Independent body needed to preserve integrity of fiscal forecasts

Does politics affect the integrity of economic forecasting? K

Independent body needed to preserve integrity of fiscal forecasts

Does politics affect the integrity of economic forecasting? K

The Melbourne Institute’s recent “Intergen +10” workshop was a retrospective on Australia’s pioneering Intergenerational Reports, an outgrowth of the fiscal responsibility legislation put in place by the Howard government in 1998.

It was also the location of a heated exchange between Professor Adrian Pagan and the Treasury’s David Gruen over the economic growth assumptions that went into the 2010 Intergenerational Report (IGR).

Pagan said that the 2010 IGR’s assumption of an extended period of above-trend economic growth between 2011-12 and 2014-15 was unbelievable and could only have been the outcome of a political process. He went on to call for an independent process to be put in place for the preparation of future IGRs.

Gruen said the IGR growth assumptions were defensible, based on the pattern of growth seen coming out of past economic downturns. He also characterised Pagan’s suggestion that the IGR growth assumptions had been politicised as “outrageous”.

Gruen is correct in arguing that had Australia seen a severe economic downturn as a result of the financial crisis, a period of above-trend growth could be expected to follow, although the expected duration of any such above-trend expansion is debatable.

Where Treasury went wrong was not in its forecast for recovery, but in its expectations for the preceding downturn, which Gruen acknowledges was much less severe than had been expected.

The conventional narrative holds that this better-than-expected economic performance was the result of the federal government’s timely fiscal stimulus efforts. The problem with this argument is that the forecast downturn already incorporated assumptions about the effectiveness of both monetary and fiscal stimulus. The Treasury abandoned its former practice of assuming current monetary policy settings and instead conditioned its forecasts on expectations for further reductions in the Reserve Bank’s official cash rate.

The fact that the Australian economy outperformed Treasury’s forecasts during the crisis can be interpreted in one of two ways. Either fiscal and monetary stimulus were much more effective than even the government and Treasury dared to assume. Or alternatively, the economic forecasts were themselves overly pessimistic and the government over-reacted in implementing one of the world’s largest fiscal stimulus packages as a share of GDP instead of allowing monetary policy to do the heavy lifting. Monetary policy could then have been tightened relatively quickly when the downturn proved less severe than expected.

Australia’s better-than-expected economic performance during the crisis can be seen as a forecasting error rather than a vindication of the fiscal stimulus measures. Benchmarking economic performance and policy effectiveness to the budget forecasts assumes that these forecasts were correct to begin with and not overly pessimistic, as now appears to be the case.

Treasury has since tried to claim that the economic outperformance relative to its previous forecasts meant that the fiscal policy multipliers were larger than they had assumed. But this effectively concedes the point that the Treasury is only guessing at the size of these multipliers.

The economic growth assumptions that went into Treasury’s 2010 IGR were defensible, but only because the Treasury had made a more serious forecasting error in relation to the implications of the global financial crisis for the Australian economy.

Professor Pagan is nonetheless correct in arguing that an independent process needs to be put in place, not only for the IGRs, but also for the annual budget process. Even if the IGR assumptions were not the outcome of a political process, the perception on the part of serious observers that they could be is obviously a problem. The Pagan-Gruen exchange demonstrates that the IGRs and the budget forecasts have, at the very least, a perception problem in relation to the integrity of their underlying assumptions.

It makes sense to reconcile the IGR projections with the current budget papers, not least because journalists would be quick to seize upon and beat-up any apparent inconsistencies in their assumptions or presentation. However, the link to the budget estimates is problematic because the budget is seen as a necessarily political document.

The perception problem can be addressed through Pagan’s suggestion that an independent process be put in place for the preparation of the IGRs. Robert Carling and I have taken this one step further in our paper, Fiscal Rules for Limited Government. We propose that the federal budget’s economic forecasts and fiscal projections should also be prepared by an independent statutory Fiscal Commission. The Commission would define the fiscal and economic framework within which the government then made its spending and taxation decisions in the annual budget.

This approach has the added advantage of ending pointless partisan political conflict over the economic and other assumptions in the budget. It would ensure that the budget debate was focused on the substance of spending and tax measures and not the technicalities, which should be above politics.