TCS Daily

Show Me the Productivity

By Christopher Lingle - April 14, 2006 12:00 AM

According to the International Monetary Fund (IMF), South Korea's economic recovery is "underway" and growth should accelerate next year. A revival of economic activity in the early part of this year has accelerated steadily and was being driven by private consumption. As such, the IMF expects the South Korean economy to grow by 5 percent next year after an expansion of 3.8 percent in 2005.

But could this be wrong? The idea that consumption is driving economic growth confuses the effects of excessive monetary pumping on the spending of Korean households. Higher living standards come about through increased productivity, which is permitted, in turn, by capital accumulation. Increases in the material means of production require more real savings. As more capital is accumulated, more can be produced, so that more can eventually be consumed.

Increased household consumption can only persist if there had been an increase in real personal income. But there is no evidence that pay rises are exceeding the current rate of inflation. Alternatively, there would need to be more new jobs being created that are paying higher salaries.

Household debt stood at 73.8 percent of GDP at end-2004, with an increase of 5.7 percent in outstanding debt from the previous year. The annual average growth in household disposable income of about 5 percent since 1997 does not cover the increase in debt obligations and sustained increase in consumption spending.

And so it is that most of the higher household spending is due to unsustainable increases in borrowing, on the back of record-low interest rates and a temporary flood of liquidity. When interest rates inevitably rise and the liquidity begins to dry up, households will stop binging on borrowing and splurging on consumption.

Recently, South Korea's central bank has held its benchmark overnight call rate at or close to a record low. As such, artificially-cheap borrowing costs encouraged unsustainable levels of consumer spending and business borrowing while also fueling speculative bubbles.

In all events, consumption can never be the driver behind economic growth. Consumption is nothing more than a tail that must be wagged by investment that underpins capital formation. When more capital is available per unit of labor, rising productivity leads to increased wages and income that provide households with the means both to spend and save more. In turn, this produces a sustainable cycle of economic growth, since household spending and job growth -- both -- depend upon increased business investment.

The appropriate direction of causation for economic growth is that increased production creates the basis of higher purchasing power that allows more consumption to occur. This means that economic growth is driven by capital accumulation, not consumption.

So, where is the investment productivity?

Unfortunately, the data suggests the opposite is occurring. On the one hand, the pace of growth of capital investment has been trending lower since the financial turmoil of 1997. In 2004 it totaled 74.4 trillion won ($71.47 billion) compared with 77.8 trillion won in 1996. On the other hand, the erosion in Korea's labor market competitiveness has deterred firms from investing domestically.

Despite the contrary evidence and theory, the IMF and the BOK (Bank of Korea) reveal their obsession with the demand side of the economy. Most economic policy focuses upon manipulating demand, like the record low interest rates of the BOK and Seoul's large fiscal deficits.

But persistent increases in economic growth require an increased level of real savings accompanied by technological change and a group of entrepreneurs willing to take risks. Unfortunately, Korea's household savings, once among the highest of industrial countries, have been in a continual decline. In 1984, the rate was just under 15 percent and rose to just over 25 percent. Since then, the rate declined steadily to a bit less than 11 percent as of 2004. While lower interest rates are certainly one of the most important factors for this recent declining trend, additional blame must be put on the rising overall tax burden.

Before Korea's economy can move toward a strong and sustainable recovery, policy makers must abandon misguided conventional wisdom about how an economy works. Instead of focusing upon consumption and aggregate demand, innovations should be introduced to encourage savings by allowing productive individuals to keep more of what they earn and on improving the competitive environment for private investment.

Anyone who believes that consumption and demand are essential to economic growth must also accept that government spending on armaments can boost an economy. But this same logic would conclude that terrorist acts are beneficial to overall economic growth. And so, natural disasters like cyclones or tsunamis should be welcome events due to the higher spending arising from rebuilding efforts.

Certainly, it is preposterous to assert that natural disasters are a good thing. Likewise, it is bogus to claim that higher consumption through deficit spending or super-low interest rate can change economic fundamentals and create sustainable growth.

Christopher Lingle is Senior Fellow at the Centre for Civil Society in New Delhi.


TCS Daily Archives