Monday, 16 January 2017

The weather is not the climate: predicting the economic impacts of Brexit

Interviewed for ITN/Channel 4 News, I was asked – very reasonably – why anyone should listen to economists’ views on the economic impacts of Brexit, when many short-term forecasts that a Brexit vote would lead to a sharp slowing of the economy had been proved wrong.  This was my response: 
“Short-term economic forecasting is very unreliable. Just because the weatherman gets it wrong about whether it’s going to snow tomorrow doesn’t mean that the scientists have it wrong about whether climate change is going to make the planet warmer over the medium to long term”
I think it’s worth explaining this.  The forecasters – including City economists and independent research institutions like NIESR and IFS, as well as the Treasury and the IMF - who predicted economic gloom as a direct result, not of Brexit itself but of the referendum result, did so on the basis of the expected impact on financial markets, business and consumer confidence:  “Our research shows that a vote to leave would increase uncertainty and, at best, reduce growth”.  

But they were (mostly) wrong.  On the markets, while the pound did indeed fall much as expected (which is actually good for economic activity in the short-term; the exchange rate acts a shock absorber to the expected long term hit to the economy by making UK exports cheaper) market interest rates didn’t rise and the stock market didn’t collapse (although UK companies have certainly underperformed). More importantly, after an initial shock to confidence, businesses and consumers appear to have decided that nothing has happened yet and nothing much will happen for a while; so it’s business as usual. Research on uncertainty, it turns out, isn’t exactly a certainty.

We can dismiss a couple of excuses for this failure. It’s true Brexit hasn’t happened yet – but the forecasts were explicitly related not to Brexit, but to the uncertainty and expected future impact of Brexit.  It’s true some (but not all) of the forecasts assumed immediate Article 50 notification, but that was not central – and if it was uncertainty that was supposed to drive economic weakness, delaying notification merely prolongs the uncertainty.  And it's true there was a policy response from the  Bank of England - but if anything could have been forecasted it was that.

So what forecasters fundamentally got wrong was their judgement about the short-term behaviour of millions of individuals interacting in a very complex system, where (as we know from the analysis of such systems) relatively small changes in a few variables can lead to quite different outcomes.  The claim that “the flap of a butterfly’s wing in Brazil can set off a tornado in Texas” is poetic license – but the inherent difficulty of forecasting short to medium term perturbations is true both of the economy and the weather.  

Now, despite these difficulties, weather forecasting has got considerably more reliable over the last 20 years, so there’s plenty of room for economic forecasters to improve – but  explaining how the economy will do in the next few months is always likely to be very challenging. That’s true of economic forecasting in “normal” times: but it’s even more so the case when trying to assess the short-term impacts of a political event on the psychological attitudes of consumers and investors.

By contrast, predictions about the long-term impact of Brexit – like climate science  - are based on quite different reasoning, about how changing one key factor – our openness to trade, or the degree to which the earth’s atmosphere retains heat – changes the long-run properties of the system.  The methodologies used are well-established and robust – and while of course the detailed modelling of their impacts requires considerable expertise and huge amounts of data, the basic mechanisms at work are well-established and easy enough to explain.  The operation of the greenhouse effect can be demonstrated in a school lab.

Similarly, the basic insights of the “gravity model” approach to predicting international trade – that trade between two economies depends on how big each is, how far apart they are, and historical, cultural and policy factors including the existence of special trade arrangements like the EU – are common sense, and their empirical and practical validity is not seriously in question.  More CO2 will make us hotter: less trade and migration will make us poorer.  

Now, economists’ forecasts of the long-term impacts of Brexit could still be wrong – or inaccurate- just as climate scientists could be wrong about the path of climate change. First, our scenarios could be wrong; Brexit could turn out very differently from the options (hard or soft, clean or chaotic) most people are trying to analyse; similarly, sudden technological advances could change the path of CO2 emissions.  Second, the numbers are probably more uncertain even more than the models (which already incorporate some forms of uncertainty) suggest – some forms of uncertainty are simply impossible to model.

So while we can predict that Brexit will reduce growth and CO2 will warm the planet, we should take the quantitative modelling on just how large these effects are with a large pinch of salt.  In particular, feedback effects could either amplify or dampen the impacts – and it is very difficult to guess which. But the basic point - that reductions in trade and migration will reduce growth and productivity, relative to what otherwise would have occurred – is very unlikely to be disproved, any more than the greenhouse effect.

So how should that translate into how we actually make decisions?  Well, I listen to the weather forecast: but, like most Londoners, whatever it says, I always carry an umbrella.  On the other hand, that doesn’t mean I’d buy a house on a flood plain. 

