The treatment of uncertainty in long-term economic forecasting for an economy in transition

A methodological lesson from a country study for the Czech Republic

Jaroslav Maroušek, SEVEn Prague

1 Introduction

Forecasts of economic development are the basic building blocks in all models for calculating emissions levels. Some models use the economic development scenario directly as input data, while others use selected data that must be derived from such a scenario. All countries undergoing economic transition must inevitably face the enormous uncertainties in their economic future. Under these circumstances it is difficult for many countries of Central and Eastern Europe to join the common effort to reduce greenhouse gas emissions and to submit the base forecasts of emissions trends in their countries.

I would like to take this time to analyze the current development of economies in transition and using the Czech Republic as an example, to show the primary differences between the behavior of these economies and stabilized market economies. I would especially like to concentrate on problems that prevent the use of traditional forecasting models. I will conclude by indicating the options that make it possible to work on emissions projections and to seek measures for emissions reductions.

2 Emissions projections methods

The reason for analyzing the issue of uncertainty in economic forecasts that are to be used in projecting emissions is the key position of economic forecasting. Every emissions forecast is based on macroeconomic development and associated social development (standard of living, etc.).

The foundation for all methods of calculating future emissions is the equation:

Emissions = Activity * Emission Factor

For an economy in transition, the main problem is estimating the extent of future activities, i.e. volume of production for specific industries and products, the extent of services provided, and similar activities.

In industrially developed countries energy processes are the decisive factor in greenhouse gas emissions. Figure 1 shows the methodological approach in establishing emissions resulting from the energy sector as it was used in the Czech Republic. The scenario of future economic development provided needed information about the range of activities that directly or indirectly result in the production of air pollutants. In addition to Gross Domestic Product (GDP) trends, the scenario included the volume of industrial production in individual industries, the production of selected energy-intensive products, agricultural production, data on personal and freight transport, etc.

3 Economic development in Central and Eastern Europe

All countries that abandoned centrally planned economies at the end of the 1980's and the beginning of the 1990's initially experienced very similar development. Positive political and economic changes were accompanied by a decline in production and GDP. It is not yet entirely clear where this decline will end. All countries of Central Europe believe that they are currently experiencing the depths of their economic development. Only Poland was able to raise its GDP in 1993 by 2.5% (See Figure 2).

Another associated sign of transformation is high inflation.


       1993 Inflation rates                                              

Czech Republic                                      21%                  
Bulgaria                                            75%                  
Hungary                                             23%                  
Poland                                              35%                  
Romania                                             205%                 
Russia                                              900%                 
Slovakia                                            25%                  



1

All countries battle inflation and try to reduce it. For this reason inflation trends in individual countries experience significant swings, as the example of the Czech Republic shows:


   Inflation trends in the Czech                                         
             Republic                                                    

               1990                                 10%                  
               1991                                 57%                  
               1992                                 11%                  
               1993                                 21%                  



2

One of the major goals of economic reform is privatization. The speed and manner of the privatization processes are different, but the economic situation of privatized firms is often better than that of firms in the remaining state sector. With the growing number of privatized enterprises, a reverse in macroeconomic trends is expected. Governments' inexperience with privatization on such a large scale forces them to continuously improve privatization rules and to resolve the discrepancies that arise during the process. The privatization process is long and complicated and is often marred with corruption scandals.

Another problem is unemployment, which is uncommonly high in most of the countries (with the exception of the Czech Republic). A lack of experience and capital for resolving unemployment breeds further uncertainty in the form of potential social pressures and conflicts.

4 Special features of macroeconomic development

Economies in transition have many characteristics that differ from those common in market economies. One of the most discussed features is inflation. Others include:

an increase in quality to the detriment of quantity. An improvement in the quality and variety of goods leads to both a quick growth in prices and a decline in the production of goods that were previously produced in great volume and today do not have the quality and assortment necessary to compete.

a rapid growth in the service sector and its share in the GDP. The service sector in a planned economy usually did not contribute more than 30% to the GDP. The current increase in the service share in the Czech Republic has already surpassed 35% and is continuing to grow.

Primarily as a result of the two features mentioned above, the gap between industrial production and GDP in the Czech Republic is widening. Industrial production is declining more quickly than the GDP and even in the near future it likely will not imitate GDP trends. Even more complicated are the production trends of specific industrial products. They are generally declining, although the decreases can differ widely. In contrast, the production of some products like cement is increasing.

These special features mean that economic trend forecasts cannot be based on proven macroeconomic models. Historical data for production functions, because of the economic changes, are unusable; there is no experience with price elasticity, and the official statistical service does not collect more detailed analytical data.

