The Only Certainty Is Uncertainty

Accelerating flows of data, goods and capital increase the risks of macroeconomic shocks having a global impact, but time has not passed in vain and our ability to manage crises has improved over the years. When equilibria are suddenly altered, there is less damage now than before. “In a world characterized by uncertainty, the only certainty is that other economic shocks will occur in the future,” says Chiara Scotti, Bocconi alumna and Deputy Director General of the Bank of Italy. The key is to be prepared, while being careful not to overburden the regulatory framework.

What are macroeconomic shocks and why are they dangerous?
The first thought goes to unexpected events that have negative consequences for the economy, such as a sudden collapse of financial markets or a sharp increase in energy costs. However, the meaning is broader. Economists see the economic system as a set of relationships between production, income and aggregate demand tending towards an equilibrium. A shock is an unexpected event, positive or negative, that interferes with that equilibrium. All shocks entail adjustment costs, in terms of inflation, employment, the cost of money, and the quantity and quality of lending. Some shocks, such as financial crises, are more dangerous, due to the size of the adjustment costs and the prolonged duration of the effects on economic activity and employment.

How have they changed throughout history?
Shocks have always existed. Even trade and financial integration, potential vehicles for the transmission of shocks, are not new: Florentine bankers in the 14th century funded English sovereigns and Florence purchased wool from England. However, today we observe two elements of novelty: on the one hand, the speed, intensity and interconnection in the exchange of data, goods and capital have accelerated, heightening the transmission and potential impact of shocks; on the other hand, the ability of economic systems to react has improved, also thanks to more solid institutions, coordinated actions at the international level and more adequate fiscal and monetary policy interventions. For this reason, the financial crisis of 2008 and the recent energy crisis have been much less damaging and persistent than the Great Depression of the 1930s and the oil crisis of the 1970s.

In an uncertain international scenario, do they become more likely?
Uncertainty plays an important role in the economy. In recent decades, economic literature has shown how uncertainty, understood as an exogenous shock, can have macroeconomic consequences and, more recently, has also shown how uncertainty can be an endogenous response to macroeconomic conditions. In my research, I show how the effect of shocks is stronger in periods of high uncertainty. So it is not that shocks become more likely, but their impact is magnified. Estimates on American data show that after one year the drop in GDP in response to a financial shock is three times higher in conditions of uncertainty similar to those observed during the 2008 financial crisis, as compared to situations of low uncertainty.

What impact does technology have?
Technology can be the origin of economic shocks or amplify their transmission, for better or worse. Positive technological shocks lead to an increase in aggregate output and a reduction in costs, favoring economic growth. An important part of the economic literature has focused on the development of dynamic general equilibrium models in which the macroeconomic cycle can be explained on the basis of technological shocks. This is a research program that earned Kydland and Prescott the 2004 Nobel Prize in Economics. On the other hand, technology can be a source of vulnerability for the financial system, as in the case of cybersecurity risks, and can speed up the transmission of shocks and amplify their impact.

What have we learned from recent shocks such as the pandemic?
The 2020 pandemic was a radically different shock compared to those of financial or economic origin of the previous decade. Two key lessons for the future have emerged from this experience. The first is the importance of economic policy coordination, especially during crises: monetary and financial policy must each pursue their respective objectives with their own tools but, jointly, they can effectively counter the economic effects of dramatic shocks. The second lesson is that international collaboration, in research, information sharing and coordination of policy response, contributes to a more effective reaction to shocks and therefore to the wellbeing of our societies.

How do we learn to face the consequences of sudden events?
The key is to be prepared. In a world characterized by uncertainty, the only certainty is that other economic shocks are likely to occur. To minimize the impact, we must strengthen our economies during times of favorable conditions. In Italy, the strengthening of banks’ assets has allowed them to face the pandemic crisis in more solid conditions than during the global financial crisis or the European sovereign debt crisis. From this perspective, we need to resume and maintain the path of growth, which provides the resources necessary to build and strengthen effective defenses against future shocks.

However, excessive regulation also presents risks, what is the limit?
Adequate regulation and careful supervision are essential for the financial sector to mitigate rather than amplify shocks. An international regulatory framework based on principles of clarity, coherence and harmonization must be defined, to avoid arbitrage phenomena that in an interconnected world would end up hiding risks, rather than reducing them and promoting their management. Identifying the threshold beyond which regulation becomes excessive is a challenging task. We must be careful not to create a regulatory framework that is too complex and difficult to interpret, while ensuring, at the same time, that greater simplicity does not endanger financial stability, the correct functioning of markets and respect for people's rights.

You studied at Bocconi, what advice do you have for students who are delving into these issues?
Never stop studying and learning, be curious, explore the details but at the same time maintain a 360-degree vision, open your mind to other disciplines and diverse contexts, cultivate your professional and human curiosity, invest in relational skills. Macroeconomic phenomena need to be interpreted in a broader context, which includes history, international relations and technological innovation. And they must be managed by interacting with individuals from different backgrounds, and building positive and lasting relationships with them, based on a collaborative approach, never forgetting that at the center of economic policy there are and there will always be people.