Grain, Meet Salt: Why You Shouldn't Take Budget Forecasts Seriously

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Yesterday, I detailed President Obama's 2013 budget proposal and finished with a warning: "Budget forecasts are the ultimate lesson in taking things with a grain of salt." In hindsight, most forecasts look worse than random guesses.

A new report by a group of researchers at the Federal Reserve shows what I mean. The report takes aim at the nonpartisan Congressional Budget Office, whose sole task is to "score" the cost of congressional proposals and forecast budgets.

The researchers studied the CBO's forecasting record from 1976 through 2010. What it found may not be surprising: When forecasting one year out, the CBO has a decent record, although just assuming that what happened last year will happen next year is nearly as accurate. Once it got to making forecasts five years down the road, the track record falls apart entirely, with projections looking scarcely better than darts thrown at a board.

There are periods when the CBO projected surpluses when in reality the budget produced massive deficits, and vice versa. In 2001, for example, the CBO projected that the federal government would effectively be debt-free by 2006 (try to contain yourself). Even when it gets the direction right, the magnitude of its forecasts is usually far off:   

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Source: Federal Reserve.

Worse still, the study found that "projection errors are considerably higher during Recessions." In other words, when accurate forecasts are needed the most, they are the least reliable. It's like a weatherman who is decent at forecasting when it will be sunny but offers no insight in forecasting when a hurricane might hit.

And the CBO doesn't appear to be learning from its mistakes, either. "We find no significant change in the CBO's budget projection performance over the past decade relative to our 2001 analysis," the authors found.

The report reiterates that CBO isn't totally to blame for the poor track record, and I agree. The agency operates under unusual restrictions that require it to assume that current legislation won't change, and it's often required to use assumptions provided by Congress that are, shall we say, incompatible with reality.

But there is more to it than that. The CBO, or any other budget forecaster, struggles to predict the future becausethe future is unpredictable. As Dan Gardner wrote in his excellent book Future Babble, "No one can foresee the consequences of trivia and accident, and for that reason alone, the future will be forever filled with surprises."

In this case, no one in 2000 could have known that a terrorist attack the following year would push the economy into recession and spark two exorbitantly expensive wars (except those involved, of course). No one in the 1990s could have known that George W. Bush would be elected president and push through two rounds of tax cuts and a prescription-drug bill. Those two events explain most of why the CBO's forecasts last decade were so off -- and they were entirely unforeseeable. Going forward, the same will be true. The biggest drivers of tomorrow's budget will be factors that you can't even think of today.

I write a lot about our inability to forecast the future because I think it's important, and I'll repeat it until I'm hoarse: If you are worried about current budget forecasts that predict massive deficits as far as the eye can see, remind yourself that no long-term budget forecast has ever been accurate. Ever. One-year forecasts are decent. Five-year forecasts are pretty bad. Ten-, 20-, 50-, and 80-year (they exist) budget forecasts are utterly useless. What happens in the future might be better or worse than currently envisioned, but it almost certainly won't be what is envisioned.

For more like this, check out my e-book Everyone Believes It; Most Will be Wrong on Amazon.com for your Kindle or iPad. Prediction: It'll be the best dollar you spend all year.

At the time this article was published Fool contributorMorgan Houseldoesn't own shares in any of the companies mentioned in this article. Follow him on Twitter, where he goes by@TMFHousel.Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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