Category: Essential Economics for Business: Ch 13

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The wrong kind of economics?

Business leaders and politicians pay a great deal of attention to economic forecasts. And yet these forecasts often turn out to be quite wrong. Very few economists predicted the banking crisis of 2008 and the subsequent credit crunch and recession. And the recently released 2010 Q4 growth figures for the UK economy, which showed a decline in real GDP of 0.5%, took most people by surprise.

What is more, forecasters often disagree. If, for example, you look at the forecasts made by various panel members for Consensus Forecasts, you can see the divergence between their various predictions.

So why is economic forecasting so unreliable? Is it the fault of economic models? Or are there too many unpredictable factors that can impact on economies – factors such as business and consumer confidence, or political events, or natural disasters, such as the recent floods in Australia, South Africa and Brazil? Will economic forecasting always be a very inexact science?

Articles
Davos 2011: Why do economists get it so wrong? BBC News, Tim Weber (27/1/11)
Popular Semi-Science Slate, Robert J. Shiller (24/1/11)
Fed Often Gets It Wrong In Its Forecasts on US Economy American Public Media, Justin Wolfers (26/1/11)
Don’t bet on economic forecasting CNBC, Jeff Cox (21/9/10)

Forecasts
Forecasts for the UK economy HM Treasury
Econ Stats: The Economic Statistics and Indicators Database Economy Watch (large database of worldwide annual statistics, including forecasts to 2015)
World Economic Outlook IMF (follow link in right-hand panel)
OECD Economic Outlook: Statistical Annex OECD
European Economic Forecasts European Commission, Economic and Financial Affairs DG

Questions

  1. For what reasons may economic forecasts turn out to be wrong?.
  2. To what extent is economic forecasting like weather forecasting? Which is harder and why?
  3. Wo what extent can the poor accuracy of economic forecasts be blamed on the application of the ‘wrong type of economics’?
  4. How much variation is there in the independent forecasts of the UK economy reported by the Treasury (see HM Treasury link above)?
  5. Using the HM Treasury link, compare the forecasts made of 2010 in January 2010 with those made of 2010 in January 2011. Attempt an explanation of the differences.
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Powering growth

BP has just published its latest projection of energy trends – its Energy Outlook 2030. According to the press release:

World energy growth over the next twenty years is expected to be dominated by emerging economies such as China, India, Russia and Brazil while improvements in energy efficiency measures are set to accelerate.

The following podcast from the Financial Times features a discussion of the report and the factors affecting oil prices and their relationship to economic growth

Webcast
Emerging economies seen driving energy demand Financial Times videos, John Authers and Vincent Boland (19/1/11)

Articles
Energy outlook Financial Times, Lex column (19/1/11)
BP energy outlook: main points The Telegraph (20/1/11)
High energy prices need not mean doom Sydney Morning Herald, Jeremy Warner (21/1/11)

Report
BP Energy Outlook 2030 (January 2011)

Data
Power slide The Economist: Daily Chart (19/1/11)

Questions

  1. What are the most powerful driving forces behind the demand for energy?
  2. Why does the report forecast virtually no increase in energy demand in developed countries? What assumptions are made about growth rates in OECD and non-OECD countries?
  3. What factors would lead to a substitution of sustainable energy sources for fossil fuels? What would detrmine the size of such substitution?
  4. What is the role of the price elasticity of demand for and supply of oil and the income elasticity of demand for oil in determining oil consumption in different parts of the world?
  5. Why may high energy prices not necessarily mean ‘doom’?
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Business confidence – on the cusp

Two reports on business confidence in the UK have just been published. The first, by Lloyds TSB Commercial, is its twice-yearly Business in Britain Report. The second is the Quarterly Economic Survey by the British Chambers of Commerce. Both reports paint a mixed picture about business confidence.

First the good news: the export sector is booming. Demand for exports is being boosted by (a) the depreciation of the pound, with the sterling exchange rate index some 20% lower now compared with the start of 2008 and (b) rapid economic growth in China, India and many other developing countries. Not surprisingly many exporting companies are looking to a bright future and are willing to invest.

Now the bad news. Domestic demand for many products is declining, especially services. This is not surprising given the rise in VAT, cuts in public spending and consumers cautious about their employment and income prospects in the coming year. With rapid cost-push inflation from higher oil and commodity prices, real incomes are set to fall and with it the level of real consumer demand (see Bosses gain – workers’ pain).

So where is the economy heading? The mixed picture painted by the two reports mean that the economy is likely to remain on the cusp. But with the export sector being much smaller than the domestic market, worries are likely to persist that economic growth may well slow significantly and the economy might return to recession. The main hope is that the restocking and replacement investment that follow a recession may be enough to provide just enough extra demand to avoid the ‘double dip’.

