Monday, 16 January 2017

The weather is not the climate: predicting the economic impacts of Brexit

Interviewed for ITN/Channel 4 News, I was asked – very reasonably – why anyone should listen to economists’ views on the economic impacts of Brexit, when many short-term forecasts that a Brexit vote would lead to a sharp slowing of the economy had been proved wrong.  This was my response: 
“Short-term economic forecasting is very unreliable. Just because the weatherman gets it wrong about whether it’s going to snow tomorrow doesn’t mean that the scientists have it wrong about whether climate change is going to make the planet warmer over the medium to long term”
I think it’s worth explaining this.  The forecasters – including City economists and independent research institutions like NIESR and IFS, as well as the Treasury and the IMF - who predicted economic gloom as a direct result, not of Brexit itself but of the referendum result, did so on the basis of the expected impact on financial markets, business and consumer confidence:  “Our research shows that a vote to leave would increase uncertainty and, at best, reduce growth”.  

But they were (mostly) wrong.  On the markets, while the pound did indeed fall much as expected (which is actually good for economic activity in the short-term; the exchange rate acts a shock absorber to the expected long term hit to the economy by making UK exports cheaper) market interest rates didn’t rise and the stock market didn’t collapse (although UK companies have certainly underperformed). More importantly, after an initial shock to confidence, businesses and consumers appear to have decided that nothing has happened yet and nothing much will happen for a while; so it’s business as usual. Research on uncertainty, it turns out, isn’t exactly a certainty.

We can dismiss a couple of excuses for this failure. It’s true Brexit hasn’t happened yet – but the forecasts were explicitly related not to Brexit, but to the uncertainty and expected future impact of Brexit.  It’s true some (but not all) of the forecasts assumed immediate Article 50 notification, but that was not central – and if it was uncertainty that was supposed to drive economic weakness, delaying notification merely prolongs the uncertainty.  And it's true there was a policy response from the  Bank of England - but if anything could have been forecasted it was that.

So what forecasters fundamentally got wrong was their judgement about the short-term behaviour of millions of individuals interacting in a very complex system, where (as we know from the analysis of such systems) relatively small changes in a few variables can lead to quite different outcomes.  The claim that “the flap of a butterfly’s wing in Brazil can set off a tornado in Texas” is poetic license – but the inherent difficulty of forecasting short to medium term perturbations is true both of the economy and the weather.  

Now, despite these difficulties, weather forecasting has got considerably more reliable over the last 20 years, so there’s plenty of room for economic forecasters to improve – but  explaining how the economy will do in the next few months is always likely to be very challenging. That’s true of economic forecasting in “normal” times: but it’s even more so the case when trying to assess the short-term impacts of a political event on the psychological attitudes of consumers and investors.

By contrast, predictions about the long-term impact of Brexit – like climate science  - are based on quite different reasoning, about how changing one key factor – our openness to trade, or the degree to which the earth’s atmosphere retains heat – changes the long-run properties of the system.  The methodologies used are well-established and robust – and while of course the detailed modelling of their impacts requires considerable expertise and huge amounts of data, the basic mechanisms at work are well-established and easy enough to explain.  The operation of the greenhouse effect can be demonstrated in a school lab.

Similarly, the basic insights of the “gravity model” approach to predicting international trade – that trade between two economies depends on how big each is, how far apart they are, and historical, cultural and policy factors including the existence of special trade arrangements like the EU – are common sense, and their empirical and practical validity is not seriously in question.  More CO2 will make us hotter: less trade and migration will make us poorer.  

Now, economists’ forecasts of the long-term impacts of Brexit could still be wrong – or inaccurate- just as climate scientists could be wrong about the path of climate change. First, our scenarios could be wrong; Brexit could turn out very differently from the options (hard or soft, clean or chaotic) most people are trying to analyse; similarly, sudden technological advances could change the path of CO2 emissions.  Second, the numbers are probably more uncertain even more than the models (which already incorporate some forms of uncertainty) suggest – some forms of uncertainty are simply impossible to model.

So while we can predict that Brexit will reduce growth and CO2 will warm the planet, we should take the quantitative modelling on just how large these effects are with a large pinch of salt.  In particular, feedback effects could either amplify or dampen the impacts – and it is very difficult to guess which. But the basic point - that reductions in trade and migration will reduce growth and productivity, relative to what otherwise would have occurred – is very unlikely to be disproved, any more than the greenhouse effect.

So how should that translate into how we actually make decisions?  Well, I listen to the weather forecast: but, like most Londoners, whatever it says, I always carry an umbrella.  On the other hand, that doesn’t mean I’d buy a house on a flood plain. 

