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Jun 18th 2016, 12:08 by Buttonwood
POLITICAL and economic debate is often a matter of competing visions, which
means it concerns competing forecasts. In the heat of the EU referendum debate,
I was struck by a financial adviser who tweeted me that he "derides all
forecasts." Along with the attacks on the views of "experts", it adds to a
worrying change in the tone of the debate that echoes the Trump campaign's
disregard for facts.
It is a fair criticism that economic forecasts are often wrong; it is very hard
to predict recessions in particular. The old joke is "How do we know economists
have a sense of humour? They put a decimal point on their forecasts." But
forecasts are inescapable. When the Leave campaign says that Britain will
flourish outside the confines of the EU, that's a forecast. They may not put
decimal points on their predictions. But that only makes it an imprecise
forecast where it is harder to challenge the details.
Karl Popper famously made the observation that the usefulness of a prediction
was related to its potential for falsification. "It will rain in London in the
future" is a statement that is 100% accurate. But it is useless when it comes
to telling us which day we should carry an umbrella. A statement that it will
rain at 10.30 tomorrow is much more useful; it either will, or it will not. And
if it doesn't, we can examine what assumptions used in the forecast turned out
to be false. The vague assumptions of the Leave campaign are telling; it is
hard to challenge the details when there are so few.
A valid criticism of forecasts is that, given their inaccuracy, one should not
put too much weight on their validity. But that too is a default for the Leave
campaign. It is betting the future of the country on its forecast that a
significant change in the political and trading environment of Britain will
improve the outlook. To take that risk, one would want lots of confirmation of
the forecast from outside bodies like the IMF or OECD; instead the reverse is
true.
Forecasts are built into investing as well. When a financial adviser tells a
client to pick a particular fund manager, they are making a forecast that the
individual manager will be able to outperform the market (net of fees) in the
future. (Something that there is very little evidence that it is possible to do
on a consistent basis.) They must also, if they advise clients on asset
allocation, or run a pooled fund, make implicit forecasts. They must decide how
much to put in bonds, cash and equities. In turn, that requires assumptions
(forecasts) about the outlook for inflation, interest rates and economic
growth.
When a finance minister sets the government budget for the next year, he or she
must forecast the outlook for the economy (a weaker econnomy will mean lower
tax revenues, for example). When a central bank sets the level of interest
rates, they know that it may take 18-24 months before the impact of the change
is fully seen in the economy. So they have to forecast the outlook for the
economy over the same period. Of course, they cannot be certain. So the Bank of
England uses a "fan" forecast, indicating the range of potential outcomes.
Those forecasts may turn out to be wrong in two types of ways. It can turn out
that the economic model does not work as expected; that, for example, lower
interest rates do not encourage more consumer spending. In that case, the
central bank will change the way it thinks about the impact of future rate
changes. Or the forecast can be confounded by some external event; a collapse
(or surge) in the price of oil, for example.
So any forecast about the UK's future is subject to the second danger. What
forecasts like the IMF are doing is to predict the impact on the UK economy of
Brexit, other things being equal. And here they focus on two factors; the
length of the outcome of trade negotiations and the uncertainty this will
cause.
A decision by U.K. voters to exit the EU would set off negotiations between the
U.K. and the rest of the EU over the terms of its withdrawal and over the
details of its future relationship with the Union. The U.K. would likewise need
to renegotiate trade relationships with the 60 non-EU economies where trade is
currently governed by EU agreements.
These negotiations could drag on for years, leading to a period of heightened
uncertainty and risk aversion, which in turn would discourage consumption and
investment and roil financial markets. In the long run, most formal assessments
agree that the U.K. would be worse off economically if it were to leave the EU,
as higher trade and financial barriers would lead to lower output and incomes.
The IMF explored the potential impact of uncertainty on U.K. growth during the
post-Brexit transition in two illustrative scenarios, referred to as the
limited scenario and the adverse scenario). In both cases, the impact on output
and employment could be significantly negative due to higher uncertainty. The
longer this uncertainty persists, and the less advantageous the outcome of
trade negotiations for the U.K., the larger are these short- and medium-run
costs.
Clearly, there will be some uncertainty after a Leave vote (not to mention the
political turmoil it will set off, with a change in government inevitable). And
we know that uncertainty tends to be bad for investment. So it is not
crystal-ball gazing to assume uncertainty will have an impact; it is a rational
assumption. We can argue about the extent of the impact, not about its
existence.
So my answer to the adviser is that deriding forecasts is a cop-out. We need to
make forecasts all the time, and the very detailed forecasts of the IMF, OECD
etc, at the very least give us a benchmark against which to check out
assumptions. To deride all this as the guesses of "so-called experts" is very
dangerous, not just to the livelihood of financial advisers, who claim to be
experts themselves. Forecasts won't disappear if the experts stop. They will
just emerge in the kind of vague, unverifiable form that the likes of Trump,
with his promises to slash taxes, maintain spending and balance the budget,
bamboozle the public.