How Keynes, not mining, saved us from recession

You never judge economists by whether they get their forecasts right. They rarely do. But they score points in my book if they're willing to work out why they got them wrong - and make the results public.

This is what Treasury's chief forecaster, Dr David Gruen, did in a speech to the Economic Society in Sydney on Friday.

I don't hold out much hope that such exercises will help produce better forecasts in future. But they should deepen our understanding of how the economy works.

Gruen's examination of Treasury's record in forecasting real gross domestic product over the past 21 years finds there's no upward or downward bias in its errors, but its "mean absolute percentage error" is 0.93 percentage points.

When you remember the trend rate of growth is about 3.25 per cent a year, that's a high degree of error.

Last May Treasury forecast that real gross domestic product would contract by 0.5 per cent in the financial year just ending, the first time it had ever forecast "negative growth". The year isn't over yet, but the revised forecast in this year's budget is positive growth of 2 per cent. And just the first three-quarters of the financial year are showing average growth of 1.9 per cent.

But if you think all that's bad, just remember: the smarties who purport to know better than Treasury are usually worse. Consider these reactions to the forecasts in last year's budget.

Des Moore, the climate-change denying activist: "The Rudd government's budget paints an unbelievable picture of a very mild recession (only a 0.5 per cent fall in GDP next year) followed by a recovery of 2.25 per cent in the election year (2010-11) and an above-trend rate of growth of 4.5 per cent in the following year."

John Roskam, a leading libertarian: "If Prime Minister Kevin Rudd genuinely believes Treasury is conservative when it forecasts economic growth of 4 per cent within two years, then it would be interesting to know his definition of optimistic. Treasury officials are not used to being laughed at on budget night but, as soon as their growth forecasts were revealed, no other reaction was possible."

Of course, we do know that average growth in real GDP in calendar 2009 was 1.3 per cent, and Gruen has revealed Treasury's unpublished forecast of minus 0.9 per cent. This was worse than the mean of minus 0.6 per cent for 17 private sector forecasts gathered by Consensus Economics, but right on the median.

After allowing for imports and inventories, the largest contribution to growth came from consumer spending (1.4 percentage points), followed by public sector spending (0.9 points), business investment and exports (0.4 points each), with housing investment making a negative contribution of 0.3 points.

(If you're wondering how all that adds up to just 1.3 per cent, it does so with the help of a negative contribution of 1.5 points from the "statistical discrepancy". Don't groan - the national accounts are like that; it's just one of the complications forecasters face.)

It's clear most of that surprisingly strong performance was due to old-fashioned Keynesian fiscal stimulus. Consumer spending was greatly bolstered by the cash splash, while the jump in public sector spending speaks for itself. The growth in business investment was explained by the draw-forward effect of the temporary tax break.

According to Treasury's estimates, the fiscal stimulus contributed about 2 percentage points to the overall growth of 1.3 per cent last year, meaning that, without it, GDP would have contracted by 0.7 per cent.

So much for the claim the mining sector was "a key factor in keeping Australia out of recession".

If you decompose exports' contribution of 0.4 percentage points, rural commodities contributed more (0.3 points) than mineral commodities (0.2 points), with manufactures making a negative contribution.

Treasury did allow for the effect of the fiscal stimulus in its forecast, but it's pretty clear it (and everyone else) didn't allow enough.

Gruen believes it took insufficient account of the "favourable feedback loop that expansionary macro-economic policy - both monetary and fiscal - appears to have generated".

"Macro-economic policy appears to have been large enough and quick enough to convince consumers and businesses that the domestic slowdown would be relatively mild," Gruen says.

"This, in turn, led consumers and businesses to continue to spend, and led businesses to cut workers' hours rather than laying them off which, in turn, helped the economic slowdown to be relatively mild."

The turnaround in business and consumer sentiment began earlier and was a lot stronger in Australia than in other developed economies. But that's another problem for the forecasters: swings in the collective mood are probably the biggest factor driving the business cycle, but how do you predict them?

It's true, of course, that continuing demand from China played a part in keeping us afloat. Gruen notes that the Consensus forecast for "non-Japan Asia turned out to be significantly too pessimistic".

But why? Partly because the forecasters made insufficient allowance for the Asians' lack of impairment in their financial systems, but also because they underestimated the speed and size of the fiscal and monetary stimulus, particularly in Korea and China.

As well as underrating the power of Keynesian policies - which are likely to be more potent in the young and dynamic emerging economies - too many forecasters failed to see how much success the Chinese would have in switching from external demand to domestic demand, particularly spending on infrastructure.

An economy as big as China has plenty of scope to "decouple" from the developed countries - a point worth remembering when you're tempted by the latest fear, that Europe's problems will wipe us out.