Articles published in August, 2008

Never trust an economic forecast

When people discover that I am an economist, they rarely ask me for my views on subjects that economists know a bit about – such as how to respond to climate change or pay less at a supermarket. Instead they ask me what will happen to the economy.

Why is it that people won’t take “I don’t really know” for an answer? People often chuckle about the forecasting skills of economists, but after the sniggers die down, they keep demanding more forecasts. Is there any reason to believe that economists can deliver?

One answer can be gleaned from previous forecasts. Back in 1995, the economist and FT columnist John Kay examined the record of 34 British forecasters from 1987 to 1994, and he concluded that they were birds of a feather. They tended to make similar forecasts, and then the economy disobligingly did something else, with economic growth usually falling outside the range of all 34 forecasters.

Perhaps forecasting technology has moved on since then, or is the British economy unusually unpredictable? To find out, I repeated Kay’s exercise with forecasts for economic growth for the UK, US and Eurozone over the years 2002-2008, diligently collected at the end of each previous year by Consensus Economics.

The results are an eerie echo of Kay’s: for 2004, for example, 20 out of 21 non-governmental forecasts made in December 2003 were too pessimistic about economic growth in the UK. The Pollyannas of HM Treasury were more optimistic than almost any commercial forecaster, and closer to getting their forecast right. So one might suspect that systematic pessimism is to blame.

But no, in 2005, the economy grew more slowly than 19 out of 21 forecasters had expected at the end of the previous year. At the Treasury, they were again more optimistic than anyone, and thus more wrong than anyone. A year later, all but one of the forecasters were too pessimistic again. Yet at the end of 2001, three quarters of the forecasters were too optimistic about 2002.

An interesting anomaly is 2003: the one year for which the average UK forecast turned out to be close to reality, but also the year where the spread between highest and lowest forecast was widest. The rare occasion when the forecasters couldn’t agree happened to be the occasion on which they were (on average) right.

Recent US forecasters have done a little better: the spread of forecasts is tighter and the outcome sometimes falls within that spread. Still, five out of six were too pessimistic about 2003, almost everyone was too pessimistic about 2002; three-quarters were too optimistic about 2005 and nearly nine-tenths too optimistic about 2006. Perversely, the most accurate forecasts were made about 2007, despite the fact that the credit crunch was a surprise to many.

In the Eurozone, forecasting over the past few years has been so wayward that it is kindest to say no more.

The new data seem to confirm Kay’s original finding that economic forecasters all tend to be wrong in the same way. Their incentives to flock together are obvious enough. What is less clear is why the flight of the flock is so often thought to augur much – but then, some astrologers are also profitably employed.

The curious thing is that forecasters often have something useful to say, but it is rarely conveyed in the numerical forecast itself on which so much attention is lavished. For instance, in December 2006, British forecasters were warning of the risks of an oil price spike, a sharp rise in the cost of credit, and a dollar crash. Their guesses at economic growth were wrong, and would have been little use had they been right. But the forecasters said something worth hearing – if you had been listening carefully enough.

Also published at ft.com, subscription free.

Should I subsidise my partner?

I have recently agreed with my student partner that she will move into my flat during the Edinburgh Festival so that she can sublet her room and pay for her half of our holiday together. She maintains that she should pay me for staying in the flat, whereas I argue that this would defeat the purpose of the exercise. How can we effectively resolve this dispute and look forward to our holiday? Should I simply charge her for any increase in my bills, or are there other considerations?
Ben, Edinburgh

Dear Ben,

Stop the tiptoeing about who pays what to whom. Let’s be blunt: she can’t afford this holiday, you can afford to subsidise her, but she doesn’t seem to want to incur too large a debt. It seems to me there are two solutions: an explicit contract, or an implicit one.

The implicit contract: quietly subsidise her holiday. Accept a little money from her as a tenant, and pick up a few of the extra holiday costs. The explicit contract: charge her the market rate for staying in your flat. Do not be surprised, however, if she begins to charge you for “services” provided either during her stay or on your holiday.

Choose whichever contract is to your taste. It will set the tone for your relationship – and the explicit contract may be cheaper in the long run.

Also published at ft.com, subscription free.

Bankers are laughing all the way to the bank

Going overdrawn can be an expensive business. In the UK, unauthorised overdrafts averaged £680m on any given day in 2006 – just over £10 per bank account. According to the Office of Fair Trading, the charges levied by banks on those overdrafts were £1.5bn, a tasty return of more than 220 per cent. Banks also make money by paying risible interest on positive balances – an incentive to keep your current account lean and, Doh!, to overdraw accidentally – and by other obscure charges. The Office of Fair Trading doesn’t like it and nor do many customers – although they rarely express their displeasure by switching bank accounts.

There are two common responses. People either grumble about money-grabbing banks or point out, smugly, that if only others would manage their affairs responsibly, they wouldn’t incur any of these charges.

There’s a certain amount of truth in both responses. Yes, banks are money-grabbing, but healthy competition would keep the greed in check. And, yes, careful customers are being subsidised, heavily, by careless ones. The trouble is that the whimsicality of the pricing makes it hard to find out which bank is offering a good deal. Most people realise that overdraft charges are steep, just as they realise that popcorn in cinemas is expensive and mobile-phone companies will all but pick your pocket if you make calls overseas. Knowing this doesn’t make it easy to find the best product, which means competition won’t work well. When competition works poorly, many customers lose out – even those who bring their own snacks to the cinema and use public phones on holiday.

So what’s the solution? One possibility is for regulators to step in and set price ceilings in such cases, or to ban more complex offerings. But once the tourism office starts fixing the price of a can of Heineken in your hotel fridge, that spells ossification and bad news for consumers in the long run.

Another possibility is better financial education – unobjectionable in itself, but an indirect attack on the problem of complex tariffs. The severity of that problem was clear when two economists, Chris Wilson and Catherine Waddams Price, tracked the attempts of customers to switch to cheaper electricity tariffs. Most picked up less than half of the available gains, and a quarter made themselves worse off.

I have heard one really good – and, I believe, genuinely new – solution, presented in the book Nudge, by Cass Sunstein, a law professor, and Richard Thaler, an economist with a particular focus on flaws in people’s decisions.

They advocate a system of mandatory electronic disclosure. Regulators would specify a standard electronic format in which banks would have to disclose all their fees and charges, and how they intersected with what the customer had actually done. (The idea could also work for credit cards, mobile phone services and others.) Each year, customers would receive an electronic file itemising exactly what they had done and exactly what it had cost them.

Thaler and Sunstein anticipate – correctly, I suspect – that if such electronic files existed in a standard format, other companies (Morningstar? Google? Microsoft? FT.com?) would quickly set up their own services. You would take your electronic bank account statement, upload it to Google Consumer, and be told in plain English how your bank had screwed you, and which bank would do a better job, given your particular banking habits. Even those who couldn’t or wouldn’t use such electronic advice would benefit from the sharpening of competition it would engender.

Implementing the idea may not be easy – but for those of us who think competition can occasionally be given a helping hand, it seems worth trying.

Also published at ft.com, subscription free.