The Forecast is the one you have heard, only embedded in a letter to the chief of our state's Forecast Council, who recently presented to our group of economists. In another of our hats, we are responsible for getting the speakers into the Seattle Economics Council, the region's association of economists. For this season, we elected to start off with the new chief forecaster for the State of Washington, Steve Lerch.
Now on to our more local efforts.
The previous holder of the office of director of the Washington State Economic and Revenue Forecast Council, Arun Raha has taken employment elsewhere. This followed, though was not necessarily necessitated by a series of optimistic forecasts for revenue that caused state legislators to scramble to fill big revenue holes. This experience was not by any means unique among states. In fact, it is probably more the norm than the exception.
The new chief forecaster, Steve Lerch, spoke to the Seattle Economics Council on October 12. We should note that since he has taken office, the forecasts have been dramatically improved. Whether this is because stagnation is now accepted, where recovery was just around the corner before, we do not hazard to guess.
Previewing: We suspect the problem of bad forecasts lies in the DSGE, Dynamic Stochastic General Equilibrium models, and in particular, by the reliance on Global Insight, a shop specializing in producing baseline forecasts for states and other governments. Another problem, one we've pointed out here before, is that a common practice is to take the average of the blue chip consensus of forecasters and use it as a probable outcome.
The economics profession is the last to know.
But in any event, here is the letter.
Just a note to say we very much enjoyed your presentation to the Seattle Economics Council this past Wednesday, particularly the transparency with which you presented your model update and the forecast and the various questions whose answers might alter things. I think all of us welcome you in your new post.
Following are a few comments particular to me, and reflect a view likely not widely shared among our members.
The fact that ERFC does not formally use a DSGE model is one thing, but it is very likely that those models are reflected by the practice of using the blue chip consensus to constrain your GDP forecast. This is important because it introduces an assumption of equilibrium which I do not believe we are seeing in the actual track of the economy. These models also ignore the role of debt and the financial sector. To be clear, I think what we see in the tepid recovery of the economy since the crash is not so much a tendency to equilibrium as it is a response to policy, trillion dollar federal deficits which support consumer demand and zero percent interest rates which mitigate the credit contraction.
The primacy of debt, household deleveraging, business caution, and so on, means that we are in a long-term stagnation of incomes and employment. Since the debt issue is not being resolved in a straight-forward manner, we should expect possible downside shocks, but not upside surprises.
These are exciting times for economists. As you pointed out, the models completely failed to predict the biggest event of the past seventy-five years. It should be a time to learn, but I'm afraid we are not. Karl Popper once said, "Forecasts and explanations are symmetrical and reversible," which I take to mean, if your forecasts are not good, then your explanations are not good. As a discipline, economics has yet to review the fundamentals of its explanations in light of the financial crisis. We continue to use these DSGE models, which ignore debt and credit, have a very primitive time component, and assume an equilibrium that is not apparent.
I would suggest, though I do not know, that Global Insight suffers from the same credibility problems as other forecasters, and your predecessor's problems may be based on reliance on their projections. There are forecasters who predicted the financial collapse, though not the precise timing (so they may be less useful to state budgets). Some, such as Nouriel Roubini, have predicted a hard landing in Europe and China which ought to be the baseline view.
With regard to the B&O tax receipts coming in stronger than other revenue sources: This could be a function of its biggest flaw – that it is not based on income, but on gross activity. That is, while sales taxes go up and down with discretionary income, and obviously income taxes also, the net income of businesses is not what is taxed by the B&O, but rather the top line receipts. A service business operating at a profit in the pre-crisis period may have to operate at a loss afterward to keep the doors open, but its B&O liability does not shrink so much. And further, the B&O captures sales in food and drugs, which are likely more stable in downturns than the consumer discretionaries subject to the sales tax.
There is no upside visible. Zero interest rates are translating into stronger stock and commodity markets, and to higher commodity prices, but not into any appreciable business investment (nationally). Households are burdened by debt and are deleveraging as much as stagnant incomes will allow (although younger households are taking on debt in the form of student loans that will permanently stunt their prospects). The European crisis cannot be resolved by the current policies of austerity. The structural adjustments demanded by the ECB and IMF for bailouts make our fiscal cliff look like a speed bump. Ultimately the imbalances in Europe translate to a banking crisis, as their financial institutions are very thinly capitalized and cannot withstand even a modest write-down of sovereign debt. The U.S. policy of trillion-plus deficits could probably work economically insofar as no great inflation is likely without recovery in investment spending, but whether it can work politically is very questionable.
There is downside visible in the short term. In particular, what is called the "political business cycle," where the executive in power generates as much government activity as possible leading up to the presidential election. This has been the practice of every president since Nixon, except Jimmy Carter, and although the most recent Congress has made overt attempts to frustrate such spending, it is not likely they have completely succeeded. That means that a post-election slump is very likely.
So projections for recovery are premature. Even in housing. Bright spots may appear, e.g., the Seattle metro area, but they may be countered by dead zones. (We've had too many false dawns in housing to be confident in this one.) Where credit is available, activity will pick up, e.g., auto sales, education.
Downside shocks are certain. If there is no actual financial crisis in Europe, it will only be because the core has bought time in the form of stagnation in the periphery – and now the periphery seems to include Spain and Italy. (The terminology seems to be changing from "core" to "North" and "periphery" to "South." In any event, the imbalances are only exacerbated and extended by current ECB and IMF policy, and the fundamental restructuring of the currency union is well out of reach of their austerity approach.
Households will be under pressure for years to come, so long as they are burdened with debt. Personal incomes are stagnant and will remain stagnant. Local bright spots, e.g., Amazon, are gloomy spots for competitors, which often are long-established brick and mortar businesses.
So. Even if you were to accept all this, it likely means little for the forecast in terms of the precision that may be essential for state budgeting, although it may be useful to add an estimation in some way of the prospective risks, as they impact directly state expenditures in social services. In that vein, it may also be a, perhaps Quixotic, idea to gauge expenditure estimates on a per capital basis as you do revenue estimates. Cohorts of aging citizens or school-age citizens or unemployed citizens may require more, while an influx of active workers may require less.
I hope these comments are useful, or at least entertaining. Thanks again. We are very pleased to see the quality of the new forecasts and the chief forecaster. I hope you have the job for many years to come. Washington will be well served.