Global Economics

The Uncertainty Principle: Not Sure? Don't Spend


Nicholas Bloom, an associate professor of economics at Stanford University and a former adviser to Britain's Treasury, specializes in the study of historical freakouts. He has examined 17 major events—from the Cuban missile crisis to Black Monday in 1987 to September 11 and the fall of Lehman Brothers—and tracked their impact on companies' spending in the months that followed. Each event Bloom looked at created major doubts in the minds of executives about what to do next. Says Bloom: "The optimal response to uncertainty if you're a firm is to do nothing, but if everyone does nothing, the economy tanks."

That realization has made Bloom optimistic about the global economy. "All my money is in the stock market," says the academic. While heightened insecurity can depress growth as companies put off investment and hiring, says Bloom, the effect is only temporary. Output and employment bounce back as anxiety wanes, he explains. His conclusion echoes research published in 1980 by Federal Reserve Chairman Ben S. Bernanke when he taught at Stanford. The "resolution of uncertainty," Bernanke wrote, can lead to "an investment boom" by businesses.

The question is when will the uncertainty clear and the investment boom predicted in Bloom's papers get under way. Not everyone is as optimistic as Bloom. Larry Kantor, head of research at Barclays Capital (BCS) in New York, compares the current environment with the malaise of the 1970s, when investors didn't believe government officials could whip inflation. "It's going to be difficult to sustain a bull market, because there's a lack of full confidence in policymakers to get it right," says Kantor.

In the U.S., banks are unsure how much extra capital regulators will require them to set aside. Power companies are waiting to see if the government caps carbon emissions, and human resources departments are still calculating the costs of the 10-year health-care overhaul Congress passed in March. A big unknown is the fate of former President George W. Bush's tax cuts on personal income, capital gains, and dividends, which expire in January unless Congress extends them. The midterm elections could affect all these issues, yet "none of us knows whether Republicans are going to have moderate success, significant success, or historic success," says William Lane, Washington director for construction-equipment maker Caterpillar (CAT).

Outside the U.S., many companies are waiting to see how Europe's sovereign debt crisis will play out. No one knows whether China's real estate market is headed for a meltdown. Investors are wondering if any new government can reduce Japan's enormous budget deficit. As Fed Chairman Bernanke told the Senate Banking Committee on July 21, "the economic outlook remains unusually uncertain."

While waiting for the fog to lift, companies are following Bloom's model and playing it safe. U.S. corporations had $1.84 trillion in cash and other liquid assets at the end of the first quarter, up 26 percent from the previous year, according to the Federal Reserve. Japanese businesses held $2.3 trillion in currency and deposits on their balance sheets as of Mar. 31, the most since the Bank of Japan began compiling quarterly data in 1997.

Uncertainty about the new financial regulations is the "most important" reason for delaying a hike in JPMorgan Chase's (JPM) dividend, Chief Executive Officer Jamie Dimon said to reporters on June 29. Chairman and CEO Howard Levine told analysts on July 7 that Family Dollar Stores' (FDO) earnings outlook is clouded by "what the government is going to do in terms of taxes for the wealthy, benefits for the unemployed." Private-sector payrolls in the U.S. rose only 83,000 in June, less than the 110,000 gain economists polled by Bloomberg News had predicted. Says Mark Zandi, chief economist at New York-based Moody's Analytics (MCO): "It's now time for policymakers to give some certainty to businesspeople so they will go out and hire."

Companies won't get total clarity anytime soon. Figuring out the ramifications of the financial regulation bill passed by Congress will take months. Britain's ruling coalition of Tories and Liberal Democrats has a bold plan to cut the deficit, yet decisions on which programs get the ax won't become clear until October. Some big issues, however, could get resolved more quickly. The one Bloom has focused on is Europe's sovereign debt crisis. The region's regulators have carried out stress tests on their banks to see how the institutions would fare if the euro zone's debt troubles were to intensify. Should the results convince investors that the banks can handle more fallout, that good news could help "in eliminating an enormous overhang over growth," says Raghuram Rajan, a former International Monetary Fund chief economist who teaches at the University of Chicago. Any good news is welcome.

The bottom line: The uncertainty facing companies is reminiscent of the 1970s. When the situation becomes clearer, companies should start investing.

Kennedy is a reporter for Bloomberg News in London.

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