Over-Optimist Forecasts and their implications

As the last few weeks we were flooded in Romania with overly optimistic forecasts for 2012(at least in my view) is good to put those numbers in perspective after reading this paper by Jeffrey Frankel:
Over-Optimism in Forecasts by Official Budget Agencies and Its Implications“.

Here is the abstract of the paper:
“The paper studies forecasts of real growth rates and budget balances made by official government agencies among 33 countries. In general, the forecasts are found: (i) to have a positive average bias, (ii) to be more biased in booms, (iii) to be even more biased at the 3-year horizon than at shorter horizons.

This over-optimism in official forecasts can help explain excessive budget deficits, especially the failure to run surpluses during periods of high output: if a boom is forecasted to last indefinitely, retrenchment is treated as unnecessary. Many believe that better fiscal policy can be obtained by means of rules such as ceilings for the deficit or, better yet, the structural deficit. But we also find: (iv) countries subject to a budget rule, in the form of euroland’s Stability and Growth Path, make official forecasts of growth and budget deficits that are even more biased and more correlated with booms than do other countries. This effect may help explain frequent violations of the SGP. One country, Chile, has managed to overcome governments’ tendency to satisfy fiscal targets by wishful thinking rather than by action. As a result of budget institutions created in 2000, Chile’s official forecasts of growth and the budget have not been overly optimistic, even in booms. Unlike many countries in the North, Chile took advantage of the 2002-07 expansion to run budget surpluses, and so was able to ease in the 2008-09 recession.”

What I find very interesting is that while everyone is advocating establishment of rules (make the deficit zero by constitution, make it 3% by some treaty), Frankel finds that countries subject to a budget rule — particularly the euroland’s Stability and Growth Path — make official forecasts of growth and budget deficits that are even more biased and more correlated with booms than do other countries. Of course when when such governments exceed the deficit limits set by the rules, they respond by adjusting their forecasts rather than by adjusting their policies. This is all too familiar to anyone watching Romanian economic rhetoric by our officials.

26 thoughts on “Over-Optimist Forecasts and their implications

  1. Richardo Semler:

    “A 5 year plan is just an extrapolation added to wishful thinking. Have you ever seen a business plan that says, “I’m going to go up 5% and then down -14% and then -22% and then I’m going to recuperate a little bit and then it’s going to go to hell?”

    ‘Cuz that’s what happens. That’s how it looks in practice, but that’s not the way we design it. We’re willing to trick ourselves into thinking we have control as long as we do it with wishful thinking.”

    Most forecasts are based on wishful thinking rather than on the fundamental reality behind the numbers.

  2. I like the article, as a question of general information, although not even secondary in decision making.

    And I don’t really think it does matter too much if it will be +2%, +1%, 0%, -1%, -2%. Any of them is no big difference, in any of the 2 directions. Tells us if you are concerned about a -5% :)) This would be another story.

    Liked the TV show last night, Congrats for both of you.🙂 >.<

    1. Those papers are good that they show the political bias present in all countries. Radu Soviani calls it lies I just think is part of their job. But it is upon us to see through the B-S and take decisions after we discount the bias. That is why I think there should have been more defaults b/c banks should know better than listen to empty promises (I will cover the issue of defaults later today or tomorrow).
      Thanks for watching last night. We are planning a series of special editions to be aired sometime in January. They will be a real version of the last 4 years of economic policy and implications in Romania.

  3. Adrian, the whole investment process is based on wishful thinking, because nobody would ever invest a single penny if he would not be optimistic, and no employee would still have a job, as a result. And, also, only stupid people invest while everything around looks pink, the smart investor always invest when things do not go very well around, in order to be ready to receive that pink days, when they will come. We have examples in Romania, also🙂.

    So it seams to me that some are trying to behave more catholic than Papa is, while talking about these stuff🙂 Most probably they never invest, mostly in a business. A really easy way to be the perfect planner :))

    1. This is not entirely true. Investment in research and technology , setting a small firm, investing in eduction for yourself or your family, investing in trip after a hard year of work are not based on wishful thinking. You only see investment as a decision to part or not to part with your paper money for sometime. Every day you take investment decisions. The problem is that if you believe the people you elect than you might end up either broke or overinvested (too much education for country that does not value it, for example).🙂
      All great investors and hedge fund managers do not look at investment in a narrow sense of taking a position. They look at investment as an opportunity that others have not seen yet (or ignored). That is why most of the time those guys see the world differently, kind of like myself and Lucian last night if you allow me the comparison.

