A pattern has emerged for the right to criticize the Bank of England whilst the left, obviously, attacks the Chancellor. This raises a paradoxical thought. Could it be that both the Bank and Osborne are wrong, and for the same reason - that both are thinking along “Keynesian“ lines.
What I mean is that both think there’s such a thing as the “macroeconomy” - that there’s a single “representative” firm employing fungible inputs.
So, Mervyn King has expected inflation to fall even as the economy recovered because this “firm” had excess capacity and idle resources, and so increased demand and output would not increase costs. And Osborne thinks that because resources are fungible, the “firm” which loses a government contract can rebalance easily to producing exports or capital goods.
Let’s imagine, though, that this view - which I admit is a caricature - is entirely wrong. Let’s replace it with a caricature at the opposite extreme.
Imagine there are two firms whose inputs - capital and labour - are entirely firm-specific. One produces paperclips for the government. The other produces machine tools for businesses. And let’s assume there is “equilibrium” with full employment, stable prices, and firms operating at full capacity.
But then imagine that the government cuts its spending on paperclips. And let’s imagine that this cut increases business optimism and demand for machine tools. What happens?
We’ll see increased unemployment as paperclip workers are laid off. But because these are - ex hypothesi - specific to the paperclip industry, they’ll not be able to work in the machine tool industry. The machine tool firm, then, will be unable to hire the extra staff to produce the extra tools. Instead, it will have to pay its existing workers expensive overtime, and raise its prices to meet the demand.
Macroeconomists will therefore see both increased unemployment - among paperclip makers - and inflation, in the machine tool sector. The Nairu, if you like, will have risen. There will be an “output gap”, as production of paperclips is below “potential” - but it will not hold down inflation.
Which brings me to my point. It might be that one reason why inflation has been higher than Mervyn King expected is precisely that we have suffered such a mismatch. And one reason to be sceptical about the feasibility of rebalancing is that resources are indeed organization-specific; librarians in Swindon cannot easily become tool-makers in Stockport. If so, we might get a rise in the Nairu.
King’s optimism about inflation, and Osborne’s about rebalancing, therefore have a common root - in a macroeconomic worldview in which resources are fungible.
In saying this, I am channelling Arnold Kling. What matters is not (just) aggregate demand but what he calls patterns of sustainable specialization and trade. Recessions don’t just reduce aggregate demand, but shake up these patterns, with the result that inflation can exist alongside unemployment.
Now, I stress that my two stories are caricatures. In the messy real world, resources are neither entirely fungible nor entirely specific. The degree to which they are either varies from firm to firm and worker to worker.
One reason why macroeconomics goes wrong is that it doesn’t account for this - and perhaps cannot, because knowledge of the degree of mismatch is the sort of thing that just cannot possibly be known by a single central mind.
There are some policy implications here. An important role for government is to help mitigate such mismatches. This gives a role for active labour market policies. By these, I don’t mean some shyster haranguing the unemployed, but rather informing workers about vacancies, and helping them move and/or retrain for them.
It also means that the supply of finance is crucial. One aspect of our present mismatch could well be that the firms that are sitting on huge cash piles are not those who are looking to expand; in a sense, this is true by definition, as one reason for those cash piles is that firms haven’t been investing. This raises the possibility that growth could be retarded by a lack of finance even though companies “in aggregate“ have plenty of it.
It is paradoxical - to put it gently - that the government is hoping to rebalance the economy at a time when the most fungible of all resources, bank credit, is scarce.