Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday 25 May 2012

On not taking sides, and forecast uncertainty

                The last time I can remember Chris Giles of the FT writing about fiscal policy, I came down on him pretty hard. It was the phrase “..the area in which Britain still leads the international debate is fiscal policy” that really got to me then. So before taking up something in his latest piece, let me say two things. First, after my earlier critical post, Chris took the time to send me a lengthy email defending his position. It didn’t change my view, of course, but I did appreciate the effort. It confirmed my belief that Chris is serious about trying to get things right. Second, the article today is more sensible. It basically takes the IMF view I described recently here, which is that we need more monetary expansion, and that if things become worse than expected we should have bond financed fiscal expansion. Not as far as I would want to go, and I would disagree with his arguments for keeping to current fiscal plans, but Jonathan Portes takes on that task here. What I can say is that I approve of his direction of travel, and that he is prepared to make it!
                  What I want to discuss now is a remark Chris makes about economists taking sides. The article starts by chiding the Prime Minister when he claims that low interest rates represent the result of his tough decisions. Chris argues, as Jonathan has said many times, that low rates reflect the poor prospects for UK growth. He goes on: “The prime minister must know that what he is saying is silly, so it suggests he holds the intellectual capabilities of his audience in contempt.” I have recently expressed sentiments along similar lines. He then goes on to examine a recent statement by Labour’s Ed Balls. To quote again: “Blaming changes in deficit forecasts on the pace of austerity alone is not worthy of a serious politician.” If you take the statement Chris quotes as implying that the deficit is higher just because of austerity, then that does indeed make little macroeconomic sense.
                It is what Chris says next that is interesting. “In the current hysterical climate, economists should be wary of taking sides. We know that austerity hurts, but we have little idea how much of the current economic pain is caused by deficit reduction.”  If by taking sides he means trying to argue that everything said by one political party is wrong and everything said by another is right, then this has to be sound advice in an age of macroeconomic spin.
                However, I would also argue that in a hysterical climate, economists really should go public with what they believe to be true, particularly if that belief comes from years of study. If their view reflects what is taught to students up and down the land, then I might go so far as to say that they owe it to their discipline to tell the world what they tell their students.  What in my view makes the austerity announced in 2010 a major policy error was that it attempted to deny this knowledge. We do know with reasonable certainty that fiscal contraction in the form of spending cuts will, ceteris paribus, reduce output by a significant amount. We also know that when interest rates are at their lower bound, what monetary policy can do to counteract this fiscal impact is highly uncertain. Not all macroeconomists will agree with these statements, but I would conjecture that the vast majority do. Given this, it was highly likely that additional austerity would reduce UK output compared to what it otherwise would have been, and if this led to weak or zero growth then it was a huge gamble to hope that monetary policy would put things right again.
                It was in part this belief that macroeconomics had important things to say that current policy seemed to ignore that started me blogging some five months ago. I’ve also found that among the macroeconomic blogs I read there is refreshingly little partisan commentary. OK, maybe that is partly self selection – there is a popular US blog that I do not read for this reason – but only partly. There is a bit more ideology in what I read, but unfortunately that reflects the discipline itself.   
                I also agree with the second sentence from Chris that I quote above in the following sense. Although there has been no growth since the coalition started to influence macroeconomic events, we should never claim that we know that this is all due to their fiscal plans. There are too many unknowns here – in particular, it is hard to know how much future austerity might have influenced current expectations among firms and consumers. I hope that in the past I have simply claimed what I said above, which is that austerity has just made things worse. To say that we know precisely what a policy has done to the economy is almost as bad as saying that we can accurately forecast.[1]
                What all macroeconomists know is that forecasting is a very imprecise game. Study after study has shown that macroeconomic forecasts are little better than guesswork. Forecasts are worth doing, because getting things a bit better than guesswork has benefits that exceed the costs. A corollary of being just better than guesswork is that whether you get forecasts right or wrong is largely down to luck. So to infer, as is frequently done – even in blogs – that because the Bank of England has been consistently overoptimistic about inflation this must reflect some kind of incompetence is simply wrong. Equally, to assert that the OBR were overoptimistic about UK growth because they must have been somehow infected by the government’s beliefs is wrong. Both things are possible but, given what I know in each case, highly unlikely. Given the state of our current, and in all probability, future macroeconomic knowledge, forecasts are generally wrong because the economy is too damn unpredictable. That makes it all the more important that we do not ignore the things we do know.

