Reading Paul Seabright has made me want to once again dismiss the theory of aggregate demand and instead push Recalculation.
There are two patterns that must emerge in a complex modern economy. One is a pattern of labor specialization. People need to develop general human capital (broadly-applicable skills) and specific human capital (on-the-job know-how), and this human capital has to be useful, as determined by the market.
The other pattern is financial trust. We want to have safe, liquid savings in a world where entrepreneurs undertake risky, illiquid investments. Financial intermediaries can issue safe liabilities while holding risky assets, provided (a) that they are operating wisely and (b) that we trust them.
In normal times, these patterns change gradually. People shift their assets, but slowly. The mix of labor demand shifts, but not too quickly for people to adjust.
Both the Great Depression and our current Great Recession have involved disruptive shifts in these patterns. Currently, the pattern of financial trust that built up in the asset-backed securities market has been shattered. The pattern of labor specialization has been sharply disrupted also, in ways that are both obvious and subtle. The obvious disruption is the shrinkage in industries linked to housing construction, sales, and finance. But the subtle disruption is that organizations are pressed by the recession into accelerating some of the pruning that they would have undertaken anyway.
I am slowly reading Paul Kennedy's Freedom from Fear, about the 1930's. One point he makes is that the agriculture sector was probably the weakest. My view is that the U.S. had not yet adapted the structure of farming to the internal combustion engine. Once we did so, we needed many fewer farmers, because farming could be concentrated in land that had the most comparative advantage for growing crops. Farms no longer needed to be adjacent to cities.
Similarly, I think that we have not yet adapted to a structure of production that is efficient given the Internet. Many patterns of specialization that existed as of 1995 are obsolete today, and the Great Recession represents a sudden collapse of many of those patterns.
When the economy recovers, new patterns of financial trust will have emerged. Also, new patterns of labor specialization will be evident.
The traditional macroeconomic villains are weak aggregate demand and sticky wages. They may be part of the problem today. However, I think they are at most just a small part.
[UPDATE: I think that it is very hard to separate empirically a Recalculation story from a sticky-wage and weak nominal demand story, but macroblog has a post by Menbere Shiferaw and John Robertson that I view as providing some support for the view that changes in the pattern of specialization (or restructuring) are playing a role in the current recession.
My view of the 2001 recession is that the recalculation effects were relatively large in the labor market. In my macro lectures (and in this essay written in 2003), I pointed out that using hours worked as the cyclical indicator, that recession was long and deep (what others called a "jobless recovery" I said we should call a productivity-cushioned recession).
On the other hand, although the stock market took a large hit in 2000-2001, there was much less institutional disruption in the financial sector. That certainly accounts for the less-panicky government response, and either the lack of financial disruption or the lack of panic helps to explain the fact that employment did not drop as badly back then.]