Cyclical Zombies

Stephen Roach argues in this article that the “current medicine being applied to America’s economy” is wrong. The real disease is a “protracted balance-sheet recession that has turned a generation of America’s consumers into zombies – the economic walking dead. Think Japan, and its corporate zombies of the 1990’s. Just as they wrote the script for the first of Japan’s lost decades, their counterparts are now doing the same for the US economy”.

This is an argument that has been used before during the current crisis: we are trying to fix a structural problem with medicine that can only deal with cyclical misalignments. Using Roach’s words: “Steeped in denial, the Federal Reserve is treating the disease as a cyclical problem – deploying the full force of monetary accommodation to compensate for what it believes to be a temporary shortfall in aggregate demand.”

There is no doubt that asset bubbles and excessive optimism during the pre-crisis years are now reflected in weak balance sheets that will take time to fix and will represent a drag on growth. And this clearly is not a mere cyclical issue. But there is something else that is going on: advanced economies have gone through a deep recession and are still producing below potential. This is not structural, this is cyclical. And finding a solution to the structural problem in the middle of a recession is not easy. While households have to reduce spending to repair their balance sheets, doing so at the same time that income is below potential just becomes more painful. Monetary and fiscal policy cannot eliminate the effort that is associated with deleveraging but they need to ensure that this happens in the least painful way. And this requires producing a path for output and income in the short run that is as close as possible to the level of potential output. We can debate about what this level should be but it is hard to argue that given current economic conditions and high levels of unemployment we are close to potential.