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Wishful Thinking not Volatility to Blame for Poor Forecasts

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John Robertson

World growth is more volatile than it has ever been, according to Australia's new Treasurer, trying to explain another revenue forecast failure. There is an important distinction, for politicians and corporate leaders alike, however, between genuine volatility involving wildly fluctuating economic outcomes and having to pare back expectations as a result of too much wishful thinking.

New Treasurer Chris Bowen's explanation on Friday for how $33 billion had disappeared from the government's revenue estimates relied heavily on how volatile global growth had become and how the resulting uncertainty made the forecasting task too challenging for even the best in the land.

World output, which had grown by 5.4% in 2007, contracted by 0.6% in 2009, two extremes not matched in the prior 25 years. Also according to the International Monetary Fund, output growth again reached 5% in 2010. That is volatile, no doubt, but these outcomes happened three years ago or more.

For the past three years, global output has expanded at a more consistent 3-4% pace. The worst fears for the global economy in 2008 and 2009 have remained pleasantly unrealised. Europe, too, has seemingly averted the worst of what could have happened as a result of government debt burdens becoming unsustainably high. At the same time, the prolonged weakness in the advanced economies has fed back to the emerging economies which are growing less quickly. The result is convergence on a narrowing range of lower growth outcomes. This sounds like the antithesis of volatility.

Prompted by the Treasurer's repeated insistence that volatility was unprecedented, I calculated two statistics, one to take account of variability in growth between successive years and the other to take account of intra year volatility across regions and countries. The calculations were based on annual movements in constant price GDP for the European Union, developing Asia, Latin America, the MENA countries, Japan, the USA, Germany and the UK.

The first measure quantified the difference between average growth in successive years since 1980. The second measure quantified the difference between the highest growth rate and lowest (relative to the average) over the same 30 years or so for the same collection of countries and regions.

There is a chart of the first of these measures in my daily market diary for 4 August with a brief comment at http://www.eimcapital.com.au/PortfolioDirect/daily_views.htm. Certainly, 2008-09 redefined the nature of volatility in a global growth context. However, since then, the statistics show the global economic system stabilising. The most recent measures of volatility are unexceptional in the context of the last 30 years, not unprecedented.

Use of volatility as an excuse for forecasting failures might be just another example of how politicians habitually re-fabricate history to suit their current needs. Nonetheless, the revenue shortfall is very real and, for that reason alone, warrants some greater understanding than a one word slogan alone might convey.

There are usually three reasons a forecast ends up being inaccurate. The first is faulty data inputs. The second is a material change in the way in which the world is behaving. Being too deeply rooted in past behaviour patterns, analytical models are sometimes not sufficiently general to grasp the import or the speed of a change and anticipated outcomes are correspondingly biased (or simply wrong).

A third reason for forecasting inaccuracy is insufficient questioning of projected outcomes and, consequently, a failure to modify model structures to minimise ongoing forecasting errors.

During Australia's recent history (i.e. since about 2004), politicians and their officials seemed to have persuaded themselves that the Australian economy had lost much of the cyclicality which had characterised its history. Reflecting this attitude, notions of the miracle economy entered the political lexicon.

Such a mindset framed the responses to official forecast inaccuracies which first began to emerge nearly a decade ago with revenue outcomes then running ahead of the forecasts as the global economic cycle gathered momentum.

Rather than admit a forecasting problem and proceed cautiously, governments readily embraced the consequences of the analytical missteps at the time with tax cuts and higher transfer payments. There was no talk then of volatility causing inaccurate forecasts despite it being a more apt description of conditions then than now. Being able to take advantage of economic cyclicality blinded politicians of all persuasions to these forecasting faults.

In this they were shamelessly abetted by company executives, not least those within the resources sector from where a disproportionate part of the economy's volatility arises.

At the top of the cycle, executives were adamant that prices would go higher. No executive ever conceded that his own market was going to contract. Supply would never catch up with an insatiable Chinese demand. These were the ultimately unrealistic sentiments being conveyed to government.

Then, there were analysts who set the tone for many discussions about business outcomes substituting slogans like "supercycle" for quality analysis, sometimes to grab attention and sometimes to help ingratiate themselves with their investment banking sales desks. Whatever their motivation and whether they meant to or not, they also put the case for cycles having been eliminated.

In this environment, officials were naturally reluctant to contradict what the private sector was telling them. Even where government forecasters thought markets were likely to move from deficit to surplus, they avoided forecasting significant (i.e. genuinely cyclical) price changes. The terms of trade would deteriorate, they said, but not by a material amount.

Implicit in this reluctance to embrace reality was the false idea that Australia was no longer a cyclical economy. That was the wishful thought on which a fiscal edifice was being built.

Paradoxically, as an economic cycle approaches its nadir and the dispersion in growth rates narrows, politicians, officials and corporate executives alike are now talking about volatility. The term volatility is now being used erroneously not to describe wildly fluctuating economic variables but to describe the embarrassing disparity between actual outcomes and the wishful thinking on which decisions had been based.

(John Robertson is a director of E.I.M. Capital Managers, a Melbourne-based funds management group. He has worked as a policy economist, corporate business strategist and investment market professional for over 30 years after starting his career as a federal treasury economist in Canberra. His daily Market Diary - Brief Thoughts on Current Issues is available at http://www.eimcapital.com.au/PortfolioDirect/daily_views.htm).


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