The Unassuming Economist

An already sluggish global recovery shows signs of further weakness, mainly because of continuing financial problems in Europe and slower-than-expected growth in emerging economies, the IMF said July 16 in a regular update to its World Economic Outlook.

Feb. 2 is Groundhog Day. Legend has it that if the groundhog—Punxsutawney Phil—casts a shadow that day, six weeks of winter lie ahead. No shadow and the forecast is for an early spring. Statistical records suggest the groundhog has been right about 40% of the time. Are we headed for economic spring or winter? If past performance is any guide, we might be better off asking groundhogs than economists.

A dismal record

     In 2000, I wrote in the Financial Times that “the record of failure to predict recessions is virtually unblemished.” A dozen years and many recessions later, there is little reason to change my assessment.

     My initial conclusion was based on my findings that only two of the 60 recessions that occurred around the world during the 1990s were predicted by private sector forecasters a year in advance. About 40 of the 60 recessions remained undetected seven months before they occurred. As even as late as two months before each recession began, about a quarter of the forecasts still predicted positive growth for the country concerned.

     With my colleagues Jair Rodriguez and Hites Ahir, I’ve since looked at the record of forecasting recessions over the decade of the 2000s and during the Great Recession of 2007-09.

     Let’s consider the 2000s first and restrict attention to forecasts for twelve large economies—the G7 plus the ‘E7’ (emerging market economies–Brazil, China, India, Korea, Mexico, Russia and Turkey), which together account for over three-quarters of world GDP.

     There were a total of 26 recessions in this set of countries. Only two recessions were predicted a year in advance and one of those predictions came toward the turn of the year. Requiring recessions to be predicted a year ahead may seem like an unreasonably high bar to set.

     Lowering the bar to the start of the year in which the recession occurred does indeed improve the performance somewhat: 8 of the 26 recessions were predicted in February of the year in which they occurred and 16 were predicted by August. But even as the year drew to a close, 6 of 26 recessions remained undetected by forecasters.

     Moreover, while forecasters increasingly started to recognize recessions in the year in which they occurred, the magnitude of the recession was underpredicted in the vast majority of cases. For instance, even as late as December of the year of the recession, the forecast was more optimistic than the outcome in 15 cases.

     Figure 1 shows the evolution of forecasts on average across the 26 episodes. The forecast in February of the year before was for about 2.5% growth. This forecast was slowly lowered over the course of the year and by the start of the year of the recession the average forecast was for a small decline in real GDP. It was only as the year was drawing to a close that the average forecast caught up with the reality of the recession.

     The impression one gets is of forecasts chasing the data rather than staying a step ahead of it.

     The forecasting performance at the onset of the Great Recession was no better. Looking at forecasts for over 80 countries, it turns out that none of the nine recessions that started in 2008 was predicted a year in advance. Even by April 2008, none of the nine recessions were predicted and by October 2008, only four were.

Figure 2

Official sector forecasts?

     If private sector growth forecasts are of little use in spotting recessions, why not use the forecasts made by the official sector? The IMF, the World Bank and the OECD all provide economic forecasts for free.

     Yet there is not much to choose between private sector and official sector forecasts. Statistical “horse races” between the two tend to end up in a photo-finish in most cases. As just one example of this, look at Figure 2 above which compares private sector (consensus) forecasts vs. the IMF’s World Economic Outlook and the OECD’s forecasts. It is evident from these charts that there is little daylight between private sector forecasts and official sector forecasts: the forecasts have a correlation of over 0.9.

     This finding casts new light on claims sometimes made that the growth projections of international organizations tend to be over-optimistic. Since the private sector is not subject to the same pressures, it is puzzling that its forecasts end up so close to those of international organizations. At the same time, the pressures acting on private forecasters to lead them towards over-optimism are not faced by forecasters in international organizations.

     One possible explanation for the similarity of the predictions is that private and official sector forecasters feed on each other and—in many countries—are heavily reliant on government forecasts. Exuberance on the part of governments may affect both private sector forecasts and those of international organizations.

Buyer beware

     The failure to predict recessions does not mean that forecasts of economic growth have no value. But it does suggest that users of forecasts might be better served by paying greater attention to the description of the outlook and the associated risks than to just the central forecast itself.

