Why people don’t tend to forecast recessions

By Buttonwood

IN LATE 2008, during a briefing at the London School of Economics, Queen Elizabeth II famously asked why no one had seen the downturn coming. There can be no better answer than the current furore over the outlook for the British economy in the wake of the vote to leave the EU. A poll by Bloomberg shows that economists expect the UK economy to shrink by a modest 0.1% in each of the third and fourth quarters, compared with the 0.6% gains expected before the vote. And the forecast growth rate for next year is a sluggish 0.6%. The IMF is a bit more upbeat, expecting 1.3% growth next year, but that is still 0.9 percentage points lower than its pre-referendum expectation.

Why the gloom? This explanation from Barclays is fairly typical:

We expect already elevated levels of uncertainty will spiral out of control. Therefore, we forecast fixed investment to materially contract immediately, with consumption to ease at first before contracting by end-2017 as households feel the pinch from rising unemployment and a sharp increase in headline CPI weighing down spending power. Hence, we forecast UK GDP growth of 1.1% in 2016 and -0.4% in 2017, following 2.2% in 2015.

Such forecasts are hardly a surprise, given the widespread view of economists before the referendum that the short-term impact of a Brexit vote would be damaging. But this is not going down well with the Leave camp, which essentially accuses such economists of sour grapes. Driving back from Devon on Monday, your blogger heard a discussion on the BBC about whether the gloomsters should just "shut up" for fear of creating the very recession they forecast.

It is a fair point that economists have not been very successful at predicting recessions. But that it is not because they cry wolf too often. Paul Samuelson made the quip that "stockmarkets forecast nine of the last five recessions". But economists have a tendency to extrapolate; if growth has been 2% over the last year, they tend to forecast it will be 2% (plus or minus a bit) in the next. A recession is a sudden change in trend.

For economists employed in the financial sector, there is an implicit bias towards optimism. As one once told me "There is no incentive to forecast a recession, If you are wrong, you'll be fired. And if you're right, no one will thank you." Or as Keynes put it,

Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.

Go back to the dotcom boom and sceptics of those high tech valuations were told they "just didn't get it". Even Warren Buffett was called a dinosaur for expressing doubts.

So the reception to today's negative forecasts helps explain why so few forecasters called 2007 or 2008 right. Some of us spotted straws in the wind but fell far short of anticipating the full horror. Indeed, had any economist in early 2007 predicted the effective collapse of much of the banking sector, and the deepest recession since the 1930s, they would have faced either deep scepticism or similar accusations of "talking the economy down".

Now, of course, those of us who backed the Remain camp need to be careful about the sin of "confirmation bias"—looking for evidence that confirms our gloomy view. Take the Bank of England's agents' report on regional conditions. It said that

Following the EU referendum, business uncertainty had risen markedly. Many firms had only just begun to formulate new business strategies in response to the vote and, for the time being, were seeking to maintain ‘business as usual’. A majority of firms spoken with did not expect a near-term impact from the result on their investment or staff hiring plans. But around a third of contacts thought there would be some negative impact on those plans over the next twelve months. As yet, there was no clear evidence of a sharp general slowing in activity.

Leavers will take that report as showing there is no sign of a slowdown; Remainers will worry about the third of companies that expect an impact on employment and job hiring over the next year. Similarly, retail sales fell 0.9% in June—a sign of Brexit-related weakness or simply statistical noise that offset a 0.9% increase in May?

It is clearly too early to tell whether there will be a recession. But let us suppose there had been no referendum at all. Anyone looking at the Deloitte survey of chief financial officers that found...

82% of CFOs expect their firms to shrink capital spending in the next year, with 83% forecasting a slowdown in hiring. Both are the highest level recorded by Deloitte’s survey and up significantly from 34% and 29%, respectively, in Q1.

...might reasonably worry, as they might about the construction survey which showed the weakest level of activity since 2009.

Now, some of this may indeed be down to confidence; and confidence may return if nothing bad happens to the economy in the short term. But let us go back to why business might be worrying. The UK has voted to upend its trading relationships and no-one knows what will replace them; indeed the government does not intend to begin formal negotiations on leaving the EU until next year, meaning that the process will not be completed until 2019. So the uncertainty will be prolonged. The surprise would be if economists were not forecasting an impact on activity.

The economists at Barclays have no financial interest in forecasting a recession; quite the reverse since they work for a UK bank. They are making their best, honest prediction. Rubbishing those who forecast a downturn will only add to the complacency bias that surrounds economic forecasting and make us even less prepared for the next global recession.