Articles
UK Business Confidence Hit By Domestic Demand Fears-Survey NASDAQ, Emma Haslett (4/1/11)
More doom and gloom as business confidence falls? Management Today, Nicholas Winning (5/1/11)
Smaller businesses do not share optimism Financial Times, Brian Groom (5/1/11)
New Year business confidence hit by domestic demand fears The Telegraph, James Hurley (5/1/11)
UK’s fragile services sector risks undermining recovery, BCC warns The Telegraph, Philip Aldrick (11/1/11)
Companies fear double-dip recession Oxford Mail, Andrew Smith (10/1/11)
Firms ‘planning investment freezes’ Press Association (4/1/11)
Surveys paint bleak picture for British economy Reuters, David Milliken (11/1/11)
Kern Says U.K. Services Industry Growth Is `Mediocre’ Bloomberg, Watch Video, David Kern (11/1/11)
UK economic growth rate slowing, BCC says BBC News (11/1/11)

Reports
Business in Britain, December 2010 Lloyds TSB Commercial (January 2011)
Quarterly Economic Survey, Q4 2010: Summary British Chambers of Commerce (January 2011)
Quarterly Economic Survey, Q4 2010: Tables British Chambers of Commerce (January 2011)

Data
Interest Rates and Exchange Rates Bank of England (for sterling effective exchange rates)
Economic and Labour Market Review Office for National Statistics (see Tables Chapter 1, worksheets in Table 1.03 for components of aggregate demand)
Business and Consumer Surveys European Commission, Economic and Financial Affairs (see latest ESI – Economic Sentiment Indicator, Table 1)

Questions

  1. Summarise the findings of the two reports.
  2. Using the data in Table 1.03 of the Economic and Labour Market Review, calculate the percentage of UK GDP accounted for by each of the main elements of aggregate expenditure.
  3. Why is the manufacturing sector as a whole experiencing relatively strong economic growth?
  4. If the service sector shrank by x% and the manufacturing sector grew by x%, what would be likely to happen to the rate of economic growth in the economy? What else would you need to know to establish the precise rate of economic growth?
  5. The BCC said both the government and the Bank of England must “act forcefully to support growth”. What measures would this include?
  6. If real wages fall, what could cause real aggregate demand to rise in these circumstances?
  7. What is likely to drive the level of investment in the coming months?
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A financial health check

Every six months the Bank of England publishes its Financial Stability Report. “It aims to identify the major downside risks to the UK financial system and thereby help financial firms, authorities and the wider public in managing and preparing for these risks.”

In the latest report, published on 17 December 2010, the Bank expresses concern about the UK’s exposure to problems overseas. The two most important problems are the continuing weaknesses of a number of banks and the difficulties of certain EU countries in repaying government bonds as they fall due and borrowing more capital at acceptable interest rates. As the report says:

Sovereign and banking system concerns have re-emerged in parts of Europe. The IMF and European authorities proposed a substantial package of support for Ireland. But market concerns spilled over to several other European countries. At the time of writing, contagion to the largest European banking systems has been limited. In this environment, it is important that resilience among UK banks has improved over the past year, including progress on refinancing debt and on raising capital buffers. But the United Kingdom is only partially insulated given the interconnectedness of European financial systems and the importance of their stability to global capital markets.

The Bank identifies a number of specific risks to the UK and global financial systems and examines various policy options for tackling them. The following articles consider the report.

Articles
Bank warns of eurozone risks to UK as EU leaders meet Independent, Sean O’Grady (17/12/10)
Deep potholes on the road to recovery Guardian, Nils Pratley (17/12/10)
It’s reassuring that regulators are still worried about financial stability The Telegraph, Tracy Corrigan (17/12/10)
Europe is still searching for stability and the UK must find it too Independent, Hamish McRae (17/12/10)
Shafts of light between the storm clouds The Economist blogs: ‘Blighty’ (17/12/10)

Report
Financial Stability Report, December 2010: Overview Bank of England
Financial Stability Report, December 2010: Links to rest of report Bank of England

Questions

  1. What are the most important financial risks facing (a) the UK; (b) eurozone countries?
  2. What is the significance of the rise in banks’ tier-1 capital ratios since 2007?
  3. Which is likely to be more serious over the coming months: banking weaknesses or sovereign debt? Explain.
  4. What is being done to reduce the risks of sovereign default?
  5. Why might the weaker EU countries struggle to achieve economic growth over the next two or three years?
  6. How do interest rates on government debt, as expressed by bond yields, compare with historical levels? What conclusions can you draw from this?
  7. What is likely to happen to bond yields in the USA, the UK and Germany over the coming months?
  8. What has been the effect of the extra £200 billion that the Bank of England injected into the banking system through its policy of quantitative easing?