GUATEMALA CITY — Misguided central-bank policies are wreaking havoc around the world. From Seoul to Washington and back, central bankers have forced down short-term interest rates in an orgy of monetary promiscuity.
The most obvious example — which has also been the most damaging — is the role of the U.S. Federal Reserve System in engineering what is shaping up to be a dollar crisis. With U.S. interest rates kept so low, domestic markets were flooded with cheap credit that overflowed into international markets that became awash with dollars.
And so it is that South Korea’s economy is laboring under the effects of a wicked combination of ill-advised policies. Politicians and central bankers have acted under the illusion that they can conjure up economic growth through deficits or cheap credit.
This alchemy of creating something (real economic growth) out of nothing (pieces of paper money or public-sector debt) would embarrass the boldest sorcerer. But in the case of bad policy choices, they can survive due to ignorance of economic processes that leads to inept advice.
The Bank of Korea has followed the bad example of its U.S. counterpart. Recently, good sense seems to have inspired America’s central bankers to mend their ways by allowing interest rates to be guided by market forces. However, the BOK decided to continue along its ruinous path, cutting its inter-bank call rate twice this year to a record low 3.25 percent.
Among the costs of the policy choice to continue with artificially low interest rates is that domestic banks are experiencing a sort of domestic capital flight. Known as “disintermediation,” savers are moving out of one form of financial intermediary (banks) into others.
The balance of savings fell in 2004 for South Korean banks as record-low interest rates sent savers in search of higher yields. According to the Bank of Korea, the total balance of savings deposited with domestic lenders was about 1.4 percent lower than in 2003.
With consumer prices rising by 3.6 percent last year and an interest-income tax of about 16.5 percent, negative “real” rates of interest encourage Koreans to move out of banks. Under current conditions, bank deposits incur losses in purchasing power for those that depend most on interest income, such as pensioners and retirees.
When central banks purposely push down interest rates, they seriously undermine banking sectors. While conventional wisdom praises central bankers for forcing down interest rates to stimulate growth, more harm is done to the economy than good. New credit through the expansion of bank lending cannot boost sustainable economic growth unless the new credit is supported by additional real savings.
When central banks force down interest rates, businesses borrow more for investment purposes, including the import of some capital goods, and add to productive capacity. Investment will exceed savings when the money supply has been inflated. Under these conditions, increased demand for capital goods should be seen as a symptom of an inflationary process rather than a blessing of beneficial growth.
For their part, banks cannot conjure up an increase in real credit since they are only an intermediary between savers and borrowers. However, when central banks initiate artificially low interest rates, they allow banks to issue “counterfeit” or false credit.
Printing new paper money or allowing credit expansion does not and cannot change the real amount of funds. These can only arise from an increase in real savings that arise due to increasing labor or capital productivity, or both. Without more real savings, the amount of available credit cannot be increased on a sustained basis.
As indicated above, low interest rates encourage the expansion of unsupported credit while discouraging saving. The consumer savings rate in the U.S. has been driven relentlessly lower to below 2 percent, down from a bit over 10 percent in 1980.
And low interest rates encourage the acquisition of debts that would be unsupportable at higher rates. In America, the decline in the personal income-to-personal outlays ratio has been such that consumers are spending at a faster pace than they are generating income. With the pace of credit expansion outstripping the capacity of households to generate income to repay debt, banks are increasingly vulnerable to widespread defaults. This problem is evident in South Korea given the deep trouble among credit-card issuers.
Monetary pumping associated with low-interest rate policies create distortions in the micro-economy. Individuals exchange goods and services for money based on cheap credit under the illusion that they can reclaim goods and services with similar or higher value.
In sum, the continued policy of cheap bank credit that is created from “thin air” ultimately undermines the economy and weakens the banks. It turns out that prolonged monetary pumping by central banks depletes the real pool of savings while encouraging an expansion in the levels of private debt.
Without sufficient real savings to support the existing pool of credit, South Korea’s banking sector is vulnerable to the fallout from an inevitable rise in interest rates. And so it is that loose monetary policy has laid the foundations for another recession.
In a time of both misinformation and too much information, quality journalism is more crucial than ever.
By subscribing, you can help us get the story right.