Points of view – the ‘value’ of macroeconomic forecasting

By Nick Kirrage.

Regular visitors to this blog and Kevin Murphy’s will know we are not universally complimentary about macroeconomic forecasts, but we are hardly alone in this. After all we did not come up with the line: “Economists have correctly predicted nine of the last five recessions”, we just happen to think it’s quite appropriate.

Another one that is not ours is “the function of economic forecasting is to make astrology look respectable”. At this time of year, however, when practitioners of both arts are at their most productive, it may be instructive to consider the real function of economic forecasts – although the point of astrology we will leave to others to dissect.

Economics is an unusual discipline in that economists are seldom wrong. That is because, by the time whatever happens actually happens, the writing on the wall means they will have revised their forecasts to take that into account. That, of course, is like corporate analysts claiming they correctly predicted a business’s earnings when, three weeks before its results, management gently “guide” consensus towards a reasonable figure, seeking to avoid a positive or negative profit shock on the day of results.

However, in many ways, that is actually the point. A major function of economic forecasts – and this may come as a shock to a number of supporters, not to mention a few of the practitioners themselves – is not to predict the future but to act as a mechanism for informing people what is happening on a gradual basis.

Nobody wants to find out suddenly that the economy is in recession – just as no company wants to be seen suddenly to issue a large profits warning. In each case it is more preferable for expectations to be guided down over a period of time in order to allow people to grow more comfortable with the new situation and not to provoke panic.

Again, something similar occurs with ratings agencies. As we have seen more than once over the last 12 months, an economy or a government will not suddenly be downgraded but there will be talk about the possibility for months before even moving to “negative watch”. Once again, it is a way of allowing people gently to adjust their thinking to deal with a new reality.

Of course, it would be foolish to argue that economists stop making forecasts. In reality, everybody needs to plan for the future and it’s necessary to have a base case on which to plan, demanding some form of guess about the future. However, this needs to exist alongside the knowledge that whatever forecast is made will almost certainly be wrong and thus other scenarios, potentially extremely different to the central case, must also be considered.

Perhaps some readers will think I’m being overly harsh and they would highlight that several high profile forecasters have predicted major economic events in the past. The difficulty is that no one forecaster appears to have a monopoly on this and without the benefit of hindsight it’s very hard to work out who will be correct next time. Meanwhile the economist community as a whole has a woeful track record of getting it right, on average, with the difference between the consensus GDP forecast just prior to each of the last six recessions and the actual number during those recessions being more than three and a half percent – a simply enormous number in GDP terms. Despite this many investors will again be hanging on the predictions currently being made for the year ahead, which – to judge from history – might politely be described as a willing suspension of disbelief.

The 19th century US novelist William Gilmore Simms said it best when he observed: “I believe economists put decimal points in their forecasts to show they have a sense of humour.”

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