The Rise of the Era of Uncertainty

The Rise of the Era of Uncertainty
Carlos M Pelaez

“All human planning and execution involve uncertainty, and a rational social order can be realized only if all persons have a rational attitude toward risk and chance,” Frank H. Knight (The ethics of competition. Quarterly Journal of Economics 37 (4, Aug 1923), 565).

The objective of this post is to relate uncertainty as widely perceived today to the frustration of investment by business and individuals and the weakening hiring decisions by small and large business. (I) relates the work of Frank Knight and the era of uncertainty, (II) provides the information on financial turbulence and (II) and (IV) evaluate economic indicators and interest rates. (V) concludes.

I Frank Knight and The Era of Uncertainty. The economist Frank H. Knight considered in his 1921 classic opus Risk, Uncertainty, and Profit three different types of probability (http://www.econlib.org/library/Knight/knRUP6.html#Pt.III,Ch.VII ). First, a priori probability is explained by the example of tossing the perfect die that will show a given number one-sixth of the time (see William Feller, An introduction to probability theory and its applications. Wiley, 1968, 7-25). Second, there is the work of actuarial science in insurance in which past information is used to calculate the fair premium. The present value of the actuarially fair premium is equal to the expected costs of the benefits to be received from the plan, or costs weighted by probability of occurrence, if the load, or administrative costs, is assumed to be zero. Knight finds that the distinguishing characteristic of this type is that “it rests on an empirical classification of instances” (Ibid). Third, there is what Knight calls “estimates,” for which “there is no valid basis of any kind for classifying instances” and constitute an “uncertainty” (Ibid). Knight argues that “an uncertainty which can by any method be reduced to an objective, quantitatively determined probability, can be reduced to complete certainty by grouping cases.” The process of Value at Risk (VaR), measuring the maximum loss in a target horizon for a desired level of confidence, could fit into this category (Pelaez and Pelaez, International Financial Architecture, 106-12). For example, JP Morgan Chase reports a decline of the investment bank trading VaR from $170 million in 2Q09 to $72 million in 2Q10, measuring the highest loss per day 99 per cent of the time from the trading transactions of the investment bank (http://files.shareholder.com/downloads/ONE/889418027x0x387171/79855d7d-cc5f-4a91-87ed-8ca848266fd8/2Q10_ERF_Supplement_7-14-10_FINAL.pdf ). An important concept used by Knight is that change causes uncertainty.

The method used by business in reducing uncertainty is capital budgeting in investment decisions. As Knight argues in his classic work, the entrepreneur receives the difference between the selling price and cost. An entrepreneur deciding on a project would construct the “estimates” mentioned by Knight. The method is similar to the cost/benefit analysis of economics (Pelaez and Pelaez, Financial Regulation after the Global Recession, 22, Regulation of Banks and Finance, 27-32, Government Intervention in Globalization, 52-6, 87, Globalization and the State, Vol. I, 119-25) and applied in the economics of climate change (Pelaez and Pelaez, Globalization and the State, Vol. II, 59-63). The entrepreneur projects forward to the horizon or year of maturity of the investment the cash flows to be received, or revenue, and the cash flows to be paid, or costs. For each year, the projections would show net revenue, or revenue less cost. The future net revenues have to be converted into dollars of today by discounting them by another estimate of the rate of interest. The sum of the discounted net revenues is the present value of the project. The entrepreneur chooses projects with positive present value.

