Economists are the butt of much mirth about their forecasting ability, but the recent performance may be getting beyond a joke. Failing to predict the precise outcome is one thing: being consistently wrong in the same direction is harder to explain, and very unhelpful for the policy-making process. Here's what Robert Skidelsky (John Keynes' biographer) has to say:
"In its 2011 forecast, the International Monetary Fund predicted that the European economy would grow by 2.1 per cent in 2012. In fact, it looks certain to shrink this year by 0.2 per cent. In the United Kingdom, the 2010 forecast of the Office for Budget Responsibility projected 2.6 per cent growth in 2011 and 2.8 per cent growth in 2012; in fact, the UK economy grew by 0.9 per cent in 2011 and will flat-line in 2012. The OECD's latest forecast for eurozone GDP in 2012 is 2.3 per cent lower than its projection in 2010. Likewise, the IMF now predicts that the European economy will be 7.8 per cent smaller in 2015 than it thought just two years ago."
All the international agencies (the Bank for International Settlements, as well as the IMF and the OECD) were too optimistic in predicting where we would now be, and it wasn't just the European stagnation they got wrong: the fund's US forecast for 2012 was a full percentage point too high. Without the spanking pace of growth in the emerging countries, the world would be barely growing.
Skidelsky lays the blame on two policy misunderstandings. The first involves fiscal policy. At around the time these forecasts were made, economists were still arguing among themselves about the effect of fiscal contraction: whether it would be positive or negative.
Some (a minority, but with loud voices) argued that fiscal contraction would boost private sector confidence so much that the effect would be expansionary. Others dismissed this counter-intuitive 'confidence fairy' view, but forecasters must have been subliminally influenced, as they now accept that they drastically underestimated just how contractionary the fiscal consolidation would be. Even though the IMF agreed it had got this wrong, the debate continues.
The second mistake identified by Skidelsky was thinking that expansionary monetary policy was still powerful, even when interest rates had reached zero. While interest rates at zero should still help the economy, the greater mistake was to overestimate the power of quantitative easing.
The IMF's formal revision of its fiscal multipliers may reflect another problem: the over-reliance on model-based forecasts. When the shell-shocked Goldman Sachs chief financial officer complained, during the 2008 financial meltdown, that he had just seen 25 standard-deviation changes in asset prices, three days in a row, this was not to be interpreted literally as an event which would happen only once in many multiple life-times of the universe. The proper translation of his comment is 'the risk model was hopelessly wrong'.
This possibility, rather than a simple parameter mistake, might be relevant for the IMF's forecasts as well. The real world is far more complex than the models.
It might also be argued that the uniformly downward revisions were a reflection of globalisation: when a critical mass of countries slows, everyone slows because they are so interconnected. In fact this doesn't seem to have been a strong factor: the emerging countries have done remarkably well, with China sailing along at its 'new normal' pace of 7-8 per cent, despite predictions of near-stagnation.
Another possibility is over-confidence in the self-equilibrating forces that usually help an economy to return to normal growth after it is hit by a shock. But this heuristic is a weak short-term forecasting tool, with these self-equilibrating forces battling the headwinds of politically-constrained policy-making and (related to this) subdued confidence among businesses and households.
There were probably other problems too, more intrinsic to the politics of the forecasting process itself. In Europe, the US and the UK, the heavy official debt build-up has made policy makers reluctant to add to the debt through fiscal expansion. The UK, in particular, embarked on a 'courageous' debt consolidation budgetary tightening strategy. When policy makers need to take tough but necessary measures that they know will crimp growth, they feel the need to bolster the case for these policies with a growth forecast which is at the upper end of the credible range. Why give opponents ammunition by producing a dismal forecast? It will just provoke them to argue that if policy is going to produce such an unhappy outcome, then policy ought to be changed.
Why should this last bias apply to the supposedly independent IMF, OECD and BIS? In practice, they find it hard to differ much from official forecasts, especially in the pessimistic direction. They don't want to be accused of 'talking the economy down'.
With the Greek debt can kicked down the road and the US fiscal cliff averted, financial markets have regained some composure. This will be reflected in forecasts for the year ahead. But confidence – the elusive animal spirits which drive the economy – will be weighed down by the political intractability of underlying economic problems (unsustainable debt in Europe and medium-term fiscal problems in the US). Reversion to normal rates of growth still seems some way off in most advanced countries.
Originally published by the Lowy Institute publication The Interpreter. Reproduced with permission.
Why forecasting has broken down
Predictions about the global recovery have been proven woefully incorrect due to misunderstandings of both fiscal policy and the power of expansionary monetary policy.