An independent professional's take on the latest news and trends in global financial markets

Forecasts be damned

If someone told you that the end of the world was coming tomorrow, and the day passed without incident, would you be inclined to believe the same person the next time they came out with a piece of radical advice? I doubt it.  Yet one of the wonders of markets and economics is how quickly even sensible investors will switch their assumptions about the future without missing a beat.

The latest example of this bizarre phenomenon was evident in the Chancellor’s Autumn Statement. The independent Office for Budget Responsibility, run by Robert Chote, a formidably bright former economist colleague of mine on The Independent, has drastically reduced its forecasts of future economic growth. They are radically different from the forecasts the same body presented just a few months ago. Yet by some magical process they are already being treated as gospel truth.

So for example the OBR is now forecasting that the Government will not be able to eliminate its  structural budget deficit until two years after the next general election, due in 2014 at the latest. Instead of saying “why should we believe this forecast any more than the last one?”, the media and politicians are uniting to debate the implications of the prediction that the Government will now have to borrow at least £100 billion more than was forecast six months ago.

That may be how it all turns out, but experience suggests that it is not at all likely. One of the most powerful findings in all social science is the inaccuracy of economic forecasts. Even one year out they are flaky. Five or six years into the future they are so unreliable as to be essentially worthless. There is a very low probability that the future beyond next year will be anything like the one which the OBR expects.

Of course you need some kind of framework when making decisions, and the process of producing a forecast is not without value. The creation of the OBR is an important step forward: it provides an important counterweight to the natural tendency of Governments to fudge the figures for political purposes. (The Greeks are by no means the only culprits). The integrity of my former colleague and his team of number-crunchers at the OBR is not in question.

But it doesn’t mean you have to believe every specific of  the forecasts he or any other serious forecaster presents you with. They are bound by the same constraints as every other forecaster. The truth – and the reason why nobody knows for certain how the Eurozone crisis will play out – is that the way economies behave is too complex and too multi-layered to be modelled with any confidence. It is dynamic, not linear. Outcomes are not pre-determined.

As the Governor of the Bank of England said when presenting his notably downbeat Financial Stability Report this week, we simply don’t know how Europe or the world economy will go from here. What we do know is that crises associated with excess debt take time to work through and there are plenty of bad potential outcomes. The fascinating  interplay of politics, elections and the real economy make the crisis in the Eurozone  an even harder than usual nut to analyse corrrectly.

Given all that has happened, it is understandable that official forecasters, whether at the Bank of England or the OBR, should now be erring on the side of gloom. My best guess as we all peer through the fog remains, s it has been for some time, that Europe is moving towards some kind of patched up solution that will cheer the markets for a while, and any sign of good news will lead to further equity market rallies like the one we saw earlier this week. But of course we are a long way from being out of the woods just yet.

Written by Jonathan Davis

December 3, 2011 at 11:30 AM