Streetwise Professor

September 5, 2011

Regime Uncertainty: The Real (Option) Deal

Filed under: Economics,Financial crisis,Financial Crisis II,Politics,Regulation — The Professor @ 7:37 am

I read Mark Thoma’s Economist’s View blog to get a view on the views of people who think quite differently than I.  It is particularly useful in that regard because although Thoma writes quite a few posts, he is more of a linker than a writer, so EV is an efficient way to get exposed to the views emanating from the Keynesian-left of the blog world.

Which means that whereas I think “aggregate demand” has something to do with the cement market, Thoma is definitely of the what-we-have-here-is-a-failure-to-demand-enough-in-aggregate kind of guy.  Which further means that he is frequently looking to rebut alternative explanations for poor economic performance.  Him being him and me being me, I usually find his efforts implausible, but this one particular effort of his is particularly lacking, and is sufficiently close to my bailiwick to warrant a rebuttal.

“Of his” might be a little strong, for the post in question primarily endorses the analysis of another blog, but he doesn’t even quibble, so attributing ownership is fair.  In any event, the alternative theory at issue is “regime uncertainty”; the view (originally developed by Robert Higgs) that uncertainty about government policy (and the economic environment at large) discourages hiring and investment.  Higgs originally applied the idea to the Great Depression: he argued that the frenetic regulatory activity of the Roosevelt administration created investment-killing uncertainty that prevented a normal rebound.  The similarities between what happened in the 1930s and what is happening today has led to an application of this view to current circumstances, just as it has led to a revival of old school Keynesianism which was born during the Great Depression.

Thoma links to a Gary Burtless piece that purports to debunk regime uncertainty as a cause of the current lack of growth in hiring and investment:

A couple of hours after talking to an ABC correspondent about the woeful job numbers and what might be done to improve them, I was in the Bloomberg TV studios debating a guy from Heritage. He went on for several minutes about the damage being done by high taxes, excess regulation, business “uncertainty” about future tax hikes and regulatory burdens.  I asked Bloomberg’s host whether he was aware that corporate profits relative to national income had just hit a 60-year peak?  He had heard rumors to that effect.  Was he aware that taxes on corporate earnings were at a 60-year low?  The Heritage guy had heard that might be the case.

Then why was uncertainty about taxes and the future burden of the Affordable Care Act holding back business investment and hiring right now?  If managers thought taxes or regulatory costs might go up in the future, wouldn’t it make sense to take advantage of today’s low taxes and lower burdens to invest and hire today?  According to the “uncertainty” argument, businesses are fearful they might face high taxes and extra health costs in 2016 or 2018.  Shouldn’t they expand hiring right now and scale back employment when they actually face higher costs (if they ever do)?

The “tax uncertainty” and “regulatory uncertainty” arguments would make more sense if, say, taxes were already high and might be going higher or regulatory burdens were heavy and might be getting heavier. But when taxes are at a 60-year low and the regulations are pretty much the same as they were in the 1990s boom, the argument makes no sense at all.  As we used to say down on the farm, you should “make hay while the sun shines.” In other words, if you think it’s going to rain later in the week, it strengthens the case for cutting and baling right now.

This is utterly confused, and a complete mischaracterization of the regime uncertainty view.  It focuses on expected costs associated with policies like Obamacare (and, I might add, like Frank-n-Dodd and the EPA and the NLRB and on and on); the argument is essentially that if costs are expected to be higher in the future, why not hire more today?

But this focus on expectation (itself flawed–more below) is to misstate completely the essence of the regime uncertainty argument, which, believe it or not, is about uncertainty–variation around the expectation.   It can be conceived best as a real options argument.  Hiring is like an investment: there is a cost of hiring–and firing–workers.  This cost is not immaterial.  This cost is like the strike price of an option on the right to hire a worker and receive a stream of benefits from employing her.

This stream of benefits is uncertain.  Moreover, policy uncertainty is a major driver of the variability of this stream of benefits.  Nobody knows how Obamacare is going to play out.  Nobody knows what the actual costs of compliance are going to be.  If the burden turns out to be very high, the stream of benefits from hiring a worker (or investing in a new machine or a new product) could be quite low, and even negative.  If the burden turns out to be low, the stream will be commensurately higher.

Options pricing theory basically implies that in the face of such uncertainty, it is often optimal to defer paying a sunk cost (the strike price) until the uncertainty is resolved.  This is why it is usually better to defer the exercise of an option as long as possible, unless there is a stream of benefits (e.g., dividends, interest on the strike price) that can be obtained only after the option is exercised.  When to exercise the option–including exercising the option to hire somebody–depends on a trade-off between getting some benefits immediately, and waiting for the resolution of uncertainty about the value of those benefits in the future.

