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Understandably Henry has to defend the indefensible

Comments on ABC news “Henry hits back at Treasury critics”, By Online parliamentary correspondent Emma Rodgers, 19/05/2009, http://www.abc.net.au/news/stories/2009/05/19/2575093.htm?section=justin

The starting paragraph reads: “Treasury Secretary Ken Henry has rejected criticism of the "optimistic" economic forecasts put forward by his department and defended its independence from government interference.”

While Henry might be right on the second point in that statement but is wrong on the first one. On the second point, while people should generally respect the Treasury for its independent advices to the government of the day, one has to be puzzled by the changes to the forecast methods used in Swan budget 2009 to underpin the budgetary positions over the course of the next decade. Were those changes the initiative of the Treasury or the government? Yes there have been reasons put out by the government and possibly the Treasury, but people’s doubt and suspicions can’t and won’t just disappear that easily just by those reasons and explanations.

Elsewhere I have commented why the Treasury forecast is too optimistic and is likely to be very wrong in this case (see http://mrlincolns.blogspot.com/2009/05/critique-of-treasury-economic-forecast.html). Although it has been some time past and most current Treasury forecast officials may have forgotten that Lucas’s critique on macroeconomic modeling using highly aggregate variables of the past. The key message of Lucas critique was that those parameters were variable and not constant and not structural. So forecast based on those estimated parameters is unreliable.

One should remember that the Lucas critique contributed to some of the revolutionary thinking in macroeconomics and the rational expectations revolution. Any macroeconomic modeler must take that into account in their modeling.

What Henry said in defending the Treasury forecast? See the following excerpt from the news report:

[Dr Henry said Treasury's method for calculating GDP used several factors, including the unemployment rate, the population aged over 15 and productivity.
"We can obtain an index of real growth domestic product simply by multiplying together those five things and that's actually what we did," he said.
"Taken together, those factors produce a GDP growth rate of 4.5 per cent."
Dr Henry also pointed out that while some critics said if the projections were realised there would be an unprecedented six years of growth, there was seven years of growth above 5 per cent in the 1960s.]

Some of the most important ones among those five things that Henry mentioned are subject to the Lucas critique. One can’t just simply do what Henry said one can do in this occasion. This recession is much severe world-wide and the recovery of the world economy is very much likely to take longer and slower. That is the first point why Henry is wrong.

The second point is that the current great recession exposed the deep problems of international imbalance in savings, consumption and investment. While in the past some people had talked about these problems, no serious actions were taken by the main parties to the problems. Now the further rising US government debts are forcing people to rethink about these problems of international imbalances. Already concerns have been raised about the safety of US government securities. There have also been reports that the Chinese, the largest US government securities holder, have recently been stockpiling metals to diversify its investment.

All these suggest that there will be an international adjustment to address or at least to mitigate those imbalances. Adjustments to savings and consumptions are not necessarily an easy matter and take time. In the processes, the world economy is likely to be adversely affected in the short term in terms of growth. In other words, it is highly likely that there will be a period of slower world economic growth as a result of addressing international imbalances. This gives the second reason why Henry is wrong in deriving the Treasury forecast.

Further, while it is possible even likely that the prices of world commodities will rise in the next few years above their current levels, but they are unlikely to rise to those levels immediately prior to their recent collapse, as a result of a slower growth of the world economy. This is unlikely to benefit Australia in terms of terms of trade to the same degree as that happened pre-recession. So growth in a few areas in Australian economy, such as company profits and investments, is unlikely to be as robust as back then. This will place another damper factor to Australian growth in the medium term.

So it is so obvious to experienced macroeconomic modelers why the Treasury forecast is too optimistic. However, it seems that it is difficult for top Treasury officials to realize them. After all, it is too late now for them to change their mind and forecast, even if some of them may realize what went wrong with their forecast in hindsight, especially after listening to some many economists’ reactions and considering carefully why other equally reputable agencies such as the RBA and IMF have got lower growth forecasts.

There are more to Henry’s talk. The following excerpt says why:

[Dr Henry also pointed out that while some critics said if the projections were realised there would be an unprecedented six years of growth, there was seven years of growth above 5 per cent in the 1960s.
"Having approached the projections exercise in this way, we were a little surprised to hear some people suggesting that our projections were too optimistic because they failed to take account of the impact of imminent population ageing," he said.]

He mentioned the there was seven years of growth above 5 per cent in the 1960s to make the point that six years of above trend growth of the Treasury forecast is not unprecedented. But it is no more than an irrelevant wining debating point, and does not really answer many of the underlying questions. For example, he did not mention whether that seven years of above trend growth were above trends of higher growth period or not. He also failed to mention other context of the 1960s, such as labour force growth, participation rates and other international/external factors. Those factors were all have an important bearing on growth.

So while it is understandable why Henry was doing what he did, it does not change the fact he is wrong in defending the indefensible – in this case the Treasury overly optimistic forecast of above trend growth for six years following this great recession and international adjustments of imbalances. As the head of the Treasury department, he has had few other choices.

Henry's last point re argument on whether Treasury "failed to take account of the impact of imminent population ageing" is probably the least concerns among economists in terms of the Treasury recent forecast. Anyone who said that would have shown a lack of understanding in economic forecasting. As a result, it was equally futile to use that point to defend the Treasury's funny forecast.

What we need now is meaning debates between those people who doubt Treasury's recent forecast and Treasury officials. One sided speeches are not really productive or helpful to the debates. It would have been better that there should have some representatives from the other side of the debates at the gathering when Henry made his speech. Maybe there were, but the report did not show it.

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