I.

Assessing the impact of uncertainty on consumption

and investment (1)

Economic theory suggests that uncertainty has a detrimental effect on economic activity by giving
agents the incentive to postpone investment, consumption and employment decisions until uncertainty
is resolved, and by pushing up the cost of capital through increased risk premia.

To test the impact of uncertainty on activity in the euro area, indicators of uncertainty for industry and
consumers are derived from business and consumer surveys (BCS). The indicators measure the
divergence of business and consumer expectations about the economy and their finances. The
underlying assumption is that the more economic agents disagree in their expectations, the higher the
uncertainty in the economy. The impact of uncertainty is then estimated using fully specified
investment and consumption models. To benchmark the results of the estimation against alternative
measures of uncertainty, the BCS indicators are compared with a widely used indicator of Policy
Uncertainty. A key finding of the analysis is that uncertainty has a significant negative impact on both
investment and consumption. The effect of uncertainty on economic activity also appears to have
increased since the crisis.

The econometric analysis indicates that uncertainty is currently hindering economic activity in the euro
area. Although uncertainty in financial markets has abated significantly in recent months on the back of
decisive policy interventions, other sources of macroeconomic uncertainty remain high. The policy
uncertainty and BCS indicators are still unusually high and have so far shown only limited signs of
improvement.

I.1. Introduction through which uncertainty can dampen economic

activity include a higher cost of finance and lower
Arguably, a defining feature of the macroeconomic asset prices due to increased risk premia, ( 3) as well
and financial market situation since the start of the as increasing managerial risk aversion. ( 4)
crisis in 2008 has been an unprecedented level of
uncertainty. In particular, many commentators The purpose of this focus section is to examine the
have argued that the weakness of the recovery after evolution of macroeconomic uncertainty in recent
the financial crisis has been partly due to this years, and to estimate its impact on economic
exceptionally high level of uncertainty. Uncertainty activity. To do so, it reviews developments in a
in financial markets has abated in recent months on range of uncertainty indicators, including two new
the back of decisive policy measures, but available indicators derived from business and consumer
indicators suggest that uncertainty remains survey data. The impact of uncertainty is then
unusually high in other sectors of the economy. ( 1) estimated using fully specified investment and
consumption equations.
According to economic theory, a high level of
uncertainty can depress economic activity through I.2. Measuring uncertainty
a number of channels: investment, consumption,
employment or risk premia. When investment, In a broad sense, uncertainty can be illustrated as a
consumption or employment decisions are costly mean preserving increase in the ‘tails’ of the
to revert (e.g. due to fixed and adjustment costs), probability distribution of an event. An increase in
high uncertainty gives agents an incentive to uncertainty makes future outcomes more uncertain
postpone or cancel their decisions until uncertainty in the sense that ‘tail events’, or realisations at the
is resolved and more information is available, thus
depressing economic activity. ( 2) Other channels

(1) Section prepared by Narcissa Balta, Ismael Valdés Fernández and

Eric Ruscher. (3) Gilchrist, S., J. Sim and E. Zakrajsek (2010), ‘Uncertainty,
(2) Bernanke, B. (1983), ‘Irreversibility, uncertainty, and cyclical financial friction and investment dynamics’, 2010 Meeting Papers
investment’, The Quarterly Journal of Economics, MIT Press, 1285, Society for Economic Dynamics.
Vol. 98(1), pp. 85-106, February; Dixit, A.K. and R.S. Pindyck (4) Panousi, V. and D. Papanikolaou (2009), ‘Investment,
(1994), ‘Investment under uncertainty’, Princeton University Press, idiosyncratic risk, and ownership’, MPRA Paper 24239, University
Princeton, N.J. Library of Munich, Germany.