[1] It is only ‘almost’ as bad because conditional forecasting (if something changes by x, then something else will change by y), involves less uncertainty that unconditional forecasting (something will be y). Note that my statement about fiscal policy is much weaker than a conditional forecast, because it just says that if government spending falls, output will be lower. That is why we can be much more certain about this kind of statement. 


  1. I think one of the main drawbacks of the OBR forecasts are that they are based off the Treasury model. As this is intended to produce a fiscal forecast, not an economic forecast, it is often unreliable in that respect.

  2. I'm doing Masters in Economics at LSE, did undergrad at Oxford late 70's (Roger Opie time). In between spent 30 years in markets, so macro's been a constant backdrop.

    I've been somewhat startled at the lack of development in the understanding of growth, specifically the struggle to explain the Great Moderation.

    Am I missing something? I've read over that 30 years a lot of stuff re macro as it related to markets, interest rates, currencies, growth, unemployment, deficits of all types, and of course Bernanke and Greenspan during the good times, and they don't really seem to have a clue.

    Specifically (and perhaps unfairly) no-one apart from some stopped clocks and some hedge fund managers saw what was going to happen 2007 onwards. Certainly not the IMF from their tortured evaluations since.

    Acemoglu and Robinson (WNF) just leads me to further dismiss macro.

    How unfair is that simplistic blanket dismissal, and what should I read that might make me temper it?

    1. When geologists fail to predict earthquakes and tsunamis does that mean we should dismiss geology?

    2. Of course not, my main point was the Great Moderation, and my overall question was mildly asked, hoping for useful response from S W-L. Not sure a parallel between geologists and economists, especially given SW-L's comments on forecasting above, holds much water.

      However I do find it endlessly interesting that 'no-one' saw it coming, dont you? The IMF evaluations make interesting reading, recommended.

    3. " When geologists fail to predict earthquakes and tsunamis does that mean we should dismiss geology?"

      Well, Sheldon Cooper says geology isn't a real science...

  3. Yes it's definitely interesting.

    That noone saw it coming is interesting in itself. (I am not Fooled by Random hedge fund managers.)

    The great moderation I think is well understood. Positive supply shocks (technology, globalisation) and to a lesser extent macroeconomic policy. During the GM some economists over-emphasised the latter.

    2007 onwards we know that excessive irresponsible lending/borrowing was to blame. By definition something has gone wrong in the financial sector. Depending on your ideology/allegiances you can blame central banks for allowing easy money to banks, or you can blame the deregulation and multiple principal-agent problems interacted with excess optimism within the financial sector as a whole. I think the evidence (i.e. securitization, leverage ratios) suggests the latter mechanisms were more important.

    One central element of principal-agent problems is hidden information. So that explains to some extent why noone saw it coming - the information was hidden.

    I think the parallel with geologists more than holds water. In economics there are some pretty good theoretical reasons why we can't predict the future (current prices already contain all the available information about the future given rational agents). There's no such equivalent in geology.

  4. The geological analogy is a very poor one making the neoclassical mistake that everything is steady and solid bar a random and unpredictable external 'shock'.

    No a lot of people did see it coming (Hudson, Keen, Roubini, Magnus Bootle, etc.) and made firm predictions and forecasts, and it wasnt because they got lucky but because they saw that the platform for the great moderation was not a solid one but one built on unsustainable expansion on debts to create overvalued assets in land and the FIRE sector. Until models incorporate these Minksyian elements the forecasts will be worse than guesswork - in Tale'bs words in the NYT it would be safer for society to teach anything than such models - even needlework.

  5. I don't know what geologists do! Didn't know that forecasting, or policy to achieve ends was in their brief, but let's leave them alone anyway.

    My question to Simon stands, in general, for when he sees it. It's really about how well macro handles growth. I say very poorly, wish to be corrected!

