Thursday, March 29, 2012

How to Parse like Krugman

Adam Posen, external member of the Monetary Policy Committee in the Bank of England has a great new speech analyzing why the post-recession recovery in the UK has been slower than the US.

Krugman links to it here, concluding "It's the austerity, stupid."

What Adam Posen actually writes in conclusion :

Monetary policy and its effectiveness were not the source of difference, nor was business optimism (especially since forecasts for UK growth, not just the MPC’s, surprised on the downside). Credit was more poorly allocated in the UK, producing less investment for a given pound of credit or financing issued. The spillovers of risk from the euro area on the UK financial system, inherently much less of a problem for the US financial system, also distorted the cost of capital and risk taking behaviour.


Deleveraging by households was not a major factor, given the comparable state of US and UK balance sheets.


Fiscal policy, however, played an important role as well. Cumulatively, the UK
government tightened fiscal policy by 3% more than the US government did – taking local governments and automatic stabilizers into account – and this had a material impact on consumption. This was particularly the case because a large chunk of the fiscal consolidation in 2010 and in 2011 took the form of a VAT increase, which has a high multiplier for households. The fact that British real incomes were hit harder than American households’ incomes by energy price increases could be ascribed in large part to the past depreciation of Sterling, which also hit real incomes directly. All combined, these factors significantly dampened consumption growth in the UK, with knock on effects on investment and stockbuilding.


Going forward, most of these factors causing the difference between UK and US behaviour will recede. Inflation is only a temporary difference, and the national rates are now converging on their long-run targets. On official forecasts, fiscal policy is likely to remain more contractionary in the UK than the US for a couple of years to come, but the difference will shrink significantly from both ends over the next couple of years. Monetary policy is continuing to support recovery of investment in both economies, and must continue to do so. A longer-term troubling difference is in the apparent relative inefficiency of the British domestic finance system in allocating capital to businesses. While some of that should recede when the banks build up their capital buffers, and if and when euro area risks themselves recede, there remains a clear structural agenda for the UK to deal with in its financial system.

Poor allocation of credit, austerity and currency depreciation. With poor allocation of credit being the only major threat going forward. Note that the fiscal austerity here is a tax increase, not a reduction in subsidies/ transfers as one is likely to assume.

The British banking sector is highly oligopolistic, and as Ashwin Parameswaran would say, almost all assets that it owns which could be monetized are probably already monetized. It is highly plausible that it does a worse job of allocating credit. Posen's speech also brings to light a fundamental truth for energy/commodity importing nations - the effects of monetary easing (rates/ currency) through the wage/price/credit channel may be eroded by the income effect of prices of imports.

In conclusion, it's not just the austerity. Don't be stupid - read Posen, not Krugman.

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