-1.340) and kurtosis 15.01 (11.96). The year 2007 is omitted because according to the NBER the recession began in December 2007, so 2007 is not a clean “before” or “during” recession year.

  36. Counter-cyclical: micro uncertainty, proxied by the variance of plant sales growth, rose in the recession Density Sales growth rate Notes: Constructed from the Census of Manufactures and the Annual Survey of Manufactures using a balanced panel of all 15,752 establishments active in 2005-06 and 2008-09. Moments of the distribution for non-recession (recession) years are: mean 0.026(-0.191), variance 0.052 (0.131), coefficient of skewness 0.164 (-0.330) and kurtosis 13.07 (7.66). The year 2007 is omitted because according to the NBER the recession began in December 2007, so 2007 is not a clean “before” or “during” recession year.

  37. Higher (third and fourth) moments are not cyclical

  38. Same in other micro measures – economy seems ‘fractal’: uncertainty rises at every level in recessions Idiosyncratic shocks appear more volatile in recessions at all levels: - industry - firm - plant - product

  39. Industry growth dispersion (by month) 99thpercentile 95th percentile 90th percentile 75th percentile 50thpercentile 25th percentile 10th percentile Industry level quarterly output growth rate (%) 5th percentile 1stpercentile Note: 1st, 5th, 10th, 25th, 50th, 75th, 90th, 95th and 99th percentiles of 3-month growth rates of industrial production within each quarter. All 196 manufacturing NAICS sectors in the Federal Reserve Board database. Source: Bloom, Floetotto and Jaimovich (2009)

  40. Firm growth dispersion (by quarter) Across all firms(+ symbol) Inter Quartile range of sales growth rate Across firms in a SIC2 industry Note: Interquartile range of sales growth (Compustat firms). Only firms with 25+ years of accounts, and quarters with 500+ observations. SIC2 only cells with 25+ obs. SIC2 is used as the level of industry definition to maintain sample size. The grey shaded columns are recessions according to the NBER. Source: Bloom, Floetotto, Jaimovich, Saporta and Terry (2011)

  41. Plant growth dispersionpre & during great recession Density Source: “Really Uncertain Business Cycles” by Bloom, Floetotto, Jaimovich, Saporta and Terry (2012) Notes: Constructed from the Census of Manufactures and the Annual Survey of Manufactures using a balanced panel of 15,752 establishments active in 2005-06 and 2008-09. Moments of the distribution for non-recession (recession) years are: mean 0.026(-0.191), variance 0.052 (0.131), coefficient of skewness 0.164 (-0.330) and kurtosis 13.07 (7.66). The year 2007 is omitted because according to the NBER the recession began in December 2007, so 2007 is not a clean “before” or “during” recession year. Sales growth rate

  42. Productlevel price dispersion (by quarter) Source: Joe Vavra (2014, QJE) “Inflation dynamics and time varying volatility”

  43. Suggests recessions can be characterized as a negative first moment and positive second moment shock Recessionary distribution of TFP shocks Normal distribution of TFP shocks

  44. Measuring uncertaintyModelSimulation of an uncertainty shockPolicy experiment

  45. Technology • Large number of heterogeneous firms • Macro productivity and micro productivity follow an AR process with time variation in the variance of innovations • Uncertainty (σA and σZ) follows a 2-point markov chain

  46. Capital and labor adjustment costs • Capital and labor follow the laws of motion: where i: investment δk:depreciation s: hiring δn:attrition • Based on micro data allow for the full range of adjustment costs • Fixed – lump sum cost for investment and/or hiring • Partial – per $ disinvestment and/or per worker hired/fired • Quadratic – to invest/disinvest and/or hire/fire more rapidly • Assumed adjustments costs paid on all investment and hiring (even replacement investment and hiring)

  47. Households

  48. Firm’s value function

  49. General equilibrium solution overview • We have a recursive competitive equilibrium • Solve numerically as no analytical solution • Numerical solution approximates μ (the firm-level distribution over z, k and n) with moments, building particularly on Krusell and Smith (1998) and Khan and Thomas (2008)

  50. Baseline calibration of the parameters

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