Becoming More Certain about the Role of Regime Uncertainty

I agree with Tim Congdon that Robert Higgs’s work on regime uncertainty is quite useful to the larger exploration of why unemployment sometimes remains stubbornly high for long periods of time. It’s true that Higgs pays little attention to fiscal and monetary policies and to aggregate demand. That’s not to say that the phenomena that do command his attention are not justifiably classified as “macroeconomic.” But those phenomena also happen to be ones that neither monetary nor fiscal policies in the usual sense are capable of curing.

F.A. Hayek correctly warned that “Mr. Keynes’s aggregates conceal the most fundamental mechanisms of change.”[1] This warning applies also to monetarists’ focus on the role of the aggregate spending M*V (money supply times velocity of spending) in driving recovery.

Before getting to the heart of my argument that Higgs’s regime uncertainty thesis supplies at least as plausible an explanation for the length of the current recession as do theories that appeal to the (alleged) inadequacy of aggregate demand, I wish to prevent a possible misunderstanding. I don’t at all intend to deny that a sudden reduction in M*V—whether it be caused by falling M, falling V, or a combination of both—can result in a serious and troublesome decline in real economic activity. Nor do I deny that, should such a decline materialize, the monetary authorities should take whatever steps are necessary to combat it. Like many economists, and unlike Joseph Stiglitz,[2] I find Milton Friedman’s and Anna Schwartz’s account of the depressing consequences of the 1930–33 “great contraction” of the U.S. money supply to be quite compelling.[3]

But to recognize that a recession can be triggered or worsened by a collapse in spending, and to understand also that the problems destined to be unleashed by such a fall are better avoided by increasing the nominal stock of money rather than by waiting for the price level to fall, does not commit one to look exclusively, or even chiefly, to inadequate spending as the cause of any prolonged bout of sluggish economic activity and high unemployment. (Indeed, compelling as Friedman’s and Schwartz’s thesis is in accounting for the bottoming out of U.S. economic activity in 1933, it hardly suffices—as Friedman and Schwartz themselves fully recognized—to account for the prolonged period of unemployment that followed.)

Back to Regime Uncertainty

Without denying that a prolonged slump in economic activity could be caused by deficient aggregate demand, Higgs looks beyond this conventional macroeconomic variable for other possible explanations. Why else might investors hesitate to invest, and entrepreneurs hesitate to plan to produce more output, especially when the economy has an unusual number of idle resources available to be put to productive use?—this is one way to frame the question Higgs asks. Just because macroeconomic textbooks and journal articles focus overwhelmingly on changes in aggregate demand as the chief cause of changes in the vigor of economic activity is no reason for a scholar not to search for some other cause, especially if another identifiable cause is solidly grounded in economic theory.

Higgs argues that he has found some such other cause: regime uncertainty. A good deal of investment and entrepreneurship that would have occurred under a different policy regime will not occur under a regime perceived to be hostile to wealth accumulation, hostile to profits higher than some politically trumpeted norm, hostile to creative destruction, and hostile to many of the other elemental features of dynamic market capitalism. As Higgs himself describes it, “regime uncertainty … has to do with widespread inability to form confident expectations about future private property rights in all of their dimensions.”[4]

Who can doubt that (1) government is capable of creating such fears regarding the security of “private property rights in all of their dimensions”; (2) if such fears are sufficiently widespread, private investment and entrepreneurial activity will slow significantly regardless of consumers’ current and future propensity to spend; and (3) among the symptoms of such curtailed investment and entrepreneurial activity will be deficient aggregate demand and high and lasting unemployment?

Unless one is ready to jettison most of microeconomics—or be prepared to insist that microeconomic factors such as a falling expected rate of return on each of many long-term business plans are simply inadmissible in discussions of conventional macroeconomic troubles if these falling expected rates of return are caused by something other than falling aggregate demand—regime uncertainty must be reckoned with as possibly supplying an explanation for prolonged slumps.

Some Evidence

So what’s the evidence?

Among Higgs’s evidence that regime uncertainty played a prominent role in prolonging the Great Depression is the yield curve on bonds. Here’s Higgs:

My most striking financial evidence for the New Deal episode pertains to the yield curve for corporate bonds, that is, to the spreads between the effective yields on high-grade corporate bonds with various terms to maturity. I found that this yield curve became suddenly much steeper sometime between the first quarter of 1934 and the first quarter of 1935 (a period when the New Deal lurched from its first, or business tolerant, phase to its second, or business hostile, phase) and remained very steep until sometime between the first quarter of 1941 and the first quarter of 1942 (a period when the New Deal handed over the reins to the military and the big businessmen who, along with the president himself, ran the war-command economy for the duration). I interpreted these extreme spreads as risk premiums on longer-term investments caused by regime uncertainty.[5]

Higgs finds a similar yield pattern for the current recession:

Thus, corporate bond yields have exhibited three distinct periods: pre-crisis stability with a shallow yield curve; extreme volatility of the yield curve, including some inversions in the latter part of 2008; and post-crisis stability with a much steeper yield curve since mid-2009.

