The perils of prediction

This Perspective column was first published in today’s edition of Fund Strategy.

Whenever encountering any kind of forecast it is always best to remember a wise maxim: “It is difficult to make predictions, especially about the future”. The saying, or variations of it, is attributed to many different people. It is true of short-term forecasts and even more so of long-term ones.

I was reminded of this aphorism when I recently stumbled across news stories suggesting the world economy is in the midst of a fundamental shift. They pointed to research by the Organisation for Economic Cooperation and Development, an inter-governmental think tank, predicting that the Chinese economy could overtake America by 2016. Another headline prediction was that China and India combined will be larger than the entire developed world by 2060.

The tricky question is how to interpret such claims. It is relatively uncontentious to suggest that the Chinese economy could be larger than that of America in a few years’ time. But making predictions almost 50 years into the future is fraught with difficulties.

Who in the early 1960s would have predicted the demise of the Soviet Union or the rise of China as a substantial power? These trends may seem obvious now, with the benefit of considerable hindsight, but few anticipated them at the time.

As is often the case it is worth going back to the original OECD research to see what it actually says. That way it is possible to determine whether it contains any insights or whether its predictions are flawed or simply guesswork.

For a start the prediction that China will overtake America by as early as 2016 is not quite what it appears. It is true that by then China could be consuming as much as America once the different costs of living are taken into account. But on the basis of market exchange rates, a better way of comparing economic power, it is likely to be a while before China is number one.

It is also worth emphasising that America remains way ahead of China in terms of income per head. It should not be forgotten that the Chinese population is over four times that of America. So even when the economies were equal in size in consumption terms the average American will still be about four times wealthier than the average Chinese.

This is not to suggest that the America will remain the world’s pre-eminent power forever. Only that its relative decline is a slower process than many assume.

But more interesting than the conclusions in the research is the method used to reach them. Essentially the OECD assumes in its “baseline” (most likely) scenario that, give or take a few tweaks, the future will be more-or-less resemble the past. So, for example, emerging economies will continue growing fast although at a slightly reduced rate than in recent history.

The research also reads contemporary concerns into the future. Most notably it is worried that an ageing population will damage economic growth.

Both sets of assumptions are open to question. For a start, as already noted, there is a high chance that in important respects the future will be different from the past. It is difficult to say exactly what dramatic changes will happen but over a half-century time horizon some big shifts are almost certain. The usefulness of any really long-term predictions is therefore open to severe doubt.

But even its shorter-term premises are dubious. The report attaches far too much importance to demography: arguing that the falling share of the population that is of working age is likely to hit economic growth in many countries.

As I have argued previously this is a false premise for many reasons (“Auto-enrolment is wrong answer”, Fund Strategy, 15 October 2012). In principle it is possible to raise the retirement age, as the OECD shyly acknowledges, and to bring many more of the unemployed into work. It would also be possible for developed countries to allow in many more migrants from poorer nations but the OECD plays down this option.

The most important omission though is the limited discussion of the possibility of boosting economic growth through capital investment. Although the OECD does refer to this possibility there is little consideration of how it can be achieved.

Discussion of structural reform in the report focuses on such factors as improving product market regulation, bolstering labour force participation and lowering tax rates. The possibility that the state could play a role in creating a framework to bolster investment and innovation receives relatively little attention.

The OECD report reveals much more about the organisation’s blinkered outlook than it does about prospects for the global economy. It grossly exaggerates the importance of demographic factors while systematically underestimating the possibilities for growth-promoting policies.

To the extent that it makes short-term predictions they are uncontroversial – such as the closing output gap between China and America – while the long-term outlook is of little use.

The research says a lot about the low horizons of the OECD, as well as of mainstream thinking in general, but little about the world’s future.

* OECD. Looking to 2060: Long-term growth prospects for the world.