How people, rather than policy makers, drive the economy in times of uncertainty

In past recessions, we have seen that high levels of uncertainty hold a strong influence on economic performance. Lack of confidence or uncertainty involving expectations discourages decision making; essentially, businesses find that the cost of investing or making a costly decision exceeds the hoped-for benefit, given that there is no baseline upon which to estimate the likelihood of the optimal situation’s occurrence. With this said, it is important to pause and discuss the distinction between risk and uncertainty, as these terms are often used interchangeably. 

The unfavorable outcome of a known risk can be insured against during the decision-making process because it has a well-defined distribution of expected probabilities. That is, we can often reference past statistics in order to predict the likelihood of the outcome of a risky decision being cost-effective. Although it is inherent, by definition of a risk, that the outcome is unknown, there is often a means of predicting the outcome. In contrast, uncertainty does not have a well-defined distribution of expected probabilities. This leads to an even stronger likelihood that firms, banks, or businesses will refrain from non-essential decision-making. 

To state the obvious, the coronavirus has essentially paused economic activity, as people’s health is clearly a higher priority than their economic prosperity. However, when the economy slowly gears itself to opening up again, we may experience unprecedented levels of economic stagnation. Inherent to the virus is its uncertainty; we have no idea how long it will last, how many lives it will impact, etc. We have seen that acts of monetary policy involving attempts to induce investment, as well as fiscal interjections involving government stimulus packages have not had as pronounced of an effect as was hoped for. This highlights the crucial role people’s expectations play in driving the economy. Not until this uncertainty is cleared will people begin to make any sort of crucial decisions or investments, as the unknown costs are too high to bear. This is a bit of a dark, disturbing reality, as this suggests that the economy will not be able to function as it did prior to the pandemic, despite the government’s attempts involving fiscal and monetary interjections, until people are relieved from the uncertainty associated with the virus. The silver lining of this may be that we, not the government, are in fact in control of economic activity. Power to the people!