How can uncertainty be good for the market?
“Positive Uncertainty” is what drives entrepreneurship and investing. According to Frank Knight in his paper, “Risk, Uncertainty, and Profit” (1921),
We do not need to strain the imagination by supposing supernatural powers of prescience on the part of men. We can think of the adjustment as the result of a long process of experimentation, worked out by trial-and-error methods alone. If the conditions of life and the people themselves were entirely unchanging a definite organization would result, perfect in the sense that no one would be under an incentive to change.
So in the organization of the productive groups, it is not necessary to imagine every worker doing exactly the right thing at the right time in a sort of “preestablished harmony” with the work of others. There might be managers, superintendents, etc., for the purpose of coordinating the activities of individuals. But under conditions of perfect knowledge and certainty such functionaries would be labourers merely, performing a purely routine function, without responsibility of any sort, on a level with men engaged in mechanical operations.
With the introduction of uncertainty—the fact of ignorance and necessity of acting upon opinion rather than knowledge—into this Eden-like situation, its character is completely changed. With uncertainty absent, man’s energies are devoted altogether to doing things; it is doubtful whether intelligence itself would exist in such a situation; in a world so built that perfect knowledge was theoretically possible, it seems likely that all organic readjustments would become mechanical, all organisms automata. With uncertainty present, doing things, the actual execution of activity, becomes in a real sense a secondary part of life; the primary problem or function is deciding what to do and how to do it.
The two most important characteristics of social organization brought about by the fact of uncertainty have already been noticed. In the first place, goods are produced for a market, on the basis of an entirely impersonal prediction of wants, not for the satisfaction of the wants of the producers themselves. The producer takes the responsibility of forecasting the consumers’ wants. In the second place, the work of forecasting and at the same time a large part of the technological direction and control of production are still further concentrated upon a very narrow class of the producers, and we meet with a new economic functionary, the entrepreneur.
Why is uncertainty bad for the market?
Expectations are the driving factor in the decision to invest, either by a firm planning its following year’s spending on building a new facility or committing to new R&D, or by an investor allocating to different assets in his portfolio. “Negative Uncertainty” may beget a revised outlook, choking a potential source of capital for a particular venture that would otherwise be funded. Growth companies survive on optimism and flounder like a fish out of water in a pessimistic environment.
Regardless, uncertainty incurs costs, either in terms of raising hurdle rates, having to buy extra insurance, or delaying a project, or even abandoning what was already in the pipeline. As for investors, it might mean altering the composition of the portfolio, which costs too.
Quantitatively, the impact of uncertainty has a large economic effect on the various macro variables. For example, the GDP growth increases by about 2.5% one year after good uncertainty shock and this positive effect persists over the next three years. On the other hand, bad uncertainty shocks decrease output growth by about 1.3% one year after and their effects remain negative for several years.
The responses of investment and R&D to these shocks are even stronger. Both capital and R&D investment significantly increase with good uncertainty and remain positive five years out, while they significantly drop with a shock to bad uncertainty…Uncertainty can be quite significant in economic magnitude and underscores the potential importance of decomposing uncertainty into good and bad components.
It is incumbent upon policy makers and leaders in general to create an atmosphere of reasonable certainty. It needs to be just enough to leave room for ideas, some experimentation and dynamic responses to changing circumstances. However, we should hope to avoid excessive uncertainty to the extent where uncompromising views win the day over pragmatic solutions.