Nick Rowe writes,

For an open economy, like Canada, a lot of our PSSTs are with foreigners. Americans especially. That’s why Canadian recovery depends on US recovery, even though we have our own monetary policy so we can make our own AD curve shift independently of the US AD curve, if we want to. The Canadian recovery has been slow because the US recovery has been even slower. We can’t rebuild some of our PSSTs until the Americans rebuild some of theirs. We are waiting for the Americans to join in our cross-border PSSTs.

One way to think about PSST vs. AD-AS is to think about reversible or irreversible shifts in patterns of specialization and trade. If it’s reversible, then AD-AS is probably the best way to think about it. Because of excess inventory, housing construction and durable goods manufacturing are cut back, but that gets reversed when inventory/sales ratios get back down to normal levels. If it’s not reversible, then PSST may be the best way to think about it.

Now, on to business psychology and business reality.

If you like the old paradigm, then think of business psychology as if it were aggregate demand and business reality as if it were aggregate supply.

In business reality, opportunity can be high or low, and adversity can be high or low. Four possibilities for the overall state of business reality:

1. High-opportunity, low-adversity would describe an economy unleashed. This is a rare combination. Maybe the U.S. in the post-WWII hegemonic period? Maybe the parts of the Chinese economy that were freed by reforms? There are lots of opportunities to create new patterns of sustainable specialization and trade, but old patterns are not heavily threatened.

2. Low-opportunity, high-adversity. This typically reflects major government policy mistakes. Wage-price controls in the U.S. in the early 1970s? Hyperinflation in Zimbabwe. There are few opportunities to create new patterns of sustainable specialization and trade, and old patterns become unprofitable.

3. High-opportunity, high-adversity. This would be a very dynamic economy. The 1920s in the U.S.? 1990-2007 in much of the world? New patterns of sustainable specialization and trade are created, while old patterns break down.

4. Low-opportunity, low-adversity. This would be a relatively stagnant economy. Think of sectors where regulation restricts entry (health care and education come to mind). It’s hard to get into business and hard to be driven out of business.

Now, superimpose on this business reality the state of business psychology. Are entrepreneurs highly attuned to opportunities, or are they relatively timid? Are incumbent businesses highly attuned to adversity, or are they relatively blithe? These psychological conditions affect overall employment. The four possible psychological conditions:

1. High-opportunity, low-adversity. Something like the late 1990s, when new firms are chasing opportunities but old firms are not seeing the handwriting on the wall (Amazon expands, but Borders does not realize that its under threat).

2. Low-opportunity, high-adversity. You have the 1930s, or the past five years. Old firms are firing, because they are very attuned to adversity, but new firms are not thriving and growing.

3. High-opportunity, high-adversity. The economy is dynamic, and everybody knows it. Rapid restructuring takes place. The telecom industry in the U.S., where hundreds of thousands of telephone operators lost their jobs, but the cell phone industry created even more jobs.

4. Low-opportunity, low-adversity. An economy that tunes out the dynamism in the world. The economy fails to restructure, but few people get fired. Japan in the 1990s?

Note that this is close to the way Schumpeter thought about things. Note that “stagnation” can be primarily in business reality (#4 in the first list) or primarily in business psychology (#2 in the second list). Possibly both.