The mismatch recovery

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.

Comments

[David Ward]

"librarians in Swindon cannot easily become tool-makers in Stockport"

This is dangerously close to admitting that location is important to growth, and that different local economic areas might exist. Which I know the Treasury and BIS would have a problem with.

Of course, to everyone else it seems blindingly obvious that the same factors aren't at play in Gateshead and London. But there we are.

[Stephen]

"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. "

I take you point that your analogy is a hypothetical caricature...and yet surely the most damaging fallacy by far that Osborne and King share is right there.

[NM]

Agree with your general point, but surely if we look at how the job losses during the height of the recession (and gains in the recovery) are distributed across sectors, then we can at least get some estimate of how big a problem this is. The more even the distribution of losses / gains, the less of an output gap we would expect.

[Luis Enrique]

"One reason why macroeconomics goes wrong..."

not for the first time, I recommend this book "Specificity and Macroeconomics"

http://mitpress.mit.edu/catalog/item/default.asp?tid=11193&ttype=2

[Left Outside]

I'm not ure its clear that certain segments of the economy are overheating. Which sector's costs are skyrocketing?

Much inflation has not arisen from inflation busting wage demands in some sectors or big price increases in some industries, commodities are up, consumption taxes are up and the pound is down.

Without some more crossindustry data, which points to X industry is overheating, Y is not, I'm not happy buying the PSST story for the UK yet. Iceland, yes, the UK, I'm not convinced.

[Ralph Musgrave]

“One reason why macroeconomics goes wrong is that it doesn’t account for this….” Sorry, but macroeconomists with their heads screwed on (like me hopefully) are well aware of the microeconomic foundations of macroeconomics.

You and Kling have fallen for the latest fashion (particularly in the US) namely that unemployment is “structural”. There is precious little evidence to support this, and much evidence in the opposite direction.

In particular one might expect that in view of the housing downturn that it would be construction workers and employees from allied industries (estate agents, etc) that are experiencing the greatest difficulties in finding work. The evidence does not support this. See:

http://rortybomb.wordpress.com/2010/09/20/the-stagnating-labor-market-2-what-can-the-employed-tell-us-about-the-unemployed

More generally, it seems that shortage of skilled labour is nowhere near top of the list of employers’ problems. See:

1. http://www.nfib.com/Portals/0/PDF/sbet/sbet201009.pdf (Page 18).

2.http://www.blumshapiro.com/pub/articles/BlumShapiroCBIASurvey.pdf (Page 4).

3. http://www.pwc.com/us/en/industrial-manufacturing/barometer-manufacturing

As I said in a comment on an earlier post, Kling is a waste of space.

[guthrie]

Surely the issue is what is causing the inflation, and if it is as Left OUtside says, commodity prices etc, that means it has nothing to do with excess capacity or suchlike, but rather rising prices of material imports that are necessary for the economy. The increase in costs then feeding through to the rest of the economy, thus causing inflation.

[Ralph Musgrave]

Guthrie, The Bank of England has ascribed so called inflation to two main factors: the effect of the 2008 Sterling devaluation and, as you point out, raw material price increases.

These two factors may not be “inflation causers” at all, as long as they don’t result in excessive wage increases, and cause a wage price spiral. That is, they are just once and for all, or secular factors, which will hopefully work their way thru the system in due course, and peter out.

The ultra important point is to keep an eye on wage awards. As long as these remain subdued, then we can forget about the so called inflation stemming from the above two factors.

[Rob]

I know that anecdote is not the singular form of data, but I'm working in an industry that has difficulty finding enough qualified people, and has had to pay higher rates in order to attract qualified staff (which is a bit of a boon for me, at least). I wouldn't want to generalise too much, but I strongly suspect that the technology sector is at least partially constrained by a labour shortage, particularly in and around London.

This is consistent with the model that Chris outlines, although I'm not sure that this is happening on anything like the scale necessary to show up in the national statistics.