Economists expect the UK economy to grow strongly this year, despite falling household incomes. According to a survey by the Treasury, forecasts for gross domestic product (GDP) growth range between 3.1 and 5.7 per cent, with a median of 4.1 per cent. We should not trust such numbers.
Jan Magnus at the Free University of Amsterdam has shown why. He shows that a best forecast will quite often lie outside the range provided by forecasters. He proves this mathematically, but the intuition is simple. Our best forecast will use all available information, but as Friedrich Hayek said such information is dispersed, fragmentary, perhaps contradictory and not available to any single mind. This wouldn’t be so much of a problem if forecasters were so diverse and independent that they covered all this information. But they don’t. Forecasters look at similar information and overlook other things, so even the range of forecasts omits some valuable information. This means that sometimes the best forecast lies outside that range.
There are two crucial elements to the story here: professional deformation and correlation neglect.
Professional deformation is the tendency for our professional training to inculcate in us not just useful skills but biased ways of seeing the world. Lawyers, for example, overestimate the extent to which social problems can be legislated away; engineers see too many things as control problems; academics overvalue intellectual ability; and so on.
So it is with economists. We know we have blind spots: the International Monetary Fund's Prakash Loungani has shown that, around the world, they have consistently failed to foresee recessions.
One such blind spot is the failure to empathise sufficiently with those in less comfortable positions – this is one reason perhaps why Brexit was a surprise. Economists expect demand to grow well this year because they expect households to cut their savings. But what about those who lost their jobs and businesses in the pandemic and so don’t have savings? Or those on low incomes who cannot borrow? Well-paid professionals are prone to overestimate the extent to which others are in their position, and are able to dis-save.
Also, economists – like everyone else – are shaped by their formative years. For older ones, these were years of decent economic growth, which we assume to be normal, and so we underestimate the forces of stagnation.
The Office for Budget Responsibility’s forecasting record shows this. In March of every year since 2011 it has expected business investment to accelerate the following year. And in eight of these 10 years it has overpredicted that growth. This suggests it overestimates the number of profitable projects and underestimates the forces militating against capital spending. It’s possible, therefore, that economists are too optimistic.
Professional deformation, however, isn’t the only cause of this. Ordinary incentives have the same effect. Forecasters who stray too far from the consensus risk looking foolish and will feel uncomfortable even if they are eventually vindicated. Many therefore adjust their forecast towards the consensus, with the result that the range of forecasts is upwardly biased. This is a form of what economist Timur Kuran has called preference falsification.
The range of professional forecasts can therefore be too narrow. This brings us to the second part of our story: people tend to ignore correlations. economists Erik Eyster and Georg Weizsacker have shown that “people tend to ignore correlation and treat correlated assets as independent”. People overestimate how much they can spread risk by investing in equity funds, for example. And behavioural economists Florian Zimmerman and Benjamin Enke have shown that investors don’t discount correlated information and stories and so become overconfident about the scant information they really have. This, they say, is one reason why, over time, share prices over-react to good and bad news.
In the same way, we underestimate the extent to which economists’ blind spots and biases are correlated, and so have too much confidence in them. And not just economists: we could tell a similar story about journalists or fund managers or financial advisers.
None of this is to endorse a crass anti-intellectualism: the opinions of philistines are also biased and correlated. Instead, we must ask of economists and other experts: is there any information they are systematically underweighting?
And herein lies a reason for optimism. There’s something else economists under-rate – the wisdom of crowds, the fact that thousands of dispersed opinions can in the right conditions tell us something about the future. And right now, two such indicators are encouraging.
One is that the ratio of retail sales to the All-Share index is around its long-term average. This tells us that consumers are not hunkering down much in anticipation of bad times, which could be because the bad times will be only mild and short-lived. This is important, because the ratio has been a fantastic predictor of equity returns, correctly predicting falling prices in 2000 and 2007 and rising ones in 2003 and 2009, for example.
The other is that the yield curve is still upward sloping. This tells us that investors expect yields to rise, which means they anticipate the economy doing OK - and such anticipations are often correct.
Perhaps, therefore, professional forecasters might be right after all. But the best reason to believe so is not so much the weight of their opinion as the wisdom of crowds.