Volume 12 No 2 | 7
extreme of the distribution, have a higher standard economic confidence indicators — which
probability of occurring. ( 5) measure average expectations about future
economic conditions, but do not convey
Uncertainty is difficult to quantify but economic information on the dispersion of responses.
research has come up with several ways of
constructing uncertainty measures based on stock Although using dispersion measures to track
market volatility, ( 6) dispersion in forecasts by uncertainty is not a new approach, survey-based
professional forecasters, ( 7) or the prevalence of uncertainty indicators have rarely been used for
terms such as economic uncertainty in the that purpose. They offer several advantages,
media. ( 8) including wide data availability (all EU countries)
and the fact that uncertainty is measured directly at
A widely used uncertainty indicator in the current the level of the agents who make investment and
empirical literature is the one developed by Baker consumption decisions.
et al, hereafter, the Policy Uncertainty Indicator.
For the EU, this is a composite index based on I.3. Recent developments in uncertainty at the
both a news index indicator tracking the number of euro area level
entries related to ‘economic uncertainty’ in the
press, and dispersion in professional forecasts’ Financial market uncertainty in the euro area has
about budget deficits and CPI inflation. abated in recent months (Graph I.1). Stock market
volatility has decreased to almost historically-low
In addition to this Policy Uncertainty Indicator, the levels. Uncertainty in sovereign debt markets has
analysis presented in this focus section is based on also abated since the end of 2012, although it
two new indicators capturing uncertainty at the remains high by historical standards.
level of industry and consumers. The indicators are
constructed for all EU Member States using the Graph I.1: Financial Market uncertainty has
European Commission Business and Consumer abated in recent months (1) (2)
Surveys (BCS). The industry indicator measures
(1997Q1-2013Q1)
divergence in manufacturing firms’ expectations 7,00 70
about future production, whereas the consumer Sovereign bonds 10Y spread (LHS)

indicator measures divergence in the expectations 6,00 Stock market volatility (RHS) 60

of consumers’ future financial situation (see

5,00 50
Box I.1 for more details on the methodology).
4,00 40
The basic idea guiding the construction of the two
BCS indicators is that a divergence of economic 3,00 30

agents’ expectations about future activity or 2,00 20

financial situation should be a sign of higher
uncertainty in the economy. The BCS uncertainty 1,00 10
indicators represent a different concept from
0,00 0
Mar-01
Nov-01

Mar-03
Nov-03

Mar-05
Nov-05

Mar-07
Nov-07

Mar-09
Nov-09

Mar-11
Nov-11

Mar-13
Jul-02

Jul-04

Jul-06

Jul-08

Jul-10

Jul-12

(5) There is a body of literature which has made a distinction between

risk, which is understood to be measurable, and uncertainty,
which is not; see ‘Risk and uncertainty in euro area sovereign debt (1) Sovereign spreads represent the difference between the
markets and their impact on economic activity’, Quarterly Report on average 10-year government bond spreads of Ireland, Italy,
the Euro Area, Volume 11 No 4 (2012), DG ECFIN, European Spain, and Portugal v. Germany, in p.p.
Commission. In this section, however, both concepts are used (2) Stock Market volatility represents the volatility of the
interchangeably. Eurostoxx 50 option traded on Eurex.
(6) Kose, M., and M. Terrone (2012), ‘How does uncertainty affect Source: Bloomberg, Eurostat.
economic performance?’, World Economic Outlook, Box 1.3, pp.
49–53; Bloom, (2007), ‘The impact of uncertainty shocks,’ NBER
Working Papers 13385, National Bureau of Economic Research.
However, non-financial indicators of uncertainty
(7) Bachman, R., S. Esltner and E. Sims (2010), ‘Uncertainty and paint a less encouraging picture (Graph II.2). The
economic activity: evidence from business survey data,’ NBER BCS indicators reveal that overall uncertainty
Working Papers 16143; Baker, S., N. Bloom and S. Davies (2013),
‘Measuring economic policy uncertainty’, Chicago Booth Research remains unusually high for both consumers (green
Paper No. 13-02. line) and industry (purple line). The EU-wide
(8) Baker et al. (2013), op. cit. ; Knotek, E.S. and S. Khan (2011), Policy Uncertainty Indicator (blue line) is also at
‘How do households respond to uncertainty shocks?’, Economic
Review, Federal Reserve Bank of Kansas City, issue QII. almost record levels, despite having abated
somewhat from its peak in mid-2012.

8 | Quarterly Report on the Euro Area

 I. Assessing the impact of uncertainty on consumption and investment

Box I.1: Assessing uncertainty with business and consumer survey data

The Joint Harmonised EU Business and Consumer Surveys (BCS) coordinated by the European
Commission provide a battery of indicators tracking consumer and business sentiment. This information is
usually exploited to perform nowcasts or short-term forecasts of macroeconomic variables such as GDP,
industrial production or consumption. This box argues that BCS data can also be used to construct
uncertainty indicators. Using surveys to analyse uncertainty is appealing on several grounds:

- The BCS offer relatively long time series (in many cases back to the mid-1980s) available at monthly
frequency. They are available for several sectors (e.g. consumers and manufacturers) and cover all EU
countries, giving a greater degree of granularity in the analysis than most other uncertainty indicators.

