“Why did no one see the crisis coming?” Queen Elizabeth IIasked economists during a visit to the London School of Economics at the end of2008. Four years later, the repeated failure of economic forecasters to predictthe depth and duration of the slump would have eliciteda similar question from the queen: Why the overestimate of recovery?
Consider the facts. In its 2011 forecast, the InternationalMonetary Fund predicted that the European economy would grow by 2.1% in 2012.In fact, it looks certain to
shrink this year by 0.2%. In the United Kingdom, the 2010forecast of the Office for Budget Responsibility (OBR) projected 2.6% growth in2011 and 2.8% growth in 2012; in fact, the UK economy grew by
0.9% in 2011 and will flat-line in 2012. The OECD’s latestforecast for eurozone GDP in 2012 is 2.3% lower than its projection in 2010.
Likewise, the IMF now predicts that the European economywill be 7.8% smaller in 2015 than it thought just two years ago. Someforecasters are more pessimistic than others (the OBR has a particularly sunny disposition), but no one, it seems, has beenpessimistic enough.
Economic forecasting is necessarily imprecise: too many things happen for forecasters to be able to foresee all of them. So judgment calls and bestguesses are an inevitable part of “scientific” economic forecasts.
But imprecision is onething; the systematic overestimate of the economic recovery in Europe is quiteanother. Indeed, the figures have been repeatedly revised, even over quiteshort periods of time, casting strong doubt on the validity of the economicmodels being used. These models, and the institutions using them, rely on abuilt-in theory of the economy, which enables them to “assume” certainrelationships. It is among these assumptions that the source of the errors mustlie.
Two key mistakes stand out. The models used by all of theforecasting organizations dramatically underestimated the fiscal multiplier: the impact of changes in governmentspending on output. Second, they overestimated the extent to which quantitativeeasing (QE) by the monetary authorities – that is, printing money – couldcounterbalance fiscal tightening.
Until recently, the OBR, broadly in line with the IMF,assumed a fiscal multiplier of 0.6: for every dollar cut from governmentspending, the economy would shrink by only 60 cents. This assumes “Ricardianequivalence”: debt-financed public spending at least partly crowds out private spending through its impact onexpectations and confidence. If households and firmsanticipate a tax increase in the future as a result of government borrowingtoday, they will reduce their consumption and investment accordingly.
On this view, if fiscal austerity relieves households ofthe burden of future tax increases, they will increase their spending. This
may be true when theeconomy is operating at full employment – when state and market are incompetition for every last resource. But when there is spare capacity in theeconomy, the resources “freed up” by public-sector retrenchmentmay simply be wasted.
Forecasting organizations are finally admitting that theyunderestimated the fiscal multiplier. The OBR,
reviewing its recent mistakes, accepted that “the average[fiscal] multiplier over the two years would have needed to be 1.3 – more thandouble our estimate – to fully explain the weak level of GDP in 2011-12.” TheIMF
has conceded that“multipliers have actually been in the 0.9 and 1.7 range since the GreatRecession.” The effect of underestimating the fiscal multiplier has beensystematic misjudgment of the damage that “fiscal consolidation” does to theeconomy.
This leads us to the second mistake. Forecasters assumedthat monetary expansion would provide an effective antidoteto fiscal contraction. The Bank of England hoped that by printing £375 billionof new money, ($600 billion), it would stimulate total spending to the tune of£50 billion, or 3% of GDP.
But the evidence emerging from successive rounds of QE inthe UK and the US suggests that while it did lower bond yields, the extra moneywas largely retained within the banking system,and never reached the real economy. This implies that the problem has mainlybeen a lack of demand for credit – reluctance onthe part of businesses and households to borrow on almost any terms in a flatmarket.
These two mistakes compoundedeach other: If the negative impact of austerity on economic growth is greaterthan was originally assumed, and the positive impact of quantitative easing isweaker, then the policy mix favored by practically all European governments hasbeen hugely wrong. There is much greater scope for fiscal stimulus to boostgrowth, and much smaller scope for monetary stimulus.
This is all quite technical, but it matters a great dealfor the welfare of populations. All of these models assume outcomes on thebasis of existing policies. Their consistent over-optimism about thesepolicies’ impact on economic growth validatespursuing them, and enables governments to claim that their remedies are “working,” when they clearly are not.
This is a cruel deception.Before they can do any good, the forecasters must go back to the drawing board,and ask themselves whether the theories of the economy underpinning theirmodels are the right ones.
jg-xs1
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