12 comments:

  1. Interesting and thoughtful post.

    Other areas in which economists could be wrong about the long-term consequences are:
    1) Underestimating the benefits (could be cost, but more likely benefits) of moving much regulatory and virtually all agricultural policy to a national level, which will probably tend to a more liberal direction than at an EU level. Prior to the referendum most economists accorded little or no weight to this.
    2) a) Underestimating the speed and extent to which the UK completes FTAs with 3rd parties (again, they could be wrong in the other direction too; but given the conservative assumptions in this area of most pre-referendum forecasts, it is more likely that UK will perform on the upside. And political developments in the US have been an early boost to the UK) b) They may also have underestimated the benefits of trade diversification: that is to say, even if the net effect of freer trade beyond the EU and less free trade within the EU was neutral, the indirect effects on competition/ innovation may be net positive by being more exposed to different economies with which the UK currently trades little, whilst still trading a lot (but less than present) with the EU
    3) There being galvanising effects of the referendum on intangibles: UK companies spurred to seek out new markets; UK consumers more confident about their long-term prospects now that finally the elites have listened to them; and overseas consumers more aware of and positive about the UK brand (research show an overall positive impact on the UK’s international reputation so far, in most geographies outside Europe itself); also, arguably a government which will be more single minded in pursuing pro-growth policies
    4) A shock in the EU (e.g. eurozone implosion) which generally weren’t included in the counterfactuals – clearly this would hit the UK in or out of the EU, but exposure would be greater if in
    None of these would contradict the argument of the post that open trade and migration are good for an economy.

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  2. All these points are potentially true - although equally as you recognise both 1) and 3) could go in the other direction (it's far from obvious we will pursue more liberal policies outside the EU..). On 2, see my former NIESR colleague Monique Ebell's work.

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  3. Personally I struggle with the Brexit analysis that trade with rest of the world was significantly restrained by being part of EU. There is no iota of evidence for this looking at Germany's exporting prowess. In trade terms I think we are being guided by people who finding their boat is sinking in the harbour, decide to leave the harbour. The comment above ignores the fact that nearly all the EU animal welfare and environmental legislation was driven by Whitehall. We were using the EU to stop our nearest and dearest neighbours from competing with UK farmers on an unfair playing field. Brexit will stop us stopping them (if you follow the logic), but I doubt it will stop Whitehall imposing rules on UK farmers. UK Farming needed Whitehall exit not EU Exit. Our economic performance has been better than expected post Brexit, but we will see this is uncharted territory and it misses the point which is "how much better would our performance have been had we not voted Brexit"? What psychologists call the "confirmation bias" has resulted in people going into silos where they talk only to each other about things that confirm their prejudices. I include myself in that. Brexit has been better than I feared ... but pointing to businesses investing in the UK only proves Brexit did not stop them, it does not show who else has gone elsewhere.

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    Replies
    1. Not sure what your struggle is. The EU has a Customs Union which has a CET and other barriers to trade with those outside it. Germany does relatively well at trade - so what? That is of no relevance to the question of whether countries would trade more with non-EU countries if not part of the CU. The net effect of being out of the CU (negative impact on intra-CU trade but positive upside beyond) is highly debateable of course. For a country like the U.K., with a minority and declining share of trade with EU countries and a mindset which is more pro-free trade than the average EU member, it is more likely to be positive than for most others.

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  4. Prof Portes
    I agree with what you have written. Short term forecasting is essentially a mug's game - but cannot be avoided. The bigger issue is that some (e.g. Economists for BREXIT) argue the models used by many to think about the long term / structural effects of BREXIT are wrong. For example, my reading of a 13 July 2016 PowerPoint presentation of Economists for BREXIT is that they even reject even the gravity trade model. To use your analogy, those favouring BREXIT appear to argue that the UK has already bought a house on a flood plain (membership of the EU). Therefore the UK must sell up and relocate.

    Ian Bright

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  6. I have to say I find this whole argument a bit of a stretch. The comparison of economic forecasting with climate science seems intended to lend credibility to the former which it does not deserve. I find the idea, based on the comparison with climate science, that short term forecasting is difficult and longterm forecasting more reliable hard to swallow. If economists were so good at predicting the economy in the long or medium term, then presumably they'd all be rich. The comparison with weather/climate does not work.
    You make the comparison with a weather forecast of snow tomorrow. Where the weather forecaster's prediction usually goes wrong is where and when it will snow. So if it does not snow on my house at the predicted time, I regard the forecast as wrong. It probably did snow, but they got the timing or location wrong.
    Long term economic forecasting is not like climate change. Scientist may argue about how fast global temperatures will rise, but there is consensus that they will and the causes. Apart from the planet being struck by an asteroid there are few totally unpredictable factors. Though of course more science leads to more information. For long term economic forecasts however there are a huge number of unpredictable factors.
    What happens, for example, if North Korea fires off a nuclear rocket? Or the USA invades North Korea to prevent them from doing this? There are endless unpredictable possibilities.

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