Held Back by Uncertainty

• Author: Nicholas Bloom, M. Ayhan Kose, and Marco E. Terrones
• Position: a Professor of Economics at Stanford University. and are Assistants to the Director in the IMF’s Research Department.

SOME economists and politicians argue that the two years of harsh times visited on the United States and euro area during the Great Recession of 2008–09 should have been followed by rapid recoveries. Milton Friedman—the late Nobel Prize–winning economist—called this the “guitar string” theory of recessions. When you pull a guitar string down, then release it, the string bounces right back. And the farther you pull it down, the faster it returns.

However, the economic performance in many advanced economies since the Great Recession has not followed that script. Instead, the deep recessions in those economies were followed by recoveries that have been disappointingly weak and slow. It is as if the guitar string was pulled down so hard that it snapped.

These developments are something of a mystery: Why has the current recovery been so slow? Some argue that recoveries following financial crises tend to be slow because the legacy of the crisis—balance sheet repair, weak credit expansion, and lingering problems in housing markets—weighs on activity (for example, Claessens, Kose, and Terrones, 2012). This argument certainly has its merits, considering the historical record.

However, the ongoing recovery has been different at least in one important dimension from the earlier ones—whether associated with financial crises or not. It has experienced bouts of elevated uncertainty. This suggests a complementary explanation for the anemic recovery, one that emphasizes the roles played by macroeconomic and policy uncertainty in curtailing economic activity. Businesses have been uncertain about the fiscal and regulatory environment in the United States and Europe, and this fear of an unknowable future has probably been one of the factors leading them to postpone investment and hiring. This is clearly illustrated in a recent survey in the United States by the National Association for Business Economics (Economic Policy Survey, 2012), which reported that the “vast majority” of a panel of 236 business economists “feels that uncertainty about fiscal policy is holding back the pace of economic recovery.”

How important is uncertainty in driving economic activity? This article addresses that question by analyzing the main features of uncertainty and its impact on growth.

Here, there, and everywhere

Economic uncertainty refers to an environment in which little or nothing is known about the future state of the economy. There are many sources of economic...