There are two common mistakes policy makers make when setting the future path. First, they reject a hypothesis when it is true, and adopt a policy heading in an opposite direction. Second, they fail to reject a null hypothesis when an alternative hypothesis is the reality. In statistical terms, these are referred to as “type 1” and “type 2” errors.
We saw consumption-led growth and low interest rates spurring surges in house and stock prices, and a money game gain popularity due to new derivative financial products.
One expert suggested that we should prevent a bubble from inflating by adopting monetary policies that anticipate the future and by reinforcing supervision of the financial industry.
Policy authorities refused the suggestion, however, devising policies based on the assumption that the new phenomena were a result of a new economy with a different structure, based on improved productivity in the information and communication age. We need to maintain the low interest rates and continue to deregulate, they said, in order to extend the boom, because new financial methods diversify the market risks.
The global financial turmoil is the result of a type 1 error.
On the other hand, as stock prices plunged after the 9/11 terrorist attacks on the United States, policy makers were worried about the worsening market conditions and drastically lowered interest rates worldwide, setting the stage for housing and stock market bubbles. This was a prime example of a type 2 error.
Although the shocks were not big enough to have an impact on the economy, policy makers accepted the hypothesis, insisting that the shocks may be huge. They devised policies designed to maintain excessive interest rate cuts over the long term.
Now, policies such as super low interest rates are being created left and right to deal with the unprecedented financial meltdown. If a government is slow, it receives harsh criticism from the public both at home and abroad that it is unwilling to cooperate in the global effort to beat back the crisis, and that it is remaining idle in times of trouble.
However, the possibility of committing a type 2 error is always there. There may prove to be strong inflationary pressure when money is circulating in the market. Excess liquidity may make things more difficult than ever. But despite that, the United States and Europe are adopting such policies and winning widespread public support.
These regions experienced how an economic crisis can change politics and lead to huge catastrophes during the Great Depression of the 1930s.
As people lose hope, some forces may mislead them by drawing them toward a dazzling light, bringing new disasters upon society. The Great Depression spurred fascists and Nazis to gain power, leading to World War II. Therefore, it may be considered inevitable that the central banks of the United States and Europe are rapidly coming up with policies that are not included in economics textbooks.
It is impossible to prevent the possibility that type 1 and type 2 errors may be committed at the same time. They regard it more appropriate to lower the possibility of economic panic, in which the economy gets caught in a vicious circle of expanding liabilities, stagnant consumption and growing unemployment caused by depression, opening up the possibility of inflation. In addition, the world supports their policies, because the global economy can only recover when major economies get back on track.
However, Korea must be careful about following in their footsteps. The United States is leading the way with the drastic interest rate cuts, with Europe, China, and Japan following suit. The cuts are focused not only on preventing credit shrinkage, but on encouraging exchange rates to weaken, as they saw an excessive upward revaluation that still threatens to further erode the nations’ ability to keep up in export markets. Competitive interest rate cuts are quite similar to competitive exchange rate devaluations.
However, we are in a different situation. The exchange rate is excessively devaluated with the persistent insecurity on the foreign exchange market. There is still no possibility of deflation. The economy will soon recover, but only when foreign capital starts flowing in again, when we maintain a gap between interest rates at home and abroad.
Although we need to implement extraordinary measures, we should have the wisdom to open both an entrance and an exit.
We should be careful not to fall into the trap of structural rigidity of cash flow. In that sense, bonds would be devices to be used in case there arises the need to withdraw cash from a market experiencing overheated liquidity.
The writer is a professor of economics at the Graduate School of International Studies at Sogang University. Translation by the JoongAng Daily staff.
by Cho Yoon-je