Consider the development of pharmaceuticals. Industry data reported to the Federal Drug Administration (FDA) find that 5 of 5000 compounds entering preclinical testing actually move on to clinical testing and only 1 of the 5 is finally found satisfactory for sales to the public (http://www.fda.gov/Drugs/ResourcesForYou/Consumers/ucm143455.htm ). The estimate of expenditure costs per approved new drug is $403 million but rises to $802 million when discounting sales backwards and capitalizing costs forward over the gestation period. The time cost of investment is about 50 percent of the cost (Joseph DiMasi, Ronald Hansen and Henry Grabowski, The price of innovation: new estimates of drug development costs. Journal of Health Economics 22 (2)). The capital budgeting of a pharmaceutical requires the estimation of the revenue that it will bring, which depends on the capacity of the pharmaceutical company to anticipate a host of uncertain future decisions by patients, providers, institutions, health insurance and regulation. The costs require estimates of the transition probabilities and costs of moving the compound from the synthesis to animal testing, New Drug Application at the FDA, human testing in three clinical phases of the FDA process and the costs of approval and final marketing. The development of drugs is characterized by risk because of thousands of compounds only one reaches the pharmacy counters as the compound moves through this prolonged and costly process to final approval and marketing. The conversion of costs to current time when the decision is made requires a continuum of investments over time. The costs to be incurred are brought to current time by an appropriate discount rate. The pharmaceutical company would require estimation of the sales of the new product in the “in patent” period less the costs to calculate if it could remunerate the investment at the rate of return required by investors. The process absorbing two decades more or less is similar to the third category of probabilities that Knight calls “estimates.” In his subsequent work on The Ethics of Competition, Knight adds that “a rational social order can be realized through individual action only if all persons have a rational attitude toward risk and chance” (The ethics of competition. Quarterly Journal of Economics 37 (4, Aug 1923), 565). Harold Demsetz provides the check by government of the rational risk attitudes that can encourage prosperity by “the design of institutional arrangements that provide incentives to encourage experimentation (including the development of new products, new knowledge, new reputations, and new ways of organizing activities) without overly insulating these experiments from the ultimate test of survival” (Information and efficiency: another viewpoint. Journal of Law and Economics 12 (1, Apr 1969), 20). The essence of the argument is that both government and markets may fail, requiring adequate balance of their institutional roles (Pelaez and Pelaez, Government Intervention in Globalization, 1-12, 80-6, Globalization and the State, Vol. I, 133-43, Financial Regulation after the Global Recession, 11-5, Regulation of Banks and Finance, 33-5). An adequate role of government can create incentives to innovation that result in prosperity while an asphyxiating role of government imposed by drastic changes in one year can frustrate innovation, causing lower living standards, unemployment and underemployment.

The entrepreneur has to finance the project in the capital markets for debt and equity, a process that shows the equivocal political discourse of a dichotomy of “Wall Street” and “Main Street” when in fact there is only one and indivisible general economy. A misleading characterization of the credit/dollar crisis is that financial institutions took careless risks on products that nobody understands. The fact is that financial institutions face the same uncertainty as other types of business and used methods to reduce them to “certainty,” similar to those considered by Frank Knight that are used by business and individuals in making investment and hiring decisions. A high school student considering a medical career faces an even more complex decision of at least a million dollars of costs incurred or in foregone income over the next fifteen years that may be more uncertain in terms of returns than those of a pharmaceutical company pondering on a new drug or actually almost any business large or small. Banks and other financial institutions use models of risk management to estimate their exposures to risks and to protect the market value or capital of their institutions. The models did not fail (Christopher C. Finger cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 131, 176, 193, Regulation of Banks and Finance, 236). What failed was the illusion of a floor on house prices and real estate wealth created by government policy of a near zero interest rate on the Fed funds rate in 2003-4, the reduction of mortgage rates by suspension of the auctions of 30-year Treasuries in 2001-5, the housing subsidy of $221 billion per year and the purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie and Freddie (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). These combined actions clogged the securitization of credit with mortgage-based securities and their derivatives referenced to nonprime mortgages that brought down world finance, causing the global recession. Investors would evaluate the project of the drug manufacturer that could be financed by multiple alternatives such as bank loans, corporate bonds, and placement of equity and so on. There would then be a calculation by lenders and investors of the discounted net cash flows. The entrepreneur would receive the funds and begin hiring and spending on the project. Breaking the functions of the final system and its own process of innovation by the Dodd-Frank bill will prevent the calculation of the cost of investment, retarding the overall economy, frustrating technological progress and undermining future prosperity and employment. The criticism that financial products and risk management are not understandable to users such as borrowers of car loans with funds from securitized credit is as ridiculous as requiring airplane travelers to hold a PhD in physics.

