Does Uncertainty Reduce Growth?

[D]ifferences in uncertainty across countries appear to explain about half of the variation in GDP growth following major shocks.

A growing body of evidence suggests that uncertainty rises sharply in recessions and falls in booms. This was evident during the Great Recession. But does uncertainty cause recessions, or is higher uncertainty simply a natural outcome of economic downturns? Unfortunately, identifying the causal direction of the relationship between uncertainty and growth is difficult because many economic variables move together over the business cycle.

In Does Uncertainty Reduce Growth? Using Disasters as Natural Experiments (NBER Working Paper No. 19475), Scott Baker and Nicholas Bloom explore the relationship between uncertainty and growth in 60 countries including the United States since 1970. They focus on uncertainty created by arguably exogenous shocks that occur in the form of natural disasters, terrorist attacks, political coups, and revolutions.

The authors find that differences in uncertainty across countries appear to explain about half of the variation in GDP growth following major shocks. This finding provides important support for the hypothesis that rising uncertainty can have a large negative effect on economic growth. The findings are robust to the use of alternative measures of volatility such as exchange rate volatility or bond price volatility, rather than stock market volatility.

The authors observe that some shocks, such as natural disasters, are bad news for the level of economic activity but they do not raise the level of uncertainty about future events. Other shocks - like political coups - also induce a lot of uncertainty and raise the level of volatility in the economy. The authors use data on stock market returns and volatility to distinguish the mean effects (bad news) and volatility effects (higher uncertainty) of these shocks. During the year following these shocks, the bad news and uncertainty components have roughly equal effects on GDP growth.

--Claire Brunel