Judging by output, employment, and unemployment, the Canadian economy hit bottom around the middle of 2009. Two and a half years later, output, employment and unemployment have recovered a lot. But like most observers I believe, and certainly hope, that we have not yet had a full recovery to the long run sustainable path.
Why is recovery taking so long?
You might argue that the economy recovered slowly because Aggregate Demand recovered slowly. Never mind the reason why AD originally fell, if the Bank of Canada had followed a more aggressive monetary policy beginning in mid-2009, the economy would have recovered more quickly. But the data on inflation, for both total and core inflation, suggest that AD was not the whole story. If deficient AD had been the only thing slowing the recovery, I would have expected inflation to have been below the 2% target, or even falling relative to target, since mid-2009.
I want to suggest a supply-side explanation for the slow recovery. I am not saying that a supply shock caused the recession. I believe the recession was caused by an AD shock. I am not even saying that there was a supply shock. I don't believe there was. But that doesn't mean we can ignore the supply side of the economy when we want to understand the slow speed of the recovery.
Suppose a big negative AD shock hits the economy. Given nominal rigidities, that has real effects. Patterns of Sustainable Specialisation and Trade get disrupted. Workers lose their jobs, firms go bust, and teams get broken up. A recovery of AD is a necessary condition for recovery. But it takes time for Humpty Dumpty to recalculate and put himself back together again. At the really micro-micro level, right down at the level of individuals, we won't expect to see the same people back in exactly the same jobs in the same firms selling to the same customers as before the recession. It takes time for new workers to be interviewed and hired and trained on-the-job, for new firms to get started or surviving firms to expand to replace those that disappeared, and for those firms and customers to find each other.
Arnold Kling doesn't need a supply shock to make PSST and recalculation relevant.
If the original negative shock to AD is big enough, and lasts long enough, you can't suddenly increase AD back to normal and expect the economy to put itself back together again instantly. If you increase AD too quickly, the only result will be inflation.
The standard natural rate model with an approximately linear Phillips Curve says that the average level of output, employment, and unemployment will be approximately independent of the variance of output, employment, and unemployment, if that variance is caused by AD shocks. Milton Friedman's "plucking model" disagrees. Here is Mark Thoma's (2006, positively ancient by blogging standards) exposition of that model, and its empirical support. The plucking model says that an increase in the variance of unemployment will increase the mean rate of unemployment. The business cycle is asymmetric. Loosely speaking, in the plucking model there are recessions, but no booms.
Let me now try to put these three themes together.
If good monetary policy gives a steady growth in AD, there will be no disruptions of PSST, other than those caused by the steady stream of little supply shocks. If bad monetary policy causes a high variance of AD, PSST's will be disrupted in negative AD shocks, and will only restore themselves slowly over time even if AD recovers quickly. Negative AD shocks will do harm to PSST, but positive AD shocks cannot do good to PSST. In any designed or evolving system, like PSST, cars, and organisms, the news is skewed. There can be bad news, but the only good news is the absence of bad news. As Frances Woolley said, her Toyota Matrix might unexpectedly stop working, but it won't unexpectedly start driving like a Lamborghini. Frances' Toyota is like Milton Friedman's plucking model. Jeremy Fox tells me how Fisher explained why genetic mutations are mostly like that too.
(Scott Sumner gave me the idea for the link between the plucking model and the news being skewed.)