A critique of Treasury economic forecast for the budget

Treasury forecast that the Australian economy will grow above trend at 4.5% for a number of years following this recession. This has been used in the federal 2009 budget documents. It is said that this is based on past experiences, re those ones in the early 1990s and the early 1980s. The media and many commentators said it was optimistic, much more so than both the IMF and RBA forecasts.

While it is not uncommon to use past experiences in economic forecasts, one must realise its inherent danger if used mechanically. The famous Lucas critique should serve as a sobering reminder. Lucas pointed out that it is naïve to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. This undoubtedly applies to the Treasury forecasts.

My critique of the Treasury forecast is that it has conveniently ignored the most likely implications of the great recession we are still having now. One implication of this recession is that there will be a much greater international effort to address the huge international imbalances in savings, consumption and investment.

A manifesto of the imbalances is the low or negative savings by the US and its huge debts. It is likely that the US has to increase savings to fund its domestic investment and government deficits. The contribution of consumption to the economy is likely to fall significantly to boost savings. This is likely to cause the US economy to grow more slowly than the case in the 1990s or in the early this century. When the world biggest economy does this, the world economy is likely to be dragged to slow somewhat. What this means is that the world economy is likely to experience a period of slower growth.

The financial crisis has caused great damages to the international banking and financing system. It needs to be repaired. Many banks and financial institutions need to deleverage and/or increase own capitals. This means the costs of capital will increase above those prevailing prior to the crisis. Higher capital costs will reduce investment and slow economic growth.

Besides the damages to banks and financial institutions, this great recession has also caused enormous damages to some non-banking companies. Some examples of big ones include GM and Chrysler that are facing a real possibility of bankcruptcy. These sorts of business failures destroy social wealth and reduce productive capacities/capital. They decrease demand through the wealth effects and reduce supply, further compounding the effects of international rebalancing of savings and consumption.

China is expected to continue grow rapidly and that is likely to benefit Australia. But even China will be affected by the expected international rebalancing. A slower US economy will limit China’s exports to the US. As a result, the Chinese economy is also likely to experience growth below its trend growth prior to the crisis.

All these point to a period of slower world growth ahead. It is against this background that I say the Treasury has probably got it wrong in its forecast by assuming above trend growth for Australia after this recession, especially for a lengthy period. It appears that it has not made the plausible assumptions on world economic growth. As a result, it has failed to take into account the changed structure of the world growth and its impact on important parameters such as world growth in its model, a point not too dissimilar to that of the Lucas critique.

It is worth noting that the government and Treasury have recently changed the conventional practice of assuming trend growth for the outer years in government budget documents. It is said that this is to make the forecast more accurately reflect the likely future course. On this account, they have either conveniently ignored the Lucas critique, or made a seriously bad judgement in the modelling process, under the understandably very strong pressure of preparing the budget.