Over-optimism in Economic Forecasts and Its implications

This is a serious problem for  most countries. Policymakers give overoptimistic targets for growth and fiscal deficits and land up in trouble later.

Jeffrey Frankel documents this problem in this superb paper (cannot find free version). A short summary is here. He says these overhyped estimates firstlead to complacency and then to higher tax cuts and excessive spending. The end result is even higher deficit. He estimates these findings for 33 countries grouped into developed, developing and commodity rich:

Analyzing data for 33 countries, Frankel finds that the average upward bias in the official forecast of the budget balance, relative to the realized balance, is 0.2 percent of GDP at the one-year horizon, 0.8 percent at the two-year horizon, and 1.5 percent at the three-year horizon. The longer the horizon, and the more genuine uncertainty there is, the more scope there is for wishful thinking.

The forecast bias results are similar across nations. The bias is not larger for the commodity producers in Frankel’s sample, or for the developing countries, than for others. Both the U.S. and U.K. forecasts have shown positive biases, reaching around 3 percent of GDP at the three-year horizon, which is approximately equal to their actual deficit on average. In other words, on average the U.K. and U.S. forecasters repeatedly predicted a disappearance of their deficits that never occurred.

He says both overestimating growth and fiscal deficit are part of the problem. Higher growth rates leads to lower estimates for fiscal deficit:

Frankel argues that one likely reason for the optimism bias in official budget forecasts is an optimism bias in forecasts of economic growth. He finds that a country’s growth rate is an important determinant of the budget balance at all three time horizons, so over-optimism in predicting growth appears linked to over-optimism in predicting budget balances. On average, the upward bias in growth forecasts is 0.4 percent when looking one year ahead, 1.1 percent at the two-year horizon, and 1.8 percent at three years. The bias in growth forecasting appears in the United States and most other industrialized countries, but not among the commodity producing countries in the sample.

Frankel also finds that over-optimism is more prominent, for both budget balances and for economic growth, during economic booms. This is especially true as the horizon of the forecast lengthens. This over-optimism in official forecasts can help to explain excessive budget deficits, and especially the failure to run surpluses during periods of high output: if a boom is expected to last indefinitely, then saving for a rainy day is unnecessary. Forecasters over-estimate the permanence of booms, and also underestimate the persistence of busts. Frankel thus finds evidence of over-optimism in downturns as well as booms.

Hmm.. He adds that fiscal rules do not really help and actually worsen the problem as all kinds of games are played to achieve the rule targets.

Despite calls for the establishment of rules, such as a formal ceiling for the deficit, Frankel finds that countries subject to a budget rule — particularly the euroland’s Stability and Growth Path — make official forecasts of growth and budget deficits that are even more biased and more correlated with booms than do other countries. Evidently when such governments exceed the deficit limits set by the rules, they respond by adjusting their forecasts rather than by adjusting their policies.

He points to success of Chile whose estimates do not have any upward bias. Why? Because of their good institutional fixes to this problem:

How was Chile able to achieve a countercyclical fiscal policy during the years 2000-2010? The actions of individual leaders were important. But equally important was an institutional framework within which the political process operated. Chile introduced a structural balance regime for fiscal policy in 2000 and codified it legally in 2006. Under this regime the government must set a structural budget target. It can run a deficit larger than the target only to the extent that: (1) output falls short of its long-run trend, in a recession, or (2) the price of copper is below its 10-year trend. If GDP and the price of copper are above their long-run trends, the government must save the resulting revenue in the form of surpluses. The key institutional innovation is that there are two panels of experts whose job it is each mid-year to make the judgments, respectively, what is the output gap and what is the medium term equilibrium price of copper, rather than leaving the job to government officials.

So much so, Chile policymakers are pessimistic in their outlooks:

Chile’s official forecasts have not been subject to the same bias toward overoptimism that typifies other countries. If anything, its forecasts have erred on the pessimistic side. The official forecast of real growth has fallen short of the ex post numbers by an average of 0.8 per cent at the one-year horizon. The official forecast of the budget surplus as a percentage of GDP has fallen short of the ex post numbers by an average of 1.4 per cent at the one-year horizon.25 In Figure 1a, the observations corresponding to Chile are indicated by Xs. Most lie below the line of zero budget forecast errors and almost all of those that lie above miss by only a small margin. There is no tendency for the forecast error to rise in booms, as with other countries.

Countries can adopt many kinds of variants of  Chile’s budget rule:

Any country could apply variants of the Chilean fiscal device. Countries could set up independent institutions charged by law with estimating the output gap and such other budget-relevant macroeconomic variables as the inflation rate and the fractions of GDP going to wage versus non-wage income. A reinforcement of the Chilean idea would be to give the panels legal  independence. There could be laws protecting them from being fired, as there are for governors of independent central banks.  One could imagine also broadening the responsibility of such panels beyond simpl y estimating the long-run trend in income. The principle of a separation of decision-making powers would be retained: only elected political leaders determine how spending is allocated or taxes are raised.

The United Kingdom in 2010 established an Office of Budgetary Responsibility, designed explicitly to be independent and free of political bias. In addition to making forecasts, the OBR scrutinizes the Treasury’s costing of Budget measures, judges progress towards the Government’s fiscal targets, and assesses the long-term sustainability of the public finances. The U.S. Congressional Budget Office, in addition to making forecasts, estimates the fiscal impact of any sort of proposed measures and undertakes a wide variety of research to aid in federal economic and budgetary decisions.

For India analysts and economists. all this is such a familiar territory. The government did mention the usefulness of Chile fiscal policy structure in its 2010 mid-year economic review but has never been serious about it.

And this practice of overestimating deficits and now growth has been going on for a while. Earlier deficits were  reported lower via taking off oil/food/fertilizer subsidies from its deficits via oil/food/fertilizer bonds. Thankfully growth was in line than as a result deficits never really ballooned as much. Now as growth has been estimate higher, deficits estimated lower we are into all kind of problems. There is no independent agency evaluating and guiding the markets and evaluating the fiscal position of the  government.  Despite 3 years of breaking away from FRBM, there is still no announcement of a new rule which restrains the rising deficits and non-plan expenditure.

The game is to project much higher growth and lower fiscal deficits. Then try and cover rising expenditure by some one time item like 3G auctions in 2010-11. 2011-12 is an year when many things have gone wrong and could push the government into a corner. It is already being pushed but like a boxer is in a denial and trying to push back. Union budget for 2012-13 could be a negative surprise and may be then we see some changes. But again with UP elections in 2012 and general elections in 2013, one should not be too hopeful.

But then now India has too many countries doing the same. So it is more of a global problem and not limited to developing economies..

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One Response to “Over-optimism in Economic Forecasts and Its implications”

  1. Kevin Says:

    Sounds like this over estimation is in part caused by what Dr. Sam Savage calls the flaw of averages. In his book he suggests using full probability distributions as a cure.

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