Why policy makers should focus on reducing uncertainty

The Economist has a very interesting piece this week ( 31/01/09) by Olivier Blanchard, IMF Chief Economist, in it he argues that by removing uncertainties the current financial crisis would largely go away.

”]CBOE Volatility Index (Vix) [The Economist / Chicago Board Options Exchange]Blanchard talks about how there are many indicators of uncertainty at the moment, from the Vix index of stockmarket volatility (See Chart), the dispersion of growth forecasts, to the use of the word ‘uncertainty’ by journalists. But not just objective factors, there are the “unknown unknowns”, the subjective uncertainty, and they are currently dominating making the economy appear incomprehensible due to its complexity. This has resulted in extreme prudence, or even paralysis, from investors, firms and consumers, thus feeding the crisis further.

As a result of this paralysis, investors have shifted from risky assets to perceived risk-free ones, almost wholly because they realised that they had underestimated the complexity and hence riskiness of many of the newer assets (CDOs etc), in effect many of the world’s investors have adopted a ‘better safe than sorry’ motto, “while making sense for individual investors, it is having catastrophic macroeconomic consequences for the world.

Blanchard’s solutions:

  • Reduce uncertainty […] by removing tail risks and the perception of tail risks. Establish a price, or at least a floor on the price of the troubled assets. Ricg-fence them or take them off bank balance sheets.
  • Adopt clear policies and act decisively […] do too much rather than too little.
  • Undo the effects of uncertainty on portfolios [… by] returning the private financial sector to health through recapitalisation
  • Undo the effects of the wait-and-see attitudes of consumers and firms on the demand side. Get them (and the state) to spend more, offer incentives to buy now rather than later.

What does Richard think about this?

One of the problems in the present financial crisis is most definitely a fear of the unknown, with everyone (individuals and companies) not entirely sure what is safe for their situation, and as such have broadly decided that it is better to hold onto any spare cash just in case their situation changes dramatically (redundancy etc.), but there is also an element of ‘lets wait and see a bit longer if we can get a good deal on a new TV we have been talking about’ from those with cash to spare. Companies are really feeling it at the moment because of this contraction in spending, but in some ways it is a good thing… It is forcing companies to review their finances, strategy, and organisational structure; those that are able to innovate and evolve will be the ones to survive and lead our economies out of the crisis. But even these companies will be looking to governments to act in a decisive way, and show that governments have confidence in what they are doing (something I think is lacking at the moment).

Reduce uncertainty by acting decisively and everything will eventually turn out ok. We hope….


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