Scenarios: A valuable tool in an uncertain world

Every month, the Treasury publishes a summary of the forecasts of around 40 economists. In June 2010, their projections of growth in 2011 ranged from 1.2 to 3.2 per cent. By June 2011, the spread had more than halved to 1.0 to 1.9 per cent.

Is it right to believe that the outcome for 2011 had become so much more certain, even if almost half of the year in question was already in the bag? Forecasts and the models behind them are valuable when used properly. They force you to be explicit about your assumptions and about how you think parts of the economy relate to each other.

First, no matter how sophisticated they may appear, models are a simplification of reality yet they churn out precise answers. They tell us that growth will be, say, 1.7 per cent, not somewhere between 1.0 and 2.5 per cent. Secondly, models cannot cope with events that occur very rarely but can be hugely significant – the best recent example being the events of autumn 2008.

A very useful complement to the use of models is scenario planning, which has its roots in military tradition. One corporate pioneer of this approach was Royal Dutch Shell, which continues to devote much energy to this way of trying to understand the future. In the early days, scenario planning was an industry in its own right, seemingly demanding armies of planners and fit only for the largest corporates. Yet businesses of any size can develop their own scenarios.

To start, think about the timescale over which you wish to plan. Next, identify the underlying trends in the world around you. Trends should be features that you are very confident will apply pretty well regardless of how the rest of the world evolves. Concerns about climate change seem a good example of this. Having identified trends, think about the most important uncertainties in your world. For an economist, one of those is how the eurozone and the US will manage their sovereign debt problems. How many countries will default? How will it happen and when? It is not difficult to identify uncertainties about exchange rates, interest rates, unemployment and a host of other factors.

Next, figure out a plausible range of variables for each of your uncertainties over your chosen time period. The bank rate sits at 0.5 per cent today but has been well into double figures in living memory. A range of 0.5 to 7.5 per cent over the next five years seems plausible, even if the top end is unlikely.

Decide the top two uncertainties, which, when combined, produce distinctly different but feasible worlds. If those uncertainties are how sovereign debt is managed and whether emerging markets can grow sustainably, the outcomes might be: (a) an orderly resolution of debt problems and sustainable growth; (b) a disorderly resolution of the problems and sustainable growth; (c) an orderly resolution and inflationary growth; or (d) disorderly resolution and inflationary growth.

Think hard about what each world would entail. The first might involve a steady recovery in global growth, with moderate inflation and falling unemployment in the UK, rising exports to a growing eurozone and emerging markets. Contrast that with the third option with its higher inflation, rising UK interest rates, slower growth and a generally weaker world economy.

Now judge how likely it is that each one of these worlds will happen, and how your business would be affected if it did, and decide the steps you would need to take to benefit from that set of events or to mitigate its effects.

Scenarios don’t dispel uncertainty. But in an uncertain world, they may help you to prepare better than would a spuriously accurate conventional forecast. Try it.

Stephen Boyle is head of RBS group economics. For more information, videos and advice for SMEs, visit www.freshbusinessthinking.com