Value of gloomy short-term forecasts is questionable
OPNION:Relentlessly revising forecasts downwards is of far less importance than pursuing the right kinds of policies, the effects of which will be felt long into the future, writes JIM O'LEARY.
I CANNOT remember the last time anyone revised upwards their forecasts for the Irish economy. It seems like an uninterrupted procession of downward revisions has been going on for several years now. The ESRI’s spring Quarterly Commentary contains the latest addition to that doleful catalogue. The institute now reckons that GDP will contract by over 8 per cent this year, compared with the forecast of a 4 per cent contraction in its winter commentary in December and its expectation of a sub-1 per cent decline at the time of its autumn commentary. Taken together with the latest forecast for 2010 and the latest estimate of what happened in 2008, the implication is that the Irish economy will shrink by a cumulative 12 per cent in the three-year period. There are few precedents for a recession of such severity in modern times.
Meanwhile, the rest of the world is not doing too well either, and forecasts for our main trading partners have been slashed in recent months. Last week’s World Economic Outlook from the IMF is replete with grim detail on this score. The US, the epicentre of the current global crisis, is now expected to endure a reduction in GDP of just under 3 per cent, itself a record for the post-war era. But the number of economies expected to suffer a significantly sharper setback than this is growing all the time. The IMF is now forecasting declines of over 4 per cent in the UK and the euro zone economy in 2009, with Germany projected to shrink by almost 6 per cent. Other notably severe recessions are being forecast for Japan (minus 6 per cent), Taiwan (minus 7.5 per cent) and Singapore (minus 10 per cent).
Parallels between the current crisis and the Great Depression of the 1930s, once dismissed as hopelessly far-fetched, are becoming increasingly and disturbingly close. A recent short paper by Barry Eichengreen and Kevin O’Rourke*, concludes that the world economy is now tracking or doing worse than during the Great Depression: industrial output has been shrinking at least as fast; world stock markets have been falling more steeply and world trade has been contracting more rapidly. The one consolation is that policy-makers this time have been responding more aggressively, although how effective that response proves to be remains to be seen.
Context is everything. The state of the Irish economy, dire though it may be, could be worse (and may yet become worse), given the kind of conditions that obtain internationally. The ESRI’s latest forecasts, bleak as they are, still contain an element of downside risk. One area where I think this is especially the case is exports. Here, the institute expects a volume decline of 5 per cent this year. On the face of it, this is a dismal prospect, but it is a prospect that is being held out in the context of an expected 13 per cent reduction in the volume of world trade, and compares with OECD forecasts of near-vertical drops in the exports of the likes of Germany (minus 16.5 per cent) and Japan (minus 26.5 per cent).
Granted these economies specialise in the production of the kind of goods (machinery, consumer durables, motor vehicles) the demand for which has been especially hard-hit, but Irish exporters face their own distinctive challenge in the shape of a steep currency appreciation. If we can limit the decline in our exports to 5 per cent against this background, it might suggest that our international competitiveness is in better shape than is commonly perceived.
As the current recession/depression matures, attention increasingly shifts to the questions of how soon the recovery will start and how strong it will be. Last week’s IMF report suggested less than cheerful answers to both. A detailed examination of previous recessions and recoveries by IMF staff concludes that recessions associated with financial crises tend to be more than usually severe and protracted and the subsequent recoveries tend to be anaemic. Broadly similar conclusions obtain in respect of highly synchronous recessions (where a large number of economies experience recession at the same time). Since the current episode is highly synchronous and associated with a financial crisis, the inference to be drawn is that recovery is likely to be slow in coming and weak when it arrives. A particular problem with recovery from highly synchronous recessions is that exports tend to grow sluggishly.
These conclusions would appear to be especially relevant for Ireland because of the severity of the financial crisis here and the dependence of the economy on international trade. In this respect the ESRI’s forecast of a further 1 per cent drop in GDP next year, implying as it does a pick-up in activity in the second half of the year, may be a little too sanguine. The IMF, by the way, is forecasting a 3 per cent decline in Irish GDP in 2010.
One could spend a lot of time picking over the detail of short-term economic forecasts. However, the value of doing so is especially low at this time, for two reasons. First, recent events have been so tumultuous and the changes in economic and financial variables so large that there is little by way of precedent to rely on when it comes to plotting the responses of households and firms. In this connection, as Alan Ahearne wryly remarked in a speech reported earlier in the week, there are two kinds of economist, those who know that they don’t know and those who don’t know that they don’t know. Indeed, in current conditions, one wonders about the utility of producing regular short-term economic forecasts. If such exercises are deemed necessary, it might be better to publish ranges rather than point forecasts. It might be better still to build different scenarios, corresponding to different assumptions about policy and the external environment.
Second, the short-term outlook for the economy is a matter of much less importance than the identification and pursuit of good policies the effects of which will be felt well into the future. Whatever the trajectory for GDP, exports, employment and unemployment over the next 18 months or so, there are some immutable imperatives: the banking system must be restored to health; the public finances must be stabilised, and the competitiveness of Irish firms must be secured. The challenge for political economy is to pursue resolutely this agenda at a time when the pay-off from doing so may be distant and unclear.
* A Tale of Two Depressions (www.voxeu.org/index.php?q=node/3421)