Mervyn King on the “mismatch recovery”

Some time ago Chris Dillow argued that it was possible that economic recovery was sluggish because of a mismatch. It seems that Mervyn King is coming round to this view (via).

What is limiting our ability to do more is not on the monetary side, it’s on the real side that the economy has to adjust to a new equilibrium. That is what I think is going to pose the constraint.

What we need now – it’s very clear if you look at the numbers – what the UK economy needs is more demand in the rest of the world to buy goods from the United Kingdom. And that is the key bit that’s missing from our attempt to rebalance and that’s why the challenge is so great.

The Bank of England hasn’t released the model it uses (much to Simon Wren-Lewis’s chagrin), but given the above this is how the model Mervyn is working with must look.

Imagine there are only two firms. One firm gives haircuts and the other firm makes hats. Haircuts can’t be exported, but hats can. Theoretically if people in the UK decided to wear hats less and get more haircuts workers at the one could shift to the other firm to avoid unemployment. However, if there are non-negligible costs to retraining these people and matching them to new jobs a shift in the competition of demand could result in high inflation and high unemployment.

Now because haircuts cannot be exported but hats can we end up in the odd situation where domestic demand as delivered by the central bank through interest rate cuts or quantitative easing or whatever won’t work. External demand will boost employment by helping people find work in the hat industry, but domestic demand will not because people would rather spend the money on haircuts. Domestic demand causes inflation not job growth but external demand (say from China) causes job growth but not inflation.

This is a neat story for Mervyn, because as a story it completely lets him off the hook! Imagine that. A central banker who manages to create a model where he is not responsible for the catastrophic screw up which happened on his watch.

However, there are a number of weaknesses with this model. Firstly, if Mervyn wants more external demand he can create that by weakening the pound. In fact, I’m not even sure how Mervyn could ease monetary policy without weakening sterling and increasing external demand. Secondly, it is a very pessimistic view of the economy. I thought the deal was that markets could sort this stuff out? Five years is a long time to wait for a rebalancing.

Mervyn King is still well respected and it seems he is creating “just so” stories to justified this continued respect. Unfortunately the stories just don’t add up.