The Effect of Fiscal Policy Uncertainty
The word 'uncertainty' is reportedly appearing in the media more frequently than it had in the past decade. The sudden “Trump tsunami,” as I mentioned in my previous post, has left many unprepared, and, more critically, unsure of what to prepare for.
To explain this heightened uncertainty, allow me to draw an analogy from thermodynamics to describe how the current US administration’s approach affects the economy and markets.
Picture an enclosure filled with gas at a specific pressure and temperature. We can adjust the size of the enclosure. Now, imagine that instead of gradually increasing its size and gently lowering the pressure, we abruptly reduce the pressure from five bar to one bar.
What happens to the gas inside? It becomes highly unstable and falls out of equilibrium. Some parts of the system remain at five bar, others drop to one bar, and some may even reach zero bar. During this transition, the system cannot be described by a single state variable. If we measure different points within the enclosure along this path, we’d need distinct pressure and temperature values for each. In short, the system is no longer in equilibrium.
In thermodynamics, such a process is irreversible. Returning to the initial state requires external input - say, heat or additional work - because the rapid change squanders energy.
The same principle applies to the US economy. What else is irreversible? Time. How much time and energy have we lost in this process, resources that could have been directed toward more productive ends? What else is lost? The integrity of infrastructure and networks, and I’m not just talking about the trade system.
The best framework I can think of to describe this type of uncertainty is Knightian uncertainty. Consider this example: An investor is evaluating a stake in a startup developing a revolutionary technology, like a new form of renewable energy. The venture could yield enormous profits if the technology succeeds or result in a total loss if it fails. Yet, because the technology is unprecedented, there’s no historical data or market precedent to gauge the likelihood of success - say, a 70% chance - or failure. This isn’t merely uncertainty about the outcome (success or failure); it’s uncertainty about the odds of those outcomes. With no basis to assign probabilities, this is a textbook case of Knightian uncertainty.
We don’t know - not only because the administration itself is clueless of what it’s doing, but also because when we present them with history’s lessons about the consequences of their actions, they ignore them and take the excessive risks anyway, which is yet another factor we cannot quantify. A risk-loving administration does not actually scream stability.
Frank Knight, in his 1921 work “Risk, Uncertainty, and Profit”, captured this distinction: “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.”
Much like monetary policy, fiscal policy must avoid undermining business and consumer confidence. Yet this administration seems indifferent to how its actions shape public sentiment. Expectations are formed where monetary and fiscal policies converge, hence the apathy of fiscal policymakers poses a challenge for their monetary counterparts. Monetary policy relies on the credibility of fiscal policy to be effective. If fiscal policymakers lose that credibility, monetary policymakers may struggle to achieve their goals of price stability and maximum employment.