Economics must heed political risk
Amid the marathon reality show of the American elections, the tense theatre of the Chinese transition and the anarchic agitprop of eurozone politics, non-risk-weighted economic forecasts verge on irrelevance. Even with the US election behind us, this is not about to change.
The International Monetary Fund’s recent World Economic Outlook illustrates the point. The IMF dutifully produced a precise forecast: next year the world economy will grow by 3.6 per cent. But it warned its prediction was based on political assumptions: that US politicians would avoid the fiscal cliff; that European politicians would hold the eurozone together. The IMF might have added that its forecast was also hostage to China’s new leadership. Will China reconcile itself to growth at the new rate of 7-8 per cent, accepting that sustainable, domestically led expansion makes the 10 per cent growth rate of 1990-2011 unattainable? Or will it stimulate aggressively, as it did after the Lehman Brothers bust?
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Apply a conservative multiplier of 0.8 and the IMF’s projection of 2.1 per cent US growth is reduced to almost zero. Likewise, China’s post-Lehman stimulus caused the year-on-year growth rate to soar from 6.8 per cent in the fourth quarter of 2008 to 10.7 per cent a year later; another fiscal Tarzan act would play havoc with the outlook. Meanwhile in the eurozone, one plausible analysis of a disorderly break-up projected that output would crater by 13 per cent in Greece and 7 per cent in Germany. Given such effects, the IMF’s point estimate for eurozone growth seems beside the point.
Nobody is more aware of the forecasts’ fragility than the IMF’s own staff, whose report plays out scenarios that deviate wildly from its base case. Suppose, for example, that eurozone authorities fail to contain sovereign and banking stress – a scenario that falls well short of break-up. Capital will flee from Europe’s periphery to the centre and from risky corporates to the remaining comparatively safe sovereigns; beyond Europe’s borders, general risk aversion will create an echo effect. In the IMF’s model, the euro area’s periphery will suffer a 6 per cent contraction in gross domestic product, relative to the base case. The US, Japan, emerging Asia and the Middle East and Africa will be heavily affected, suffering an output loss of about 1 per cent.
According to a new index devised by Scott Baker and Nicholas Bloom of Stanford University and Steven Davis of the University of Chicago, US policy uncertainty appears to be higher now than at recent elections, with the exception of Lehman-tinged 2008. It is also higher than after the stock market crash of 1987, the start of the first and second Gulf wars and the default of Russia and Long-Term Capital Management in 1998 (see chart 1). In Europe, policy uncertainty spiked last November after the Greek leadership proposed a referendum on austerity, but is still far higher than during the Asian crisis or the takeover of Northern Rock (chart 2). And whereas in the past policy uncertainty spiked when governments responded to economic shocks with emergency measures, today’s policy uncertainty is more political in origin. Professor Bloom’s analysis suggests that uncertainty over long-run fiscal policy is the key issue in the US (chart 3).
In China and Europe, as well as in America, politicians are grappling with structural challenges they have ducked for ages: there is therefore little prospect that uncertainty will abate. One clear consequence is that there will be an additional drag on the recovery. Prof Bloom and his co-authors find uncertainty weighs on investment, hiring and output. Lewis Alexander of Nomura estimates that additional uncertainty, defined as a one standard-deviation increase in the dispersion of earnings forecasts for companies in the S&P 500 index, is associated with a 0.5 per cent fall in gross domestic product over one year (see chart 4).
But there is a second consequence of enduring uncertainty, which relates to an old truth about economic forecasting. In acutely uncertain times, precise predictions are of dubious value; the risks around a forecast are more significant than the forecast itself. Although it is fashionable to decry finance and its models, financiers are ahead of the game here. Back in 1966, the future Nobel Prize winner William Sharpe invented a way of combining expected returns from a security with the expected risk of holding it. It is time now to create something similar for economies: a forecast of output divided by a measure of the risks to the forecast; a Sharpe ratio for economic growth.
The writer is a senior fellow at the Council on Foreign Relations and an FT contributing editor