Recently I have had a couple of posts (here and here) on biases in the forecasts of policy makers and why central banks and governments should use prediction markets to do forecasting instead of relying on in-house forecasts that might or might not be biased due to for example political pressures.

Anybody who have studied the forecasts of government agencies are well aware of the notorious biases of such forecasts.  Jeffrey Frankel in a recent paper “Over-Optimism in Official Budget Agencies’ Forecasts” documents strong biases in government growth and budget forecasts. Here is the abstract:

“The paper studies forecasts of real growth rates and budget balances made by official government agencies among 33 countries. In general, the forecasts are found: (i) to have a positive average bias, (ii) to be more biased in booms, (iii) to be even more biased at the 3-year horizon than at shorter horizons. This over-optimism in official forecasts can help explain excessive budget deficits, especially the failure to run surpluses during periods of high output: if a boom is forecasted to last indefinitely, retrenchment is treated as unnecessary. Many believe that better fiscal policy can be obtained by means of rules such as ceilings for the deficit or, better yet, the structural deficit. But we also find: (iv) countries subject to a budget rule, in the form of euroland’s Stability and Growth Path, make official forecasts of growth and budget deficits that are even more biased and more correlated with booms than do other countries. This effect may help explain frequent violations of the SGP. One country, Chile, has managed to overcome governments’ tendency to satisfy fiscal targets by wishful thinking rather than by action. As a result of budget institutions created in 2000, Chile’s official forecasts of growth and the budget have not been overly optimistic, even in booms. Unlike many countries in the North, Chile took advantage of the 2002-07 expansion to run budget surpluses, and so was able to ease in the 2008-09 recession.”

Hence, the conclusion from Frankel’s paper is clear: We can simply not trust government forecasts! His solution is to set-up independent budget institutions as in Chile. Sweden and Hungary as in recent years set-up similar Fiscal Policy Councils. Obviously this is much preferable to the politicised forecasts that we see in many countries (and from international institutions such as the EU and the IMF!), but I strongly believe that budget forecasts based on prediction markets would be much better. The easiest thing would be to let the central bank of the country set-up a prediction market for key macroeconomic numbers which are relevant for the conduct of monetary and fiscal policy and then all government institutions would use these numbers in the conduct of policy.

Robin Hanson reaches a similar conclusion.