Uncertainty Has Increased Unemployment Rate by up to 2 Percent, Fed Study Says

Categories: Recession Watch
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Tough times.
"Uncertainty!" Scottish dramatist David Mallet wrote. "Fell demon of our fears! The human soul that can support despair, supports not thee."

The human soul and the economy have that in common. By now, it's been ingrained in our consciousness by news stories and stump speeches: Uncertainty is holding back America's economic recovery.

For the first time, thanks to a new study from the Federal Reserve Bank of San Francisco, we have evidence that quantitatively illustrates uncertainty's effect. According to the Fed's estimates, "uncertainty has pushed up the U.S. unemployment rate by between one and two percentage points since the start of the financial crisis in 2008."

"To put this in perspective," wrote San Francisco Fed research advisers Sylvain Leduc and Zheng Liu, "had there been no increase in uncertainty in the past four years, the unemployment rate would have been closer to 6 percent or 7 percent than to the 8 percent to 9 percent actually registered."

As researchers explained, uncertainty "acts like a decline in aggregate demand." Consumers and employers save more and spend less, stocking their financial storm shelters to prepare for even rainier days. The atmosphere feeds into itself -- less profit for businesses, less hiring, less consumer spending, and so on.

There is much to be uncertain about, of course. Republicans argue that new regulations -- environmental, banking, consumer protection -- heighten uncertainly. Democrats argue that the Tea Party faction's willingness to allow America to default on its debts heightens uncertainty. Most everybody agrees that the current partisan gridlock heightens uncertainty -- the most glaring example, of course, being the $109 billion across-the-board automatic budget cuts that will activate on Jan. 2, 2013, if Congress cannot pass a suitable deficit reduction bill by then. And, for the time being, two diametrically opposed views of government's role in re-igniting the economy (among other issues) are competing for the White House.

The S.F. Fed, which used decades of consumer survey data to measure uncertainty, points to another reason for the Great Recession's high uncertainty: Since inflation rates were already so low at the beginning of the Recession, the Federal Reserve had less ability to "counteract uncertainty's negative economic effects."

Uncertainty is not inherent to economic slumps.The study contrasts our current recession to that of the early '80s, when interest rates hovered around 8 percent. The Fed states in the paper that "our statistical model suggests that uncertainty played essentially no role during the deep U.S. recession of 1981-82 and its following recovery." By the end of the Carter-era downturn, interest rates had dipped to around 6 percent, which is around 6 percent higher than where they are now.

Interest rates were in the low single digits when the economy collapsed. In December 2008, the Fed pulled short-term interest rates down to zero. Over the past few years, the bank has also bought trillions of dollars worth of treasury bonds to lower long-term interest rates. But, simply, the Federal Reserve has less control over monetary policy this time around.

"As a consequence, high uncertainty has been a greater drag on economic activity in the Great Recession and recovery than in previous recessions," officials concluded.

With less room to work, Federal Reserve Chairmain Ben Bernanke and co. have heavily relied on quantitative easing, which is, basically, when the Feds print more money and pump it into the economy by buying stuff from banks and other institutions. We're now in Q.E. Vol. III. On the first two attempts, the Feds spent a per-determined amount of money. This time, though, it's open ended. As Joseph Lawler of RealClearPolitics elegantly put it, "QE2: We're going to buy a bunch of bonds and see if it works. QE3: We're going to buy a bunch of bonds until it works."

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