Pirrong uses options pricing theory to show why the Keynesians are missing the point of the regime uncertainty concept and why, even on their own terms, their arguments for disregarding regime uncertainty and simply pumping up aggregate demand are wrong.
To adapt a familiar saying: first they ignore you, then they ridicule you, then they embrace the idea and claim that they had it first. We are now passing through Stage II.
Although I am pleased that the concept of regime uncertainty has come to be recognized in some quarters as an important part of our understanding the economy’s operation, I continue to be disconcerted that many of those who speak of it, including some of those who speak favorably of it, fail to understand its full scope. As I understand regime uncertainty, it has to do with widespread inability to form confident expectations about future private property rights in all of their dimensions. Private property rights specify the property owner’s rights to decide how property will be used, to accrue income from its uses, and to transfer these rights to others in various voluntary arrangements. Because the content of private property rights is complex, threats to such rights can arise from many different sources, including actions by legislators, administrators, prosecutors, judges, juries, and others (e.g., sit-down strikers, mobs).
Because of the great variety of ways in which government officials can threaten private property rights, the security of such rights turns not only on law “on the books,” but also to an important degree on the character of the government officials who administer and enforce the law. An important reason why regime uncertainty arose in the latter half of the 1930s, for example, had to do with the character of the advisers who had the greatest access to President Franklin Roosevelt at that time—people such as Tom Corcoran, Ben Cohen, William O. Douglas, Felix Frankfurter, and others of their ilk. These people were known to hate businessmen and the private enterprise system; they believed in strict, pervasive regulation of the market system by—who would have guessed?—people such as themselves. So, as bad as the National Labor Relations Board was on paper, it was immensely worse (for employers) in practice. And so forth, across the full range of new regulatory powers created by New Deal legislation. In a similar way, the apparatchiki who run the federal regulatory leviathan today can only inspire apprehension on the part of investors and business executives. President Obama’s cadre of crony capitalists, which he drags out to show that “business is being fully considered,” in no way diminishes these worries.
Thus, regime uncertainty is a multifaceted and somewhat nuanced concept. Many economists don’t like it because it cannot be measured and compiled along with other standard macro variables in a convenient data base. But, as I have tried to show for fifteen years, various forms of empirical evidence can be and have been brought to bear to show that regime uncertainty is not simply a figment of the analyst’s imagination or an all-purpose club with which the Chamber of Commerce whacks the government’s every move to increase taxes or augment regulations. Anyone who actually manages a business or makes serious investment can readily understand the idea. Keynesian economists, who generally do not manage businesses or make serious investments, view the idea as merely something their ideological opponents toss out to obstruct the application of their “science” in policy making. It is good to have analysts such as Craig Pirrong showing that the Keynesian rejection of regime uncertainty has no firm foundation.