Why forecasts are necessary

By Buttonwood

POLITICAL and economic debate is often a matter of competing visions, which means it concerns competing forecasts. In the heat of the EU referendum debate, I was struck by a financial adviser who tweeted me that he "derides all forecasts." Along with the attacks on the views of "experts", it adds to a worrying change in the tone of the debate that echoes the Trump campaign's disregard for facts.

It is a fair criticism that economic forecasts are often wrong; it is very hard to predict recessions in particular. The old joke is "How do we know economists have a sense of humour? They put a decimal point on their forecasts." But forecasts are inescapable. When the Leave campaign says that Britain will flourish outside the confines of the EU, that's a forecast. They may not put decimal points on their predictions. But that only makes it an imprecise forecast where it is harder to challenge the details.

Karl Popper famously made the observation that the usefulness of a prediction was related to its potential for falsification. "It will rain in London in the future" is a statement that is 100% accurate. But it is useless when it comes to telling us which day we should carry an umbrella. A statement that it will rain at 10.30 tomorrow is much more useful; it either will, or it will not. And if it doesn't, we can examine what assumptions used in the forecast turned out to be false. The vague assumptions of the Leave campaign are telling; it is hard to challenge the details when there are so few.

A valid criticism of forecasts is that, given their inaccuracy, one should not put too much weight on their validity. But that too is a default for the Leave campaign. It is betting the future of the country on its forecast that a significant change in the political and trading environment of Britain will improve the outlook. To take that risk, one would want lots of confirmation of the forecast from outside bodies like the IMF or OECD; instead the reverse is true.

Forecasts are built into investing as well. When a financial adviser tells a client to pick a particular fund manager, they are making a forecast that the individual manager will be able to outperform the market (net of fees) in the future. (Something that there is very little evidence that it is possible to do on a consistent basis.) They must also, if they advise clients on asset allocation, or run a pooled fund, make implicit forecasts. They must decide how much to put in bonds, cash and equities. In turn, that requires assumptions (forecasts) about the outlook for inflation, interest rates and economic growth.

When a finance minister sets the government budget for the next year, he or she must forecast the outlook for the economy (a weaker econnomy will mean lower tax revenues, for example). When a central bank sets the level of interest rates, they know that it may take 18-24 months before the impact of the change is fully seen in the economy. So they have to forecast the outlook for the economy over the same period. Of course, they cannot be certain. So the Bank of England uses a "fan" forecast, indicating the range of potential outcomes.

Those forecasts may turn out to be wrong in two types of ways. It can turn out that the economic model does not work as expected; that, for example, lower interest rates do not encourage more consumer spending. In that case, the central bank will change the way it thinks about the impact of future rate changes. Or the forecast can be confounded by some external event; a collapse (or surge) in the price of oil, for example.

So any forecast about the UK's future is subject to the second danger. What forecasts like the IMF are doing is to predict the impact on the UK economy of Brexit, other things being equal. And here they focus on two factors; the length of the outcome of trade negotiations and the uncertainty this will cause.

A decision by U.K. voters to exit the EU would set off negotiations between the U.K. and the rest of the EU over the terms of its withdrawal and over the details of its future relationship with the Union. The U.K. would likewise need to renegotiate trade relationships with the 60 non-EU economies where trade is currently governed by EU agreements.

These negotiations could drag on for years, leading to a period of heightened uncertainty and risk aversion, which in turn would discourage consumption and investment and roil financial markets. In the long run, most formal assessments agree that the U.K. would be worse off economically if it were to leave the EU, as higher trade and financial barriers would lead to lower output and incomes.

The IMF explored the potential impact of uncertainty on U.K. growth during the post-Brexit transition in two illustrative scenarios, referred to as the limited scenario and the adverse scenario). In both cases, the impact on output and employment could be significantly negative due to higher uncertainty. The longer this uncertainty persists, and the less advantageous the outcome of trade negotiations for the U.K., the larger are these short- and medium-run costs.

Clearly, there will be some uncertainty after a Leave vote (not to mention the political turmoil it will set off, with a change in government inevitable). And we know that uncertainty tends to be bad for investment. So it is not crystal-ball gazing to assume uncertainty will have an impact; it is a rational assumption. We can argue about the extent of the impact, not about its existence.

So my answer to the adviser is that deriding forecasts is a cop-out. We need to make forecasts all the time, and the very detailed forecasts of the IMF, OECD etc, at the very least give us a benchmark against which to check out assumptions. To deride all this as the guesses of "so-called experts" is very dangerous, not just to the livelihood of financial advisers, who claim to be experts themselves. Forecasts won't disappear if the experts stop. They will just emerge in the kind of vague, unverifiable form that the likes of Trump, with his promises to slash taxes, maintain spending and balance the budget, bamboozle the public.