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Persistent Unemployment and Policy Uncertainty: Numerical Evidence from a New Approach

Written by Patrick L. Anderson, Persistent Unemployment and Policy Uncertainty, was honored with the Edmund A. Mennis Contributed Paper Award in 2013. This award is presented to the author of the most meritorious original work submitted each year to Business Economics, NABE’s quarterly professional journal. This paper lays out an innovative and very promising approach to analyzing a host of important policy approaches.

Abstract:

In the recovery from the deep recession that formally ended in 2009, unemployment has proven resistant to both aggressive fiscal policy and expansionary monetary policy. The persistence of high unemployment, fully four years after the trough of the recession and despite aggressive policies to combat it, raises a critical question about the ability of standard macroeconomic models to grasp fundamental business decisions faced by private firms, including hiring and investment decisions.

One competing argument to those regularly made in fiscal and monetary policy debates is the policy uncertainty hypothesis. This holds that managers of private firms have been rationally avoiding hiring workers, due to the risk of higher future costs imposed by government policies. However, such a hypothesis cannot be directly tested in standard models of firm behavior that rely on the presumption that firms maximize profits in each time period. The probabilities of transitioning from one policy regime to another, and the consequences of such transitions to the value of the firm, are not inputs these models.

To formally test the policy uncertainty hypothesis, we use a novel “value functional” or “recursive” model of firm behavior, in which managers maximize the value of the business rather than its profits. This model allows for managers to explicitly consider policy uncertainty, and the consequences of future business decisions they might make if conditions change. We create a data set that includes income statement information for firms in a selected U.S. industry in the relevant time period, parameters that reflect policy-related costs of employing workers in that industry, and probabilities of changing policies in the future.

Using this approach and these data, we demonstrate that policy uncertainty affects rational hiring decisions of firms. We show that business managers can make rational decisions to maximize the value of their businesses that forego available current-period profits, due solely to uncertainty about future policy-related costs. Tests for robustness indicate that this effect is not dependent on particularly onerous assumptions, that the response to policy uncertainty is higher in some industries than others, and that the scale of the firm also affects its sensitivity to policy risk.
Finally, we conclude that this approach has potentially broad application within business economics, particularly in evaluating investment and hiring decisions; real options; and other aspects of uncertainty, fixed costs, and managerial flexibility.

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Click here for the article in Business Economics as published by Palgrave Macmillan.

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