[Viewpoint] Time for a macro strategyProposition 1: If you stand up in a movie theater, you’ll get a better sight angle at the screen because nothing will block your view. Proposition 2: If the price of a product rises, the company selling it will make more money. The two propositions seem unrelated but have something striking in common: They only hold partially true. If everyone in a theater watches a movie standing up, no one will be able to see the screen well. In the second case, if the price of a particular product rises, and other products and materials go up too, it will lead to inflation, and the company would make less profit despite the price increase.
When something is true in part but is false in the whole pattern, it is called “fallacy of composition.” In game theory, the “prisoner’s dilemma” is similar. According to this theory, each individual entity does his best to make a decision that benefits himself the most, which could lead to the worst possible outcome for the whole if the two parties mistrust each other.
Before the global financial crisis broke out, exporting companies in Korea used a currency risk strategy of fixing an exchange rate for the dollar to be earned. In this kind of deal, your dollar income in the future would be paid in Korean won according to the pre-set exchange rate, so even if the exchange rate changed disadvantageously, you could secure your income in Korean won.
However, the banks that offered the deal used a risk management strategy called “money market hedge.” This is a strategy of securing won by procuring and selling liabilities equivalent to the dollar amount you are entitled to receive. For example, if you have a forward exchange deal to receive $10 million three months later, the bank would borrow $10 million worth of liability from a foreign bank and sell it on the spot market for won.
Therefore, for the economy as a whole, short-term foreign currency liabilities increase, and the exchange rate against the dollar falls due to the disposal of dollars. The foreign currency liability for Korea rose to nearly $100 million, and in the end, the foreign exchange market in Korea was in trouble as the international financial market froze during the global financial crisis.
To put it simply, a fallacy of composition arose in the Korean economy. Each individual company and bank did its best to manage its risks but the combined result actually aggravated the risk of loss of confidence in the country as a whole.
Lately, one of the hottest topics in financial regulation is the so-called “macro-prudential supervisory.” Micro-prudential supervision is not enough, and therefore, a broader perspective is seen as crucial. For example, when foreign exchange risks increase, each individual economic entity can do its own risk management, but it could lead to a considerable cost.
However, if the central bank promotes an appropriate foreign exchange market policy to prevent drastic fluctuations of exchange rates, the situation would improve. Furthermore, it would be even better if major economies have coordinated policies or cooperate with each other to prevent radical changes from occurring in the first place. The aggregated risk existing in the global economy would also be reduced, and a financial safety net will be created.
When foreign funds suddenly flee, a country will suffer a tremendous shock and be hit with an overall economic crisis. So if there is an apparatus to procure foreign currency easily, the economy can avoid the worst and is easier to manage.
Therefore, the G-20 Summit meeting, scheduled for this week in Seoul, is very significant. Establishing a cooperative system and avoiding a foreign exchange war is akin to reduce the risk of large-scale fires. Setting up a global financial safety net is like providing a number of extinguishers in advance. If a fire breaks out, serious damage can be prevented. After all, most of the agenda discussed and implemented in this meeting will be the best macro-prudential strategies that can be applied in the domestic economic system.
If conflicts between countries decrease, and the foreign exchange war is ended through the meeting, the chance of fallacy of composition will naturally decrease and the possibility for the “prisoner’s dilemmas” will diminish. Moreover, CEOs of the global companies that dominate the real economy will have wide exchanges in the business summit, probably leading to an effective mechanism to prevent risks in advance.
There is talk of creating a permanent organization for the G-20 Summit, and it is a very meaningful proposal that must be implemented as it would be the best macro-prudential strategy to reduce the aggregated risks existing in the global economy. I hope for a successful hosting of the G-20 Summit, and wish that the meeting will produce a permanent establishment of an overall risk management mechanism while solidifying the direction for healthy macroeconomic policy of the global economy.
*The writer is a professor of business administration at the University of Seoul.
By Yun Chang-hyun