Forecasting the unpredictable

In his fascinating book, The Signal and the Noise, Nate Silver of the New York Times FiveThirtyEight blog explores the fallibility of predictions, including ones on the economy.

Silver reveals economists have failed to accurately predict any of the seismic economic events of modern history, including the Great Depression of the 1930s and the Great Recession of the late 2000s. Why we're so bad at predictions is better left to the book. However, after reading Silver's analysis, it makes you wonder why we put so much emphasis on predictions. Especially things like the fortunes of a national economy.

The fact is, we don't really know what an economy will do from year to year, especially now when the data used to make forecasts are, as Silver would say, particularly "noisy." As such, the best economic forecasters are probably the ones that resist the temptation to make definitive forecasts.

None of that seems to prevent elected officials from making predictions. They love to reduce complex economic equations to statements of certainty measured to the second decimal place. Thursday's budget was a good case in point.

The name of the game for Finance Minister Jim Flaherty is deficit reduction. Despite efforts to slow spending, the deficit is a painful, stubborn thorn in the finance minister's paw. He made progress last year extracting it, only to find it was longer than he first thought.

On Thursday, Flaherty reported a deficit for 2012-13 of $25.9 billion, up nearly $5 billion or 25 per cent from his forecast one year ago. This, despite billions of dollars in program spending cuts. Economic growth, the main driver of government revenues, simply did not live up to expectations. Hence, the forecasts were wrong.

Notwithstanding that maddening experience, Flaherty's new budget continues to feature a strong vein of optimism. The deficit, it is now forecast, will be reduced to $18.7 billion this year, and $6.6 billion in 2014-15. In the March 2015 budget, Flaherty believes he will be forecasting a balanced budget.

To accomplish this, overall spending this year will increase by less than one per cent. That is by any measurement a remarkable accomplishment, but there will be consequences. Government program inflation runs much higher than the CPI; a one per cent increase in overall spending is, by any name, a cut.

The incredible reality is that even with a staunch commitment to austerity, there is a pretty good chance we'll fall further into deficit this year.

The economy underperformed two years ago. It underperformed last year. And expected growth for the upcoming year has already been cut to 1.5 per cent from about 2.5 per cent. Although estimates vary, it is believed each point of GDP lost translates into $3 billion less in federal revenues. In that context, it's very difficult to figure out how Ottawa's deficit will shrink this year, even with billions of dollars in spending cuts.

Hanging in the balance are several 2011 election campaign promises, including big-ticket items such as a doubling of the child tax credit, a doubling of the Tax Free Savings Account limits, and income-tax splitting for couples with children under 18. Those pledges are contingent on eliminating the deficit.

Also hanging in the balance is the fate of federally delivered and funded programs and entitlements, most of which will continue to shrink.

Parliamentary Budget Officer Kevin Page, in his last week on the job, is fighting the Conservative government in court over its refusal to explain exactly how it is cutting expenditures. This is a key to understanding not only the likelihood of success, but also what kind of federal government we'll have when the cutting stops, if it stops.

Even without those details, Page still believes Ottawa will be fiscally stable over the long-term thanks to a decision to curb provincial transfers. Starting in 2017, transfers will rise with the rate of economic growth. Although it's hard to forecast that number, most provinces believe it will be a fraction of the six per cent escalator being used now.

Page noted this one decision means that even as Ottawa sees its fiscal situation improving, the provinces will become less and less stable, and thus less likely to afford the programs they provide now. Expect this to directly affect health care, education at all levels, and other entitlements that are lifeblood to many Canadians. The future for provinces and municipal governments is one of increasing pressure to raise taxes or drastically cut services.

That very much brings into question how valuable a balanced federal budget is to the average citizen.

For now, we can gorge ourselves on the numbers of the budget, the forecasts and predictions and estimates of expenditure and revenue. But we'll do that with the knowledge the federal balance sheet will likely look much different in a year's time.

At the risk of making yet another prediction, if the last two years are any indication, it won't be a pretty picture.

dan.lett@freepress.mb.ca

Republished from the Winnipeg Free Press print edition March 22, 2013 A1