[FORUM]Low interest rates and hangovers

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[FORUM]Low interest rates and hangovers

No one seems to want to raise interest rates with the presidential election less than two months away. The lull in the real estate market and sluggish retail trade have also cooled off the ardor for a rate hike. In fact, now that the status quo seems to be maintaining the current interest rate level, some pressure to cut rates could develop. At a time like this, there should be more examination of the level of current rates and their effect on the whole economy, not just on short-term economic trends or politics.

There is a simple method used by economists to decide if the current interest rate is appropriate. They add the current growth rate and the inflation rate and compare that with the interest rate paid by three-year government bonds. Recently, the South Korean economy has been growing at 6 percent and the inflation rate has been 3 percent, making a total of 9 percent nominal growth. Government bonds earn 5.3 percent, suggesting that their interest rates are too low. That becomes even clearer if you look at the rate on bank time deposits, which are running at about 5 percent, or 4 percent after withholding taxes are deducted. Factor in inflation, and the return is barely positive -- less than 1 percent after the 3-percent inflation rate is considered. The annual income growth of Koreans is 6 percent (5 percent, taking taxes into account), but people who live on interest earnings are at a huge disadvantage.

And financial authorities will face resistance from many interest groups if they want to raise interest rates. In the past the administrative branch of the government and corporations were against an interest hike, but these days, the majority of the people have joined the movement against higher rates.

The main reason for that sentiment is that over the past few years, household lending has increased exponentially, leading people to resist any increase in the amount of money they have to repay. Lowering interest rates is tempting politically; low rates would make corporations that have high debt loads very happy. They want to invest more by getting additional loans. Individuals can spend more if interest rates drop further.

The drop of interest rates would lead to the rise of stock and real estate prices, making stock and real estate holders happy. The government welcomes lower interest rates as they would likely spur consumption and investment. That would lead to economic growth and improve employment.

But intervention in financial markets to lower interest rates would probably bring about distortions and bad side effects. Everybody would prefer to spend money rather than save it if earnings from bank deposits are too low. Saving rates would fall and the balance of payments would turn worse. Korea has run a current account surplus for five straight years, but will probably run a deficit next year. Low interest rates and plenty of spending would lead to inflation, and another bubble could begin to develop in the real estate market. It will cost the Korean economy dearly if the government does not control interest rates in a timely manner.

Japan paid a heavy price for ignoring the initial signs of its bubble economy; it has taken too many drastic measures to solve the problems belatedly. The authorities sat on their hands, and a fatal blow was dealt to the economy there.

Increased corporate earnings would also spur demands for wage hikes, and an economy with low interest rates and high wages cannot last for long. If inflationary pressure becomes greater, the pressure to raise interest rates would rise. There is a danger that the Korean economy could return to the situation during the financial crisis of high interest rates and high wages.

We should heed the warnings of the economists. Easing monetary policy and lowering interest rates are like getting drunk on wine, the economists are saying. We can relish the sweet taste of the wine as it flows down the throat, but we might suffer from a hangover the next day and our livers will be damaged if we drink too much too often.

* The writer is director of the JoongAng Economic Research Institute.

by Ro Sung-tae

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