- With survey data, economic uncertainty is measured ‘at source’, i.e. directly at the level of the economic
agents who make investment and consumption spending decisions. This contrasts with other measures that
capture uncertainty indirectly via financial market indicators, disagreement among professional forecasters or
occurrences of certain words in the press.

The general idea guiding the construction of BCS-based uncertainty indicators is that divergence in the
expectations of survey respondents can be interpreted as an indication of rising uncertainty. Using
divergence in opinions to measure uncertainty is an old idea which has, however, so far been mostly applied
to the opinions of professional forecasters. Only a handful of empirical studies have so far used business and
consumer surveys in that context (see Bachmann et al (2012) and Fuss and Vermeulen (2004)).

To better capture potential differences in the perception of uncertainty by different economic agents,
indicators of uncertainty can be constructed using the BCS consumer and industry surveys. The surveys
include a range of questions, only some of which have a clear forward-looking dimension that lend
themselves to measuring divergences in expectations. The industry survey only includes one such question:

Question 5: How do you expect your production to develop over the next 3 months?

The consumer survey includes several questions on consumers’ expectations about the next 12 months. For
the present analysis, two questions are selected covering, respectively, consumers' expectations about their
personal situation and about the general macroeconomic outlook:

Question 2: How do you expect the financial position of your household to change over the next 12 months?
Question 4: How do you expect the general economic situation in this country to develop over the next 12 months?

Respondents to the industry survey must select one of three possible categories (+ increase, = remain
unchanged, − decrease). In the consumer survey, respondents must choose between six categories (+ + get
a lot better, + get a little better, = stay the same, − get a little worse, − − get a lot worse, N don’t know).

Standard cyclical survey indicators are calculated as balances between positive and negative responses and
therefore ignore the underlying heterogeneity of the responses. To measure this heterogeneity and thereby
uncertainty, Theil’s entropy formula can be used as follows:

uncertainy indicator for firms = (1 / 3) × ∑ α × Log (α )

i = 1 to 3
i i

uncertainy indicator for consumers = (1 / 6) × ∑ α × Log (α )

i = 1 to 6
i i

where α i is the share of respondents choosing each of the categories described above.

The resulting indicators are shown in the two charts below. All indicators have a relatively high degree of
cyclicality with uncertainty generally rising during downturns. In particular, all of them show a steep rise in
uncertainty with the onset of the global financial crisis, followed by a fall and another rise during the
sovereign crisis. However, the timing and magnitude of these recent swings vary depending on the indicator
(Continued on the next page)

Volume 12 No 2 | 9
Box (continued)

considered. In particular, the consumer measure of uncertainty based on question 2 (as opposed to Q4, the
more general macroeconomic question) seems to have been affected earlier than the other indicators by the
global financial crisis and more severely by the sovereign crisis. As shown in Box I.3, this indicator is also
the one that is the most closely linked to private consumption and produces the most meaningful results in a
consumption regression.

References:

Bachmann, R., Elstner, S. and E.R. Sims (2010), ‘Uncertainty and economic activity: evidence from business
survey data’, National Bureau of Economic Research, Working Paper No. 16143, June.

Fuss, C and P. Vermeulen, (2004), ‘Firms’ investment decisions in response to demand and price
uncertainty’, European Central Bank, Working Paper Series No. 347, April.

Graph I.2: Uncertainty is highly rising during recessions, and falling during boom
counter-cyclical (1) times, although in the case of consumers this is less
pronounced than for the other two indicators.
(1997Q1-2013Q1)
However, during the last cycle (2008-12),
200 2,5
Policy uncertainty indicator (LHS) uncertainty has reached exceptionally high levels,
180 BCS Industry (RHS) 2,0
and has oscillated sharply.
160 BCS Consumers (RHS)
1,5
140
1,0 For the BCS industry and the Policy Uncertainty
120
0,5
indicators, uncertainty increased sharply in 2008 to
100 reach unprecedented levels, and it has remained
0,0
80 high since then, despite a decrease in 2009-10.
60
-0,5
Policy uncertainty abated again since the beginning
40 -1,0 of 2012, which may largely be due to
20 -1,5 improvements in the governance of the euro. The
0 -2,0
BCS indicator has shown only very modest
improvements since the beginning of 2013.
1995Q3

1997Q1

1998Q3

2000Q1

2001Q3

2003Q1

2004Q3

2006Q1

2007Q3

2009Q1

2010Q3

2012Q1

Overall, the correlation between the BCS industry

uncertainty indicator and the Policy Uncertainty
(1) LHS: Index of Policy Uncertainty; RHS: Index of Indicator is strikingly high (0.7), given that the two
uncertainty based on dispersion of BCS responses. measures are based on completely different
Source: Baker, Bloom and Davies (2013); DG ECFIN
calculations based on EU Business and Consumer
methods and capture different concepts of
Surveys. uncertainty.

