The Unassuming Economist

In a new paper, Daniel Aromi shows that “excessive optimism after the arrival of positive information” for a few years about a country’s prospects can lead to large forecast errors when the information turns negative but forecasts don’t.

“[…] some years before the Asian crisis, Krugman (1994) warned against ‘popular enthusiasm about Asia’s boom’. More recently, Pritchett and Summers (2014) indicate that growth expectations regarding the Chinese and Indian economies might suffer from excessive extrapolation of recent trajectories. In addition to these warnings, further motivation is provided by macroeconomic episodes in which improved economic prospects are followed by crises. For instance, several European economies, among them Greece and Ireland, went through this type of trajectory. Another case is given by recent events in Brazil, where prominent optimism regarding economic prospects was later proven wrong in a stark manner.”

“The empirical analysis shows a significant association between mean forecast errors and earlier information flows. The sign of the documented relationship is consistent with the overreaction hypothesis. More positive information is followed, on average, by higher forecast errors, that is, by increments in the mean difference between forecast growth and realized growth.”

“It is worth noting that the strongest evidence is documented for information flows and forecasts errors that are between 4 and 8 years apart. In other words, the evidence indicates the presence of a process that develops at a frequency that is lower than the usual business cycle frequency.”

“This work documents the presence of systematic errors in growth forecasts. Mean forecast errors are positively associated with the tone of information flows observed in previous periods.”

“The inefficient use of information and the associated errors in decision-making could explain economically significant aggregate fluctuations. In particular, excessive optimism after the arrival of positive information can contribute to the emergence of vulnerabilities that increase the likelihood of economic crises.”

The article is available from the International Finance.