Sunday, 11 January 2009

How Bad Will It Get?

All forecasts about the future are based upon a set of assumptions. We normally have a view of how the world works – a mental view of the underlying reality of the world and how its various components fit together. We then take in data about the world, feed it into this underlying model of the world, and out pops a view of how the world will look in the future. This method relies crucially upon two sets of assumptions – assumptions about the validity of our model of reality and assumptions about the validity of the data that we are feeding into the model. This is what we mean when we say that a forecast is only as good as its assumptions and that the way to test the sensitivity of a forecast is to test the sensitivity of its assumptions.

In a recent post (see post) we took the view that the levels of borrowing outlined in the Pre-Budget Report ought to be affordable on a horizon out to 2017. A key assumption in the scenarios that gave rise to this view was that the current downturn would not be too long and too hard. The key assumptions were that the downturn would continue until the middle of 2009, where unemployment would peak at 2.25 million. In recent weeks, we have been examining this assumption.

Unemployment is currently at about 1.8 million. It has been increasing at an average of about 45,000 a month, but the rate of increase has accelerated in the most recent months (see statistics). If it continues at this lower rate until mid-2009 the forecast in our base assumption is not likely to be too far from the mark. However, if it continues at this lower rate until the end of 2009, then our base assumption is likely to understate unemployment, which could peak at about 2.5 million.

In recent weeks, there has been some discussion in the press about the possibility of unemployment peaking at about 3 million by the end of 2009 (see references). In order for that to happen, unemployment would have to increase by an average of 100,000 each month for the whole of 2009, which is over double the current rate of increase in unemployment. While this entirely possible, we feel that it is very unlikely. Such forecasts are often associated with a political agenda hostile to the present government and are open to the accusation of being highly partial forecasts.

Whilst the first half of 2009 may see the occasional monthly increase in unemployment of 100,000 or above, it is extremely unlikely that the liquidity pumped into the economy in the second half of 2008 will fail to have an effect in the second half of 2009, which is when we would expect the impact to start to be felt. There is ‘wall of money’ is currently flushing through the system and there is nothing to suggest that we will not see credit conditions easing in the second half of 2009. It is possible that the banking system might still be restricting credit, but a good deal of political pressure will be placed upon the banks to start lending again. In the New Normal, where the government owns a significant proportion of the banking sector, this political pressure is likely to be felt commercially.

It is quite important that we keep in mind the assumption about the length and severity of the recession. If we are understating the length and severity of the current recession, then the forces to increase the PSBR will be much larger than expected and the point at which the borrowing can be repaid – along with the concomitant withdrawal of the Public Sector from the financial markets – will extend beyond the 2017 horizon that we are examining. Of course, we could be wrong in the other direction and the recession may well ease before mid-2009, thus bringing forward the point at which the debt can be repaid.

It really all hinges around the question of how bad the recession will get. There has been some wild talk about a 1930s style depression. This is exactly that – wild talk. An interesting article in The Economist (see article) provides us with some perspective. The key point is that in the 1930s, the money supply contracted along with the real economy. The lesson from that mistake has been learned, and we are now seeing a monetary expansion to counteract the downturn in the real economy. Sadly, it is far from clear that the lessons from the policy of protectionism learned in the 1930s have yet to be fully absorbed.

Coming back to the original question: how bad will it get? It is hard to tell at the moment because we are in the downswing of the recession. However, we know that it will end at some point, and we know that recovery will follow. By Easter, we ought to be able to take a view on whether or not the bottom is likely to be mid-2009. At that point we shall be able to take a better view of how long into the next decade the Public Sector will dominate the economy.

© The European Futures Observatory 2009

The European Futures Observatory is currently co-ordinating the Europe Chapter of the World Future Society. To this end, we have arranged a meeting in Paris on Wednesday 18th February 2009 to launch the Chapter. A cordial invitation is extended to all members, friends, and supporters to attend the lunch. Further details can be found on our web site. Click here for details.

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