All three measures of uncertainty represented in By contrast, the BCS consumer uncertainty
Graph I.2 are correlated with the business cycle, indicator has followed a somewhat different

10 | Quarterly Report on the Euro Area

 I. Assessing the impact of uncertainty on consumption and investment

evolution throughout this cycle. As the other two exceptionally high levels of uncertainty. However,
indicators did, it increased sharply in the early for the core countries, the evolution of uncertainty
stages of the recession but then it dropped much has been more heterogeneous. For instance,
more rapidly. It increased again between 2010 and whereas uncertainty in Germany is at a record-low
2012, but more steeply than the other two level, France is experiencing a high level of
indicators did. This points to a bigger impact of the uncertainty by historical standards.
sovereign crisis on consumer uncertainty.
The BCS industry indicator also shows substantial
I.3.1. Country dimension of uncertainty differences by country. However, it is difficult to
draw any meaningful pattern from country
Whereas the euro area-wide BCS uncertainty developments. Regression work also shows that the
indicators for industry and consumers have clearly overall euro area industry uncertainty indicator
followed a crisis-related pattern, their evolution at correlates better with investment fluctuations at the
the country level has shown a high degree of country level than the individual country industry
heterogeneity. indicators. This suggests that, contrary to the
consumer indicator, the country dimension of the
For the BCS consumer indicator, there has been a industry indicator is probably not very robust and
distinct pattern between ‘core’ and ‘peripheral’ that the analysis of this indicator should be limited
countries since as early as 2002 (Graph I.3). to the aggregate euro area level.
Consumer uncertainty increased in the core
countries between 2002 and 2006, but it decreased I.4. Estimation of the macroeconomic impact
of uncertainty
Graph I.3: BCS consumer uncertainty is at
record levels in peripheral countries (1)(2) Some insights from the empirical literature
(1985Q1-2012Q4)
2.50
So far, most empirical research has tried to
Core
Periphery
estimate the impact of uncertainty on investment
2.00
or GDP based on some of the existing uncertainty
1.50 measures listed in section I.1 using VAR models.
1.00 Although existing research has established a
0.50 negative correlation between uncertainty and
0.00
investment, there is no real consensus regarding
the magnitude of the effect. For instance, Baker,
-0.50
Bloom and Davies (2013) estimate that an increase
-1.00 in uncertainty of the same magnitude as the one
-1.50 experienced between 2006 and 2011 results in a
-2.00 decline of investment of about 14% in levels, and a
fall in GDP of about 2.6 %. Kose and Terrone
Mar-85

Oct-00
Mar-02
Jun-89
Nov-90

Dec-97
Apr-92

Jun-06
Nov-07
Apr-09
Aug-86

Sep-93
Feb-95
Jul-96

Sep-10
Feb-12
Jan-88

May-99

Aug-03
Jan-05

(2012) estimate that a one standard deviation

(1) Core: Ireland, Italy, Spain and Portugal; Periphery:
increase in uncertainty reduces investment growth
Austria, Belgium, Finland, France, Germany and Netherlands. by between 0.7 and 2.2 p.p.
(2) Index of uncertainty based on dispersion of BCS
responses.
Source: DG ECFIN calculations based on EU Business By contrast, other authors such as Bachman et al.
and Consumer Surveys. (2012) ( 9) conclude that uncertainty has a limite
impact on economic activity. They argue that high
in peripheral countries. It increased sharply for uncertainty is a mere epiphenomenon of bad
both country groups in the very early stages of the economic times, and that recessions breed
crisis, before decreasing again in 2009. Since 2010, uncertainty. A number of other researchers have
uncertainty has been on an increasing trend for concluded that the direction of causality runs from
both country groups, but whereas uncertainty in uncertainty to the business cycle but, so far, the
the periphery now is at record-high levels, it sense of the causality is not firmly established.
remains low in the core.

