Nikkei Business., 28th September 2004
Few economists expected the weakness shown by Japan’s economy in the second quarter of the year. This is part of a worldwide trend as similar errors were made in the US, eurozone and UK. Economists, it seems, are not good at forecasts. An outstanding example occurred in March 2001, when 95% of American economists forecast that there would be no recession, while subsequently published data showed that one had already begun. It is of course much more important that doctors can cure illnesses rather than forecast them, and the same applies to economists. It is, however, both interesting and important to note the reasons why economic forecasts are so fallible and to consider the consequences.
Accurately timed economic forecasting is, I think, inherently impossible due to the interaction between the financial and real economies. It must be impossible to forecast the level of the stock market at a precise time in the future. If such predictions could be made then the stock market would adjust now. At the same time, however, markets have an important impact on the economy, as the ending of the bubbles in Japan in 1990 and the US in 2000 have dramatically shown.
We can be confident that overvalued markets will fall and undervalued ones rise, but we cannot predict their timing. We cannot therefore make money out of this knowledge, at least not without taking great risks, nor predict the timing of economic swings either.
Despite this obvious problem, many economists are driven to attempt the inherently impossible and make timing predictions about the economy. As these refer to points of time in the future, they are known as point forecasts. Economists can, reasonably enough, blame the market for this. There is a great demand for point forecasts and economists therefore provide them. The demand does not seem to fall simply because the answers are incompetent, with the result that the supply continues without interruption.
The drive to do what can’t be done has the undesirable side effect that it reduces the attention given to what can be done. While it is not possible to time changes in the economy, it is possible to identify the major disequilibria and from these to point to important changes that are almost certain to occur.
Looking around the world today there are an unusually large number of such disequilibria. I would like to point to some important ones. First, we have high budget deficits in all developed economies. Second, we have low household savings and high debts in the US and UK. Third, we have excessive corporate investment in Japan and fourth, we have many overvalued asset markets.
Other economists would point to the US current account deficit as a fifth and the low level of US interest rates as a sixth. I am doubtful about both these claims. The US current account deficit is, I think, largely the natural result of differences in the demographic changes that are taking place among the economies of the developed world, and the low level of US interest rates is the proper response to an economy which is still far from robust.
US interest rates and its current account remain, nonetheless, hazards for the world economy, as the widespread perception that they are problems can lead to mistaken policies, such as a premature increase in interest rates or a rise in protectionism.
The major disequilibria that I have listed are particularly dangerous today, as they reduce the chances that the world economy will pick up again despite its current signs of weakness, and because policy changes to stimulate demand in this event are unusually difficult to implement.
The low savings and high debt levels of American and British households increase the chances that savings will rise and thus consumer demand weaken. The corollary, of overvalued asset markets, is that share prices everywhere, and house prices in the UK and US, are highly likely to fall. On past experience this makes a rise in household savings even more likely than the current low level alone would indicate. Excess investment in Japan reduces the chances of a worldwide improvement in capital spending, which might otherwise offset a fall in consumption.
These factors increase the risks of another worldwide recession. The problem of high budget deficits and low interest rates is that they reduce the likelihood of a prompt response to economic weakness. It will not be easy for governments and central banks to ease either fiscal or monetary policy in today’s conditions.
These problems do not mean that a world recession in say 12 months time can be forecast. They do, however, suggest that the risks are considerable and the fact that most economists are confident that we won’t have one means nothing at all.