Regime uncertainty and the great recession: a market-process approach.

• Author: Von Laer, Wolf
• Position: Essay

The U.S. recovery from the Great Recession has proceeded at a slow pace. Brady Lavender and Nicolas Parent (2012-13) show that the economy has been rebounding more slowly than from any other post-World War II recession. An International Monetary Fund (2012) report comes to a similar conclusion, and Edward Lazaer (2012) has gone so far as to call it "the worst economic recovery in history."

Although the recession formally ended in June 2009, key indicators of economic vitality have continued to lag for several years. Net domestic investment was 32 percent lower in 2013 than the average from 2000 to 2007 (U.S. Bureau of Economic Analysis 2015). The unemployment rate of 5.0 percent in December 2015 may be close to full employment, but a more detailed comparison of employment indicators depicted in table 1 provides a more somber view of the recovery. Table 1 shows that in spite of an increase of 20 million in the U.S. population since 2007, the number of workers employed full-time has hardly risen. Part-time work has risen but not enough to compensate for the increase in population. Moreover, Matthew Dylan (2013) finds that the reduction in unemployment since the crisis started is due nearly entirely to the decline in labor force. The labor-force participation rate, at 62.6 percent in December 2015, is the lowest since February 1978 (U.S. Bureau of Labor Statistics 2014).

A number of economists in both popular and academic outlets have pinned the slow recovery on uncertainty triggered by government policy. Scott Baker, Nicholas Bloom, and Steven Davis (2012) have constructed an Economic Policy Uncertainty Index that draws on discrepancies between forecasts and macroeconomic data, newspaper search results, and other indicators. They find that heightened policy uncertainty corresponds to lower output and employment. Thomas Siems (2010) argues that both consumer and investors are holding back due to uncertainty generated by Washington's eclectic policies. Similarly, Allan Meltzer (2010) decries uncertainty' about future taxes and regulations as the chief current enemy of economic growth. (1) Robert Higgs has argued in various popular outlets that the slow recovery is consistent with an episode of regime uncertainty' (see Higgs 2008, 2010a, 2010b, 2010c, 2010d, 2011, 2012, 2013), a concept he first formulated to explain the "Great Duration" of the Great Depression (Higgs 1997).

This essay takes Higgs's concept of regime uncertainty as a point of departure, utilizing the recovery from the Great Recession as an opportunity to investigate a possible extension of Higgs's theory. Our primary goal is to show that regime uncertainty can be fruitfully situated in the broader theory of the market process as articulated by thinkers such as Israel Kirzner and Ludwig Lachmann. (2) This approach has several advantages. First, locating regime uncertainty within a broader framework insulates it from charges that it is an ad hoc explanation of economic sluggishness. Second, it facilitates the generation of new hypotheses about regime uncertainty that can be empirically examined. We offer one such examination to illustrate the fruitfulness of our approach. Third, these new hypotheses provide indirect evidence that can help judge what role regime uncertainty can play in explaining the Great Recession. This last task is far beyond the scope of one essay, in which we have only enough space to introduce our theory and explain one implication of it rather than to flesh out fully all such implications and adjudicate between our approach and other theories.

This essay begins by recapitulating and reinforcing Higgs's arguments that the slow U.S. recovery from the Great Recession can be plausibly characterized as an episode of regime uncertainty. The first section offers a uniquely comprehensive treatment of regime uncertainty in the Great Recession, synthesizing evidence from a wide range of qualitative and quantitative sources. We do not argue that regime uncertainty is the only explanation or even the best explanation of the slow recovery; rather, we seek only to establish that it is a sufficiently powerful explanation to merit further examination. The next section argues that the theory of regime uncertainty can be fruitfully recast in terms of market process theory. We conceptualize regime uncertainty as a negative shock to entrepreneurial alertness caused by government policies that substantially alter the rules of the game by which markets operate. This new theoretical approach to regime uncertainty fits the stylized facts identified by Higgs and allows us to generate new hypotheses subject to empirical investigation. The final section explores one such implication, presenting evidence that regime uncertainty has an asymmetric effect on small and medium enterprises and thus demonstrating the fruitfulness of our approach.