At present, all peripheral countries (Spain, Italy, (9) Bachman et al. (2010), op. cit.
Portugal, and Ireland) are suffering from

Volume 12 No 2 | 11
 Box I.2: The impact of uncertainty on productive investment

Based on the neo-classical framework of investment (Jorgenson, 1971), an investment equation is estimated
in an error correction framework. The long-term equilibrium is identified as a co-integrating equation that
relates productive investment to traditional long-term determinants, such as the cost of capital, to which
variables that express the financial position of the corporate sector are added. The short-term dynamic
equation links changes in investment to its own lags, lagged changes in GDP, lagged changes in the cost of
capital, (1) lagged changes in the ratio of equity liabilities to total liabilities, lagged deviation of investment
from its long-term value (the error correction term) and lagged changes in several economic activity and
policy uncertainty indicators. The estimation methodology was originally proposed by Stock and Watson
(1993) and extended to a panel context by Kao and Chiang (2000). The analysis includes nine euro-area
Member States during the period 1996 q2 - 2011 q4. Cyprus, Estonia, Greece, Ireland, Luxembourg, Malta,
Slovenia and Slovakia were not included in the panel due to data availability problems.

Results

In the long term, the volume of productive investment is determined by real GDP, the real cost of capital
and a measure of the corporate sector financial position calculated as the ratio of equity liabilities to total
liabilities. The latter variable gives an indirect measure of the external financing premium attached to the
corporate sector. The higher the ratio, the lower the external financing premium should be. The long-term
elasticities are shown in the table below for the period 1996 q2 - 2007 q4, for which investment seems to be
explained by its long-term determinants, as estimated in the co-integrating equation. In the long term, a 1 %
increase in the cost of capital will lead to a decrease in investment of 0.6%, while a 1% decrease in the ratio
of equity liabilities to total liabilities will dampen investment by 0.15%. From 2008 q1 to 2011 q4, a
structural break in the long-term relationship disconnects investment levels from its long run fundamentals.

Productive investment Real GDP Real cost of capital Equity liabilities/Total liabilities

Long run elasticities 1 -1,16 0,64 -0,15

Note: The variables are all non-stationary. Group tests for the null of co-interation were performed. The real cost of capital is
calculated as log(1+real cost of capital). All variables are in logs. The model was estimated by DOLS. All estimated coefficients are
significant at 1%.

Short-term elasticity is illustrated in the table below. Columns (1) and (2) show the estimates for the period
1996 q4 - 2007 q4, for which the long-term investment equilibrium is given by the co-integrating relation.
Columns (3) to (5) show the estimates for the period 1996 q4 - 2011 q4, using for the deviations from the
long-term equilibrium for the period 2008 q1 - 2011 q4 theoretical model-based estimates of the error
correction term (ECT). The ECT is also interacted with a time dummy for periods after 2008 to account for
the structural break. Column (4) gives the estimates when both activity uncertainty and policy uncertainty are
taken into account. Column (5) gives the estimates when the BCS balance is used to account for the cycle.

Variable 1 2 3 4 5

Error correction term (t-1) -0.1309*** -0.1548*** -0.1015*** -0.1169*** -0.1011***

2008 Dummy*Error correction term (t-1) 0.0201 0.0313 0.017

Changes in productive investment (t-2) 0.2607*** 0.2593*** 0.1283*** 0.1322*** 0.1108**

Changes inr real GDP (t-1) 0.6252*** 0.4770** 0.9154*** 0.8275*** 0.8172***

Changes in equity/total liabilities (t-1) 0.1854*** 0.1998*** 0.1487** 0.1672*** 0.1245**

Changes in the BCS industry uncertainty indicator (t-2) -0.0016 -0.0012 -0.0028*** -0.0027*** -0.0026***

Policy uncertainty based on Stanford indicator (t-1) -0.0124** -0.0184***

BCS balance (Q5) (t-1) 0.0002**

2008 Dummy -0.0117*** -0.0117*** -0.0114***

Note: ***, ** and * denote respectively statistical significance at 1, 5 and 10%.

(1) For details on the construction of the real cost of capital variable, see ‘Prospects for non-residential investment in the euro area,
Box 8: The real cost of capital’, in Quarterly Report on the Euro Area (2008), Vol.7, No 4.

(Continued on the next page)

12 | Quarterly Report on the Euro Area

 I. Assessing the impact of uncertainty on consumption and investment

Box (continued)

The estimated parameters in the short-term dynamics bring several interesting results for the period
considered:

• For the pre-crisis period, 1996q4 - 2007 q4 (Column (1) and (2)), when investment deviates from its
long-term determinants, the ECT term brings the system back to the long-term equilibrium from
the following quarter (i.e. the estimate on the ECT is significant at 1 %). Normal time economic
activity uncertainty over the cycle has no impact on the short-term dynamics when investment is
determined by fundamentals (i.e. the estimate on the BCS uncertainty indicator in industry is
insignificant, Columns (1) and (2)). However, policy uncertainty is negatively correlated with
investment growth (Column (2)).

