“Never before has our future seemed so shrouded in fog and noise,” I’ve written, and discussed its paralytic effects on our decision-making. Comes now academic vindication of just how strong the effect is.
But I’ve also dug up, from the same academic source (the Wharton School), a potential antidote. If we have the courage to embrace it.
The disabling power of having no forward visibility is recapped in “‘Uncertainty Traps:’ Why a Lack of Information Can Paralyze an Economy,” published last month in “[email protected]”
We know that no one is fond of uncertainty, but in relatively mild recessions it takes only a few augurs of good news to begin to revive the economy’s natural “animal spirits.” Deep recessions—that would be this one—create a self-reinforcing information vacuum where no one seems to be generating signals indicating a turnaround in the works. The academics (one each from Wharton, NYU, and UCLA) give their theory the full-dress graduate-level economics mathematical treatment in a paper, explaining for example, that “Standard [Bayesian] updating rules have a straightforward interpretation: the mean of the posterior belief is a precision-weighted average of the past belief û and the new signals Y and X,…”
(Toldja.) We’ll stick with the English language version.
But by way of digression, here we have an example of much of what I fear ails modern economic theory, at least as practiced in graduate programs at leading universities. The French economist Thomas Piketty, now on something of a victory lap up the East Coast in connection with his recently published book Capital in the Twenty-First Century, a formidable, rigorous, 700-page history of wealth, and which improbably just made The New York Times best-seller list, acerbically critiqued his own profession:
“For far too long,” [he wrote,] “economists have sought to define themselves in terms of their supposedly scientific methods. In fact, those methods rely on an immoderate use of mathematical models, which are frequently no more than an excuse for occupying the terrain and masking the vacuity of the content.”
Back to the Uncertainty Trap: The heart of the theory is that at least as important to economic decision-makers in evaluating the state of the markets going forward is not just the goods and services being churned out, but the information that’s generated as a byproduct of economic activity. Not just macroeconomic variables like new claims for unemployment or housing starts, which are doubtless of great moment to the Fed Board of Governors, but less so to the managing partner of an AmLaw 200. The information that’s pertinent includes, “Is your competitor hiring? Opening in new markets? Investing in practice management or technology?”
“The production process itself generates information, and this information, at least some of it, is available to everyone in the economy,” [co-author] Taschereau-Dumouchel says. “When there is a lot of information, it reduces firms’ uncertainty about the economy, which makes more firms invest…. We are basically trapped in that bad state where uncertainty is high and the economy is not producing very much. Everyone is waiting for others to invest, which leads to no one investing.”
Commonsensically, much of the truly useful information flows through social channels, not BLS statistics. While more (positive) information is generally better, it turns out that less information is not worse simply in a linear way, but that below a certain threshold of a minimal amount of information, everything comes to a halt.
Fewer signals lead to greater uncertainty and less investment, and vice versa. But this ebb and flow is not steady. Below a certain threshold, information is so skimpy that investment virtually ceases. That stops the flow of social-learning information, creating a vicious cycle that becomes hard to break.
The authors note that “the long-run response to a temporary negative shock becomes considerably more protracted when the magnitude is above some threshold. The economy quickly recovers after a small temporary shock, but it may permanently shift to a low activity regime after a large shock of the same duration. In turn, a positive temporary shock of sufficient magnitude can put the economy back on track.”
So what, pray tell, is to be done?