An immediate implication of this is that the greater the uncertainty about the future, the costlier it is to exercise an option early.  In the present context, higher uncertainty about the future means that firms will hire less today, all else equal.  Hiring a worker today (or investing in a machine or product) generates a stream of benefits for the employer in the short term, but if there is considerable uncertainty about the future value of that stream, it is often wise for potential employers to defer incurring the strike price (the cost of hiring) until some of that uncertainty is resolved.

In the investment literature, the option value of waiting for the resolution of uncertainty drives a wedge between the rate at which firms discount risky expected cash flows and the discount rate implied by something like the CAPM.  It helps explain why firms frequently use very high hurdle rates in capital budgeting decisions–and high hurdle rates tend to discourage investment, relative to those that would be undertaken using CAPM.  In other words, real optionality tends to reduce investment.

The same effect is at work here.   The Burtless argument endorsed by Thoma focuses on expected future benefits.  But since these future benefits are risky, and a cost must be sunk to achieve these benefits, there is a cost wedge–the option value of waiting–that is attributable to uncertainty.  The more the uncertainty, the greater the wedge.

In other words, the Burtless-Thoma “rebuttal” of the regime uncertainty analysis is nothing of the sort, because it completely misses the basic insight of that analysis.  When hiring is viewed as a real option–which is a fair analogy–uncertainty matters.  It is variation around the expected value that matters, but Burtless-Thoma focus on the expected value.

In other words: swing and a miss.  (Burtless’s argument is also strange even on its own terms because it presumes that firms don’t take future costs into account when making hiring decisions today.  Even absent uncertainty, higher future costs will deter hiring today if there is a fixed cost to hiring.)

There is no doubt that uncertainty is abounding today.  Just look at Europe for one example.  But even closer to (my) home, the uncertainty is immense.  One small example: the Obama administration’s request that the EPA defer action on ozone rules.  The key word here is defer.  It hasn’t been killed with certainty.  Its return depends on future political and economic developments: Obama loses, it is likely dead forever; Obama wins, it is likely to be revived, especially if the economy is doing somewhat better.  These future developments are fraught with uncertainty.  Moreover, the costs of the rule itself are highly uncertain, ranging from the EPA’s (typically risible) estimate of around $100 billion to more than ten times that.  Which means that although the suspension of the rule should reduce the expected cost of compliance which should in turn lead to greater economic activity, the suspension also creates a significant increase in uncertainty that will offset this effect.

One could repeat this exercise over and over and over.  Just focusing on one agency–the CFTC–would provide numerous examples.  And if you think that particular policy uncertainty would just affect, say, banks, you would be so wrong.

It is foolish in the extreme to disregard the economic drag that such policy uncertainty can create.   Most economic decisions–hiring and investment notable among them–are effectively real options.  The decisions to exercise real options depend on the amount of uncertainty.  Uncertainty has first-order effects on these decisions.  Thoma (and Burtless) may believe they have discredited regime uncertainty as an explanation for our current malaise, but they have done nothing of the kind.  Indeed, they completely miss the point and thrash a straw man.  Regime uncertainty is still a very viable and plausible explanation of the reluctance of firms to hire and investment.

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  1. [...]    As the idea of regime uncertainty has gained ground in recent years as a partial explanation of the economy’s failure to recover quickly and fully, economists and others invested in Keynesian thinking have begun to strike back. One such Keynesian debunking of regime uncertainty was offered recently by Gary Burtless and seemingly endorsed by Mark Thoma. Now, Craig Pirrong, an economist at the University of Houston, has debunked Burtless’s arguments. [...]

    Pingback by Regime Uncertainty: Pirrong Debunks the Keynesian Debunking | The Beacon — September 5, 2011 @ 11:24 am

  2. Excellent post. The sad thing is that such a post is required at all to explain something that should be intuitively obvious to anyone with any training in economic thinking or even any experience in making investment decisions. But I guess many economists these days have forgotten that economic activity is actually the aggregate of individual decision-making and that creating major disincentives to the behaviour you claim you want is a bad idea. I think the academic situation would be dramatically improved by requiring economics professors to opt out of managed pension funds and to manage their own retirement and investment funds. I suspect that concepts like regime uncertainty would suddenly become very obvious to them.

    You focus for purposes of your post on the sunk costs caused by adding labour but your argument is reinforced when one considers that, particularly in an economy in need of restructuring, hiring may well be associated with new or greatly expanded ventures, i.e., with lots of new capital-related sunk costs.

