Confronting Uncertainty in a Changing Economy

Uncertainty plays a significant role in global economic growth and in financial markets. It’s essential that we account for that uncertainty, both in our economic models and our policymaking, according to University of Chicago’s Becker Friedman Institute co-director and 2013 Nobel laureate Lars Peter Hansen.

In a talk for a Hong Kong audience of alumni and friends of the University of Chicago on November 18, 2015, Hansen outlined the multifaceted role of uncertainty using recent economic examples.

The 2008 financial crisis caused an immediate drop in gross domestic product in both the US and the European Union. Unlike previous recessions, US GDP did not quickly return to the long-term growth trajectory, causing uncertainty and speculation about the reasons why. Uncertainties about the Euro and debt crises produced an even more sluggish recovery in the EU.

“Does that shift that occurred in 2008 have permanent consequences, or do we get back to the original trajectory? To this day, there’s been debate about this,” Hansen said. “Economists speculate about the so-called secular stagnation hypothesis. Similarly, there are debates about technological change. Some economists are arguing, well that’s a very special type of technological growth, and it’s not going to be repeated in the future. There’s considerable macroeconomic uncertainty about long-term growth rates, and I think that carries over to China, as well.”

Uncertainty has long been recognized as a factor in financial markets as well. “The field of finance is about making predictions about how investors get compensated for exposures to that uncertainty,” he noted. “Market forces are going to say that as you confront more risk of particular types compensations ought to get larger.” Small changes in that risk premium accrue over time; likewise, “This uncertainty we talk about also is going to compound over time.”

Research shows that risk premia vary over time and are bigger in magnitude in bad times than good times. “The question is: what explains these movements?” he asked.

Uncertainty about the global economy is linked to the financial markets, Hansen explained. In an interconnected global economy, with a global macroeconomic shock such as the 2008 crisis, “everyone’s exposed to it, across the board. There’s no ability to diversify. So it’s the macroeconomic shocks, the macroeconomic changes, that are the ones that get the biggest compensations in financial markets. That’s why there’s a very direct connection between macroeconomic uncertainty and how financial markets behave.”

It’s important to push uncertainty to the forefront of our analysis of both macro and market conditions, Hansen argued, and to incorporate it into models that are essential for predicting what will happen when the economic environment changes, whether by policy or other forces. Too often, such efforts focus on risk, which can readily be incorporated into economic models as mathematical probabilities. The bigger challenge is determining whether you are applying the right model or how much you trust the model (ambiguity, in Hansen’s terms). Models are simplifications of reality and therefore imperfect, so you also need to determine whether they are wrong in meaningful ways.

“Rather than dismissing them because they are imperfect, I prefer to think about ways we can still use them sensibly,” he said. “The sensible thing to be doing is to add some caution in terms of the use of that model.”

Hansen called for more public acknowledgement of doubt in economic policy discourse. He shared Milton Friedman’s quote of a 19th century humorist: “As Josh Billings wrote many years ago, ‘the trouble with most folks isn’t so much their ignorance, as knowing so many things that ain’t so.’”

Especially in monetary policy, for politicians and the economists they turn to for advice “there’s a tendency to make bold statements—to express yourself with great confidence and not to acknowledge uncertainty in your answers because that becomes a sign of weakness. I think that’s problematic.”

This can be seen today in today’s debates about whether or not the Federal Reserve Bank should hike interest rates. “We can produce arguments as academic economists on both sides of this, and we don’t have firm evidence to sort it out. If it is such a close call, it probably doesn’t matter so much. But, at this critical point, it’s fair to ask the Fed for a much clearer message about what its strategy is and what this implies for the future.”

“But the right part of this perspective is also, if they’ve got multiple models on the table, you have to start asking does a certain policy work well under the different models and not just taking one model too literally,” he continued. “Any specific model we write down with a whole lot of detail might well imply a complex solution, but as I look across models, they each might imply a different complex solution. Instead, it’s better to think about robust policies, policies that work well across the different models, which might be sensible. It may well be that the simple robust policies are the ones that also avoid adding uncertainty to the economic environment.”

“This carries over on climate change policy,” Hansen added. “Climate models are quantitatively and mathematically ambitious. But they’re also wrong. They’re known to have failings. We’re still trying to sort how to quantify the uncertainty attached to those models. Taking them too literally could be problematic.”

But that doesn’t mean we should do nothing, he stressed. “Perhaps simple things like carbon taxation and the like could be very sensitive policies, even when we don’t fully understand the timing and resolution and uncertainties associated with climate change.”