Brexit and Modelling

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Bill Mitchell draws attention to a study by the Cambridge Centre for Business Research which shows that eminent institutions of economic research continue to base their findings on models that are unable to reflect economic reality. Having been incapable of recognising patterns pointing in the direction of the imminent Great Financial Crisis, these models continue to produce predictions that are wildly off the mark, yet viable owing to their political compliance - such as horror forecasts on the putative impact of Brexit.

The Cambridge researchers (Graham Gudgin, Ken Coutts and Neil Gibson) from the Centre for Business Research conclude from this that:

This catalogue of failure suggests that something is badly wrong with the state of forecasting models.

And like all those trapped in Groupthink:

The modellers themselves appear to have shrugged off these failures …

So business as usual – move on.

But:

The forecasting failures however have a cause in an emphasis within conventional models on supply-side factors, in face of what has proved to be a large failure of demand.

These failed models all impose ‘long-run’ restrictions – which mean they make up a solution that eventually has to be reached (irrespective) which satisfies their theoretical biases. In this case, they assume away long-run demand effects and conclude that eventually general equilibrium is restored.

They then impose ‘adjustment restrictions’ or ‘policy rules’ that force the adjustment path (short-run dynamics) of the economy to be consistent with where they have forced the model to go when all adjustment is over and the ‘solution’ settles down (after all the effects of the change are exhausted.

As the Cambridge researchers state:

The Government’s OBR model, for example, starts by projecting a trend path for potential output and then assumes that monetary policy will guide the economy toward that path. Any off-path point due to shocks leads to a return to trend within 3 to 4 years. Other forecasters, including the OECD, IMF, and several commercial forecasters, use an approach based on similar principles.

Feeding from the same trough!

The problem is that these models cannot cope with real world events, especially when major demand (spending) shocks occur.

The Cambridge researchers say:

Failures in forecasting of this magnitude exhibited since 2008 suggest that some modesty may be required in guiding future macro-economic policy in the UK. In practice, policy advice has continued as if little has happened. The Government asserts that reducing the size of the government debt must be a key priority if the UK economy is to return to economic health, and that major public spending cuts are required to reduce the debt. There has been relatively little modelling work to investigate whether such a strategy is either necessary or practicable. Indeed the nature of the OBR model (and similar OECD and IMF models) means that they cannot be directly used to investigate such questions.

So they are just asserted and ad hoc model manipulations are then used to reinforce these assertions.

They also note that:

The academic economics profession is equally unworldly. The mainstream approach is now to use so-called DSGE (dynamic stochastic general equilibrium) models … assuming that market forces will bring the economy back to its full capacity operation subject to certain frictions caused among other things by government regulations. We agree with Keynes’s view that neo-classical ideas are of little relevance to the macro- economic behaviour of real economies in major recessions … Most Central Bank forecasters, including the Bank of England, use a direct DSGE approach with, in the BoE’s case, generally poor results.

With regard to the economic impact of Brexit, Bill Mitchell summarises:

Overall, the Cambridge researchers find that:

The economic outlook is grey rather than black, but this would, in our view, have been the case with or without Brexit. The deeper reality is the continuation of slow growth in output and productivity that have marked the UK and other western economies since the banking crisis. Slow growth of bank credit in a context of already high debt levels, and exacerbated by public sector austerity prevent aggregate demand growing at much more than a snail’s pace.

[...]

That really should be the story – the deliberate undermining of growth by government austerity and the behaviour of the zombie banks.

The conservatives (including all the misguided neo-liberal ‘progressives) who are obsessed with the damage that Brexit will cause are just diverting the conversation away from the destruction that their fiscal ideology has caused and is continuing to cause.

Brexit is a smokescreen. It will not be detrimental to Britain in the long-run if the British government takes responsibility and uses its fiscal capacity to focus on domestic growth and employment.

But Britain will suffer if the fiscal austerity mindset continues (with or without Brexit) and the disruptions that will, in the short-run, accompany Brexit will be made worse by on-going austerity.

 The source.