The Value of Certainty

Aug 28, 2011 by Adam C. Powell, Ph.D.

On August 9th, 2011, Ben Bernanke declared that he would maintain a zero interest rate policy for two years. While I am not sure whether 0% is the right interest rate to set, I think that he should be commended for reducing uncertainty. Uncertainty makes investments worth less.

According to expected utility theory, if a risk-averse individual picks an investment, he will be willing to accept less return from a certain investment than from an uncertainty investment. For instance, if given the choice between a 50% chance of making $50 and a 50% chance of making $100, and a certain investment, a risk-averse person would prefer a certain investment with a pay-off of less than $75 to the above gamble. When politicians introduce uncertainty into the market, even if they do not change the expected returns of investments, they diminish the value of investments if they widen the potential range of returns. Thus, when risk-averse decision makers evaluate potential investments, they are less appealing in an environment of greater uncertainty than in an environment of lower uncertainty.

One way that the government may be able to make investment (in pretty much anything) more appealing is to reduce uncertainty. Doing this would require making binding commitments to particular actions and perhaps a reduction in legislative activity. Under a more stagnant environment, firms and people could work towards optimizing their behavior towards the conditions of the market. Stability would facilitate participation in investments with longer pay-off horizons. Without arguing for particular political and economic policies, behavioral economics can be used to argue for more stable policies.