Brad DeLong writes,

When you ask believers in “recalculation” what pattern of production and trade proved to be unsustainable in 2007, they answer: “building so many houses.” When you ask believers why the market economy has been unable to sort out this problem in three years, they answer with nothing–silence. When you say that OK, there were $300 billion of excess houses at the start of 2007 but now construction has been so depressed for so long that there are $1 trillion fewer of houses than trend and why isn’t the 2007 pattern of production and trade sustainable again, they answer once again with nothing–silence.

Pointer from Daniel Kuehn.

I am well aware that the current economic slump includes more than just housing. Let us focus on just one example of an industry that is undergoing a severe contractionary adjustment: the legal industry. Many large firms have undertaken massive layoffs, and new law school graduates are having a horrible time finding jobs. How can we explain this?

Here, my thinking is somewhat reminiscent of Leijonhufvud’s “corridor” theory. The economy behaves differently inside the corridor than outside the corridor.

Most of the time, individuals and firms are adjustment-averse. Adjustment-aversion is rational in a world that is mostly mean-reverting. If you stand pat in the face of a transitory drop in demand, as a firm you avoid paying excess adjustment costs associated with hiring and training, and as an individual you avoid paying the excess adjustment costs associated with making new investments in human capital.

However, the world is not always mean-reverting. There are secular changes taking place as well. In my view, the Internet and globalization have produced a lot of secular change. Because of adjustment-aversion, by 2008 a number of industries, such as the legal industry, had not kept up with these secular changes. Because they had failed to adjust gradually to the underlying technological changes, what we got was a large step adjustment, greatly reducing the size of the legal industry relative to its previous trend. This took place in many other industries as well.

So far, the market has managed to figure out that we do not need so many lawyers. What it has not figured out is where the excess lawyers should go and how to make the transition happen. Again, multiply this out by many sectors, and you get a lot of unemployment.

For economists who use the paradigm of aggregate supply and demand, there is an aggregate production function, which ties aggregate labor demand to aggregate output. In AS-AD, this aggregate production function seems so real that you can touch it. But I have lost this macro religion. I do not think of employment as a function of output. I think of it as part of an incredibly complex system that creates patterns of sustainable specialization and trade (PSST) that can persist for a while.

Many of these patterns, not just housing construction, were unsustainable as of 2008. The patterns had persisted because individuals and firms acted as if they over-estimated the mean-reverting component of ongoing change and under-estimated the secular component. Once a shock took place, the need for adjustment was exposed in many sectors. These sectors, including the legal industry, have since adjusted relatively rapidly and painfully to what now are recognized to be secular trends.

The AS-AD paradigm says that we can go back to something like the 2007 status quo with expansionary fiscal and monetary policy. The PSST paradigm says that there is no going back. The market needs to figure out new ways to best utilize would-be lawyers and other unemployed workers. Maybe expansionary fiscal and monetary policy can speed this process, but the mechanism by which policy will do this is not as simple and reliable as the AS-AD paradigm suggests.