Top economic forecast takes a grain of salt
The White House will soon release the report of the President's Council of Economic Advisers, with its prediction of the nation's economic path over the next year. Unfortunately, when the report comes out Jan. 30 you will not be able to put very much confidence in its forecasts, for over the years the council has been too optimistic. With few exceptions, it has forecast a more attractive economic picture than what actually came to pass.
Congress created the Council of Economic Advisers in 1946 and directed the president to use it in preparing an annual report on the economy for Congress. The Economic Report of the President has thus become a January ritual, observed with considerable interest by many of the nation's economists and business analysts. Although its typical distribution of about 50,000 does not qualify it as a best seller, it is the chief vehicle through which the administration explains its economic policies to the public.It is also the vehicle through which official forecasts of economic activity are developed for the coming year.
The policy discussions may make interesting reading. The forecasts, however, are among the worst in the business. Its forecasts of real economic growth are typically too high, those of inflation are almost always too low, and those of unemployment are usually less gloomy than what actually occurs.
In earlier years, the three-member council escaped criticism for inaccurate forecasts by keeping its predictions as vague and nonquantitative as possible. For example, during the Eisenhower years, when Raymond Saulnier was its chairman , a typical forecast was for "continued economic expansion." Since that was equivalent to a prediction that real economic growth would lie somewhere between zero and infinity, there was little risk of error. Only a surprise recession could have negated a forecast of that variety.
It wasn't until Walter Heller took the helm in 1962 that the council grew bold enough to venture quantitative forecasts. The first one by this Kennedy-appointed council went something like this: real economic growth, 7.5 percent; inflation, 1.5 percent; and unemployment by year-end, less than 5 percent. The actual figures for 1962 were: real growth, 5.8 percent; inflation, 1.8 percent; and unemployment at year-end, 5.5 percent. In each case, the forecast was too rosy.
Compared with the councils that followed, the Heller panel didn't do too badly. In fact, its average inflation forecast has been the best of any council since quantitative predictions bega. Of course, forecasting inflation in those ancient days, when it waddled along at 1 to 2 percent a year, was considerably easier than it has been since the late 1960s. But in both low and high inflation years, virtually every council has been overly optimistic on inflation. Only three times in the last 18 years has this not been the case. In 1968, the inflation forecast of the Heller council was right on the button, and in both 1975 and 1976, Alan Greenspan (who served under President Ford) thought inflation was going to be much worse than it turned out to be.
Does the accuracy of the council's forecasts depend upon the political party in power at the time? It is difficult to say. Inflation forecasts by Republican councils have been almost six times as bad as those appointed by Democrats. Of course, Republicans have faced a tougher forecasting environment, with some of the most extreme inflationary swings in recent history. As if to balance things a bit, Democratic councils have missed forecasting the nation's real economic growth by margins of error about three times the size of those made by Republican councils.
Why does the economy rarely perform as well as the Council of Economic Advisers promises?
Since top-notch economists are usually appointed to the council, we must rule out gross incompetence as the explanation. Being a part of the administration, it may be that the council makes predictions that are really a mixture of objective forecasts and campaign promises. Since it does not do much for the incumbent president's rankings in the polls, a too-dismal economic projection is something to be avoided. And if the council is to err, far better to err on the side of optimism.
There is, however, another element. the forecasts are usually conditional upon some set of proposed economic policies -- a tax cut here, an investment tax credit there. If Congress does not agree with the proposed policy or put it in effect, then the assumptions underlying the forecast have been in error, and so will be the forecast.
But again, the political element comes into play. While private forecasters can make an objective assessment of the probability that a policy will be put through by Congress, the council must play the role of policy, advocate and assume that this "best of all policy world's will prevail. So no matter how you cut it, it is the political character of the councils that will probably continue to cause them to promise us more than the economy will usually deliver.