There are psychologists who argue that healthy people tend to have an inflated view of their abilities and how they are regarded by peers. In contrast, these psychologists contend, there is a tendency for depressed people to accurately assess where they stand. This hypothesis is called “depressive realism.” It explains our current economic gloom.

Recently, we have suffered three major blows to our economic self-esteem.

First, the price of imported petroleum doubled between late 2001 and the spring of 2004, then doubled again by the summer of 2007, and has increased by another 50 percent since then. All together, the price has risen more than sixfold since late 2001.

Second, house values have fallen, by 4.64 percent from April of 2007 through April of 2008, according to an index compiled by the Office of Federal Housing Enterprise Oversight. 

Third, the stock market has dropped, with the S&P 500 index on July 3 down over 19 percent from its peak on October 9, 2007.

Today’s oil price probably represents a more realistic estimate of long-term supply and demand conditions. The market seems only recently to have realized that growth in demand from China is real, while some hoped-for increases in supply elsewhere have failed to materialize.

It now appears that we were living in a dream world a few years ago, with oil prices unsustainably low and house price inflation unsustainably high.

House prices, too, seem to be adjusting toward more realistic levels, following a spectacular run-up from 1999 to 2006. That period saw house prices outpace general inflation every year. Prices never rose by less than 6.6 percent from April of one year to April of the next year, with the increase from April 2004 to April 2005 reaching nearly 10 percent.

Finally, the stock market is reflecting the other developments. The transportation sector has been hit by high oil prices, and the financial services sector has been hit by the declining values of securities backed by home mortgages.

It now appears that we were living in a dream world a few years ago, with oil prices unsustainably low and house price inflation unsustainably high. Reality is less pleasant.

In theory, a student who suffers a blow to his or her self-esteem can continue to work hard and learn. In practice, educators worry that this will not happen.

Similarly, the asset revaluations that represent blows to our economic self-esteem could be shrugged off by workers and businesses. We still have all of the capital equipment and know-how for the U.S. economy to continue growing.

However, a significant reallocation of resources is required. For example, we need fewer construction workers. During the boom, the housing stock grew faster than the rate of family formation. It will take several years for this excess housing inventory, which some economists estimate may be as much 3 million units above its normal level, to be occupied.

Educational credentials that seemed useful four years ago may not be as valuable during the current transition phase. Wall Street hiring will not return soon to the levels of the boom years. A friend’s son, who just earned a master’s degree from a leading journalism school, is bagging groceries for Trader Joe’s. The opportunities for young people without college degrees must be even worse.

Orthodox Keynesian macroeconomics says that the cure for economic pessimism is for government to create an illusion. Congress can cut taxes or the Federal Reserve can print money in order to make people feel more prosperous. 

What government cannot do, however, is figure out how to reallocate workers to new industries in a way that reflects long-term reality. Government does not know whether the journalism graduate should wait patiently for a relevant job or whether he needs to find a different career path.

Adapting to the reality of higher energy costs and an excess housing stock requires myriad complex adjustments, some of which may be obvious but many of which are subtle. Chances are, it will take several years to complete the transition. Meanwhile, there is little, if anything, that policymakers can do to hasten that process.

Arnold Kling is an economist living in Silver Spring, Maryland.

Image by The Bergman Group/ Darren Wamboldt.