Soft-landing corridor is narrowing
The author is an editorial writer of the JoongAng Ilbo.
Central banks in the United States, Europe, South Korea and elsewhere are raising interest rates to contain galloping inflation. The U.S. Federal Reserve last month raised the base rate by 75 basis points, the steepest single rise in 28 years. Late last month, the Bank for International Settlements (BIS), dubbed the central bank of central banks, issued an annual economic report advising central banks to act “quickly and decisively” to prevent the entrenchment of inflation and stagflation. It stressed the priority should be to combat inflation even if the moves lead to short-term pain and economic slowdown. In its last report in 2021, the BIS warned of “a bumpy pandexit.” The exit from an unprecedentedly lengthy pandemic has caused lots of damage.
I talked to Shin Hyun-song, economic adviser and head of research at BIS to learn the details of the report. The interview was conducted through a video dialogue and e-mails.
Q. In this year’s annual report, the BIS highlighted the danger of entrenchment of inflation as employers and workers respond to inflation differently. In Korea, wage increases have been steep at large companies and big-tech enterprises.
A. Wages and prices can mutually fan one another under the mechanism of deepening inflation. When the economy enters a high inflationary phase, the wage-price spiral kicks in. In this case, the cost of lowering inflation can be high. Central banks must first stop inflation from shifting from low to high levels. Since the transition occurs quickly, prompt and decisive action by central banks is important.
Still, BIS did not foresee 1970s-style stagflation, saying the environment was more “benign” than in the aftermath of the oil shocks of the 1970s.
The international financial system was unsettled during the oil crisis in 1973 shortly after the fall of the Bretton Woods system. Today, monetary policy systems of each country and the global financial order are strong enough to fend off 1970s-style stagflation — and each country has greater policy maneuvering room. The oil price surge also has been less menacing than in the 1970s. Energy efficiency in the global economic structure also has improved. Energy consumption as compared to GDP has been reduced by around 40 percent when compared with 1973. Oil reliance has been much lessened thanks to prices for renewable energies, which fell faster than expected.
That doesn’t mean everything is safe, right?
Of course not. The high volatility of raw material prices can stifle growth of the global economy and fuel inflation. The path to a soft-landing is being narrowed. As the BIS mentioned in the report, central banks must quickly subdue inflation before household and corporate decisions affect inflation. In short, we cannot rule out the possibility of lengthy stagflation as in the 1970s, but that likelihood is slim.
Developed economies have been rolling back or normalizing their loose fiscal policies during the pandemic. South Korea doled out billions of dollars to the self-employed through supplementary budgets. Will that help curb inflation?
I cannot comment on an individual country based on BIS rules. Generally speaking, a government must set a mid-term roadmap to rebuild fiscal ammunition after its large-scale spending to combat an economic crisis or recession. To normalize fiscal and monetary policy, growth-inducing investment and restructuring on the supply end can be helpful. Such moves can raise the growth potential and reduce reliance on macroeconomic policy.
Growth-friendly investment and restructuring on the supply end has also been emphasized in South Korea.
Growth-friendly expenditures such as corporate investment and policies to restructure the supply side can raise economic growth rates and place fiscal and monetary policy on a normal path for the longer run. When a fiscal spending means is restricted, growth-inducing taxation code can be a useful tool. Bolstering human capital through education and a sustainable energy mix also can be good policy examples for supply-end restructuring.
But developed and developing economies can differ in fiscal integrity.
Upholding fiscal integrity is important to all countries, but it becomes a critical issue to countries tempted to mobilize central banks’ money-printing authority to reduce government debt. Historically, countries that had central banks purchase government debt through printing money suffered collapses in their currencies. Latin American countries faced default in the 1980s. They were cases in which central banks failed in their duty to defend their currency’s value.
Explain in more detail.
It is wrong to argue that fiscal and monetary policies are separate. When the economy flows smoothly, that doctrine can stand. But when a country’s public finances are recklessly managed — and fiscal deficits are covered through money printing by the central bank — fiscal and monetary policies become one. Due to the adverse interaction of the two, the value of a currency can be impaired from changes in inflation and exchange rates. Therefore, fiscal integrity is crucial for price stability, and central bank must pay greater heed.
Household debt is a big worry for South Korea. It hit 1,859 trillion won ($1.41 trillion) as of March, accounting for 104.3 percent of the GDP.
Again, I will speak in general terms. Developed economies have addressed household debt problems since the global financial crisis, but debt went on increasing in countries that had been less affected by the financial meltdown. To stimulate the economy, future spending has been advanced. Policy has less impact when debt has already surged. Countries with a high ratio of mortgage loans on floating rates would be vulnerable to interest rate hikes. There is also a generational gap in household debt. While the elder generation can benefit from gains in housing prices, the younger generation will have to carry more debt to buy a home. Such a generational conflict can cause not just economic problems but also social problems.
Do you agree with the argument that foreign exchange reserves have become less important than in the past due to greater overseas assets held by the private sector?
We must not just look at the current account, but overall portfolio of external assets. If institutions invest greatly in foreign-denominated bonds, that much hedging demand for short-term debt will be created. There must not be a mismatch in short and long-term assets in capital markets. That kind of mismatch caused a default crisis for South Korea. To prevent disruptions from mismatches in debt maturities, foreign exchange reserves must be strong as a safety net.
What do you think about the simultaneous crash of financial asset prices — stocks, bonds, and digital coins?
The synchronized drop in stock and bond prices has been unusual, given the decoupling trend since 2000. This has been caused by inflation, which has become a critical macro danger. The bond market is sensitive to inflation and rate increases by the central bank. The strong U.S. dollar also has worsened the liquidity squeeze on international capital markets. A BIS study found that a strong U.S. dollar tends to invite a tightening environment in international markets. Crypto investors are faced with triple whammies from the crashes in stocks, bonds and digital assets. The stock-bond downward spiral can only end when inflation is contained.
If the digital coin free fall deepens, won’t it develop into a financial system risk from chain bankruptcies of institutions that invested in digital coins?
From the current perspective, the collapse in cryptocurrencies won’t likely cause a subprime mortgage crisis like the global financial meltdown of 2008. But when decentralized finance (DeFi) becomes commonplace, its fragility could one day undermine the stability of the financial system.