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Economic forecasts are hardwired to get things wrong
Economists have been found guilty of groupthink, guided by political ends and using error-prone gravity modelling. No wonder they crash back down to Earth
Sun 8 Jan 2017 07.08 EST Last modified on Wed 14 Feb 2018 10.49 EST
The Queen questioned how economists missed the 2008 financial crisis. She could ask why they got it wrong on Brexit, too. Photograph: Kirsty Wigglesworth/PA Archive/Press Association Ima
It took the Queen to show that the emperor had no clothes. On a visit to the London School of Economics in November 2008, when a second Great Depression was looming large, she asked a simple but devastating question: why did nobody see it coming?
Almost a decade later, the Queen might be tempted to lob another grenade at the economics fraternity: why did you get it wrong again about Brexit?
In fairness, the economics profession had its Cassandras in the run-up to the financial crisis and not all economists thought a vote to leave on 23 June meant instant Armageddon. Even so, it is a valid question. How can it be that the Bank of England, the Treasury, the IMF, the OECD, not to mention the vast majority of academic economists, all predicted so confidently and yet so wrongly that the UK economy would plunge straight into a stonking great recession after a Brexit vote?
On both occasions, economists have been guilty of groupthink. On both occasions they pretend to have forecasting powers that don't really exist. As the economist Paul Ormerod points out, in the short term it is nigh-on impossible to sort out genuine information from noise. Andy Haldane, the chief economist at the Bank of England, last week compared his profession to poor old Michael Fish, who insisted there would be no hurricane on the eve of the biggest storm to hit southern England in living memory.
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Meteorology has moved on in the past three decades: the use of satellite technology has made forecasting more reliable. The same cannot be said of economic forecasting, which is no better now than it was half a century ago.
The models, however sophisticated, don't work awfully well, particularly when big shocks occur. And that, of course, is when they are needed most. The "great moderation" – the period in the 1990s and 2000s when growth was steady and inflation low – lulled economists into a false sense of security.
There are lessons to be learned. The past is not a reliable guide to the future. The consensus is not always right. Economic forecasting is not a hard science, even though it pretends that it is.
The fallback position for those who said the sky would instantly fall in after the referendum is that they were right about everything apart from the timing. Armageddon has been postponed, not cancelled. The consensus is that in the long term there will be a sizable and permanent hit to the economy from Brexit, caused by a loss of trade and inward investment. The Treasury's central forecast is that the cost of leaving the EU is an economy that will be 6% smaller in 2030 than it would be under the status quo.
Yet models are only as good as the information they process: garbage in equals garbage out. The garbage factor increases if forecasts are designed to serve a political end, as was the case with both sides during the referendum campaign.
A new Cambridge University study* shows that forecasting the medium to long term can be just as prone to error as forecasting the short term. Their argument is simple. Leaving the EU is a unique event. No other country has tried to do it. There is no past experience to draw on, which means that the best forecasters can do is construct "a series of scenarios based on assumptions about future trading arrangements, migration controls and about the short-term uncertainties which could affect business investment in the run-up to the likely leaving date of 2019".
This is what the Treasury purportedly did in its study of the long-term impact of leaving the EU, published last April. It concluded that leaving, but remaining a member of the single market, would carry a 3.8% of GDP cost after 15 years; leaving with a negotiated bilateral trade deal would cost 6.2%; while having access to the single market on the same terms as any other member of the World Trade Organisation (WTO) would cost of 7.5% of GDP.
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The Treasury used what is known as gravity modelling to come to these conclusions. So do other forecasters, such as the IMF, which is why once they have all crunched the numbers they all come up with the same result.
Gravity modelling is Newtonian physics adapted for economic forecasting. Just as the attraction between two heavenly bodies is directly proportional to their masses and inversely proportional to the distance between them, so the volume of trade and the amount of foreign direct investment between two countries depends on how big and how geographically close they are.
Using this approach, the Treasury says there would be a 43% loss of trade with the EU were the UK to revert to WTO rules, and because almost half the UK's trade is with the EU this would result in a 24% loss in total trade. The assumption is that there has been a 76% increase in UK trade as a result of membership of the EU and that all of these gains would be lost. There would be no gains in trade with non-EU countries to compensate for the loss.
How plausible is this? Not very, according to the Cambridge economists. They note that the share of UK exports going to Europe peaked in the late 1980s and has been falling in recent years as a result of weak demand in the eurozone. EU external tariffs average only 3% and the Treasury forecasts take no account of movements in the exchange rate. The Cambridge paper estimates that the 15% drop in the value of sterling since the referendum would be enough to offset the impact of a 10% external tariff on cars, which perhaps explains why the government has been able to persuade Nissan to build a new model in Sunderland.
The paper expresses similar doubts about the Treasury forecasts for inward investment, since they are heavily influenced by the wave of capital attracted by the ultra-cheap labour on offer in eastern Europe after the collapse of communism.
Using different but still relatively pessimistic assumptions, the Cambridge study says the loss peaks at 3% of GDP early in the 2020s. The loss of GDP per head is smaller – never much more than 1% – and soon recovers.
The chancellor, Philip Hammond, would do well to have a squint at the Cambridge paper, since its findings are much more in tune with the May government's view about how the economy will perform after Brexit. It will, of course, still be the same economy – warts and all.
*The macro-economic impact of Brexit; Graham Gudgin, Ken Coutts and Neil Gibson; Centre for Business Research; Cambridge University, working paper No 483
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