Uncertainty and Irreversible Investments

Negative shocks also increase uncertainty, which is bad for business investment. Bad news usually also means uncertain news, as the arrival of the bad news causes people to rethink how the world works. For instance, when the 9/11 attacks hit the United States, uncertainty about the future increased. All of a sudden many people started worrying—rightly or wrongly—that subsequent terrorist attacks would be a big problem. The initial response was to hold off on business investment. Until it became clear that such attacks would not become regular occurrences, for instance, many investors were reluctant to fund new construction in New York City. When investors are uncertain, often they prefer to wait and sample more information before committing themselves.

Irreversible investments have high value only under specific conditions—they cannot be easily moved, adjusted, or reversed if conditions change.

The key idea here is that many investments involve sunk costs, that is, they are irreversible investments, or very costly to reverse. Once a new office building has been constructed on Wall Street, for example, it is difficult to tear down that building and redeploy the steel and glass to other economic uses. So, before investors build a new skyscraper, they will try to make sure that there will be a demand for the offices. Of course, investors sometimes get this wrong, just as commercial real estate overexpanded in the mid- to late 1980s, or too many homes were built in the years preceding the real estate crash of 2007. But prior to expansion, investors want to see many strong signals that market conditions will validate their plans.

One of the most irreversible investments of them all
TIM TADDER/CORBIS

The more uncertain the world appears, the harder it is for investors to receive definite signals about where to invest their resources. Investors may see that the demand to watch television programs is shrinking, as it has been for years, but investors do not know which new sectors will be expanding. Will all those extra TV-watching hours be replaced by time spent on Facebook, on Netflix, or by time spent outdoors? When investors wait to see what happens, that means resources are sitting idle rather than being productive. That means lower GDP and it contributes to the economic slowdown.

To see the logic of irreversible investment, consider the decision to marry. Marriage is a kind of investment and not just in the financial sense. It is making a commitment to the future and it is often for a very long period. Given the seriousness of this commitment, you ought to make (relatively) sure that your marriage is a good idea. If you receive some information causing you to doubt your potential partner (did someone hint he or she is a convicted felon?), maybe you should wait a while and discover the truth before proceeding. Of course, if you wait to decide on marriage, you may also wait to buy a house together, even if buying a house is a good idea. That’s just common sense. The point is that the same logic applies to economic investments. Uncertainty usually slows investment and keeps resources in less productive uses.