A Slow Recovery for a Happy New Year.

Andrew Smithers
Nikkei Veritas - Market Eye column, 18th February 2010


Economic forecasts are notoriously unreliable; what is perhaps less understood is the way in which they tend to err. The OECD is a highly professional body and their forecasting errors are typical of the ways in which even the most skilled economists tend to disappoint us when they turn to forecasting.

If one looks at the forecasts published by the OECD in June for the next calendar year, they appear in recent years to have suffered from one mild and persistent error and one large mistake. In the three mid-year forecasts made up to June 2006 the OECD was always a bit too optimistic. For example, they expected US growth to be, on average, 0.74% faster than it actually turned out to be. Their major mistake, however, came later when they failed to foresee the weakness of the economy in 2008 and 2009. Even on the most optimistic view of the final quarter of 2009, for which we do not yet have data, the forecasts for both years will have proved to be wrong by more than two percentage points.

It is the major forecasting errors of the past two years, rather than the previous, and relatively small, degree of over-optimism which stand out and provide the real ammunition for those who abuse economists for their incompetence. It should, however, be noted that both in their mild over-optimism prior to 2006 and their more serious errors of the past two years, the OECD was in line with the general consensus among economists.

Today there seems no longer to be a consensus. Expectations for 2010 cover a much wider range than is usual. While the average forecast is that the US will grow this year by around 2.5%, it is common to find, among professionally competent economists, forecasts ranging from near zero to 4% or even higher.

This divergence of opinion reflects the fact that forecasts amount in essence to asking “what happened last time we were in this situation.” Naturally enough this works best when there are lots of similar occasions to the present one. This is usually when the economy is growing around its average pace and has few exceptional features. Today, however, the world is recovering from one of its rare financial crises, such as those that followed the stock market peaks of the US in 1929 and Japan in 1990. On this occasion, however, the response from governments and central banks has been far more stimulatory than on either of the previous occasions.

Economists who expect a rapid recovery tend to point to the experience of post-war recessions from which recoveries have tended to be particularly robust when the previous recession was severe. Those who expect a weak recovery usually point out that economic recoveries have tended to be weak when they have been preceded by financial crises. Both views are therefore sensible and we simply lack sufficient examples of heavily stimulated post-crises recoveries to make a sensible choice between them.

The result is a justified and wide divergence of views. Both optimistic and pessimistic views are also perfectly sensible provided their proponents recognise that the outcome is unusually uncertain.

Oddly enough I think that a mild recovery is more desirable than a strong one. After the stock market bubble of 2000, the US introduced major tax cuts and very low interest rates. These moves were successful in creating an economic recovery at the cost of the next bubble in 2007. The response this time has again been major tax cuts and low interest rates, which seems to have been successful. But if we experience another asset bubble, I doubt whether it will be possible to introduce another round of major cuts in taxes and interest rates. It is therefore vital that another bubble is avoided and this is more likely if the recovery is initially sharp than if it is relatively slow.

An important contribution to the current recovery has come from central banks buying assets – the process called quantitative easing. Naturally enough this buying, which has been massive, has driven up asset prices and, in the case of bonds and US shares, these have already risen to worryingly high levels. At their current level this provides an excellent opportunity for companies, and most notably banks, to improve their balance sheets which are still extremely fragile, by making new issues. A mild recovery accompanied by lots of equity issues would reduce the fragility of the world economy and, combined with a slow recovery, would probably disappoint the stock market, both of which would have the desirable consequence of making the world less vulnerable to another financial crisis.

I am optimistic enough to think that such a slow recovery is quite likely.


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