     Reassuringly, it is becoming more common to show how much uncertainty there is about whether the central forecast will come true. It is particularly useful to be explicit about the downside risks to a growth forecast as it can provide a wake-up call for policies and actions needed to keep those risks from materializing.

Recent headlines suggest the ‘Made in the USA’ label is back in business. “Manufacturing employment has grown faster in the US than in any other leading developed economy since the start of the recovery,” says the FT. Indicators of the manufacturing sector also point to an optimistic outlook, according to January’s Business Outlook Survey of Philadelphia Fed.

The manufacturing outlook seems good in the rest of the world too with the exception of Europe. World industrial production will grow 5% next year, compared to 4.5% in 2011, according to Dan Meckstroth (Chief Economist of Manufacturers Alliance for Productivity and Innovation—MAPI).

But, beneath the surface things seem less hopeful, particularly in the advanced economies. For more than a decade, there has been a “hollowing out” of jobs in these economies — a striking loss of middle-income and manufacturing jobs – as summarized in a research piece I coauthored. The chart below shows a striking decline in middle-income jobs in advanced economies between 1993 and 2006.

This trend has continued over the past few years. “During the recession and recovery … highly skilled workers have done best, low-skill workers have done poorly, and those in middle-skill employment have done very, very poorly,” according to a recent article in The Economist. “Even as the job market has improved over the past year … employment among workers without a high-school degree rose by 126,000. Employment for workers with a college degree rose by just over 1m jobs. For those with just a high-school diploma, however, employment fell by 551,000.”

Advanced economies are also losing market share in manufacturing to emerging economies.

And in both advanced and emerging economies, manufacturing share’s of GDP is declining.

My research notes that the decline in manufacturing jobs accelerated during the 2000s and was accompanied by a huge increase in advanced economies’ imports from low-income countries. Other authors estimate that at least one-third of the aggregate decline in U.S. manufacturing employment during 1990–2007 can be attributed to increased imports from emerging markets. The chart below shows the sharp decline in U.S. manufacturing jobs and the increase in the profits of multinational firms during the 2000s. Meckstroth also points out that non financial corporate profits are nearly back to their peak, in particular, income for foreign affiliates which are extremely profitable.

The Economic Cycle Research Institute (ECRI) made a controversial call in September last year: it said a U.S. recession in 2012 was a ‘done deal’. Yesterday, Ethan Harris of BofA/Merrill Lynch was more hedged: he said there was a 40% chance of a U.S. recession but a 50% chance that U.S. growth would be 1.9%. Harris was pretty sure the eurozone was headed for a recession in 2012.

Harris, the co-head of Global Economics Research at BofA/Merrill Lynch, was speaking yesterday to the National Economists Club in Washington, D.C.

Europe: a recession, but how big? Europe is almost certainly going to go into a recession, according to Harris, and this will have an impact on the U.S. economy through banking, trade and confidence channels. For the Eurozone’s 2012 GDP growth, Harris forecast -0.6% with a 50% probability and -2.5% with a probability of 40%.

U.S. Triple Dip: in 2012, look for another soft patch. Harris said the U.S. is facing three shocks in the year ahead.

•  First, the U.S. will get a downgrade. Neither party has a credible deficit reduction plan. Also, the deficit commission has no chance of success. 

• Second, there will be an automatic tightening of U.S. fiscal policy. The total of programs expiring in 2012 adds up to US$225 billion (1.4% of GDP). 

• And third is the post election pothole. He said that the post-election fiscal shocks adds to US$430 billion (2.9% of GDP), this include debt deal part I and II and the expiration of Bush tax cuts. 

Putting all the three shocks together, he forecasts US real GDP growth of 1.9% for 2012 and 1.4% for 2013 (vs. Consensus projections of 2.1% and 2.5%, respectively). On a quarterly basis, he projects a downward path for GDP growth of 1.8% in Q1 and Q2, 1.3% in Q3 and 1% in Q4; this is in sharp contrast to Consensus, which projects an upward path.

Harris also said the housing recession in the U.S. continues, there is way too much inventory. It will take 18 months to clear the home inventory at the current sales pace. He thus projects a recovery in the housing market around the third quarter of 2013. He expects U.S. inflation to fade in the summer. He forecasts core PCE 1.5% for 2012 and 1.3% for 2013 vs. consensus projections of 1.8% for both years.

Meanwhile, ECRI seems to be sticking with its recession call for the U.S. – see the latest on their position here.