Why Do Economic Forecasters Get It Wrong?

Mario Pianta

Mario Pianta

At year end we all assess the past and guess the future. We compare what we expected and what happened. We develop new expectations for the new year. In economic affairs this is particularly important, as expectations on growth are crucial for firms’ investment decisions, for government policies and for people’s chances to work. This is the job of hundreds of researchers that produce economic forecasts in advanced countries. The more uncertain the time, the more delicate their task. Let us see what they expected – and what did happen – for the European economy in these times of crisis.

Germany first. In the strongest EU economy 2012 GDP growth is now expected to be less than 1% over the previous year; the Bundesbank forecast of June 2011 had predicted a 1.8% growth. In 2013 the country is now expected to grow only by a modest 0.5%, while Frankfurt’s guess a year ago was an optimist 1.8%.

Alessandro Bramucci

Alessandro Bramucci

Let us do the maths for the years 2009-2011, on which we already have definitive data and compare them with the estimates that the Bundesbank did in June and December of each year, published in its press releases. Out of the thirteen estimates made in the three year period between December 2008 and December 2011, ten were wrong by more than 0.4 percentage points and only three were right (with 0.3 percentage points divergence or less). They even succeded to mispredict in December 2010 the results for the same year. In what sense were they wrong? While in 2009 they underestimated the severity of the recession, one year later they underestimated the dynamism of German growth (at the expense of the rest of Europe).

The British case has been examined in detail by Robert Skidelsky on this website (What are the Merits of Economic Forecasting?) finding a similar pattern of mistakes.

Italy – as often happens – is an extreme case. For 2012 – definitive data are not available yet – the Italian government of Mario Monti – who has just resigned – expects GDP to decrease by 2.4% (update of the Document on Economics and Finance, September 2012) and ISTAT, the National Institute for Statistics, predicts a 2.3% decline (Prospects for the Italian Economy, November 2012). Similarly, the European Commission (autumn forecast) and the International Monetary Fund (World Economic Outlook – October 2012 projections) both envisage a 2.3% decrease of Italian GDP.

What did they expect a year ago? In autumn 2011, the Berlusconi government in its closing weeks predicted a 0.6% growth (update of the Document on Economics and Finance 2011 – September 2011), the European Commission expected a small increase of 0.1% (autumn forecast), whereas the IMF estimated a slight dip of 0.3% (World Economic Outlook – September 2011 – projections). With the arrival of the “technical” government of Mario Monti official forecasts changed very slowly, and only lately the severity of Italy’s recession – resulting from the government’s austerity policies – found its way into official data.

Take now the Eurozone as a whole and the forecasts of the staff of the European Central Bank presented by the President at the periodic press conference. The ECB publishes outlook reports every three months (March, June, September, December) with estimates of a range between a minimum and maximum value. Let us take a long view – before the Mario Draghi era at the top of the Bank – and consider the forecasts for the years 2004-2011 made since June 2004. Out of a total of 61 estimates, 46 were incorrect – i.e. actual data were ouside of the range between the maximum and minimum estimates – and only 15 were right; three times out of four, ECB staff got the economy wrong.

The range between maximum and minimum can be large; two years ago, in December 2010, predictions for growth in 2012 had a minimum of 0.6% and a maximum of 2.8%. We already know that they missed the target; this year the Eurozone is going to have a decline of GDP, but only last September ECB’s predictions fell below zero.

What is wrong with the ECB? Its staff make a systematic mistake: in “good” times, between 2005 and 2007, before the 2008 crisis, the range of estimates was always lower than final data – too much pessimism. When the going got rough, the ECB did not understand it; it missed the financial crisis in 2008 and had no clue on the severe recession in 2009 – in the Euro zone GDP fell by 4.4% and one year before the ECB provided a range between 0 and -1%.

Then the ECB was caught up in pessimism for 2010 exactly when the Eurozone – thanks to increased public expenditure reacting to the crisis – had a recovery; all forecasts – even those made in December! – underestimated the 2% growth registered in that year. Following this, ECB optimism has continued to this day, based on the idea that good results had to arrive from Europe-wide austerity policies. So, wrong guesses for the slow economy of 2011 and no clue about the recession of 2012; one year ago the range of ECB estimates for 2012 was between 0.4% and 1%. What about next year? For 2013 the ECB is now suggesting a range between -0.9% and 0.3%, a moderate pessimism that is likely to fail to anticipate a deepening of Europe’s recession.

Were all these mistakes inevitable? Let us look at the predictions about the Eurozone made by other international organizations. OECD estimates – published in June and December – for the years 2010 to 2012 were wrong (0.4 percentage points difference or more with actual data) when made one year earlier, but those made in December were closer to actual data. The OECD too underestimated the small recovery of 2010 and failed to predict the recession in 2011 and 2012. It is now expecting a 0.4% fall of GDP in 2012 and a 0.1% decline in 2013.

The only international institution providing more accurate predictions has been the International Monetary Fund. If we consider the estimates made in October and April from 2009 up to now, relative to the years from 2009 to 2012, we find 80% of correct predictions (with a deviation of 0.3 percentage points or less). For the Eurozone in 2012 the IMF is estimating a decline by 0.4%, a prediction made since January 2012 – that is likely to be correct – but during 2011 even IMF predictions failed to anticipate the coming recession. What about 2013? The IMF is more optimistic than the OECD, the outlook published in October last year is expecting a 0.2% growth, scaled down compared to previous estimates.

What can we learn from these numbers? The crisis has shown how wrong the assumptions and relationships at the core of mainstream economics were. They were at the root of economic policies that have proven to be disastrous. But the same assumptions and relationships are incorporated in the models used by the international organizations to make their estimates on the future.

The lesson from this evidence is that ideology blinds forecasters as well as politicians. The most dramatic case is the failure of mainstream approaches to underestand the negative effects austerity measures have had since 2011 on demand and income in the Eurozone. At the ECB and the European Commission, at the Bundesbank and OECD it was expected that spending cuts in 2011 and 2012 in the “periphery” of Europe would only have modest effects. This is not what actually happened and the recession in 2012 hit the whole of the Eurozone. The evidence has been provided by IMF studies – such as What Determines Government Spending Multipliers? by Giancarlo Corsetti, Andre Meier and Gernot Müller – and the analysis of the World Economic Outlook issued in October 2012 that showed how cuts in public budgets have a much bigger negative effect on income than expected by mainstream models. At the start of 2013 a reassessment of the issue has been published by Olivier Blanchard and Daniel Leigh in the study Growth Forecast Errors and Fiscal Multipliers (IMF WP/13/1).

Outside the ECB, the OECD and governments practicing budget cuts, however, there are thousands of economists who have never believed in the virtues of austerity and have long argued for a change of perspective. Criticisms of austerity policies from Paul Krugman (End this depression now! Norton, 2012) or Nouriel Roubini are well known. We have now additional arguments for alternative policies from the Independent Annual Growth Survey (see also Andrew Watt) and from the Euromemorandum 2013 (www.euromemo.eu), launched last week with the support of 350 European economists.

This column is part of the European growth strategy expert sourcing jointly organised by Social Europe Journal, the Friedrich-Ebert-Stiftung, the Bertelsmann Stiftung, the IMK of the Hans Boeckler Stiftung and the European Trade Union Institute (ETUI).