As is usual in these situations, it’s the downside risk that gives the option of waiting its value. But there’s also a cost to waiting because the firm is forgoing profits in the meantime. This cost increases with the expected duration of the uncertainty: the longer a firm thinks it’s going to have to wait for things to be resolved the greater the profits foregone and the more likely it is that the firm will simply decide to get on with things and make the investment anyway. Conversely, delaying becomes more reasonable if the uncertainty is expected to last only a short time. A firm that has that expectation may as well wait to see how things turn out. One implication of this is that you’d expect the impact of uncertainty on investment to intensify as we get closer to the date of resolution. Broadly speaking I think that’s what we’ve seen in the data. Another is that investment suffers more than it needs to if firms repeatedly expect things to be resolved sooner than they actually are. A repeated series of cliff-edges, each of which is expected to be decisive but in reality just gives way to the next cliff, is more damaging for investment than if it had been clear at the outset that the process will take time. This doesn’t mean that resolving things soon, by any means necessary, is the better course.
These variables also affect the exposures of different entities to various categories of risk. This is very much what we observe in practice, where even imbalances arising in some other sector often create ripple effects throughout the financial system and, where this is not robust enough, in the rest of the economy. Consistently with this view, it can be argued that financial stability is best pursued by implementing a coherent set of policies which respond to the underlying macroeconomic fundamentals. Recent episodes of financial crisis, for example, have shown that through their effects on expectations and on  1  This paper was delivered at a seminar organised by Société Universitaire Européenne de Recherches Financières (SUERF), in conjunction with the Central Bank of Malta on Thursday 27 March 2003. 2  Knight, M. 2002. “The Central Bank’s Role in Fostering Financial System Stability: A Canadian Perspective”, in Financial Risks, Stability, and Globalization; ed. O.E.G. Johnson. Washington, D.C.: International Monetary Fund. pg. 314.  asset prices more generally, unchecked variations in property prices can contribute to precipitating a crisis. Similarly, it is often forgotten that a combination of excessive public deficits with an over reliance on short-term capital flows and an overvalued currency is the perfect recipe for a turnaround in market confidence, and consequently for sudden reversals in capital flows.