October 31, 2003, 9:48 a.m.
Who Had the Right GDP Forecast?
Hint: The supply-siders were closest.

The Commerce Department has just reported that U.S. economic growth surged to the fastest pace in nearly two decades. Various press releases and government reports show that growth was much stronger than most economists expected.

So, who had the closest GDP forecast?

I went back and looked at the tables in the January 2003 Wall Street Journal Forecasting Survey, as well as the revisions to these forecasts. As shown in the small table below, on average most economists held onto their original real GDP forecasts and did not increase their bullishness until September of 2003. This revision of the forecast was an important signal of the strength of the economic expansion. However, by that time, most people already had a feeling that the economy was doing well.

Since there was no major change in the average or consensus forecast for most of the year, the bulk of the relevant information useful to an investor is contained in the original forecasts made by the economists. I computed the annual real GDP forecasts of participating economists from the quarterly figures and ranked the economists in descending order. The results were pleasing — the four supply-side forecasters in the survey were among the top ten.

Leading the way was John Mueller, a long-time supply-sider, with a 5.32 percent forecast for 2003. Our own Larry Kudlow, at 4.40 percent, was third. Brian Wesbury, of Griffin, Kubik, and Stephens in Chicago, ranked sixth, and the Bear Stearns team of David Malpass/John Ryding followed in seventh place.

(I don't participate in the WSJ forecast, but my own forecast was in line with the above supply-siders; in December of 2002 my La Jolla Economics called for better than 4 percent real GDP growth.)

Not only were the real GDP forecasts of the supply-siders among the top ten, when I looked at the third quarter I found that the group’s performance was just as impressive. Mueller retained first place, Wesbury came in third, Kudlow grabbed fourth, and the Malpass/Ryding combo dropped to eleventh.

The results of the forecasts make one wonder: Were these supply-siders lucky, or did they see something that other people did not see?

You might think that their good economic vision stems from the fact that they all use the same supply-side forecasting model. But this can easily be dismissed. The economists mentioned above, while they are advocates of supply-side polices, all use vastly different forecasting methodology. These include the global money concept, the futures markets, and the impact of money growth on real rates of return.

What they do have in common, however, is that they focus on the substitution (or incentive) effects of policy changes.

For example, rising interest rates lead to an acceleration of the purchases of consumer durables; pre-announced tax-rate cuts slow down the economy until the tax rates take effect; etc. It was this timing of the path of the economy, based on substitution effects, that gave the supply-siders their edge.

The moral of the story is that substitution effects are perilous to ignore. Those who do not incorporate substitution effects into their forecasts will suffer the fate of missing the turning points in the economy.

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