TCS Daily

Will Korea Return to Growth?

By Christopher Lingle - November 30, 2004 12:00 AM

Ubud, Bali - Indonesia With so much economic uncertainty about when or if Korea's economy will return to its long-term growth trajectory, it is important that the correct policy response is chosen. One proposal involves boosting the components of total spending that include higher government expenditures. (Perhaps the only worse idea would be for the central bank to cut short-term call rates any lower than the record low of 3.5 percent.)

As it is, there is little historical support that fiscal deficits can effectively address such problems. Consequently, governments are loath to try spending their way out of economic difficulties or are confined from doing so from heavy debts accumulated during previous, failed attempts elsewhere.

Unfortunately, belief that a slump in domestic consumption is behind its sluggish economy has inspired proposals for a stimulus package depicted as a Korean-style "New Deal". The program announced by the ruling party hopes to raise the economic growth rate by 1 percentage point next year by spending 10 trillion won on public projects.

The plan would frontload fiscal spending in the first half of 2005 combined with mobilizing pension funds and state-run companies in the second half to finance extensive construction projects. State-sponsored infrastructure projects would seek to mobilize reserves of over $125 billion held by pension funds, foreign private equity firms, and state-owned corporations.

The Ministry of Information and the Ministry of Science and Technology will develop a Digital New Deal program by creating databases for state and public documents and assets. There would also be increased government investment in technology for saving energy and recycling.

Perhaps in hope of scoring partisan points, the Grand National Party opposes the plan by insisting that the policies contradict the principles of a market economy. Whatever the motivation, this is a fair assessment and a reasonable criticism.

This is because Korea's economic slump is a structural problem rather than a cyclical downturn. So, it is unlikely that there will be any discernible improvements can be sustainable.

If the public sector could generate a sustained recovery in domestic demand, there would be no business cycles. In fact, it is likely to increase the government's fiscal debt and defer the burden onto future generations. Expanding debts in order to foster a short-term recovery would repeat the obvious economic mistakes that created enormous public-sector debt burdens in Japan.

With this dubious avenue closed, the focus then turns to trying to engineer an economic recovery on the basis of higher household consumption spending. However, this notion is also flawed in presuming that consumption can drive economic growth. The truth is that the direction of cause-and-effect works in the opposite direction.

Although acts of consumption and production are interdependent, logic implies that production must precede consumption. Without production, neither the end of consumption nor the means to consume can exist.

As households spend more, producers of consumption goods are able to bid investment funds and other resources away from sectors of the economy. This rearrangement is disadvantageous to producers whose outputs are further up the production chain and require longer commitments of capital. And it is investments by producers of capital goods that can put the economy onto a sustainable growth path.

Relying upon "New Deal" programs allows politicians to pursue short-run results that benefit them or some narrow groups that support them, it is most likely to be selected. Like other policy choices that serve political ends rather than economic ends, it will create long-run costs that most others in the population must pay later.

When the bills come due, the politicians that invoked them may not be around to be held accountable. Even if they are, voters may not understand the cause or source of future ills and bills.

Instead of tinkering with demand, the Roh government should focus upon the supply side of the economy so that growth can be permanent and sustainable. In particular, distortions that hobble the economy should be eliminated to improve efficiency and increase competition so the market can work better for all citizens instead of delivering political spoils.

For those that believe that low spending and deficient demand is the problem, there are several approaches that involve changing conditions on the supply side. The first of these is to introduce permanent decreases in personal and corporate income taxes. Since this would give households and businesses control over more of their future earnings, this is tantamount to an increase in standard of living. By increasing both spending and saving, they will provide the basis for stable growth.

At the same time, reducing commercial regulations will encourage more business spending. On the one hand, it will allow increased competition. New entrants will begin to invest and existing businesses will be induced to spend more to increase their efficiency to remain competitive.

On the other hand, removal of regulations will lead to a decline in operating costs associated with compliance. Funds previously sequestered by government regulators will then be available to be spent by businesses.

But structural reform that includes public spending cuts and allowing bankruptcies can cause considerable pain. Entrenched interest groups and incumbent politicians tend to support policies involving deferred costs rather than the immediate pain of restructuring that can bring long-term benefits.

A better approach would be to focus on creating a business-friendly and growth-oriented environment that would include deregulation and a lower overall tax burden. Policies that keep tax rates low, encourage personal responsibility and reduce burdens on entrepreneurs will encourage wealth creation and raise standards of living.

Christopher Lingle is Global Strategist for eConoLytics.


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