TCS Daily

Bust a Move

By Christopher Lingle - August 17, 2004 12:00 AM

Do not expect much of a change in real economic conditions after the surprise move by the Bank of Korea (BOK) to cut its overnight call rate. This is all part of a reckless monetary policy that is doomed to create an artificial and temporary improvement in economic activity that will be followed by an inevitable bust.

There are several disastrous effects of this policy of monetary profligacy. Perhaps worst among these is the reduction in the domestic savings rate combined with the encouragement to incur higher debts that may become an impossible burden to bear when rates rise.

Whatever the desired effects of the most recent rate cut, local investors are unlikely to commit more funds to long-term financial products that might boost business investment spending. While the interest rate cuts were intended to stimulate the economy, the effect upon private and corporate spending depends more on whether there are clear signs that the economy will recover.

Meanwhile, investors are likely to shift their portfolios into more short-term financial assets, real estate or foreign bonds. One thing that is not needed is more air in the local property bubble. And commercial banks that lower interest rates on regular savings and short-term deposits are likely to suffer since depositors will make withdrawals in search of higher yields.

To support its cut in its call rate, the BOK suggested that it would benefit corporate and individual borrowers by saving them 2.5 trillion won per year in interest payments. But this assumes that banks reduce their lending rates.

It turns out that banks tend to reduce deposit rates rather quickly, but there is a longer lag before lending rates drop in response to moves by the central bank. This is because they are hoping to shore up their profits with the wider spread in borrowing and lending rates. The spread between lending and deposit rates was 2.23 percentage points in June, the highest figure in 31 months.

Another effect of lowering rates is that the rate of consumer price has become higher than the interest on bank deposits. In turn, individuals on fixed incomes from interest on savings or fixed pensions will be in trouble.

Unfortunately, this situation is likely to lead to urging the government to embark on populist responses. A better form of relief would be to lower the 16.5 percent tax on interest earnings.

It might also be the hope of the BOK that its previous inflationary stance combined with lower interest rates will lead to negative real interest rates to encourage spending and investment. This may have been the case since data from the Ministry of Finance and Economy indicate that the real interest rate (increases in the CPI minus bank interest) for July was around minus 0.6 percent. Consumer prices rose by 4.4 percent (year-on-year) in that month while the average interest rate on bank savings was around 3.8 percent.

Whatever the intentions behind monetary expansions, they create an illusion that tends to pay political dividends without doing much good for the real economy. Rising nominal incomes and spending from new credit or paper money flowing into the economy will increase revenues for all levels government. In turn, higher government expenditures will cause nominal output to increase, but only because more pieces of paper are sloshing around in the economy.

In all events, these new expenditures cannot be expansionary in a real sense because all that has happened is that purchasing power has been transferred between groups. As it is, total spending must remains unchanged.

Since transferring demand from one group or person or sector to another cannot increase total spending, there can be no long-term improvement in the productive potential of the real sector of the economy. Increased production can only be sustained by an increase in the capital structure that depends upon lower interest rates brought about by more real savings.

It is important not to confuse a temporary rise in nominal output from cheap credit with a higher sustainable rate of economic growth. This is because sustained growth occurs when the stages of production become increasingly complex. But that requires more savings to produce and expand this structure. When central banks force down interest rates artificially, they actually discourage private saving.

But they also distort the pricing signals sent to entrepreneurs on the cost of borrowing. Many dubious business plans become viable when interest rates are forced down artificially. While they can capture scarce resources, this will come to grief. When rates rise and the business plans are unable to face up to higher costs, there will be painful liquidations and higher unemployment.

There are alternatives to these ill-fated attempts at monetary stimulus. For example, tax cuts can increase demand if they lead to increased investment in the capital stock. There is evidence that reducing the capital gains taxes in the US led to higher investment there. At the same time, reducing the tax burden can lead to higher savings that can push down interest rates and serve as the source of new funds for investments.

Christopher Lingle is Visiting Professor of Economics at Universidad Francisco MarroquĂ­n in Guatemala and Global Strategist for eConoLytics.


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