• During the crisis period, 2008 q1 - 2011 q4 (Columns (3) to (5)), investment is no longer given by its
long-term determinants, the long-run relationship displaying a structural break. For this period, the
long-term determinants of investment do not matter for the short-term investment dynamics (i.e.
the estimate on the ECT interacted with the 2008 time dummy is insignificant). However, the
impact of the uncertainty indicators increases. The BCS indicator in industry become significant in
the short term (Columns (3) and (5)), while the impact of policy uncertainty increases (Column (4)).
During the crisis period, both the economic activity and the policy uncertainty indicator are
negatively correlated with investment growth.

References

Jorgenson, D. (1971). ‘Econometric Studies of Investment Behaviour: A Review’, Journal of Economic

Literature 9, No. 4: pp. 1111-1147.
Kao, C. and M.H. Chiang (2000), ‘On the estimation and inference of a co-integrated regression in panel
data’, in Baltagi B. (ed.), ‘Non-stationary panels, panel co-integration, and dynamic panels’, Advances in
Econometrics, Vol.15, Amsterdam: JAI Press, pp. 179-222.
Stock, J. and M. Watson (1993), ‘A simple estimator of co-integrating vectors in higher order integrated
systems’, Econometrica, 61(4), pp. 783-820.

A less-explored channel has been the impact of become more reluctant to hire when the policy
uncertainty on consumer spending. The theoretical environment becomes more uncertain.
impact of uncertainty on consumer spending is also
based on the principle that, when purchases of The approach followed in this focus section
durable goods such as homes are costly to revert, bypasses some of the shortcomings of using VAR
households respond to increases in uncertainty (e.g. models. A drawback of VAR models is that they
over their future income or taxes) by reducing their may omit important explanatory variables and may
consumption of durable goods below their normal therefore overestimate the impact of uncertainty on
levels. However, empirical research by Knotek and economic activity.
Khan concludes that changes in uncertainty
account for only a small part of the total By using fully-specified consumption and
fluctuations in household spending. ( 10) Another investment equations, the bias due to omitted
channel through with uncertainty can impact variables is likely to be reduced significantly.
consumer expenditure is through employment: Another advantage of the current approach is that
Arpaia and Turrini ( 11) find that changes in policy it estimates uncertainty using country-specific
uncertainty make the unemployment rate more measures of uncertainty, allowing to better match
responsive to changes in output as employers country-specific conditions. Finally, most of the
empirical work so far has estimated the impact of
uncertainty on either investment or consumption
in isolation. In this focus section, the impact of
(10) Knotek, E.S. and S. Khan (2011), op. cit. uncertainty is estimated for both industry and
(11) Arpaia, A. and A. Turrini (2013), ‘Policy-related uncertainty and
the euro-zone labour market’; ECFIN Economic Brief Issue 24, consumers.
European Commission.

Volume 12 No 2 | 13
 Box I.3: The impact of uncertainty on private consumption

This box presents an assessment of the impact of uncertainty on private consumption based on an estimated
consumption model. The model is an error correction model composed of a medium-term co-integrating
equation and a short-term equation. It is estimated for a panel of eight euro-area countries (DE, EL, ES, FR,
IT, AT, PT, FI) over the period 1999 Q1 to 2012 Q4. The choice of the countries and relatively short time
sample were dictated by data availability.

The medium-term co-integrating equation relates consumption to its traditional determinants: disposable
income, net financial wealth and house prices (all in real terms). To capture the effect of credit constraints
on consumption, it also includes the ratio of household credit to house prices. The ratio is assumed to be
correlated with banks’ loan-to-value ratios, meaning that an increase can be interpreted as an easing of credit
constraints, which should have a positive impact on consumption. This is in line with recent research
showing that, for the euro area as a whole, households’ savings and mortgage demand can be modelled
jointly as a system of two co-integrating relationships and that the ratio of mortgage to household wealth is
then a meaningful component of the savings co-integrating relationship (Balta and Ruscher (2012)). The
medium-term relationship is estimated with dynamic OLS (including a time trend). The results are presented
in the table below.

Real consumption Real disp income Real net foreign assets Real house prices Ratio of credit to house prices
Coefficient 1 -0.1950*** -0.0436*** -0.2195*** -0.1702***
Note: All variables are in logs. The model was estimated by DOLS. All estimated coefficients are significant at 1%.