    Off the topic of that question:

    Re GM, yes, we have explanations afterwards, and for such an extraordinary period it's unlikely to have been macro policy, although the massive credit expansion throughout didn't hinder, and then eventually caused '07 on? Economists claiming it was wise macro policy sounded foolish then (to me) and now sound foolish re their praise for China (but that's another story).

    Re sub-prime / leverage etc, certainly all the things you mention apply. I can't agree that the aggregate numbers were hidden. Least of all because of the micro hidden information argument. It's the job of regulators / central banks / IMF to know this stuff, and they did. Read the IMF evaluations for their analysis of why they didn't see what they could and should have, as should Bernanke. Some investors (although clearly not the market in general) saw that the banks could go bust, a pretty serious macro problem. (As an example, Buffet had been talking about the risks of Weapons of Mass Financial Destruction for some years)

    (The best work was by Bird and Fortune, a year before Lehman went bust, When comedians see it and central bankers didn't, you do worry!)

    Among the macro community no-one warned, nor among the regulatory / central bank community (afaik). (Maybe Roubini, bloke from Warwick was a bit too early.) Which is why the few people who were right are worthy of study (and hedge funds is the area I know best). I went to hedge-fund manager-only conferences from 2005 on where the wisest were predicting precisely what happened in credit, and not just mortgages but also sovereign credit, specifically the Euro Olive Belt. Because these were not 'stopped clocks', because they saw it coming early, because we know they did from their returns, because their arguments were precise and detailed, came true, and agree precisely with the post-mortems, and because they got credit AND the euro-soveriegn-crisis right, it means at the very least that the crisis was foreseeable. Your Talebian dismissal is too glib.

    Do you have to remain anonymous? I feel exposed!

  6. Simon,

    When you say it was likely that austerity would reduce output, you seem to be ignoring inflation. Presumably, without austerity demand would have been higher, so inflation would have been higher. Given that inflation was already well above target, one might have expected the BoE to raise interest rates, reducing output.

    I wonder if you simply think the BoE would have ignored the increase in inflation, or if somehow the mix of higher spending and higher interest rates would have caused output to be higher.

    I have been thinking that maybe there is a fundamental difference between monetary and fiscal stimulus. Maybe monetary stimulus is pushing on a string at low interest rates, but raises inflation via the exchange rate, whereas fiscal policy has less impact on inflation but is more effective at raising output. So, we would be better off with higher interest rates, less QE, and fiscal stimulus. Just a thought.

  7. Alright lets move on from geology. (Though I would say that forecasting isn't the only function of economics either - quite a small part if that.)

    And yes, those guys are all smart. But they were the minority.

    It turns out we're all smart now, but most of us have forgotten that nothing was obvious in 2006. I certainly reject the idea that because the mainstream fails to predict the future with arbitrary accuracy, it must follow that mainstream economics should be dismissed.

    The fact your guys made money I think proves it wasn't obvious.

    yours, Mervyn King

  8. If it had been obvious we wouldn't be having the conversation because it wouldn't have happened as it did; similarly by definition they are a small minority.

    I wouldn't define as requiring 'arbitrary accuracy' the musings of people who wonder why economists in charge didn't notice that we were being led up an unusually steep slope and then off a cliff? And what that might say about economic understanding?

    I end as I started - I was surprised on my LSE Masters course of the very limited advances made in understanding growth since my 70's undergrad.

    1. Right we agree it wasn't obvious, and therefore by definition that it wasn't easy to see. So the steep slope and cliff analogy certainly doesn't work.

      On growth I disagree. This field more than any other within macro has made substantial advances over the past 40 years. Take a look at Acemoglu's book - Introduction to Modern Economic Growth and see if you still think the same.

  9. Steep slope and cliff is what happened, we must agree about that. GM then crash.

    I probably should read that book; I am half way through Acemoglu's Why Nations Fail (which I accept is NOT an economics book).

  10. yep we agree on quite a lot. It was good, and then it was (and still is) bad. But it wasn't obvious.

  11. Wynne godley saw it coming. warned how UK and us growth was unsustainable. he held a v different view about how economy worked. find his stuff on levy institute website. also Elliott and Atkinson predicted a huge financial crash in their 2007 book fantasy island

  12. At least, after the devaluation of 2008, one can't blame the overvaluation of the GBP


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