Over-optimism in forecasts by official budget agencies and its implications

an article by Jeffrey Frankel (Harvard Kennedy School) published in Oxford Review of Economic Policy

Abstract

The paper studies forecasts of real growth rates and budget balances made by official government agencies among 33 countries.

In general, the forecasts are found:
(i) to have a positive average bias,
(ii) to be more biased in booms, and
(iii) to be even more biased at the 3-year horizon than at shorter horizons.

This over-optimism in official forecasts can help explain excessive budget deficits, especially the failure to run surpluses during periods of high output: if a boom is forecasted to last indefinitely, retrenchment is treated as unnecessary. Many believe that better fiscal policy can be obtained by means of rules such as ceilings for the deficit or, better yet, the structural deficit.

But we also find:
(iv) countries subject to a budget rule, in the form of euroland’s Stability and Growth Pact (SGP), make official forecasts of growth and budget deficits that are even more biased and more correlated with booms than do other countries.

This effect may help explain frequent violations of the SGP. The question becomes how to overcome governments’ tendency to satisfy fiscal targets by wishful thinking rather than by action. Chile in 2000 created structural budget institutions that may have solved the problem. Independent expert panels, insulated from political pressures, are responsible for estimating the long-run trends that determine whether a given deficit is deemed structural or cyclical. The result is that Chile’s official forecasts of growth and the budget have not been overly optimistic, even in booms. Unlike many countries in the North, Chile took advantage of the 2002–7 expansion to run budget surpluses, and so was able to ease in the 2008–9 recession.

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