Under these conditions it is considered a success if someone manages to forecast development for several months in advance. Long-term forecasts are either not made at all in economies in transition, or they are the picture of the will of the political party that stands behind the forecast. Yet emissions forecasts require an economic scenario. Is it possible to develop a scenario based on such a high level of uncertainty?

5 An attempt at a scenario of an economy in transition

5.1 Scenario approach

Development scenarios for economies in transition are fraught with high uncertainty, yet they have their role. It is useful to remember that a scenario is only one possible future. It does not measure the likelihood for that future. Sometimes scenarios of future development are created for the very reason of avoiding that future. That is the case of the well-known scenario of global warming for our planet.

5.2 Specific problems

The fact that there are no long-term development scenarios for economies in transition is not a result of uncertainties in future development, but more of current problems. On the contrary, great uncertainty in future development generates a wide range of various scenarios. The following are the primary problems:

A. Neither the current governments nor political groupings in Central and Eastern Europe want to advocate only one of the options available. For most of these groups, any scenario that leads to greater economic performance and political stability based on democratic principles is acceptable. The detail that scenario approaches offer are insignificant.

B. Input conditions are changing so rapidly that an overly detailed development scenario loses meaning. The period necessary for developing the scenario can extend beyond the period that the input conditions apply. This is especially true if the detailed scenario requires a large amount of input data.

5.3 Estimates of future development

In this situation it is impossible to apply models based on the growth theory. This theory is based on a certain stability of parameters and the principles resulting in conditions of gradual development. To estimate the rate of growth for macroeconomic values, there apparently remains only one method: expert estimates.

5.4 Balance equation

Not being able to use the growth theory for modeling the rate of development does not mean that the scenario can be constructed arbitrarily. Expert estimates must be corrected by balance relations that must apply in every economy. It is not a case only of macroeconomic balance between supply and demand. It is also possible to evaluate the consistence of development between individual economic sectors and development in general, or purely technological relations in the production process and energy use. Table 1 gives some selected balance equations that were used to create scenarios in the Czech Republic.

5.5 Base Case Scenario

Emissions projections are made not only to know the future level of pollution ahead of time, but mainly to find ways to reduce it to an acceptable level. For this purpose it is necessary to develop a Base Case Scenario of Emissions Projections that is a simple extrapolation of current trends.

The selection of an appropriate economic scenario for the Base Case Scenario is a key issue with today's broad spectrum of possibilities in economies in transition. The difference between the two extreme variations that are possible in these countries can have a greater influence on emissions than the combination of all available measures for emissions reductions.

This problem cannot be eliminated, but it can be alleviated by accepting two recommendations for the construction of a Base Case Scenario.

I. Clear and simple construction of an economic scenario

With today's high degree of uncertainty in future development, it is useless to develop extensive and detailed development scenarios for countries in transition. Rapid development constantly changes the input assumptions. One must consider that some of today's assumptions will be unrealistic in a year's time, and other, new possibilities can arise. Such changes call for updating the developed scenarios.

For that reason, economic development scenarios should be as simple as possible, should include the most explicit expressions of input assumptions possible, a description of the logical relations between specific data, and a well-constructed modular structure. Given the ongoing changes in the economy, it is impossible to expect the scenario to include a good description of the future (a precise prediction of the future). Thus the scenario should at least allow an easy check of the differences between the trends described in the scenario and actual trends. A clear modular structure of the scenario should allow a modification of the input data and a simple recalculation of new results.

II. The selection of an economic development scenario that leads to higher greenhouse gas emissions

If the range of options for future development is too broad and it is impossible to reduce it by eliminating unlikely scenarios, my recommendation is to choose a Base Case Scenario that leads to high greenhouse gas emissions.

The reason for such a choice is obvious: the ultimate goal is not a prediction of the future, but a defense against uncontrolled emissions. The strategy of reduction is most needed during the "high emissions" scenario. All countries should have a scenario prepared precisely for this option, with a group of measures for reducing emissions. If in the end the scenario with a lower increase in emissions occurs, reducing this group of measures is always easier than expanding it.

6 Conclusions

Current development in economies in transition undoubtedly involves a high degree of uncertainty that complicates both greenhouse gas emissions projections as well as the preparation of suitable measures for emissions reduction. Even with this uncertainty, however, these countries can take part in the global effort to reduce emissions. They can make use of the well-known scenario approach for modeling the future and prepare mitigation measures. In contrast to stabilized economies, the work will not be done to develop a firm reduction plan, but rather a continuous process of refining input assumptions and realistic goals. The major portion of this task will be to improve the group of measures to the point where in the future conditions of that country the measures will actually be obtainable and at the same time sufficiently effective for preventing climate changes.


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