Thus, just as the steep yield curve for the New Deal years corresponds precisely with the so-called Second New Deal, when Roosevelt and his leading subordinates and advisers went on the warpath against investors as a class, the recent transition corresponds to the volatility associated with the period of frenetic government action and financial market fluctuations between September 2008 and the middle of 2009, leaving in its wake a much steeper yield curve.[6]

Higgs isn’t alone in finding evidence in support of the regime uncertainty hypothesis. Consider the following from Stanford University’s Scott Baker and Nicholas Bloom, writing with the University of Chicago’s Steven J. Davis:

[T]he data refute the view that economic uncertainty necessarily breeds policy uncertainty. In the last decade, however, policy became a larger source of movements in overall economic uncertainty and an increasingly important concern for businesses and households. … [T]he persistence of policy uncertainty … reflects deliberate policy decisions, harmful rhetorical attacks on business and “millionaires,” failure to tackle entitlement reforms and fiscal imbalances, and political brinkmanship…

When businesses are uncertain about taxes, health-care costs and regulatory initiatives, they adopt a cautious stance. Because it is costly to make a hiring or investment mistake, many companies will wait for calmer times to expand. If too many businesses wait, the recovery never takes off. Weak investments in capital goods, product development and worker training also undermine longer-run growth.

So how much near-term improvement could we gain from a stable, certainty-enhancing policy regime? We estimate that restoring 2006 levels of policy uncertainty would yield an additional 2.5 million jobs over 18 months. Not a full solution to the jobs shortfall, but a big step in the right direction.[7]

As Higgs himself admits, none of this proves that regime uncertainty plays any role in prolonging the current recession. But I submit that the economic logic of the regime uncertainty thesis combines with available evidence to render regime uncertainty at least as plausible an explanation for our continuing economic sluggishness as any explanation offered by Keynesianism or monetarism.


[1] F.A. Hayek, “Reflections on the Pure Theory of Money of Mr. J. M. Keynes,” Economica 1931.

[2] Joseph E. Stiglitz, “A Book of Jobs,” Vanity Fair, January 2012.

[3]Milton Friedman and Anna J. Schwartz, A Monetary History of the United States: 1867-1960 (Princeton: Princeton University Press, 1963).


[5] “Regime Uncertainty: Are Interest-Rate Movements Consistent with the Hypothesis?” blog post, August 24, 2010.

[6] ibid.

[7] Baker, Bloom, & Davis, “Policy Uncertainty is Choking Recovery,” Bloomberg, Oct. 5, 2011.

Also from this issue

Lead Essay

  • Tim Congdon argues that John Maynard Keynes’ latter-day followers have badly misinterpreted the theorist they profess to follow. Led by Paul Krugman, Keynesians have claimed that a near-zero Federal Funds rate is indicative of a liquidity trap. This diagnosis has several problems. First, it is not what Keynes meant by the term; second, even a rate of zero percent does not exhaust monetary policy; and third, a genuine Keynesian liquidity trap has not happened and cannot plausibly happen, in part but not solely because Keynes assumed constant prices throughout the economy, a condition that is unlikely in the face of a rising money supply. Congdon commends to readers Milton Friedman’s monetary prescription: a gradually and predictably rising supply of money, not the wild swings we have seen in recent years.

Response Essays

  • Dean Baker argues that Keynesians have not given up on monetary policy. Although the federal funds rate can’t go negative, the Federal Reserve can still set a higher inflation target, a solution both he and Paul Krugman endorse. Alongside monetary policy, Baker recommends fiscal policy: The recent economic stimulus legislation worked as intended, he argues, although the recession was more severe than the administration anticipated, and thus the stimulus proved to be too small. Policymakers have a duty to try to return the country to full employment, as the unemployed, who are suffering the most in the current crisis, are not to blame for their troubles.

  • Don Boudreaux agrees with Congdon that a monetarist policy approach would be preferable, but he draws our attention to a third relevant consideration: regime uncertainty, as described by the economist Robert Higgs. When businesses are uncertain about the major economic decisions of governments and central banks, they will defer new investments and retain cash rather than hiring new workers. Neither monetarism nor Keynesianism does anything to address the problem, which Keynes himself conceded was real.

  • Robert Hetzel reiterates that a zero lower bound for interest rates is a different phenomenon from a liquidity trap. The latter is an “irrelevant academic construct” as long as the central bank can create new money. Still, we learn little from this distinction unless we can determine the nature of the initial shock that caused pessimism among market participants; different types of shocks, monetary and real, call for different remedies. Central banks rarely use the analytical tools that would be necessary for them to evaluate their own roles in economically rigorous ways; instead, they tend to blame difficult times on the private sector, while taking credit for good ones.