[SERI Column]Time to end dependence on easy money

For a patient seriously injured in a traffic accident, a doctor would inevitably prescribe painkillers over the short term to aid recovery. As the patient begins to recover, however, the doctor must progressively wean the patient from this strong medicine to prevent addiction. This analogy may also be applicable to describe Korea’s economic management since 1997, with the International Monetary Fund (IMF) and the Bank of Korea (BOK) acting as doctors and the economy as the patient.
In late 1997, Korea experienced an unanticipated currency crisis. Before the incident, many economists had assumed that Korea would be immune to the kind of crises that had paralyzed countries like Mexico and Argentina in the early 1990s. They obviously misjudged.
As a result, the IMF was called in to bail out Korea. In return, the Korean government pledged to implement the IMF’s conditional policy prescriptions to restore economic order. The IMF program, typical for countries afflicted with a currency crisis, included monetary tightening and higher interest rates. After implementing these policies, some market interest rates soared to near 40 percent in early 1998, sending companies with even low debt burdens into bankruptcy. The Korean economy experienced negative growth in 1998.
By mid-1998, the IMF faced increasing challenges to its mandate. Indonesia, which also became a victim of the 1997 financial crisis, similarly plunged into a severe economic recession due to IMF-imposed bailout measures.
The economic contraction ignited social and political turmoil, ultimately leading to the Suharto administration’s collapse. Russia was forced to declare a moratorium on its foreign debt the year after the IMF’s advice failed to stabilize a plunging ruble.
Escalating global financial crises, combined with the IMF’s seeming inability to quell the growing carnage, put the international lender of last resort front and center for criticism from everywhere. Under substantial pressure, including calls from prominent leaders to abolish the organization, the IMF changed its austere policy recommendations for Thailand and Korea.
The IMF’s volte-face most likely reflected political calculations and the need to show that recipient countries benefited from their prescriptions. The IMF scrapped previous advice, proposing that countries now promote growth through ― this time aggressively ― cutting target and market interest rates.
Before the elections for National Assembly members in 2000, President Kim Dae-Jung welcomed the IMF’s newfound flexibility. Indeed, the IMF’s new policy prescription dovetailed nicely with President Kim’s political pledge to “overcome the currency crisis within one-and-a-half years” after his inauguration.
Accordingly, the Bank of Korea made a series of rate cuts. For each, the IMF demanded additional cuts to stimulate demand further, thereby ushering in the age of single-digit interest rates, an unprecedented phenomenon in Korea.
Looser monetary policy undoubtedly played a key role in the nation’s economic recovery until the mid-2000s. Lower interest rates spurred higher corporate investment, improved consumer confidence, and enabled more favorable debt restructuring for struggling firms. Without lower interest rates, these achievements would have been inconceivable, and thus the Korean economy benefited in the short term.
The Bank of Korea, however, continued to keep rates low long after the economy had recovered, even well into the Roh administration.
The decision to keep interest rates low created numerous distortions in the domestic economy. Indeed, interest rates during this time period were well below equilibrium level, leading to several unwanted consequences.
First, the policy decisively contributed to “asset inflation” in the nation’s stock and housing markets. Asset inflation, while not inherently negative for the economy, can dent economic prospects by promoting capital misallocation that must then correct itself through an often-painful readjustment period. For example, the “Kosdaq frenzy,” an investment fervor that swept the nation in the late 1990s, left many middle- and lower- income investors broke after the market collapse. As a result, consumer spending plummeted, a problem that still plagues the economy today. With consumption levels still low, surging housing prices pose new threats.
Second, easy monetary policy also fueled a credit card bubble in 2002-2003 and staggering levels of household debt. With low lending rates and aggressive lending behaviors at some banks, consumers did not fear acquiring debt. After the credit bubble burst, however, 10 percent of the nation’s economically active population were credit delinquents.
Along with soaring house prices, the issue of outstanding household loans is one of the biggest factors threatening the domestic economy. Each household’s disposable income declined precipitously as a result, perpetuating sluggish domestic demand.
What does all of this mean? As the saying goes, “too much is as bad as too little.”
Going too far always causes problems. With this in mind, policy makers should pursue monetary and fiscal policies that ensure the long-term structural health of the economy, rather than politically expedient solutions that inevitably promote greater distortions.
Recent policies to tackle the housing market bubble remind me to say this once again.

*The writer is senior vice president at Samsung Economic Research Institute. Address inquiries about this article to alexkkim@samsung.com.

by Kim Kyeong-Won