Events that increase uncertainty are far more detrimental to the real economy than is usually thought, according to research by Michele Piffer and Maximilian Podstawski, published in the December 2018 issue of The Economic Journal. Their study analyses increases in the price of gold – widely understood to be an indicator of rising uncertainty – in response to notable events, such as the 9/11 terrorist attack, the fall of the Berlin Wall, the Iraqi invasion of Kuwait and the Chernobyl disaster in the Soviet Union.
The researchers’ approach disentangles the effects of variations in uncertainty and variations in news by combining variations in the price of gold with a measure of news about future economic activity. They find that while rising uncertainty depresses the real economy immediately, news about changes in the path of the economy are taken into account by financial markets on the spot, but materialise in the real economy only after several months.
The study also documents that the conventional approach to studying the effects of variations in uncertainty generates effects associated more with news than with uncertainty. Overall, the new results show that uncertainty is an important driver of business cycles, while news shocks are not.
By affecting consumption and investment decisions, uncertainty has potentially far-reaching effects on the economy. Currently, there are numerous sources of economic uncertainty, including the unknown outcome of the Brexit negotiations, potential changes to US trade policy or the future development of the euro area.
The new study looks at these uncertainty effects and documents that variations in uncertainty have a more rapid impact on the economy than is shown in previous studies. In fact, such effects materialise within the first three months of the initial variation in uncertainty, and not with a delay of around half a year. This finding suggests that selected political developments and other events that increase uncertainty are more detrimental to the real economy than previously thought.
The key challenge faced in documenting how variations in uncertainty affect the economy is that uncertainty and economic activity jointly affect each other. In other words, it is not only variations in uncertainty that may affect the economic activity: developments in economic activity may also affect current and future uncertainty.
It follows that isolating the effect that runs from uncertainty to the economy requires a suitable empirical strategy. To address this challenge, the researchers make use of the price of gold from the London Bullion Market Association, which runs the world’s biggest gold market.
Since gold is widely perceived as a safe haven asset, movements in the price of gold contain information about variations in uncertainty, tending to rise or fall when uncertainty is perceived to increase or decrease. Indeed, media coverage often explicitly indicates the connection between uncertainty and the price of gold, for example, after the terrorist attack to Charlie Hebdo in Paris on 7 November 2016.
To deploy this feature of the price of gold, the researchers first select events that are associated with variations in uncertainty unrelated to other drivers of macroeconomic dynamics. They then compute variations in the price of gold in narrow windows around such events.
A notable example of an event that they use is the 9/11 terrorist attack. Right after the attack, the price of gold jumped by 5.75%, as shown in Figure 1, probably reflecting the political and economic uncertainty due to the attack. Other events that the study uses are the fall of the Berlin Wall, the Iraqi invasion of Kuwait and the Chernobyl disaster in the Soviet Union.
Figre 1: The vertical line shows the occurrence of the 9/11 attack, while the dots indicate the price of gold from the auctions from the London Bullion Market Association.
For the assessment of a causal effect of uncertainty on economic activity based on events, it should be taken into account that each event not only changed uncertainty, but also generated news about the future path of the economy. The fall of the Berlin Wall, for example, was associated with increasing uncertainty about the future economic and political structure in Europe, but also with news that sales in Eastern Europe for firms around the globe were likely to increase.
The researchers’ approach disentangles the effects of variations in uncertainty and variations in news by combining variations in the price of gold with a measure of news about future economic activity.
They find that while rising uncertainty depresses the real economy immediately, news about changes in the path of the economy are taken into account by financial markets on the spot, but materialise in the real economy only after several months.
In addition, the study documents that the conventional approach to studying the effects of variations in uncertainty generates effects associated more with news than with uncertainty. Overall, the results show that uncertainty is an important driver of business cycles, while news shocks are not.
‘Identifying Uncertainty Shocks Using the Price of Gold’ by Michele Piffer and Maximilian Podstawski.
Michele Piffer
Marie Curie Fellow at Queen Mary, University of London | m.b.piffer@gmail.com
Maximilian Podstawski
DIW Berlin