The next table shows a number of variants of the short-term equation relating consumption to the same
determinants as in the medium-term equation (all in first differences) and the error correction terms from
the medium-term equation. The real long-term interest rate is an additional regressor entered in levels as
tests indicate that the variable is stationary. The equation allows testing the impact of three measures of
uncertainty: two indicators based on consumer survey data and the policy uncertainty indicator constructed
by Baker et al. The survey-based indicators are stationary and can therefore be tested in levels. However, the
policy uncertainty indicator is not stationary, and therefore enters the equation in first differences.

Variable 1 2 3 4 5
Cointegrating equation residual (-1) -0.2883*** -0.2878*** -0.2803*** -0.3475*** -0.3195***

∆log_net foreign assets (-1) -0.0851*** -0.0858*** -0.0774*** -0.0563*** -0.0980***

∆log_credit / house prices (-1) -0.1250*** -0.1242*** -0.1275*** -0.0375* -0.0568

∆log_real house prices (-2) -0.1230*** -0.1219*** -0.1239*** -0.0283 -0.0496

Long-term interest rate (-1) -0.0011*** -0.0011*** -0.0011*** -0.0008** -0.0009***

Consumer uncertainty Q2 (-2) -0.0020*** -0.0020*** -0.0019*** -0.0010** -0.0011**

Consumer uncertainty Q4 (-2) -0.0001

∆Stanford indicator (-1) -0.0001**

BCS balance consumer Q2 (-1) -0.0005***

Crisis dummy * Cons.uncertainty Q2 (-2) -0.0026***

Crisis dummy -0.0047***

Note: ***, ** and * denote respectively statistical significance at 1, 5 and 10%.

Results show that the regression coefficient of the uncertainty indicator based on the Q2 question of the
consumer survey (consumers' expected financial situation) is meaningful and negative, i.e. consumer uncertainty
has a negative impact on consumption (column 1). The uncertainty indicator based on the Q4 question
(consumers' expectations regarding the general economic situation) is also statistically significant but its impact is less
strong and becomes statistically insignificant when estimated jointly with the other consumer indicator
(Col 2). Adding the policy uncertainty indicator does not alter significantly the results obtained for the
survey based indicator Q2 (column 3). The two uncertainty indicators are negatively and meaningfully
correlated with consumption although the survey indicator shows some lead relative to the policy one as the
former is lagged by two quarters and the latter by only one quarter. As the policy indicator enters the
(Continued on the next page)

14 | Quarterly Report on the Euro Area

 I. Assessing the impact of uncertainty on consumption and investment

Box (continued)

equation in first differences, it appears to have a less persistent effect than the survey indicator. The survey
indicator of uncertainty also remains significant when the simple balances to the corresponding survey
question (Q2) come into the equation (column 4). This suggests that the measure of uncertainty derived
from the consumer survey adds information to traditional consumer confidence indicators. The same applies
when the more general indicator of consumer confidence is used (not shown in the table). Finally, tests with
a crisis dummy (set to 1 since 2009) indicate that the effect of uncertainty on consumption may have
increased since the crisis (column 5). This suggests that consumers may now be more sensitive to
uncertainty, which may reflect negative interactions between uncertainty and credit constraints: increases in
uncertainty may be more difficult to cope with when credit constraints are more binding.

Overall, the Q2 survey indicator of uncertainty appears to be better correlated with consumption than the
policy indicator, once the long-term determinants of consumption have been taken into account. On the
basis of this indicator, uncertainty appears to have a substantial impact on private consumption. In countries
such as Spain, Italy, France or Portugal, where uncertainty appears particularly high at the current juncture, a
return of uncertainty to its pre-crisis long-term average could boost consumption by 1.5-2.0 % over 18
months. The effect could be even stronger (2.0-3.0%) if consumers' apparently stronger sensitivity to
uncertainty since the crisis is taken into account.

Reference:

Balta, N. and E. Ruscher (2012), ‘Household savings and mortgage decisions: the role of the ‘down-payment
channel’ in the euro area’, European Economy, Economic Papers, No. 445, September.

