Is it really all aggregate demand?

In my earlier posting on jobs, I touched upon the growing debate as to whether the US is facing a structural change and must now confront structural unemployment. This brings to mind something that has been bothering me — going back to a statement last April by the Chair of the Council of Economic Advisors Christina Romer — Back to a Better Normal:

In short, in my view the overwhelming weight of the evidence is that the current very high — and very disturbing — levels of overall and long-term unemployment are not a separate, structural problem, but largely a cyclical one. It reflects the fact that we are still feeling the effects of the collapse of demand caused by the crisis. Indeed, at one point I had tentatively titled my talk “It’s Aggregate Demand, Stupid”; but my chief of staff suggested that I find something a tad more dignified.
The reason that I have been emphasizing that the high unemployment we are experiencing is cyclical rather than structural is not to somehow minimize or downplay it. In fact, just the opposite. It is to shake people out of the complacency that says, “That’s just the way life is.” It may be the way life is right now — but it doesn’t have to be. We have the tools and the knowledge to counteract a shortfall in aggregate demand. We should be continuing to use them aggressively.

Why does this matter? Dr. Romer answered that in the second paragraph above — how we should respond. If it is cyclical, then the standard economic prescriptions of demand management (aka stimulus) are in order. And there is a good chance that the economy will find its way back to equilibrium. On the other hand, if it is structural, then other actions may be needed. And the return to “normal” may be more difficult.
As I noted before, the Great Recession is a major cyclical downturn layered on a tectonic structural shift. The structural shift helped bring on the cyclical downturn as we tried to deal with the structural change by artificially inflating demand via a credit card spree. And the cyclical downturn was exacerbated by the structural shift.
As a result, the we have to face a different labor market than a traditional cyclical recession. As
Murat Tasci of the Cleveland Fed pointed out in Are Jobless Recoveries the New Norm?

Longer unemployment spells are a problem not only because they mean newly unemployed workers have a harder time finding jobs, but also because workers who are unemployed for too long can lose industry- and job-specific skills. Losing skills can reduce their odds of finding a job during the recovery as well as lower their productivity when they finally do find one.

The bottom line is that we need a transformational shift in order to create a non-bubble, sustainable economy. Dr. Romer did touch on some of the transformational points in her speech (and in the Economic Report of the President issued earlier this year). The speech cite the need to “rebalance demand”:

With appropriate policies, the normal we return to will be a higher-saving, higher-investment economy than that of recent decades. Consumer caution, sounder lending practices, and pro-saving policies are likely to lead to higher personal saving. Responsible fiscal policy will tame the budget deficit, further contributing to national saving. This will help to promote low real interest rates, high investment, and low trade deficits. New investment opportunities in areas such as clean energy, health information technology, and biotechnology, encouraged by appropriate policies to correct market failures or jumpstart key innovations, will further raise investment. A normal that involves robust business investment and exports is better for our economic health than a normal built on borrowing, consumption spending, and unsustainable construction.

It also mentions education and innovation:

Finally, there are a range of policy actions that can affect the key sources of productivity growth. Investing in education prepares our workers for the jobs of the future. An educated workforce can seize new opportunities when they arise, adapt to changing technologies, and discover better ways of producing things. All of this increases standards of living and makes our workers less like to suffer persistent dislocation as the economy evolves.
Investing in basic science — something that the private sector tends not to do enough of — is a way for the government to help spur innovation. Funding laboratories, research facilities, and graduate fellowships is a wise public investment that makes it easier for entrepreneurs to develop new production methods and whole new products. These new technologies and products not only improve our lives, they generate the jobs that will employ our children. By doing so, they make the economy stronger and more prosperous than before.

And Chapter 10 of the Economic Report of the President does specifically cover innovation. In that chapter there is an explicit reference to shifts:

The Great Recession has aggravated an already challenging trend: sectoral shifts that are changing the nature of work. While most American workers were once engaged in producing food and manufactured goods, often through physical labor that did not require a great deal of training, the United States is increasingly a knowledge-based society where workers produce services using analytical skills. The changing economy offers tremendous opportunities for American workers in high technology, in the new clean energy economy, in health care, and in other high-skill fields.

That is good as far as it goes. However, it does not go far enough to transform the economy and provide a sustained boost in productivity. Our policies need to build on that awareness of the shift — and not just look at specific industries. We need a broad economic and competitiveness strategy.

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