      1. Just for joking, I can’t allow you the comparison, because Lucian sees things more like I see them, in the essence: a bad investment plan is better than no plan, and bad investment is better than no investment. :)) Is not your and Adrian opinion also🙂.

        If you take what Adrian and you say mot-a-mot nobody should invest now in Romania because we have a stupid government, and their forecasts are inaccurate, they tell us the economy will increase but it will decrease this will happen conditioned buy our future decision, if we think it will increase, we will behave in a certain way and it will indeed increase), and this creates lots of uncertainty, and, as a result, a potential investor is a wishful thinker.

        You can never control anything, you will never be able to see the truth about the medium and long run, but only by chance, so you don’t actually think like this when you invest. And you actually need wishful thinking in order to invest in the best moments for making an investment.

        Your examples with research and technology are totally not proper, as both of them imply much more chance than we are ready to accept🙂 They are the highest risk in business. Both of them imply almost entirely wishful thinking. There’s no such thing as planning innovation, at any of the 4 stages. It’s a risky bet. There’s no real risk taking without wishful thinking on this earth🙂 I’ll die having this opinion🙂 Only wishful thinking people innovate, and invest in research and new technology.

        Than, you just gave the perfect example that makes me right :))))

        “They look at investment as an opportunity that others have not seen yet (or ignored).” -> this is wishful thinking, irationality at the general level.

        The great investors and hedge fund managers are wishful thinkers, there’s no rationality, as all the people around understand rationality, in what they do, in their bets. They take bets that not everybody are ready to take, in moments that the rest are not ready to consider. Most of them rest are red for a period of time, and then they end up being very green. This is wishful thinking. Normally, the reality looks against them, but they don;t see things this way -> wishful thinking. They don’t make money from certainty, but from taking advantage of the most uncertain environments.

        Just an example: nobody trusts BAC with their money these days, except Buffet and Paulson. May be they are wrong, may be they are right. We don’t know, they don’t know, but they are the ones taking the bet. Buffet have a long history of investing where the crowd considered to be irational, in moments considered to be irational. He made most of his fortune this way🙂. His one of the greatest wishful thinkers around. And even rationality academicians give him as an example of irationality.

        :))

        I think we have a different way of understanding wishful thinking, rationality, planning, and risk. This is why we will never get to the same conclusion🙂

        .

        st moments for making a investment.

    2. @Lavinia
      The main idea is that “planning is guessing”. If you make a plan, don’t set it in stone. And don’t believe that the situation is going to unravel in this way for sure. Have a bunch of backup plans in place.

      When the politicians come up with accurate numbers of GDP growth they are lying unless they are doing all the spending. You can’t really asses how millions of people will behave 1 year from now.

      In the same way, you don’t know if a particular investment is going to work. But if you have hundreds of investments in areas you know a lot about, you have a better chance at the game.

      Example: if you invest in farms. You don’t know if a particular farm is going to last. But you know almost for sure that people will still want food 10 years from now. So, investing in 10-20 companies that produce food and you know a lot about them can be a great investment. It’s based on things that are unlikely to change a lot.

      1. Adrian, and how does this fit to your wishful thinking theory? How can we make a forecast based on the fundamental reality if the human brain is unable to cover the complexity of the fundamental reality?🙂

        This was what I was trying to tell you🙂

        And, regarding the gov plans, I can’t remember the gov to ever respect their budget. Even in US they start amending it before the middle of the year , most of the years. In Romania this is the rule, actually. They never respect the initial plan. I don’t know if this is good or bad, but it’s just a remark. So … we shouldn’t even listen to them, or trust their plan, or alike. We should consider only punctually some of the measures they take.

        And, if you ask me, I understand them when they give better forecasts. Why would they wanna promote anxiety? May be if they tell people it will be 2% instead of 1%, then some will behave differently, and we will end up in 1.2% instead of 1%. Not 2%, but a little bit more. The problem comes when they don’t take measures for smoothing the decline, not they they give us a bad forecast. They should tell us a nice lie, but do what they have to do.

        And, then, it’s not the gov problem to tell us what to expect, but our problem to create our own expectations. In the end we can’t say that is gov fault because they gave us a misleading forecast, as you are supposed to live according to your own opinions.🙂

      2. @Lavinia
        “How can we make a forecast based on the fundamental reality if the human brain is unable to cover the complexity of the fundamental reality?”
        You just make the best decision or the safest bet based on what you know right now. While you keep in mind an overall long term objective, you make sure that with each step you get closer to it. If something you doesn’t move you closer towards your long term objective, you try something else.

