Fallacy of Economic Forecasts

Economists are too well-known for their wild forecasts of future economic conditions.  Just today, I reviewed the Economists’ poll of economic forecasts for many of the world’s economies.  Projections of the percentage change in real GNP ranged from minus 1% to minus 4% (except for Japan at minus 7.6%).  At least the poll is showing negative growth for 2009 and 2010!  A short while ago, these projections were showing modest gains!

Anecdotally, at least in Canada, we are seeing most of the population cutting back on their spending by substantial amounts (not 1 – 4%).  The cut backs are not confined to major expenditures, but include the smaller items in a household budget, like dinners out, entertainment, vacations, etc…  Among those people that I know (rich, poor and in-between), everyone has been cutting back their spending by a minimum of 10%.  I live in an area that used to receive 5 – 10 ad mail pieces per day.  Now, it is down to one or two.  Small businesses are putting a hold on their advertising to local residents.  Could it be that consumers are deferring their purchases no matter how good the product or price?  For the most part, I think this is the case.  I think it is safe to say that the true drop in economic activity is far in excess of 4%.  But this reduction is not reflected in the economic forecasts.  Why is that?

Well, so far, we have not seen the full effects of the downturn in consumption, as businesses are simply depleting their inventories.  The replacement orders will not be coming as quickly or to the same extent as they were a year ago.  When this starts being felt by the manufacturers, watch for another round of layoffs and terminations.  Watch for prices to fall, as businesses try everything to generate cashflow.

Economists use forecasting models to predict the future.  These models have numerous assumptions built into them, based on historical relationships and trends.  We are in a completely new situation in today’s economy.  The old assumptions simply do not apply the way they used to (not that economists’ forecasts were particularly accurate before)!

Take a look at the stock markets.  Their indices have dropped substantially over the last year.  In very simplistic terms, theoretically, stock prices are based on discounted future cash flows and risk.  Certainly, the economy has become riskier, and firms’ prospects of generating cashflows have decreased.  The “market” appears to have estimated that cash flows will be decreasing by as much as 40%.  This, too, doesn’t jive with the economists’ projections.

Perhaps a more likely reason for “rosy” economic forecasts is that they don’t want to be too pessimistic and they do like to stay within their comfort zone in terms of past predictions and the predictions of other economists!  If they were too pessimistic, perhaps consumers would become collectively depressed, adding fuel to the fire.

My advice, keep your eyes and ears open to guage for yourself where the economy is headed.  Until you start to see real people becoming optimistic and starting to spend on discretionary things, we will continue to be in a severe recession.

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