Chairman Bernanke states in the Fed’s Monetary Policy Report to the Congress that “of course, even as the Federal Reserve continues prudent planning for the ultimate withdrawal of extraordinary monetary policy accommodation, we also recognize that the economic outlook remains unusually uncertain” (http://www.federalreserve.gov/newsevents/testimony/bernanke20100721a.pdf page 7). The economy is in the world of doubts about the future that Frank Knight analyzed in his 1921 magnum opus on Risk, Uncertainty, and Profit. Business and individual cannot calculate risks and rewards of decisions that generate economic growth and hiring. The critical concept in the work of Frank Knight is that uncertainty is caused by “change.” Uncertainty means that it is almost impossible to calculate with some confidence the future net cash flows of investments or the appropriate rate of discount to use in measuring net present value. The uncertainty frustrates the calculations of entrepreneurs for investment and hiring and the vital investment in education and training by people of all ages. There is just too much change at the inopportune time when confidence is required to generate sufficient economic growth that will alleviate the plight of 27 million people unemployed or forced to work part time because no other opportunity is available. The Dodd-Frank bill of financial regulation creates lethal uncertainty by reduced availability of credit and the likely higher interest rate to be paid for whatever credit is available. Legislative restructurings of large segments of economic activity and other draconian regulation cloud the calculations of net present value of investments and business decisions. The government forecast for the deficit of 2011 has been increased from $1.27 trillion estimated in February to $1.4 trillion, or 9.2 percent of GDP, released on Friday with upward revisions for the next three years (http://professional.wsj.com/article/SB10001424052748703294904575385481462433508.html?mod=wsjproe_hps_LEFTWhatsNews ). The Fed balance sheet is bloated at $2.3 trillion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1c ). The largest government deficits in a peace period and the eventual unwinding of the portfolio of long-term securities of the Fed create the uncertainty of large increases in taxes and rising interest rates.
The US economy is decelerating with lowering forecasts for second-quarter GDP. There are doubts if the growth of the US economy will be sufficient to absorb 27 million people currently in job stress composed of: 14.6 million unemployed (of whom long-term unemployed of 6.8 million or 45.5 percent who have been unemployed more than 27 weeks), 8.6 million working part-time because they could not find a better job, 2.6 million marginally attached to the labor force (who wanted and were available for work and had searched for work in the prior 12 months) and 1.2 million discouraged workers (who believe there is no job for them or had not searched for work in the prior four weeks) (http://www.bls.gov/news.release/pdf/empsit.pdf ).

The President of the European Central Bank, Jean-Claude Trichet, has called for global fiscal consolidation (http://www.ft.com/cms/s/0/1b3ae97e-95c6-11df-b5ad-00144feab49a.html ). There is no dispute on the need for fiscal consolidation but rather on the timing. Trichet finds that in the four years after 2007 government debt will grow by 20 percentage points in the euro area, 35 percentage points in the US and 45 percentage points in Japan. The three elements of Trichet’s argument are: (1) fiscal consolidation with appropriate restructuring policies promote stable growth; (2) consolidation is required to prevent loss of confidence from debts perceived as growing nonlinearly; and (3) consolidation is needed to recover fiscal strength that may be used in future crises.

Lawrence Summers, chief economic adviser to the President and Director of the White House National Economic Council, argues that the US follows the correct policy of supporting economic recovery in the short term while pursuing fiscal consolidation in the medium and long term because of likely general agreement by economists on three propositions (http://www.ft.com/cms/s/0/966e25b8-9295-11df-9142-00144feab49a.html ). First, in normal economic times, increasing budget deficits may not have an impact on output and employment, affecting only the composition instead of the level of aggregate economic activity. Second, in an economy with idle capacity and a near zero interest rate that cannot be reduced further, fiscal policy may have substantial impact on output and employment. Third, anticipations of fiscal consolidation in the medium and long term will maintain confidence in an adequate environment for investment and job creation. The time may have arrived to strengthen the anticipations of fiscal consolidation to avoid adverse investor expectations such as those that occurred during the Asian crisis of 1997-1998, requiring a “credible plan” for crisis resolution (Lawrence Summers Richard T. Ely Lecture, AER 2000, cited in Pelaez and Pelaez, Globalization and the State, Vol. II, 106). The “fundamentals” of the US are deteriorating because of lack of a credible plan for fiscal consolidation.

Michael J. Boskin, Professor at Stanford and fellow at the Hoover Institution, warned in 2008 that permanently expanding government with taxes is not sound policy in hard times (http://professional.wsj.com/article/SB10001424052748703724104575378751776758256.html ). Future higher taxes to finance the current deficits will deteriorate the economy and are widely anticipated. The legislative restructurings, bailouts, regulation and mandates are forcing non-business decisions on the economy that is anticipating the uncertainty of decisions and rules by the new laws and regulations. The combined environment has created the uncertainty analyzed by Frank Knight that prevents investment and hiring.