        You keep doing what works and you stop doing what doesn’t work without making long term bets.

        You basically get out of the bias of wishful thinking and act based on what you know for sure at the moment.

        In order to make good decisions, you have to get around the biases which are built inside the human brain. By doing this, you will be able to make better decisions, not perfect decisions.

        “Why would they wanna promote anxiety?”
        They want to promote hope, not anxiety. People have to believe that there’s hope. Politicians wants the masses to believe that the promised land is just around the corner.

        Anxiety is mostly the effect of culture and of the general news. The anxiety also happens because the human brain doesn’t deal well with our modern society. Read Human Zoo by Desmond Morris for more on this.

        “it’s not the gov problem to tell us what to expect, but our problem to create our own expectations.’
        You don’t need to expect anything. Just do something towards your objectives and improvise and make short term plans as you go along. It’s important to remember your long term and short term objectives.

        Try to look at reality as close as possible to the way reality is – no matter how ugly.

  4. Regarding future GDP numbers, politicians will have a clue of what they are talking about when they will say: “I have no clue of what I’m talking about.”🙂

  5. I guess if they would want a zero deficit rule, than budgets should be made not according to forecasts but according to the last fiscal year. That way government spending at least would be anti-cyclic.

  6. @Adrian

    You know, people react more bad at bad news, than how they react good at good news. So if the gov would tell us bad stories, really bad stories, they risk the people to react really bad, worse than if they tell a gray story, instead of a black one. I don’t know if you understand what I’m trying to say🙂.

    And in the end where the economy will end up depends on how we are gonna react. Even if they would have known that we would lose 7% of real GDP in 2009, which I don’t think they actually knew, it would have been a mistake to tell us this. If their forecast would have been -7%, telling this had a risk to create -9%. And if their forecast would have been -9%, telling -5% would have the risk to create just -7%. This, just like the financial markets, is self-fulfilling. The stock market decreases because most of the people think it will decrease and they sell. Most of the time nothing changes between a great selling an a great buying :)))))) It’s about what people believe about the future.

    1. @Lavinia: So you think that government forecasts (especially bad ones) are like self-fulfilling prophecies. That’s one way to look at it. The other way is: they don’t know what they’re doing😛.

      1. dragon, it doesn’t matter if you know what you are doing or not when you manipulate the masses. You just manipulate them.

        Look for an example. The NBR clearly don’t know much of the essence of the exchange rate risk. But one of their directors said on TV immediately after the official announcement of the VAT increase that, as a result, eurron will go to 6.

        The next 3 days the newspapers were showing to us a lot of people, normal people, who I can bet know nothing about the potential impact an increase in VAT have on the exchange rate, crowded in front of exchange houses in order to exchange their ron into euro, scared by a potential exchange rate of 6. Of course this caused depreciation of the ron, and volatility in the market, most probably in excess of what we would have seen without the normal people suddenly becoming players in the market. People in the treasuries understand better the effect of putting the masses on the move, for the exchange rate. The self-fulfilling phenomenon exists, and doesn’t matter if it is created by people who know or don’t know what they are doing. If the crowd believes them, that’s it, you have a chance to see an effect from this :))

    2. I think you should read the post I just published. Also, you cannot be right all the time. By trying to be right you will compromise and your argument will weaken. Sometime you have to accept reality: governments do not have their people’s interest at heart when they make wrong forecasts. They just want to buy time and votes.

      1. From Governments point of view to make wrong forecasts maybe is the properly solution. The political capital is “tradable” only to elections. By contrast we know how public companies are prone to have exceedable forecasts of net income in order to beat this estimations and surge after financial results release. It is not a rule but often happens. Furthermore when the governments are wrong it is more easily to justify the poor forecasts, just look at Romanian government and the “european context” as default argument against their incapacity to be right. At the same time they have posibility to “rollover” this wrong forecasts which stands to be right until next official release.
        Regarding Thaler’s nudge theory and the behavioral economics approach we also should think about to the effect of expectations and that the mind gets what it expects.
        So the wrong upward forecasts could bias people in a benefic way for the country’s economy.🙂🙂

