Ever wondered why the forecast rise in inflation, improvement in growth or reduction in budget deficit and balances never materialises?
Global credit ratings agency Standard and Poor’s (S&P) has the answer.
In a new report, and with some very sharp language, S&P has issued a withering critique on the ability of governments, and supranational bodies like the OECD, to forecast the rate of growth in an economy.
In doing so S&P also said that means governments can not correctly forecast their real structural budget deficit, which means forecast improvements never materialise as the years progress.
“Economists have for many years tried to estimate these unobservable economic indicators by applying a variety of sophisticated statistical procedures. Unfortunately, the track record is not encouraging,” S&P said.
They cite the example of OECD’s estimates of output gaps, the difference between actual and so-called potential growth rates, of its member countries in 2007 and the European Unions more recent track record for its member states.
On the OECD’s experience S&P said (our emphasis):
In late 2006, the OECD was of the view that the majority of its members (59%) would have a negative output gap in 2007. That is equivalent to saying that most OECD economies were believed to be below potential. The OECD estimated the unweighted average output gap to be -0.3% of potential 2007 GDP (meaning the economy was believed to operate marginally below potential). In hindsight that assessment was a poor call: In late 2015, and with the benefit of hindsight, the same institution was actually of the view that all countries’ economies had been operating above potential in 2007. The unweighted average output gap had been revised to +4.2% of potential 2007 GDP, a massive swing of 4.5 percentage points of GDP.
That may seem a bit arcane to non-economists, but this is important because, as S&P says “the output gap is a vital ingredient in the calculation of structural budget balances”.
The impact is that when it comes to calculating structural budget balances, we are caught in a loop that end up with garbage in and as a consequence garbage out (GIGO).
So prime minister Malcolm Turnbull was being upfront and honest today saying no-one can really forecast the economy too far ahead. Unfortunately S&P is also saying it’s more difficult than governments recognise to actually forecast the economy right now.
That can impact the Australian and other government budgets over their forecast horizons and render their predictions as liable to change as a T-1000 Terminator. It also makes the job of a central bank more complicated than many would care to admit as well.
If, as S&P suggests, you can’t really estimate the potential level of growth in an economy, then how do you set a neutral interest rate and know if policy is genuinely accommodative or not?
Back to S&P.
The impact of poor forecasting and a GIGO forecast helps explain why, when the global financial crisis hit, many governments around the world couldn’t react effectively.
“As a consequence, the room for fiscal manoeuvre for many sovereigns no longer existed when it was truly needed after the global financial crisis hit. Instead governments were then forced into once again pro-cyclical restrictive fiscal policies, leading to the heated austerity debate,” S&P argues.
All of which leads me to the point of S&P’s analysis.
The ratings agency says government finances are being kept on life support by the current super-low interest rate environment.
“From our simple interest rate-corrected fiscal balance measure that, especially in the advanced economies, there is little reason for complacency. Recent budget improvements are mostly due to the palliative effects of monetary expansion. Indeed, discretionary fiscal adjustment appears to have come to a halt in many economies,” S&P said.
That’s important because “the exceptionally low interest rates brought about by super-accommodative monetary policies are flattering public finances. Assuming a “normal” interest rate level, general government deficits would have been higher by 1 to 2 percentage points of GDP in most advanced economies,” they add.
The good news for Australia is that it is one of the handful of nations that will not be materially impacted by a normalisation of interest rates. And that means, unlike many other countries Australia’s credit rating is likely to be under less downward pressure.
At least on this metric.
NOW WATCH: Money & Markets videos
Business Insider Emails & Alerts
Site highlights each day to your inbox.