The economy in 2015

Wrong, wrong, wrong

There is one big problem with all this, though. Economic forecasts are usually wrong. Since 1999, the average error in GDP forecasts made in December for the following year has been 0.8 percentage points. Even if we exclude the big errors for 2008 and 2009, when economists underestimated the severity of the recession, the average error has been 0.5 percentage points. And the average error in the inflation forecasts has been one percentage point.

One reasonable interpretation of these historic errors is that they imply that there's a two-thirds chance of GDP growing by between 1.8 per cent and 3.4 per cent next year, with a one-in-six chance of sub-1.8 per cent growth and a one-in-six chance of above 3.4 per cent growth. And they imply that there's a two-thirds chance of inflation ending 2015 between 0.9 per cent and 2.9 per cent, with a one-in-six chance of it falling below 0.9 per cent and of it rising above 2.9 per cent.

Unknown unknowns

Such big errors remind us that our economic future is inherently uncertain. Some of the uncertainties are what former US Defense Secretary Donald Rumsfeld called "unknown unknowns" - genuine surprises which we cannot know now but which, no doubt, we'll all be experts on this time next year.

There are, however, also known unknowns.

One of these concerns is fiscal policy. In his Autumn Statement, Chancellor George Osborne forecast that departmental public spending would fall by 11.7 per cent in nominal terms between 2014-15 and 2019-20. With spending in the biggest department (health) protected from the cuts, this implies swingeing reductions elsewhere. This means he envisages many years of fiscal austerity. One measure of this is the cyclically-adjusted primary balance - borrowing excluding interest payments adjusted for the state of the economy. The OBR foresees this moving from a deficit of 2.6 per cent of GDP this year to a surplus of 3.2 per cent in 2019-20. That's a tightening of 5.8 percentage points of GDP. Since 2009-10, however, we've only had a tightening of four percentage points.

Many economists regard this in the same way they regard Twisty the Clown - scary, but fictitious. "The planned cuts are now too large to be credible," says Rob Wood at Berenberg Bank.

This poses the question: what will the next government do about this? One possibility is to change the composition of the tightening, with more tax rises and fewer spending cuts. This would change the composition of economic growth - with more coming from government and less from the private sector - but, depending on the nature of the tax rises, might not much alter its size.

Another possibility, though, is to simply have less fiscal tightening. Insofar as current growth forecasts are predicated upon Mr Osborne's projected spending plans - and the OBR's are even if others' aren't - this would mean faster GDP growth. However, the Bank of England is likely to respond to this by raising interest rates by more than expected. In this sense, the policy mix would shift from tight fiscal and loose money to less tight fiscal and less loose money.

This uncertainty, however, won't be resolved in 2015. It could drag on for years. This poses another risk to the economy simply because, as Stanford University's Nick Bloom has pointed out, uncertainty tends to depress capital spending.

See you, EU?

This matters because there's not just uncertainty about fiscal and monetary policy. A Conservative election victory would mean a referendum about the UK's membership of the EU in 2017, posing the risk of UK exit. Economists disagree on the merits of this. Whereas Cardiff Business School's Patrick Minford believes it would be a good thing, some economists at the LSE warn that "the dream of splendid isolation may turn out to be a very costly one indeed". Whatever side you're on, there's a risk that businesses will delay spending until there's more clarity on this point.

These uncertainties come on top of other potential obstacles to capital spending: ongoing weakness in the euro area gives exporters little incentive to expand, and the dearth of monetisable investment opportunities, which many believe to be a cause of negative real interest rates, hasn't vanished. The fact that business investment fell in the third quarter warns us not to take a strong upturn for granted.

The OBR expects business investment to be the motor of growth next year, rising by 8.4 per cent in real terms. But this motor might splutter a lot.

Uncertainties, however, don't merely surround growth. The path of inflation is also unclear.

One of the few big (and pleasant) surprises this year has been the drop in oil prices. Futures markets don't expect this to continue. But there is huge volatility in oil prices: the standard deviation of annual changes in Brent crude since 1988 has been 35 percentage points, which implies that there's a roughly one-in-six chance of it falling below $50a barrel.

There are also question marks about sterling. On the one hand, if the ECB finally begins full-blown quantitative easing next year, sterling could rise simply because the extra supply of euros should drive down their price. On the other hand, though, it is possible that investors might eventually dump sterling as they worry about the UK's huge current account deficit. Sushil Wadhwani, a former member of the Bank of England's Monetary Policy Committee, used to say that "current account deficits don't matter - until they suddenly do".

If sterling and oil prices pose both upside and downside risks to inflation, there are also two risks on the downside.

Work, work, work

One comes from productivity growth. There have been signs recently that the long (and mysterious) stagnation in this is finally ending: total hours worked rose by only 0.1 per cent in the third quarter, implying productivity growth of 0.6 per cent, which is above its long-term average. If productivity does pick up, any rise in wage inflation might be offset by efficiency gains with the result that firms' unit costs do not rise. This would help hold down prices.

This would be especially true because it's not certain that wage inflation will rise. Although unemployment is officially just under 2m, there are another 1.3m part-time workers who want a full-time job and 2.3m people outside the labour-force who'd like a job. The excess supply of labour, therefore, is still large. This might hold down wage growth by more than expected, as it has this year.

A second downside risk - which both the Bank of England and ECB are worried about - is that low inflation might cause low inflation expectations; in recent years there has been a close correlation between the two. This matters because inflation expectations can be self-fulfilling. If people expect low inflation, firms won't raise prices much for fear of pricing themselves out of markets, and workers won't push for higher wages as they don't fear rising prices.

It's possible, therefore, that what looks like temporarily low inflation will in fact turn out to be more entrenched.

If this turns out to be the case, the Bank will hold interest rates down for longer than economists now expect.

You might think that all these uncertainties - and I could add more - merely show that economists don't know what's going to happen next year.

You'd be right. But this doesn't mean economists are useless - they can point out and assess risks, warn us about the more avoidable errors we make and show how to diversify risk well. If you want to know the future, go to a pier-end fortune-teller, not an economist.