    Comment by David Stinson — September 5, 2011 @ 2:01 pm

  3. Thanks, David. Yes, it is beyond amazing that some academics don’t believe that uncertainty actually affects investment and hiring decisions. And you are also right that in new businesses/expanding businesses, there is a complementarity between hiring and investment in capital (physical, intellectual) and that the effects of uncertainty on hiring are enhanced in those settings.

    Thanks for your comment.

    The ProfessorComment by The Professor — September 5, 2011 @ 3:11 pm

  4. Your (real) option theory is debunked by (real)investment in equipment & software. That’s quite the absence of regime uncertainty in the 2 years since the recession trough. So regime uncertainty is limited to labor (the high hurdle rate of hiring) but not capital, I presume.

    Comment by marmico — September 5, 2011 @ 3:29 pm

  5. The comments by Gary Burtless on corporate profits to national income caught my attention. It is important to know if he is including both domestic and international profits. It would be no surprise to me that the ratio is at a 60 year high as a number of our companies derive more income outside of the US than they do domestically. The same goes for taxes as the US has one of the highest corporate tax rates in the world. No one should be surprised if corporate hiring was higher outside of the US as a result. In the context of your excellent option analysis, not only is the mean higher outside the US, the volatility (uncertainty) is lower and the skew (less bad uncertainty) is more positive.

    Comment by Robert Cavallaro — September 5, 2011 @ 5:59 pm

  6. Are increased profits without hiring the best of all worlds?


    The best is hiring, growing and profiting immensely.

    Such in not available because of the current administration’s lack of respect for property rights, contracts (same thing) and consistent taxation. Intelligence (in the spy world-sense) consists of “Known Knowns”, “Known Unknowns” and “Unknown Unknowns”. The business climate and the “pragmatism” of the O administration (or, had he won, the McCain Administration) certainly provides sufficient information for the first 2 of the 3. We do not even need to conjecture about the 3rd—except it could be ugly.

    Comment by ettubloge — September 6, 2011 @ 10:13 am


    seems relevant

    Comment by David Stinson — September 7, 2011 @ 2:50 pm

  8. While uncertainty and flagrant attempts to terrorize business are very real (see Gibson Guitar), that case also highlights the federal government’s drive to explicitly (not just through regulatory stealth) force jobs OUTSIDE of these United States. In other words, corporatist mercantilism, but in reverse, whereby the mercantilists’ focus isn’t on forcing value-added jobs to stay in the Mother Country but to go abroad. I’m afraid in this case Brother Alex Jones is actually right, this is exactly the kind of crap that made the Founding Fathers revolt against England.

    Comment by Mr. X — September 7, 2011 @ 2:59 pm

  9. So in that sense it is becoming harder and harder to deny Mr. Jones’ thesis that de-industrializing these United States and creating greater dependency on an all powerful central corporatist State in this country is a feature, rather than a bug of ‘corporate (go anywhere, outsourcing) greed’.

    Comment by Mr. X — September 7, 2011 @ 3:01 pm

  10. [...] 8, 2011 Via Anti Dismal, there is a post discussing regime uncertainty and recessions – and criticising some of the world’s Keynesian bloggers for ignoring the role of [...]

    Pingback by Uncertainty, policy, and recessions » TVHE — September 7, 2011 @ 5:01 pm

  11. [...] nice post from former guest blogger Craig Pirrong on regime uncertainty and its role in hampering economic recovery. As Craig points out, it’s [...]

    Pingback by Pirrong on Regime Uncertainty « Organizations and Markets — September 12, 2011 @ 9:18 am

  12. Investments that hedge uncertainty will be accelerated by regime uncertainty. So automation to replace labor may make sense if labor commitments have especially uncertain payoffs (due to things like Obamacare).

    Comment by srp — September 14, 2011 @ 8:28 pm

  13. Sorry, but as plausible this story sounds, it is not necessarily true. The above post uses a partial equilibrium model to make assertions about a general equilibrium world. That general equilibrium effects may be crucial when dealing with uncertainty is shown in papers like Bachmann/Bayer (2011) or Born/Pfeifer (2011). Just hinting at real option effects is not sufficient. Moreover, as Ingersoll and Ross (1992) show, in the presence of interest uncertainty (due to e.g. FED policy) there are option effects involved that may act expansionary. Finally, if investment is partially reversible, there is a put option purchased when investing today. This option becomes more valuable with increasing uncertainty, thereby potentially counteracting the increase in the call option to invest later. Hence, in the end you need to make a quantitative statement that is not as straightforward as the above post suggests.

    Comment by John — November 14, 2011 @ 11:15 am

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