I.4.1. Assessing the impact of uncertainty on increase of by between 2 and 3 % over six quarters
investment and consumption in those countries where uncertainty is
exceptionally high (i.e. in Spain, France, Italy, and
The BCS and Policy Uncertainty indicators are Portugal).
tested in fully specified investment and
consumption models using panel estimations of Although the magnitude of the effects are not
Error Correction Models (ECM) — see further directly comparable (the consumption and
explanations in Box I.2 for the investment equation investment equations have different dynamics
and Box I.3 for the consumer equations. specification), the results indicate that uncertainty
can have a significant effect on consumption too.
The investment model has the following medium- This is a relatively new finding, given that most
term explanatory variables: GDP, the real cost of research on uncertainty has focused on its impact
capital, and a balance sheet variable (equity / total on investment and has to a large extent neglected
liabilities in the non-financial corporation sector). the consumption channel. It is worth stressing that
For the consumption model, the medium-term there is no reason a-priori to assume that
determinants are disposable income, net financial investment should be more affected than
wealth, house prices, and household credit to consumption. If anything, it could be expected that
house prices (to capture the effect of credit firms are better at managing uncertainty than
constraints on consumption). consumers, as they have more tools at their
disposal to reduce their risk exposure and see
The BCS and the Policy Uncertainty indicators are through uncertainty (hedging techniques, analytical
tested in the short-term dynamics of the capacity etc.).
consumption and investment equations. The main
findings of the exercise are: Result 2: The effect of uncertainty on activity
goes beyond traditional cyclical effects. To
Result 1: Uncertainty has a significant effect on account for variations in the business cycle, the
both investment and consumption. If traditional balances of responses to the BCS
uncertainty was to return to its average pre-crisis consumer and industry surveys (i.e. the traditional
levels, investment would increase upon impact by BCS sentiment indicators) were tested alongside
1.4 %. For a similar decrease in uncertainty, the uncertainty indicators. When confidence
consumption would experience a cumulative indicators are included in the estimations,

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uncertainty indicators remain statistically uncertainty are likely to have been captured by
significant, suggesting that uncertainty has an other explanatory variables, such as interest rates or
impact on economic activity, even when correcting consumer wealth through increased risk-premia.
for the business cycle. Obviously, this analysis ignores possible second-
round ‘Keynesian’ effects, as uncertainty may
Result 3: The effect of uncertainty has depress investment and thereby economic activity,
increased since the crisis. Both the BCS industry disposable income and consumption.
and the Policy Uncertainty Indicator are statistically
significant and negatively correlated with I.5. Conclusion
investment, once the determinants of investment
are taken into account. However, the effect of Although financial market uncertainty has abated
uncertainty increases in the post-crisis period. For significantly in recent months, other forms of
consumption, both the BCS consumer and the macroeconomic uncertainty remain high. Measures
Policy Uncertainty indicators are also statistically of policy uncertainty or measures of divergence in
significant and negatively correlated with consumers’ and firms’ expectations have shown
consumption once the determinants of sharp rises since the beginning of the crisis. They
consumption are included. As for industry, the remain close to historical highs and have so far
detrimental effect of uncertainty on consumption shown only limited signs of improvement. Some
has increased since the crisis. uncertainty indicators point to particularly high
uncertainty in peripheral countries, but also in
Result 4: The BCS consumer indicator appears some other Member States such as France.
to be a more robust measure of uncertainty
affecting consumption decisions than its The econometric analysis presented in this focus
industry counterpart is for investment. ( 12) section indicates that uncertainty is hindering
economic activity significantly in the euro area, and
The BCS consumer uncertainty indicator having a negative effect on both consumption and
outperforms the Policy Uncertainty Indicator for investment spending.
consumption, but the industry indicator appears
less significant for investment than the policy The impact of uncertainty on economic activity has
indicator. increased significantly since the financial crisis.
Although further research is needed to understand
There are several reasons that could explain why, the causes of this change, possible explanations
by construction, the BCS consumer indicator could include credit constraints and balance sheet effects
be a more robust measure of uncertainty than the as well as non-linear effects of uncertainty on
BCS industry indicator. First, whereas companies activity.
are asked about their production expectations in
the next 3 months, households are asked about Overall, the policy measures taken both at the euro
their financial situation in the next 12 months, and area/ EU and the Member State level to improve
it is likely that a longer time horizon yields a more the governance of EMU, address perceived
robust assessment of uncertainty in expectations. redenomination risks and reform Member Sates’
Second, responses to survey questions can fall into economies have helped to reduce uncertainty on
five categories for consumers against only three for financial markets substantially. However, for
industry. This higher granularity is likely to make businesses and households, uncertainty remains
the consumer indicator more responsive to unusually high, which calls for policy action to
changes in economic conditions. make the road ahead more predictable.

Overall, the econometric analysis shows that

uncertainty can have a meaningful effect on both
consumption and investment decisions. It is worth
stressing, however, that this effect is probably
underestimated since some of the effects of

(12) Further work needs to be undertaken to understand the reasons

behind this discrepancy.

16 | Quarterly Report on the Euro Area