The perils of predicting the future

Economic forecasts are not always a reliable guide to the future, and few can really predict whether the global economic recovery will continue.

Earlier this year, Pier Carlo Padoan, who is now Italy’s finance minister but was at the time chief economist of the Organisation for Economic Co-operation and Development (OECD), the think-tank of the wealthy economies, conceded that he really could not predict with any confidence whether the global economic recovery would continue.

What then are we to make of the reassuring if uninspiring forecasts for gross domestic product in Europe in the latest Economic Outlook from the OECD (May 6), produced by Padoan’s erstwhile colleagues. Or similar forecasts in last month’s World Economic Outlook of the International Monetary Fund (the Washington-based, government-owned financial institution which last week approved a highly-conditional $17 billion bail-out loan for strife-torn Ukraine).

First, look at the good news. As the OECD says in its April Economic Survey of the eurozone: “Five years after the onset of the global economic and financial crisis, growth is beginning to pick up in the eurozone economies. Systemic risks have been reduced, large external and internal imbalances have receded and most of the vulnerable countries are regaining competitiveness via wage adjustments and significant structural reforms.”

There are other largely encouraging signs. Italy, Spain, Portugal and Greece, the most troubled of the eurozone’s sovereign debtors, have all auctioned new government bonds. Investors bought them at strikingly low interest rates, in Italy’s case the lowest since 1999. Bankers said the successful bond issues reflected recent positive economic developments, and the allaying of investors’ fears of an imminent break-up of the eurozone as they search for higher returns.

Earlier this week (4 May), Portugal announced that it would join Ireland in exiting from the bail-out programme agreed with the IMF, the European Commission and the European Central Bank.

Remember Padoan’s warning. He was speaking as he presented the OECD’s official mea culpa for its flawed forecasting record between 2007-12 – “OECD Forecasts during and after the financial crisis; a post mortem”. The IMFs performance in the run-up to the crisis was even worse.

Stijn Claessens, an assistant director for research at the IMF, was last week in London at the launch of an IMF book on the crisis (“Financial crisis: causes, consequences and policy responses”). Behind these failures, he suggested lay economic theories and models that had policymakers in their thrall – inflation targeting and the efficient markets hypothesis (don’t ask!) – but which did not live up to the expectations of their advocates. Typically, as the OECD says, they “ignored the banking system”, at a time when banks and finance were becoming increasingly dominant in shaping the global economy.

Economic forecasts may well be a reasonable guide to the short-term economic outlook for the next 12-18 months. But they do not tell you very much at all about the potentially volcanic financial stresses and strains, which, once again, are building up in the world’s financial markets and the global economy.

Interest rates, especially in the transatlantic region, are being held at artificially low levels by governments and central banks. Finance ministers and central bankers dread raising them, but can also see that these low rates are beginning, just as in the run- up to 2007, to inflate new credit and asset-price bubbles, while not necessarily helping to solve the economic problems against which they were deployed. They are, for example, reducing the pressures on governments, banks and businesses to launch tough reforms while encouraging risky financial manoeuvres.

Perhaps the strongest public expression of concern on this score so far came last week (1 May) from Jon Cunliffe, a former British ambassador to the EU, now deputy governor for financial stability at the Bank of England. Soaring house prices triggered by low interest rates are, he said, “the brightest” warning light flashing on the dashboard of policymakers trying to steer the British economy to safety.

Separately, a senior IMF official said that a house-price “boom” in Germany was worrying policymakers there too. Unlike the UK, a country which has had four housing-price booms and busts since 1975, Germany’s housing market has been legendary for its stability. This makes what is happening there particularly troubling.

The single currency was supposed to promote economic convergence across the eurozone. For Italy, Spain, Ireland and other ‘peripheral’ countries, the opposite happened. Now, once again, the single interest rate is fostering widening economic divergences.

If the single currency is to survive these renewed stresses from a single interest rate that, this time in a politically fraught environment, does not fit all member states, then new tools are going to be needed.

Germany will soon have to launch, as yet untested, ‘macro-prudential’, regulatory restrictions to contain its inflating property-asset bubble, which has been fuelled by cheap money. Essentially, this means telling banks they have to ration credit not by price (ie, higher interest rates) but by, for example, requiring people who want a home loan to put down a bigger and bigger deposit. That is not an easy message for politicians to deliver.

Meanwhile, it is not the super-low level of interest rates that is the biggest problem for peripheral, low-growth eurozone countries. Rather, especially for small businesses, it is that troubled banks are still so busy trying to heal the self-inflicted wounds of the 2007-08 financial crisis that they are still curbing their lending, as the latest ECB figures show.

Here again new tools are needed. These, the OECD’s survey of the Eurozone makes clear, will have to go beyond the current steps, spearheaded by the ECB’s Asset Quality Review, to increase pressure on banks to raise new capital and clean up their balance-sheets. New financial instruments are needed in several EU and eurozone countries to target credit towards small and medium-sized enterprises.

The authors of the IMF’s World Economic Outlook (WEO) underplay these issues. To raise Europe’s growth rate, they are recommending that governments with room for manoeuvre (they seem to be pointing the finger again at Germany), ignore still dangerously high levels of government debt and start stimulating the economy by spending more money themselves directly.

They call, too, for the ECB to lower interest rates. The WEO’s authors should pay more attention to what their colleagues wrote in last month’s Financial Stability Report. There the emphasis is on the risks, rather than the increasingly dubious benefits, from today’s “extraordinary monetary accommodation and liquidity conditions”.

Top of the warning-list here is the awesome challenge that the US faces as it tries to get out of today’s zero- interest-rate regime and get rates up to levels – at least between 2% and 4% – commensurate with its now impressive economic recovery.

Click Here: Putters

The shock wave that ran through the world’s financial markets (not just the US’s) almost exactly a year ago when Ben Bernanke, the then chairman of the Federal Reserve, hinted that the central bank might start clawing back the flood of dollars sloshing around the global economy, tells its own story. Padoan was right: economic forecasts and models are necessary but unreliable guides to the future.

RECENT ECONOMIC OUTPUT FORECAST

IMF

2013* 2014 2015

Eurozone – 0.5 +1.2 +1.5

Germany +0.5 +1.7 +1.6

France +0.3 +1.0 +1.5

Italy – 1.9 +0.6 +1.1

World + 3.0 +3.6 +3.9

US +1.9 +2.2 +2.3

United Kingdom + 1.8 +2.9 +2.5

OECD

Eurozone -0.4 +1.2 +1.7