Regime Uncertainty in Wake of the Great Recession

Regime uncertainty is a situation in which investors are "distressed that [their] private property rights in their capital and the income it yields will be attenuated further by government action" (Higgs 1997, 568). This definition emphasizes the institutional framework within which economic activity takes place. Higgs continues: "Such attenuations can arise from many sources, ranging from simple tax-rate increases to the imposition of new kinds of taxes to outright confiscation of private property. Many intermediate threats can arise from various sorts of regulation, for instance, of securities markets, labor markets, and product markets. In any event, the security of private property rights rests not so much on the letter of the law as on the character of the government that enforces, or threatens, presumptive rights" (568).

In his analysis of the Great Depression, Higgs points to the Franklin Roosevelt administration's panoply of new government programs and antibusiness rhetoric as proximate causes of such uncertainty. He compiles extensive survey evidence indicating that businessmen believed their returns on potential investments were threatened by the new regulations and by the administration's general policy stance. As a consequence of this belief, investment remained depressed throughout the latter half of the 1930s.

The conditions of the past few years are not as severe as those of the 1930s." Nonetheless, Higgs has put forward convincing arguments that regime uncertainty plagues the current recovery. We offer here a synthesis of this and other evidence to provide a more complete picture of regime uncertainty in the aftermath of the Great Recession.

Figure 1 indicates that domestic private net investment (henceforth "private investment") finally surpassed the levels of 2006 and 2007 in the second quarter of 2014. However, these are net figures. Much of this investment was just recovery from losses incurred in the crisis. Figure 2 paints a less-encouraging picture. Private investment as a share of gross domestic product (GDP) remained below the precrisis levels as of the third quarter of 2015. Officially, the crisis period, as declared by the National Bureau of Economic Research (NBER) (2014), was from December 2007 to June 2009. In the precrisis years 2001-2007, average shares of investment amounted to 2.8 percent of GDP, but in the postcrisis years private investment has averaged only 1.9 percent of GDP. (4)

If this investment shortfall is due to uncertainty about the future, one should expect to see a steeper yield curve for private bonds (Higgs 1997). As figure 3 shows, before the crisis, the corporate bond yield curve was rather flat. The interest-rate spreads between different maturities of A-rated bonds differed between 5 percent and 6 percent. After a period of high volatility during the crisis, the corporate bond-yield curve is now much steeper than before the crisis. These yield curves are consistent with an increase in time preference due to heightened uncertainty about the future. A similar pattern was observable during the Great Depression in the midst of the Second New Deal policies (Higgs 1997, 2010c). Bond-yield curves for treasuries returned to their precrisis slope in early 2009. In addition, the private bondyield curve is much steeper than the yield curve for Treasury bonds. If a steep yield curve were the result of inflationary expectations, the two curves would have a similar slope (Higgs 2010b).

Just as in the case of the Great Depression, the past few years have witnessed a large uptick in new and sometimes sweeping policies. Regulation has rapidly expanded since the crisis. Patrick McLaughlin and Omar Al-Ubaydili (2013) report that the number of binding rules in the Federal Code of Regulation rose by 11.2 percent from 2007 to 2012. By comparison, between 2001 and 2006 binding rules increased by only 5.3 percent. From 2007 to 2012, the budget allocated to economic regulatory agencies (excluding environmental and workplace-related regulation) rose 30 percent (Dudley and Warren 2008, 22, and 2013, 17). Over that same period, the number of personnel employed by regulatory agencies grew by about 17 percent (Dudley and Warren 2008, 28, and 2013, 23). The trend continued in 2015 with an estimated increase of $3.1 billion to a total of $60.9 billion in regulatory outlays (Dudley and Warren 2014, 1). Moreover, Susan Dudley and Melinda Warren (2014) also find that this increase in regulatory activity has been focused more on economic regulation than on social regulation. Notably, these findings exclude the budget of the Department of Health and Human Services, which is in charge of the implementation of the Affordable Care Act. (5)

Survey data are consistent with this view. Although surveys are limited, what matters for our argument are not the objective effects of government policies but rather how they are perceived. A number of Gallup polls highlight the heightened level of concern with government activity in the past lew years...