Wednesday, 4 January 2017

My predictions for 2017 (from the FT Economists' survey)

The Financial Times annual survey of leading British economists' predictions, views and forecasts for the year ahead was published on January 3. Last year (that is, in January 2016) this is what I said about Brexit: 
Q2: Brexit: If the British electorate vote to leave the EU in 2016, how would that: a) change your views about prospects for next year? b) Change your views about medium-term prospects?
I'd divide this into three:
a) short-term: relatively little visible impact. No doubt there would be some turbulence in financial markets, but I doubt we'd see much impact on the real economy in the very short-term (ie next year).
b) medium-term (ie the period of the negotiation over terms of exit and post-exit relationship between the EU and the UK, lasting at least 2 years). Significantly negative. These negotiations would be protracted, complex and probably acrimonious, leading to considerable uncertainty for both UK companies trading with the EU and international investors (not to mention EU citizens resident in the UK and vice versa). All this would be likely to have a substantial and negative impact on business confidence, business investment, FDI, and possibly trade and migration.
c) longer-term (post the negotiations and any transition) — impossible to forecast with any precision at this point, given we have very little idea of what the outcome of the negotiations in b) would be. The UK could undoubtedly survive and prosper outside the EU, and in some respects (flexibility on some aspects of trade and migration policy and regulation, reduced contributions to the EU budget) might benefit; but there are obvious and serious risks, in particular to trade in services (including financial services) which are vital to the UK economy and will become even more so in the next few decades.
Below are my detailed predictions from this year.  I'm not a forecaster (and we have seen this year just how unreliable short-term forecasts can be) but they represent my best effort at providing some meaningful analysis of what we can expect over the next year.  Come back next January...
1. Economic prospects
How much, if at all, do you expect UK economic growth to slow in 2017? Please explain your answer.
I would expect it to slow somewhat in the first half of the year. What happens in the second half depends very much on developments with the Brexit negotiations (as well as events in the US and elsewhere in Europe). We could see reasonable if not spectacular growth, but downside risks are large

2. Brexit
Compared to what you thought 12 months ago about the UK's long-term economic prospects outside the EU, are you now more optimistic or more pessimistic than you were?

Please explain your answer.
The strong consensus amongst economists is that Brexit will make the UK significantly worse off in the medium to long term - not disastrously so, but significantly. This is backed up by a considerable body of theoretical and empirical evidence. Of course, this evidence is based on historical data, and past is not necessarily prologue; there is a high degree of uncertainty. But the probability must be that Brexit will make us worse off. It is also important to note that while economic developments since the referendum have certainly not borne out the pessimistic forecasts of some institutions, that really tells us almost nothing about long-term impacts - short-term forecasts are made using very different methodologies to those used to estimate long-term impacts, and (paradoxically) are much less reliable.

3. Inflation
Inflation has started to increase in recent months. To what extent do you expect inflation to rise in 2017?
If the exchange rate stays where it is to about 3%. However, if it falls a lot farther inflation could rise more (or conversely)

4. Monetary policy
In December, the Monetary Policy Committee said the next interest rate move could as easily be up as down. Will there be a shift in this monetary policy stance by the end of 2017? Please explain your answer.
It is difficult at the moment to see the next move being down , even if the economy worsens. Barring negative shocks (which are quite possible) I'd expect the next move to be up.

5. Immigration
Immigration is likely to be central to the Brexit negotiations in 2017. How much do you think immigration will change and what effect do you think this will have on the UK economy?
My recent research suggested that EU migration to the UK could fall by well over half over the period from now to 2020, resulting in net EU migration falling by more than 100,000. Both the state of the economy and the existence of free movement of workers are significant determinants of migration flows. In particular, free movement with the UK results in an increase of almost 500% - that is, by a factor of six. It follows any significant restrictions on free movement will reduce those flows. I also used the existing empirical research on the impact of migration on productivity, growth and wages to estimate the broader economic impacts of such a reduction. Over the period to 2020, the resulting reduction in GDP would be about 0.7 to 1.3%, with a GDP per capita reduction of 0.3 to 0.8%. By contrast, the increase in low-skilled wages resulting from reduced migration is expected to be relatively modest.

6. Fiscal policy
Philip Hammond is expecting government borrowing to fall in 2017. His new fiscal rules provide headroom for more borrowing than currently forecast. To what extent will he need to use it and why?
The OBR's fiscal forecasts look relatively pessimistic; however the economic ones may be too optimistic. Moreover, current spending plans for health and social care (and perhaps education) look unrealistic. The NHS is clearly significantly underfunded (it is basic economics that a richer, older society should, from the point of view of overall welfare or wellbeing, spend a greater proportion of GDP on health over time - the reverse has been the case over the past few years.) It is not clear that such spending increases should be financed by borrowing, but the government is unfortunately committed to a set of tax cuts that have little economic rationale and will mostly benefit the relatively better off. Some discretionary increase therefore seems likely.

7. Donald Trump
How do you think Donald Trump's presidency will affect the UK economy in 2017?
This is exceptionally uncertain, for obvious reasons. However, it does look likely that US interest rates may now begin to rise steadily. This will put some downward pressure on the pound and upward pressure on UK long-term rates, which may well be unwelcome.