Uncertainty Traps
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Uncertainty Traps by @FajgelbaumPablo @EdouardSchael @MathieuTD, @nberpub: Feedback loops in economic systems can amplify uncertainty, leading to prolonged recessions even when fundamentals are strong.
Uncertainty Trapspresents a new model that suggest and attempts to quantify uncertainty as a dynamic factor that generates feedback loops that can amplify its own impact. The authors explain this relationship on a firm level:
Fajgelbaum, Pablo, Edouard Schael and Mathieu Taschereau-Dumouchel, Uncertainty Traps, NBER March 5, 2014. Available at:http://www.parisschoolofeconomics.eu/IMG/pdf/uncertainty_traps.pdf
Because these relationships are driven by feedback loops they are highly non-linear.
Short-lived shocks can generate long lasting recessions, and low activity may persist even under good fundamentals. Thus, the theory rationalizes salient features of U.S. macroeconomic activity that are not easily explained by standard business cycle models, such as the slow recovery of output after recessions despite typically faster improvements in measured productivity.
The authors believe this premise explains American macroeconomic activity better than standard business cycle models as it combines two forces, “higher uncertainty about economic fundamentals deters investment, and uncertainty evolves endogenously because agents learn from the actions of others” Due to their self-reinforcing nature episodes:
The economy will converge to either a good regime (with low uncertainty and high economic activity) if the current level of uncertainty is sufficiently low or to a bad regime (with high uncertainty and low activity) if the current level of uncertainty is sufficiently high. As a result of this multiplicity, the economy exhibits strong nonlinearities in its response to shocks. The economy quickly recovers after small temporary shocks, but it may shift into low-activity regime after a large temporary shock. Once it has fallen in the low regime, only a large enough positive shock can but the economy back into the high-activity regime.
The basic thesis is the relationship between information and investment can create feedback loops - uncertainty traps - in the papers parlance “the coexistence of multiple stationary points in the dynamics of uncertainty and economic activity.” Thus:
Firms are more likely to invest if their beliefs about the fundamentals have higher mean, but also if they have smaller variance (lower uncertainty). At the same time, the laws of motion for the mean and variance of beliefs depend on the investment rate. When few firms invest, little information is released, so uncertainty rises.