It now appears that we were living in a dream world a few years ago, with oil prices unsustainably low and house price inflation unsustainably high. Reality is less pleasant.
In theory, a student who suffers a blow to his or her self-esteem can continue to work hard and learn. In practice, educators worry that this will not happen.
Similarly, the asset revaluations that represent blows to our economic self-esteem could be shrugged off by workers and businesses. We still have all of the capital equipment and know-how for the U.S. economy to continue growing.
I go on to suggest, however, that the overall economy will not just shrug off these events and plow ahead.
The essay is in fact a subtle attempt to do macroeconomics without the concept of aggregate demand. I think of aggregate demand as a rather misleading metaphor that is actually contrary to ordinary economics. It might take longer to explain what I'm doing than to write the essay, but here goes:
My intuition is that we are going to see a drop in employment and production as a result of the oil shock, the collapse of the housing bubble, and the drop in stock prices. Of course, the oil shock will lower productivity, but that's not what I'm talking about. I'm talking about the reduction in employment and output that macroeconomists typically attribute to aggregate demand.
Instead of calling these events demand shocks, I want to call them adjustment shocks, or relative-price shocks. The market is sending signals that some industries need to expand and other industries need to contract. However, it takes a long time for these signals to work their way through the economy and get processed to the extent that people get new jobs and so forth. Meanwhile, we get employment and production that are below capacity levels.
A key difference between thinking in terms of aggregate demand and thinking in terms of adjustment is the role of policy. In the aggregate-demand formulation, we don't need any complex adjustments to take place to restore full employment. We just need more aggregate demand, and fiscal and monetary policy can do that.
In the adjustment-shock story, government does not know better than anyone else how firms and workers need to adapt and where production needs to expand or contract. So, even though I am expecting the new realism in the housing market, the oil market, and the stock market to lead to a drop in employment and output, I conclude:
Adapting to the reality of higher energy costs and an excess housing stock requires myriad complex adjustments, some of which may be obvious but many of which are subtle. Chances are, it will take several years to complete the transition. Meanwhile, there is little, if anything, that policymakers can do to hasten that process.