Judge economists' forecasts on method, not decimal points
At the end of each year, economists are judged by colleagues, the press, and the business community to see who came closest, within a few decimal points, in predicting the nation's output, inflation, interest rates, etc. Is that the very best way to judge the value and the success of an economic forecast?Skip to next paragraph
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The economists may just be right for the wrong reasons. But no one will know that, because penetrating questions about methodology are seldom asked.
It's curious, for instance, that economists often speak reverently about the Federal Reserve but don't include any reference or assumptions about monetary policy in their economic forecast. Nor do they explain how this policy influences the economy.
Economists often act as though the Fed has the ability to determine the level of interest rates over six or 12 months -- but these same economists often ignore the money supply.
Anyone reading the minutes of the Federal Open Market Committee would be left asking the question, ``Why are Fed officials so concerned about the rate of growth of money? It must be important, and if it is, why do so many economists ignore it?''
Then there's fiscal policy -- taxing and spending by government. Everybody can relate to that. Just about everybody is taxed, and just about everybody is the recipient, directly or indirectly, of government spending.
Keynesianism holds that increases in government spending benefit the economy. But today, even fiscal policy receives little treatment in forecasts. The deficit, of course, is too big, even though deficit financing is deemed to be stimulative.
Instead, forecasts often rely on trends that seem fashionable under current circumstances. The most fashionable element in today's forecasts is interest rates. There are those who believe that with inflation running at less than 3 percent, interest rates are too high. This group, therefore, holds that the economy will grow at a very sluggish rate in 1986.
Of course, we enjoyed a very high growth rate -- more than 6 percent in real terms -- in the first year and a half of the recovery in spite of interest rates that were higher in both nominal and ``real'' terms. You may remember there were many forecasters who said that because interest rates were too high, the recovery would be short lived.
A great many of the forecasts for 1986 simply represent an extrapolation -- 1985 all over again. Others say the recovery is getting feeble, because it is getting old. Recoveries from recession have averaged 42 months. The one we are now in is 37 months old. Such forecasts implicitly ignore policy, as though it doesn't exist.
In my experience, consistently good economic forecasts rely on using theory to determine the effects of policy. As far as policy is concerned, monetary and fiscal policy has been highly stimulative. Officials in Washington want stronger growth than that which occurred in 1985. And we are likely to get what they want.
Good economic forecasts should not be measured by precise numbers. For example, a forecast of slow to moderate growth would embrace, say, a 2 to 3.5 percent increase in real GNP for the year.