Sunday, January 29, 2012

Over-Optimism in Official Budget Agencies' Forecasts

We're always looking for where applications of prediction markets may make sense to improve a process. It looks like official government forecasting may be one such area to tackle.

Jeffrey Frankel from the Kennedy School of Government at Harvard and Director of the Program in International Finance and Macroeconomics at the National Bureau of Economic Research has written a paper entitled: "Over-Optimism in Forecasts by Official Budget Agencies and Its Implications."

From the digest on the NBER site:

...Overly optimistic official forecasts of future budget balances have facilitated complacency and so have contributed to tax cuts and increases in government spending, and therefore to realized budget deficits, during the last decade.

Analyzing data for 33 countries, Frankel finds that the average upward bias in the official forecast of the budget balance, relative to the realized balance, is 0.2 percent of GDP at the one-year horizon, 0.8 percent at the two-year horizon, and 1.5 percent at the three-year horizon. The longer the horizon, and the more genuine uncertainty there is, the more scope there is for wishful thinking.

A prediction market's biggest advantage would be to allow a more diverse opinion pool that would hopefully eliminate this bias. One could imagine not only involving officials at the OMB but various staff from Congressional offices, experts from various Departments, and even industry experts. If the government won't take this on directly, could there be a "shadow" forecasting process with these same people? What would be their incentive to participate? Hmm...

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