II Financial Turbulence. Equity markets improved substantially but experienced significant turbulence in the current week and continue to trade much lower than their recent peaks (http://online.wsj.com/mdc/page/marketsdata.html ). Financial variables are available with high frequency, daily with market trading, while data on the overall economy become available with a lag of weeks or months. The percentage performance of major US indices to Jul 23 was: DJIA -7.0 from the recent peak on Apr 26 and 3.2 in the week; S&P 500 -9.4 from the recent peak on Apr 23 and 3.6 in the week; and NYSE Financial -13.4 since Apr 15 and 3.9 in the week. The percentage performance of major world stock markets from Apr 15 to Jul 23 was: Dow Global -11.9 and 2.8 in the week; Dow Asia Pacific TSM -8.3 and 1.0 in the week; Shanghai -18.7 and 6.1 in the week; and STOXX Europe 50 -8.8 and 2.8 in the week. The euro moved sideways, trading at $1.2930/EUR on Jul 23. The dollar has gained 17.2 percent relative to the euro since the recent trough on Nov 25, 2009, and gained 0.3 percent in the week. The DJ UBS commodity index fell 10.4 percent since the recent peak on Jan 6 and gained 1.8 percent in the week. The 10-Treasury traded at 3.000 percent on Jul 23 as funds flowed back into risk positions. Earnings of corporations have been strong, in particular with growing revenue and enhanced prospects for Caterpillar and UPS that reflect higher economic activity. Favorable news was that only seven of 91 banks in Europe had Basel Tier 1 capital ratio of less than 6 percent after stressing their balance sheets with a scenario of weak economy and sovereign risks (http://professional.wsj.com/article/SB10001424052748703294904575384940544522582.html?mod=wsjproe_hps_LEFTWhatsNews http://online.wsj.com/public/resources/documents/cebs-Summaryreport-20100725.pdf ). These tests will be scrutinized during the week.

III. Economic Indicators. Housing starts in Jun were at a seasonally-adjusted annual rate of 454,000, which is below the May estimate by 0.7 percent and 5.8 percent below the Jun 2009 rate of 583,000 (http://www.census.gov/const/newresconst.pdf ). In Jan 2006, housing starts in the US were at an annual rate of 2265 thousand (http://www.census.gov/const/newresconst_200701.pdf ). The decline from Jan 2006 to Jun 2010 is by 80 percent, a contraction of physical data that is very difficult to find in recorded history. This disaster is impossible to explain by lack of financial regulation but it can be explained by government policy of near-zero interest rates, subsidies to housing and the mismanagement of Fannie and Freddie. Building permits increased by 2.1 percent from May into Jun but were below 2.3 percent relative to Jun 2009. Existing home sales dropped 5.1 percent from May into Jun but remain 9.8 percent higher than in Jun 2009 (http://www.realtor.org/press_room/news_releases/2010/07/ehs_june_above ). Initial claims for unemployment insurance increased by 37,000 in the week ending Jul 17 from the prior week, reaching 464,000 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).

IV Interest Rates. There was a slight upward shift in the US yield curve as funds flowed back from the safe haven of Treasuries and highly-rated fixed income into risk exposures. The 10-year Treasury increased to 3.00 percent from 2.94 percent a week ago but declined from 3.11 percent a month ago. The 10-year German bond traded at 2.75 percent, tightening its spread to -0.25 basis points relative to the 10-year Treasury (http://markets.ft.com/markets/bonds.asp?ftauth=1280055941689 ).

V Conclusion. There is promise of further review of regulatory measures (http://professional.wsj.com/article/SB10001424052748703467304575383490332411012.html ). A policy shift in the form of concrete measures could encourage decisions on investment and hiring by business and investment on education and training by people of all ages that could reduce the uncertainty in the economy, promoting prosperity. Increasing uncertainty will worsen the plight of the 27 million unemployed or underemployed. A strong positive confidence shock will reignite the economy, creating far more jobs than another construction project with negative present value and eventual financing of that waste by taxpayers. (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )