Message to forecasters: Don’t assume that the future will turn out like the past

In no previous election has there been falling real wages and public sector job cuts

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The Independent Online

The distinguished Harvard economist John Kenneth Galbraith once famously quipped that “The only function of economic forecasting is to make astrology look respectable.” It was bad enough that economic forecasters collectively failed to spot the greatest recession in a hundred years, but even more worrying is that they seem to have learnt little since.

The Bank of England’s Monetary Policy Committee has been especially bad, predicting rapid recovery that never happened in all 20 of its quarterly forecasts since it failed to spot the recession in August 2008, despite the fact that the recession had started in April 2008. The MPC’s inflation forecasts have been equally bad. Hopeless.

Astonishingly, the people in charge of forecasting at the Bank of England today are the same ones who failed to spot the recession in the first place, including the chief economist, Spencer Dale, and Deputy Governor for Monetary Policy, Charlie Bean, who retires next June. A big issue will be who replaces him. Let’s hope the Governor has a high flyer from the Bank of Canada or the Fed he can purloin, or that the imaginative Andy Haldane has built bridges with his new boss.

The Organisation for Economic Co-operation and Development this week in its November 2013 Economic Outlook upped its forecast for fourth-quarter GDP growth in the UK to 2.6 per cent in 2013; 2.0 per cent in 2014; and 2.8 per cent in 2015. The latest growth forecast published by the MPC last week is even more optimistic than that, suggesting growth of over 3 per cent in the first two quarters of 2014 and around 2.5 per cent per annum through 2016. The MPC is even predicting a greater than 10 per cent chance of growth of as much as 5 per cent by 2015. 

As a guide to how overly optimistic the MPC’s growth forecasts have been in the past, the chart on the right compares the forecast made in November 2010 with the observed outcomes. It needs a little explaining: the red line is what actually occurred, while the grey band is the fan chart representing the MPC forecast.

The darkest grey part, being the central projection, suggests that just as they are forecasting now, they guessed growth would be around 3 per cent for the following  three years. The red line shows how disastrously wrong they were: instead of the rising growth they projected, growth fell; growth at the end of 2012 was at the bottom of the fan at zero, rather than anywhere near to the laughable 6 per cent they said was possible. To the left of the vertical dotted line is the backcast, which is also measured with error because data gets revised for years.

The dark “latest vintage” line is where the data estimates are now.

The red line to the left of the vertical line shows the MPC was expecting past data to be revised upwards, which to some degree did happen. It should be said that the Office for Budget Responsibility (OBR) was similarly overly optimistic about growth. In June 2010 it forecast growth of 1.2 per cent (1.7 per cent) in 2010; 2.3 per cent (1.1 per cent) in 2011; and 2.8 per cent (0.1 per cent) in 2012, so over the last two full years GDP growth was less than a quarter of what the OBR predicted.

Patterns in the data prior to the recession seem to not predict well after it. So what went wrong? The answer is that forecasters mechanically assumed that what had happened in previous recessions would happen once again, a decline would be followed by a rapid pick-up in growth, which hasn’t happened, in part because banks are not lending, especially to small firms, and the Government has engaged in austerity.

We have never seen anything like this before, with interest rates at the zero nominal bound and steadily falling real wages.

Keynes did warn about the “long dragging conditions of semi-slump”. This brings me to the second chart, which plots Labour’s lead over the Tories in the 1,286 polls that have been taken since the formation of the Coalition, starting on 20 May 2010 – a negative number implies a Tory lead.

There are five parts. The first shows a Tory lead, which steadily diminishes through the beginning of 2011. The second part is a fall in that lead through the end of 2011 when the Tories hold a lead from October through the end of January. The third stage is a Labour pick-up, with them holding a lead of around 10 points through to the end of the year. The fourth stage is a fall in the Labour lead, and then the final stage is a pick-up in Labour’s lead since the end of August 2013.

 Since the beginning of November the lead has averaged 7 points; based on the averages from the 25 November polls, assuming a uniform swing and using swing calculator, this implies an outright Labour majority of 86 seats, made up as follows: Tories 31.9 per cent (234); Labour 38.92 per cent (368); Lib Dems 9.96 per cent (23); others 19.24 per cent (7); and Northern Ireland (18).

The Tory spin machine has suggested that this lead isn’t big enough to win based on the narrowing in the polls that occurred in past elections. The commentators John Rentoul and Dan Hodges and the Tory spin machine have gone so far as to declare victory for David Cameron.

The Government is so bad it should be much further behind in the polls.

But not so fast: why should what happened in a different era have any predictive power; in all likelihood it has nil, just as it has had none in recent economic forecasts.

We have never had an election when there was a coalition government in office, UKIP or the possibility of a referendum to leave the EU. Plus in no previous elections has there been falling real wages, public sector job cuts and pay freezes and little or no growth for years. Recall that the field of international relations failed to spot the fall of the Berlin Wall.

Ladbrokes and Paddy Power rightly both have Labour as strong favourites. The best estimate we have right now is that Labour will win in 2015 with an outright majority of 86…! Beware of out-of-sample predictions. The two Eds will be pleased.