Finance & economicsFeb 3rd 2007 edition

Economics focus
Momentous modelling

When terrorists strike, what happens to investment and jobs?

ECONOMICS is a shocking profession. No, no: it's not that economists are incompetent, work in squalor or have unsavoury personal habits. Shocking is what economists do. They start with a model of the economy, administer a “shock” to it—a sudden rise in the oil price, say, or some technological advance, or a cut in tariffs—and work out what happens to output, prices, employment and so forth. Suppose oil prices jump: output goes down, the price level goes up; depending on inflationary expectations and the response of the central bank, a persistent bout of inflation may follow. Plug in plausible numbers in the right places, using some fancy statistics and a dose of computing power, and you can estimate how big the effects might be.

Almost all these exercises deal, in effect, with changes in a number's mean or expected value (in statisticians' language, the “first moment” of its probability distribution): what if the oil price doubles? Economists have spent remarkably little time working out what will happen if the world becomes less certain: what if the oil price is likely to range between, say, $20 and $100 rather than between $50 and $60? Questions of this sort (about the “second moment”) are certainly more difficult to answer—the maths is harder, for one thing—but important nonetheless.

They are important partly for the simple reason that people's behaviour may change if the world suddenly becomes a less (or more) certain place. Moreover, points out Nick Bloom, a British economist at Stanford University, events that increase uncertainty, measured by the volatility of American share prices, are fairly frequent. The most obvious recent example of a big second-moment shock is the terrorist attacks of September 11th 2001; but there have been plenty of others in the past few decades, from the assassination of John Kennedy to the collapse of Long-Term Capital Management and Enron (see chart).

Economists have not shied away from second-moment shocks altogether. Indeed, in 1983 a young American economist named Ben Bernanke published a paper* analysing how investment would be affected by uncertainty. Uncertainty, he argued, could increase the return to firms from waiting rather than making irreversible investments. Mr Bloom has revisited the subject, with the fuller treatment that modern modelling and computing tools allow. In a paper† presented at last month's annual meeting of the American Economic Association in Chicago, he builds a model in which firms choose how much to invest and how many workers to employ. The world in which they operate is uncertain, in that their revenues can vary. He introduces an “uncertainty shock” into the model by supposing that the variability of firms' revenues suddenly rises: using data from shocks over the past 45 years, he supposes that the standard deviation, a common measure of variability, doubles before returning to its old level within a few months.

Wait a moment

The model predicts, as does Mr Bernanke's, that firms wait and see what happens. Because the future is less certain, the probability that demand will be very low (or very high) is higher. The value of waiting thus increases. Firms that would otherwise have increased investment or taken on more workers postpone their plans. Meanwhile, shrinking firms hold off sacking people, but the net effect is that investment and employment fall. Productivity also drops: because hiring and firing have been put off, workers are no longer being shuffled from less productive to more productive firms. As uncertainty returns to normal levels, investment, employment and productivity bounce back.

Mr Bloom thinks that this model fits the aftermath of the September 11th attacks reasonably well. Net employment growth in America fell sharply in the three months following the attacks—judging by forecasts made by economists in mid-August, there were 1m fewer jobs than expected by the end of the year—but rebounded in the first quarter of 2002. Investment also dipped and recovered. The perception that uncertainty increased also shows up in central banks' minutes of the time. One central banker spoke of some households and businesses entering “a wait-and-see mode...They are putting capital-spending plans on hold.”

For policymakers, says Mr Bloom, it is important to tell second-moment shocks, which seem not to last long, from the first-moment variety, where the effects endure for longer. If central bankers mistake a temporary rise in uncertainty for a permanent shock, they may, say, cut interest rates by more than they need to, with inflationary results. To make matters harder, first- and second-moment shocks are likely to come at the same time.

Mr Bloom thinks that the Federal Reserve and other central banks reacted wisely to the attacks of September 11th. Still, he suggests a couple of bits of information that may help distinguish the two types of shock. First, a spike in stockmarket volatility is a sign of increased uncertainty. Second, the different types of shock should have different effects on firms. A bad first-moment shock will reduce activity across the board. But a rise in uncertainty that causes all firms to put their plans on hold will stop (or slow) growing firms, but bolster shrinking ones.

Are uncertainty shocks always transitory? Almost. None of the examples in the chart lasted long. Looking back over the past century, Mr Bloom can point to only one such episode: the Great Depression. Between 1929 and 1932, average stockmarket volatility was 30% greater than after the 2001 attacks. A prolonged bout of uncertainty—compounded by bad policy—dampened the “animal spirits” by which John Maynard Keynes set such store, with catastrophic effects on investment and jobs. The direct macroeconomic consequences of September 11th, for all the deadly terror of that day, were much briefer.

*“Irreversibility, Uncertainty and Cyclical Investment.” Quarterly Journal of Economics, February 1983.

†“The Impact of Uncertainty Shocks: Firm Level Estimation and a 9/11 Simulation

This article appeared in the Finance & economics section of the print edition under the headline "Momentous modelling"

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