Economic uncertainty and business decisions - what is the link?
In our interconnected global economy, uncertainty is like a tempest that sweeps across financial markets, businesses, and households. It’s that unsettling feeling when you’re unsure about what lies ahead—the fog that obscures the path forward. But what exactly is economic uncertainty, and why does it matter? Let’s explore.
What is economic uncertainty?
Economic uncertainty refers to a situation in which the future economic environment is challenging to predict, and there is a high degree of risk or unknowns involved.
For the new generation—the millennials and Gen Z—economic uncertainty is more than just an abstract concept. They’ve grown up in a world marked by financial crises, technological disruptions, and geopolitical tensions. Most of them have spent part of their education and/or early career during the COVID years and believe rightfully that they will carry the life-long impacts of years of quarantine with them.
Why does economic uncertainty matter?
The impact of uncertainty on individuals’ behaviour and decisions is not limited to people. Economic uncertainty has the potential to affect the firm’s performance and, hence, profitability through firm decision-making mechanisms. To understand this, imagine you’re running a business, and you’re not sure what the future holds. You might be hesitant to invest in new equipment or expand your operations. This is what Dixit and Pindyck explained in 1994. Their novel finding was that when the future is uncertain, businesses tend to hold off on investments and hiring. This is because they can’t easily change their investments once made, and it might be more valuable to wait and see what happens and then decide on the investment or hiring.
Abel and Eberly added to this idea in 1994. They said that there are fixed costs to investment, and there’s a difference between the cost to buy and sell equipment. This makes businesses even more cautious about investing. Bloom, Bond, and Van Reenen, in 2007, and Bloom, in 2009, showed that when there’s a lot of uncertainty and it’s hard to reverse an investment, businesses are less likely to respond quickly to changes in demand. This matches the observation that businesses often invest more in good times and less in bad times. Uncertainty also brings inaccurate actions. The recent studies, for instance, Mohades et al. (forthcoming), display how uncertainty can lead to low-potential firms' growth, while high-potential firms do not experience expansions.
So, in uncertain times, businesses avoid wasting resources by being careful with their investments. They might delay investing or adjust their operations to minimize losses. This is the essence of the theory of investment under uncertainty.
How can we measure economic uncertainty?
If the importance of uncertainty for business and aggregate outcomes is proven, it is, however, not an easy task to measure accurately. There are several ways to do it, and each has its strengths and weaknesses. A common approach is to ask consumers or firms about their perceived uncertainty using surveys. These can be useful but also skewed by personal opinions (D’Amico and Orphanides, 2008). More recently, advances using machine learning tools such as natural language processing have relied on text analysis. This involves scanning media articles for words related to uncertainty and counting how often they appear (Baker, Bloom and Davis, 2016). Finally, some authors have used the volatility of economic outcomes such as GDP, stock market indices or sales to formally say ‘how much things change’ (Baum et al., 2006). Others argue that one indicator isn’t enough and instead use many economic and financial indicators (Jurado, Ludvigson and Ng, 2015). For example, if a company’s sales keep going up and down, that could indicate uncertainty (De Veirman and Levin, 2018). Our paper (Mohades, Piccillo and Treibich, 2024) adds to these methods by breaking uncertainty down into different levels, revealing differences across firms and sectors. Using this method, we show that most of the firm uncertainty is rooted in reasons outside the firm’s scope, such as market or political conditions. This method has the advantage that it can be used in any economy, including developing regions.
Economic uncertainty at the next MORSE conference
In conclusion, measuring economic uncertainty is a current issue of prime relevance. Focused workshops and conferences are a useful way to explore such issues and continue the discussion. For this purpose, one of the tracks at the next MORSE conference will be dedicated to issues in measuring economic uncertainty and its effects using large firm datasets. If interested, please feel free to submit your draft to our track “uncertainty in empirical macroeconomics and firm dynamics”. We believe that there is much room for studying the interaction between economic uncertainty and firm dynamics and that insights from this work can help shed light on policymakers' impact on the behavior of managers, investors, and employees of businesses.
This blog is authored by Siavash Mohades, a double-degree PhD candidate in Economics at Maastricht University and LUISS Guido Carli University. His research interests lie in Firms' Productivity, Uncertainty and innovation. The blog is co-authored by Tania Treibich and Giulia Piccillo.
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