But this focus on expectation (itself flawed–more below) is to misstate completely the essence of the regime uncertainty argument, which, believe it or not, is about uncertainty–variation around the expectation. It can be conceived best as a real options argument. Hiring is like an investment: there is a cost of hiring–and firing–workers. This cost is not immaterial. This cost is like the strike price of an option on the right to hire a worker and receive a stream of benefits from employing her.
This stream of benefits is uncertain. Moreover, policy uncertainty is a major driver of the variability of this stream of benefits. Nobody knows how Obamacare is going to play out. Nobody knows what the actual costs of compliance are going to be. If the burden turns out to be very high, the stream of benefits from hiring a worker (or investing in a new machine or a new product) could be quite low, and even negative. If the burden turns out to be low, the stream will be commensurately higher.
Options pricing theory basically implies that in the face of such uncertainty, it is often optimal to defer paying a sunk cost (the strike price) until the uncertainty is resolved. This is why it is usually better to defer the exercise of an option as long as possible, unless there is a stream of benefits (e.g., dividends, interest on the strike price) that can be obtained only after the option is exercised. When to exercise the option–including exercising the option to hire somebody–depends on a trade-off between getting some benefits immediately, and waiting for the resolution of uncertainty about the value of those benefits in the future.
An immediate implication of this is that the greater the uncertainty about the future, the costlier it is to exercise an option early. In the present context, higher uncertainty about the future means that firms will hire less today, all else equal. Hiring a worker today (or investing in a machine or product) generates a stream of benefits for the employer in the short term, but if there is considerable uncertainty about the future value of that stream, it is often wise for potential employers to defer incurring the strike price (the cost of hiring) until some of that uncertainty is resolved.
In the investment literature, the option value of waiting for the resolution of uncertainty drives a wedge between the rate at which firms discount risky expected cash flows and the discount rate implied by something like the CAPM. It helps explain why firms frequently use very high hurdle rates in capital budgeting decisions–and high hurdle rates tend to discourage investment, relative to those that would be undertaken using CAPM. In other words, real optionality tends to reduce investment.
The same effect is at work here. The Burtless argument endorsed by Thoma focuses on expected future benefits. But since these future benefits are risky, and a cost must be sunk to achieve these benefits, there is a cost wedge–the option value of waiting–that is attributable to uncertainty. The more the uncertainty, the greater the wedge.
Tuesday, 6 September 2011
In defence of Regime Uncertainty
Craig Pirrong at the Streetwise Professor blog argues that Regime Uncertainty can be seen in terms of a real options argument. Pirromg writes,