Economic masochism

If economic forecasting is a fool’s game, forecasting in the Coronavirus world is plain masochistic. The impact of the underlying assumptions required to produce forecasts at this point is so great that one may as well produce the forecast on the back of a napkin.

In normal times, macro forecasters make assumptions about which political party is likely to win an election or the degree to which they will actually follow through with manifesto pledges. These impact the economic forecast, with GDP growth or unemployment perhaps differing by a few tenths in an developed economy, depending on the political party or policies. This pales into insignificance compared to things such as how long lock-down will last, and other related assumptions.

Nowhere is this more clear than in the UK economic forecasts published today by the OBR* and IMF, two of the most established semi-official domestic and international forecasting benchmarks. In 2020, the IMF expected a 6.5% contraction in UK GDP while the OBR expect double that at 13.5%. Given that their forecasts rarely diverge more than a few tenths, this represents a colossal difference in working-assumption. This blog is not the place for a line-by-line comparison of the underlying assumptions, but that difference in output serves as a nice illustration of how much forecast uncertainty is created by this scenario.

All forecasts that we see at this point are subject to huge uncertainty. Give the forecasters the opportunity and they would probably want to update them on a near-daily basis. We should also keep in mind that even when we begin get the official data, they are also likely to subject to much larger uncertainty than usual.

*The OBR’s refer to their’s as a “reference scenario”, not a forecast, as they do not know official government policy about the ending of lock-down. Okay, but that just puts them in the same boat as everybody else, so it’s still a reasonable comparison.

Thoughts on economic uncertainty in forecasting

Uncertainty is a hot topic in economics. This is perhaps no surprise. The economic forecasting profession lost a lot of credibility following the Financial Crisis. So the idea what economists would want to subtly remind their audience that they are not soothsayers with divine foresight is entirely rational – and economists love rationality.

There are broadly three types of uncertainty in macroeconomic forecasting. Uncertainty about the state of the world, uncertainty about one’s ability to predict economic variables when the state of the world is known, and the uncertainty that influences businesses/consumers decision-making process. The first two lead to wider or narrow error bands around a forecast, while the third influences the forecast itself.

Economists understand these differences, indeed an entire nomenclature has been developed to distinguish different types of uncertainty (the name Frank Knight is imprinted in the minds of all economists from a young age). But the way that economic forecasts are typically used seemingly ignores these distinctions, and leads to unconscious biases in forecasts to compensate.

Most ‘medium-term’ economic forecasts are modal. That is, they predict what the economy might look like IF a series of assumptions comes true, such as who will win a forthcoming election and that said party will stick to their promises. Give an economist a perfectly accurate set of assumptions and they are likely to be able to provide a forecast of the economy to a reasonable degree of accuracy.

Yet economists and the users of forecasts typically disagree about ‘a reasonable degree of accuracy’. The typical user of an economic forecast (for business planning) treat economists’ conditional forecasts as pure fact, in much the same way as actual historic data. Either that, or it is entirely ignored.

This is entirely inappropriate. Economic variables are inherently uncertain. If there are any true laws that govern the economy in the same way as the Laws of Physics, they are yet to be discovered. Economists rely on a mixture of ‘rules of thumb’ and historic relationships to take educated guesses at the likely impact of one event on another. Not only may that period of history not be appropriate, but the data relating to that period of history on which the relationships are observed are often unreliable. Although econometricians attempt to control for these, rules of thumb and generalised historic relationships will never provide precise results.

Yet it is this treatment of economic forecasts as factual inputs that leads economists to the introduction of bias on the part of forecasters, be it conscious or not. If warnings around the inability to precisely predict economic variables are essentially ignored then the factors which should lead to wider or narrower ranges around forecasts are gradually factored into the point forecasts themselves. In essence, modal forecasts become mean forecasts – at least partially.

This is a mistake. Providing decision-makers forecasts that do not accurately reflect like most likely outcome, but presenting it as such, will almost certainly lead to an inefficient allocation of resources. And if there is one thing that economists hate, it is an inefficient allocation of resources.

Switching to ‘mean’ forecasts is not the answer for business planning. If there is a path that will either lead to a booming economy or a cataclysmic recession, forecasting an economy bumbling along will lead to entirely the wrong decisions for either outcome.

Until business planning adequately accounts for the inherent uncertainty in economic forecasts, this bias is likely to persist. To change this, economists should take responsibility for better educating stakeholders in their product.

A General Election Prediction

Politics is a key factor in the economy. Step one of macro forecasting is to determine your baseline assumptions, of which the political environment is critical.

Prediction: Conservative majority

Rationale and observations:

UK political parties can loosely be divided along the traditional ‘Left-Right’ axis, and with an addition ‘Leave-Remain’ axis. While one can debate exactly where parties should lie on this spectrum and the extent to which they may overlap, there are two clear points to draw from the image below.

First, there are two quadrants which are not covered by any major political party. This is really the crux of this election, and the basis of Boris’ election strategy. Left-leaning Brexit-supporters – the typical working-class ‘Wigan Man’ stereotype – are essentially being asked to decide whether to prioritise Brexit preferences over socio-political preferences. Boris is gambling that they will do just that. This means either voting Conservative, or if they cannot bring themselves to vote Conservative (many are life-long Labour voters of which many are proud) then either voting Brexit Party or perhaps voting with their bottoms – they will not vote. For what it’s worth, I suspect that this gamble will work and that turnout in Leave-voting labour strongholds will be low. Right-leaning ‘Remainers’ are a much smaller share of the population and critically from an election perspective, more dispersed. Turnout is also likely to be small among this group, with the Liberal Democrats probably the least objectionable party.

The second observation is that there has been a near abandonment of the centre. This has been well-covered so I won’t dwell on it much, but I think it is quite stark. There are a few minor centrist parties, but even the Lib Dems have abandoned their stance of moderation with their switch to a policy of Revocation of A.50. This appears to have alienated many of their more casual supporters who find this too extreme a stance – and a particularly unnecessary one given that they were never going to be in a position to introduce it anyway. Labour have taken a centrist stance on Brexit, though not on the Left-Right axis.

This election is a real missed opportunity for Labour. Clearly the current Labour party membership does not want a centrist party at present – fair enough, it is their party and they can do with it as they wish. Yet one cannot help but feel that were they to shift even a few degrees closer to the centre, they would stand a reasonably good chance at winning a majority against a deeply unpopular Conservative government. Alas, there appears to be little/no evidence of such a shift, hence my prediction of a Conservative majority. It is ironic in a way. The insistence on a ultra-hard left platform is perhaps the thing more than any other which will lead to a Conservative/Right government for the next five years.

PS. Apologies to TIG, PC, ChangeUK (if you still exist), Lord Buckethead, Count Binface and others I omitted. The size of the boxes does not meant anything other than I did it quickly, though perhaps a psychologist may wish to suggest some latent biases in there. Feel free to disagree about where I have placed the boxes.

PS2. I recommend Electoral Calculus for converting General Election polls into seat predictions with a reasonably robust methodology.