Stephen King: Economic forecasters could learn something from meteorologists

Economists would make hopeless weather forecasters. Weather forecasters, at least those who worry about the British weather, are not keen on extrapolation. They know only too well that today's sunny spells could easily be followed by tomorrow's wet and windy conditions. While economists have learnt some things from meteorologists – notably the need to adjust data for seasonality – there is still a strong desire to believe that economies head blindly in one direction or another. How many times have economists correctly forecast a turning point in economic activity? Not many, I would guess.

Moreover, there is also a strong belief that economies "behave themselves". While most economists would accept there's some kind of economic cycle, there's also a belief that economies ultimately self-correct. They may go off the rails from time to time, but for the most part they typically return to some kind of long run steady state. Indeed, virtually all the mathematical models used by economists to capture the behaviour of national economies contain this assumption.

A year ago, when the UK economy had already entered the foothills of the credit crunch, Treasury forecasters thought 2009 would be a better year for the economy than 2008 - which, at the time, was projected to post a growth rate of around 2 per cent (the actual growth rate was 0.7 per cent). HM Treasury already recognised that 2008 was not going to be a vintage year for the UK economy but, in their words, "...the resilience of the UK economy demonstrates the pay-off to the Government's macroeconomic policy framework and promotion of open and flexible product, labour and capital markets. So beyond 2008, the forecast is that GDP growth will pick up as financial markets normalise and markets adjust." For 2009, HM Treasury thought growth would be in a range of 2.25- 2.75 per cent. At the time, the consensus of independent forecasters was a touch more cautious, expecting growth to be around 1.9 per cent.

Twelve months later, it now looks as though the UK economy will contract this year by around 3-4 per cent. The forecasting community as a whole got its projections badly wrong: HM Treasury's projections, though, were particularly misleading, pointing to a much-improved economic outlook through 2009.

On the other side of London, the forecasters of Threadneedle Street did only a little better. The Bank of England, unlike HM Treasury, does not publish detailed economic forecasts but it does, nevertheless, put together forecast "ranges" in the quarterly Inflation Reports. In February 2008, the Bank projected growth to slow sharply to around 1.5 per cent in the second half of 2008 before rebounding in standard "V-shaped" fashion in 2009. Admittedly, the range around this forecast gave a hint that recession could not be completely ruled out, but few at the Bank seemed to regard recession as a serious risk at that stage.

Three months later, the Bank offered a bleaker assessment of the near-term outlook: recession was a slightly bigger risk, but still couldn't be described as a "central scenario". Moreover, there was still every chance that activity would recover through the course of 2009. It wasn't until August of last year that the Bank was prepared to accept that a recession had become the "central view" but, by that stage, the UK was already in recession. This, then, wasn't a case of accurate forecasting but a reality check for hitherto errant forecasters.

We'll get another set of forecasts from HM Treasury on Wednesday when the Chancellor stands up to deliver his Budget. They will show, presumably, that things have got a lot worse but also that things will, at some point, get a lot better. That much, though, is obvious: even the Great Depression was eventually followed by recovery. Ideally, forecasters should be able to do a lot better than this but, to date, they haven't. Very few have been clever, or lucky, enough to have correctly anticipated the last 18 months. What can we learn from their mistakes?

The first error is hubris. Last year's Budget provided plenty of evidence of this. HM Treasury stuck to a view first expressed in the 2006 pre- Budget Report that the UK economy could grow on a sustained basis at 2.75 per cent per year, an upgrade from earlier, more cautious, estimates. The longer this downswing lasts, the less convincing this elevated estimate of "productive potential" growth becomes.

Meanwhile, HM Treasury really believed the economy had become a lot more flexible and that "the pay-off has been seen in much-enhanced macro-economic stability [which] provides a strong foundation from which to deal with current economic shocks". This seems entirely wrong-headed: the underlying problem was the size and instability of the financial system, not the flexibility or otherwise of product and labour markets. The second error is a lack of foresight and planning. It may be that forecasters have been unable accurately to predict the onset of recession but that does not mean recessions have been abolished. Instead, it means that we live in a world of tremendous uncertainty whereby the "steady-state" projections favoured by economists are more wishful thinking than an appropriate assessment of underlying risks.

A sensible fiscal rule might be "the good times won't last", thereby emphasising the need to run healthy fiscal surpluses during periods of apparent economic good fortune. Yet few governments have been wise enough to deliver such outcomes (they're mostly too focused on the next election). So when the economy suddenly and unexpectedly collapses, the fiscal situation is often not strong enough to offer sufficient cushioning.

The third error relates to wishful thinking. When an economy goes wrong, there's a natural tendency to believe that a few tweaks of policy will be enough to fix the problem. But why should this be true? Economies go wrong unexpectedly (if they didn't, economic forecasting would be easy). That, in turn, typically means that policymakers struggle to find the right cure. Eighteen months ago, for example, few would have argued in favour of quantitative easing. We may not have had a recession in the UK for a very long time, but our recessions tend to be long-lasting affairs, despite our much-vaunted "flexibility". From the mid-1970s onwards, downswings (defined as sustained periods during which GDP contracts, even if not in every quarter) have lasted between five and nine quarters. Subsequent recoveries (the time it takes to return to the level of activity at the previous peak) have lasted between five and 10 quarters. Even if activity levels off, therefore, it's still a long hard slog before "normality" returns.

The fourth error is to ignore the rest of the world. Governments and central bankers like to give the impression that, somehow, they are in control. They can certainly make a difference but, ultimately, the UK economy is at the mercy of changes in the global economic weather conditions. Weather forecasters know that developments elsewhere have a huge impact on conditions in the UK. Economic forecasters, on the other hand, seem to think the UK is, economically, an island. Hopefully, the experiences of the last 18 months will finally have put paid to this foolish belief.

Stephen King is managing director of economics at HSBC