TCS Daily


Korea's Dangerous Monetary Games

By Christopher Lingle - October 26, 2005 12:00 AM

In what it called a preemptive move, the Bank of Korea recently raised its inter-bank overnight lending rate by 25 basis-point rise from the record low call rate of 3.25 percent, the first increase in over three years. But this small move will do little to undo the effects of a reckless monetary policy that created artificial and temporary improvements in economic activity that invite an inevitable correction.

There are several disastrous effects of the BOKs monetary profligacy that kept its benchmark interest rate so low for so long. The most obvious consequence of these distortions is a serious real estate bubble that has helped widen the rich-poor gap. While these low interest rates discouraged domestic saving, it also induced households and consumer to incur higher debts that may become an impossible burden to bear when rates rise.

As it is, the rates of interest paid on bank deposits have been lower than the rate of consumer price increases with the CPI up by 4.4 percent in July. At the same time, Seoul has been merrily pushing up the overall per capita burden that includes taxes and contributions to social insurance programs that consumes about a quarter of GDP.

With individuals on fixed incomes from interest on savings or fixed pensions experiencing lower living standards, this has also added to the rich-poor gap. Some relief could be offered by lowering or abolishing the 16.5 percent tax on interest earnings.

The most pervasive distortion of flooding the economy with cheap credit is seen in ill-advised start-ups or expansions of capacity by businesses that would not have occurred if borrowing costs were higher. When rates rise further, marginal businesses brought to life under artificially-low interest rates will be forced into bankruptcy.

All the mayhem caused by the BOK's loose monetary and credit policy has provided few benefits. Using low interest rates to stimulate the economy ignores the fact that private and corporate spending depends more on the presence of clear signs of a sustained economic recovery. Absent such evidence, investors tended to shift their portfolios into real estate or foreign bonds.

It turns out that loose monetary policies can only create a temporary economic expansion that pays political dividends. But cheap credit and monetary pumping cannot generate sustained improvement in the real sector of the economy.

The primary benefit of rising nominal incomes and increased spending from new credit or paper money flowing into the economy is the increase in revenues enjoyed by the government. Higher revenues that support more government expenditures can push up nominal output, but this is only because more pieces of paper are sloshing around in the economy.

It is not hard to imagine similar effects of an economy being flooded with counterfeit banknotes. When the cause of the new prosperity is discovered to be without any sustainable base, adjustments will occur so that the affected economy moves back towards it original position.

In all events, new expenditures based upon cheap credit or additional banknotes (counterfeit or otherwise) do not boost economic growth, It can only lead to purchasing power being transferred between groups so that total spending remains unchanged.

Since transferring demand from one group or person or sector to another cannot increase total spending, there are no long-term improvements in the productive potential of the real economy. Increased production can only be sustained when there is an increase in the capital structure in response to lower interest rates that are brought about by more real savings rather than central bank dictates.

A temporary rise in nominal output from cheap credit should not be confused with a higher sustainable rate of real economic growth. Sustained growth occurs when the stages of production become increasingly complex and that requires more savings to produce and expand this structure. But when central banks force down interest rates artificially, they actually discourage private saving so that the observed effects will eventually disappear in a cloud of bankruptcies.

In the meantime, artificially-low interest rates distort the pricing signals sent to entrepreneurs on borrowing costs. Many border-line business plans become viable when interest rates are forced down artificially. Initially, they can afford to capture scarce resources. But when interest rates begin to rise, weak business plans cannot cope with higher costs so that there will be painful liquidations and higher unemployment.

Korea's recent experience is another chapter in a long history of ill-fated attempts to use monetary policy as a tool to promote economic growth. There are better ways to do this.

For example, permanent cuts in the overall tax burden can allow Korea's economy to return to its long-term growth path. A lower tax burden leaves a larger proportion of GDP in the hands of the private sector and it is only here that new wealth and a net increase in jobs can occur by increasing investment in the capital stock. At the same time, reducing the tax burden allows higher savings to push down interest rates naturally while and serving as a sustainable source of new funds for investments.

The author is chief strategist at eConoLytics.


 

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