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.


3 thoughts on “Mervyn King on the “mismatch recovery”

  1. Hi LO

    I don’t think “the model the BoE uses” that SWL is talking about has much to do with the model inside Mervyn’s head, which is what you are talking about here.

    I asked a BoE economist about this the other day, and he didn’t seem to regard it as any great secret, so I think I can write about it here. The model the BoE “uses” is a simplified Smets & Wouters. They use a deliberately simplified version – more complex versions look like this – because they found when using more complex models in an effort to be more realistic, or at least to try to incorporate more elements we might think matter in reality, they found that none of consumers of the model’s output could understand it. I put “uses” in scare quotes because they don’t place much weight on the output of this model, it is more regarded as a starting point for discussion and there is no direct link between this model and the Bank’s forecasts or policy choices.

    btw, the “we need more export demand” story gets some back-up from Gavyn Davies here:

    at first glance, looks like a pretty strong case to me.

  2. It’s odd that King should be worrying about a mismatch now.
    One good piece of evidence about the degree of mismatch is the Beveridge curve; a high mismatch implies high levels of both unemployment and vacancies. However, since late 2010, unemployment has fallen without much change in the number of vacancies, implying an improvement in the Beveridge curve and decline in the degree of mismatch.
    So why talk about it now, rather than one or two years ago?

  3. Luis:

    Yeah, mixing up two slightly unknown models, just wanted to link to SWL really. I find it difficult that public institutions don’t publish all their workings, even school kids do! I appreciate that Central Bankers still like to use their discretion, but it would be useful to know how much discretion they’re using.

    With regard to needing more export demand…well then he should act to depreciate the currency if he thinks there’s lots of slack capacity for expansion in industries that export but not in the domestically orientated sector its not like there’s nothing her can do!

    There’s a couple of real macro factors I’m coming to put more weight on. One the Energy Reform Bill going through Parliament is a fucking disaster for energy investment. Second the migrant cap is putting a squeeze on university services exports and causing a shortage of high skilled workers as they are told to bugger off after 4 months. Also, I’m beginning to think that North Sea Oil is having a bigger impact on the macroeconomy than I’m used to, so I’m not quite sure what to think. I don’t think any of them are really significant enough to challenge poor demand management/tight money from the BoE as an explanatory variable though.


    Its not odd that King is worried about a mismatch now, he’s worrying about his disastrous legacy and is covering his bum. The last year has seen him put forward a couple of theories about why things aren’t his fault. I’m becoming cynical as I age.

    Although the Beveridge curve might suggest mismatch weakening as a problem, as I’ve written above, I think it has become easy to create just so stories explaining mismatch. Sadly, just so stories are very popular.

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