Cracks in the Crystal Ball


It is a conventional joke that economic forecasters always disagree, and that there are as many different opinions about the future of the economy as there are economists.

The truth is quite the opposite. Economic forecasters do not speak with discordant voices; they all say more or less the same thing at the same time. And what they say is almost always wrong. The differences between forecasts are trivial relative to the differences between all forecasts and what happens.

This assessment is based on an analysis by the London Economics consultancy of the performance since 1987 of 34 UK groups – including all the most quoted forecasters. The predictions used are the latest made, so that the forecast selected from each group for 1990 is the last one made by the group in 1989.

Take their forecasts of growth in the UK economy in 1994, for example. The best estimates were made by Professor Patrick Minford of Liverpool university and Business Strategies, a commercial forecasting company. Both predicted that gross domestic product would grow by 3.3%; in fact it grew by about 4%.

The most accurate forecasts were also the highest. Of the 34 predictions analysed, every one was substantially below the outcome. In fact, almost all were between 2% and 3%.

Perhaps 1994 was a bad year for forecasters, if not for the economy. It was not an untypical year, however. The same thing happened in 1993, when growth was 2%. One forecasting group – the National Institute for Economic and Social Research – was spot on. Every other forecaster was below the outcome.

Perhaps forecasters are by nature pessimistic. But they were not in 1992, when the economy shrank. That outcome was worse than anyone had predicted. And the same was true in 1991. As the table shows, the outcome in all four years from 1991 to 1994 fell outside the range of all the estimates made.

It was dissatisfaction with the outcome of forecasts, and particularly his own, that led the chancellor in 1992 to establish his panel of independent economic forecasters – the so-called ‘wise men’. He need not have bothered. In the two following years, the average forecast from the wise men has been exactly the same as the Treasury’s own, and almost the same as the average of all forecasters.

The degree of agreement among the forecasts is astounding. It is just the economy that is different.

And forecasters do no better with other economic variables. For example, virtually all of them overestimated inflation in 1993 and last year – and almost all underestimated it in 1991.

The predictions were close to outcome only in 1992 – oddly enough, the most dramatic year of the four, the one in which the UK was forced out of the European exchange rate mechanism. Even a stopped clock is right sometimes.

Nor have the past four years been worse than usual for the forecasting profession. They did no better in the 1980s, and although 1995 is only two-thirds over, it already looks likely that the consensus will be too high on both inflation and growth.

It is clear from the analysis that there is a consensus forecast, which most forecasters cluster around – to such a degree that it is barely worth distinguishing between one estimate and another. Yet the consensus forecast failed to predict any of the most important developments in the economy over the past seven years – the strength and resilience of the 1980s consumer spending boom, the depth and persistence of the 1990s recession, or the dramatic and continuing decline in inflation since 1991.

There are several reasons for this clustering around a consensus. Some forecasts – such as those of the Treasury, the National Institute and London Business School – are based on elaborate econometric models of the economy. But many City and business forecasts are based only on an assessment of the opinions and predictions of others. So it is not surprising that they are not far apart.

And it is always safer to be wrong in a crowd. It is striking that the City and business forecasters, whose jobs may be on the line, rarely stray far from the consensus. It is also striking that academic forecasters are more often further from the consensus than their City colleagues. Prof Minford and Professor Wynne Godley of Cambridge university are right no more often than other forecasters, but they are more likely to be different from other people. Thus Prof Minford’s growth estimate was the most accurate in 1990 and 1994, but the worst of all in 1992.

Even when they are proved wrong, forecasters see it as important to maintain the consensus in retrospect. For example, banks maintain as an article of faith that the depth of the recent recession and the magnitude of the property market collapse could not have been predicted. If it could have been, those responsible for the lending excesses of the 1980s would be guilty of gross negligence rather than helpless victims of events.

Mr Tim Congdon, whose maverick predictions for Shearson Lehman anticipated the events of the last boom and recession better than anyone else, parted company from the investment bank just as events began to prove him right. In large organisations, it is often more important to be wrong for the right reasons than to be correct.

But another reason for the near identity in all the main forecasts can be found by looking more carefully at the figures in the tables. The consensus forecast is easy to calculate, since it can be derived by taking the average of the present and the past.

Since inflation and interest rates are now at historically low levels, the consensus is that they will rise. Growth is pretty much in line with its historic average and that is why most forecasters think that it will stay there.

Many so-called forecasters derive their predictions in this way, and if they use the same principle and the same method it is no surprise that they come up with the same answer. What is less obvious is that the Treasury model, and other systems like it, have the same property. In the absence of external shocks, or after them, they revert quickly to the long-run trend.

Economic forecasters know little about what they are forecasting, so there are worse rules of thumb than expecting that the future will be like the past. However, it is difficult to see why anyone should command the deference accorded to the chancellor’s wise men or the salaries paid to City economists for enunciating this principle.

Yet the fundamental weakness of the approach is that it is incapable of identifying structural changes in the economy. Changes in asset prices played a role in the boom of the 1980s and recession of the 1990s which had not been seen in previous economic cycles. It was that phenomenon which the consensus forecast almost entirely missed.

And the most important current economic policy issue is whether a combination of changes in inflation expectations and deregulation has finally brought to an end the 50-year age of rising prices. The consensus forecast, which predicts that inflation will rise because in the past it always has, sheds no light on the matter.

There are, in fact, good reasons why reliable economic forecasts are impossible for more than a short period ahead (see below). In spite of that, they continue to be made, just as astrologers and quack doctors stay in business.

The hope that what they say might be true overrides scepticism. And despite the low opinion which both politicians and business people profess for economic forecasts, they continue to listen to them with extraordinary credulousness.

Yet once we realise the limitations of our knowledge, there is much that can more sensibly be said. The fall in inflation, and the revival of manufacturing – two current structural changes – have wide-ranging effects on business and finance, and economic analysis can illuminate what they are.

But when someone tells you what inflation will be in the third quarter of next year, or predicts the growth of manufacturing output in 1997, do not listen. He does not know.

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