      2. There is one problem with trying to cheat the public into thinking that things will be better: they learn. It means that you can only do this once. For example, remember the messages during 2008 from the Romanian officials: NBR was 100% certain that the exchange will not reach 4.0 RON to the EURO and the Government was assuring us that the economy is sound and insulated form world’s problems. I was working in a bank at that time and I did my best to alert my colleagues in the management team and our clients about the imminent danger to the Romanian economy. In 99% of the cases I was seen as the crazy economist who cannot see the great Romanian economy for what it was. In fact there was an old guy who was heading our retail business who just believed that the real estate risk was not a real. He was my toughest opponent and he used as arguments the official government data. We all know what happened.
        Now, three years later the situation seems to repeat itself. But the public has learned not to believe the official statistics. Also, the new global threat comes after a tough period for the Romanian economy. The past experience with a similar situation can make people extra cautious with their day to day spending plans but also with their long term investment decisions.
        It will take many years until the official message regarding the economy will be once again believed by the public. The clear example is the monetary policy in Romania. Years of missing the target has made everyone skeptic even when inflation is at the target and has the best chance ever to actually be below target.
        Playing with expectations is a dangerous game. The central banks and governments have only one bullet.Unfortunately our guys have used it in 2008.

    3. @Lavinia
      “You know, people react more bad at bad news, than how they react good at good news.”
      Yes, people in general are more motivated not to lose(the negative side of the story) than to win.

      “And in the end where the economy will end up depends on how we are gonna react.”
      Our politicians display great levels of confidence towards how the economy is doing. Why the economy didn’t catch up with the political dreams? I don’t think that there’s such a strong connection between what the politicians say and how hard and smart people work during the day.

      “2009 political forecast”
      People start worrying when they see other people being laid off from work. They worry when they can’t put food on the table. Most people start worrying when they lose what they have and when it’s hard to buy food and the things they consider as necessary.

  7. I do agree with you that they don’t care about us, but I can’t agree when wishful thinking, and mostly on taking their forecasts or planned budger seriously.

  8. @Flo

    “In fact there was an old guy who was heading our retail business who just believed that the real estate risk was not a real.”

    Are you kidding us? :)))) I can’t believe it. We, the normal people, were talking about this ever since the the spring of 2007, when prices got really mad, and people started to take all their family to the bank in order for their loans to be accepted. Almost nobody normal around had a monthly revenue to be accepted. May be only the bank’s and multinationals high paid employees, but they were the only ones. Some were using fake documents, arrangements with the employer, were paying more from their pocket for the company to pay to the state, just to be written on their employment documents a higher amount than they were indeed gaining. It was madness. It was not a question of IF, but a question of when. GOD.

    Yes, exactly. I learnt not to listen to them. I have no trust in them. I don’t care about them. I just want them to do something about the industry and agriculture in this country. But I’m afraid they are to stupid for this job😦.

  9. In 2007 I was kidding with my friends telling them: we will end up having more empty buildings than full factories, and the whole population will become buildings guardians. In 2008 I was saying: we are probably more and more closed to having more and more empty buildings than full factories, jut a little bit and they are done. In 2009 the word was: see? told ya. now we have more empty building than full factories. And I was a young person interested in having fun, I wasn’t even watching the statistics those days, it was only intuition. It;s really freak to hear about a guy in a bank being that far way from Terra. It was enough to just look around. Almost everything I was buying from Carrefour or from the mall was imported, but you could see more and more new buildings. It’s impossible not to ask yourself any question.

    1. @Lavinia: There it is! That’s the main problem, that we don’t produce nearly as much as we consume, thus we import many of the goods we buy. And in the long term this will mean ongoing poverty. You cannot build an economy just on real-estate and finances. I think in the EU only the Germans understand this.
      Unfortunately in the whole of Europe are lots of socialist tendencies. Recently I saw in German TV a guy who was 26 years old and was a pensioner just because he was fat and depressed. I would have told him, move your ass and do something for a change, it will make you feel better.

      1. It already means poverty for us :((. We don’t have an increase in the real employment, but a decrease, if we also take into account the romanians outside the borders. We think we have more, but we actually pay much more than in 2004 to the banks, mostly for houses the cost is huge for the romanian consumer, and those money goes outside the country, they don’t even remain in our economy. So we have a lot of constrained households, which we didn’t have in 2004, when this madness began. Now we seem to take it back from the beginning, from a lower level than in 2004. Unfortunately, this is all about the exchange rate risk, which was improper in Romania from the end of 2004 until the beginning of 2008, inside the context of our commercial partners, and a central bank that can’t understand the importance of the international trade for the welfare of a nation will fail. In the euro zone the problem is that they don’t even have an exchange rate risk anymore. So they entered this construction unprepared for competition between the countries, some, like Germany, were producing, others were importers, and the lack of risk amplified the spiral and pushed them more into this imbalance. This is what got to less and less production, and more and more real-estate and finances.😦.

        But it seams like it will take some centuries to the authorities to understand some of these simple essences.

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