Like in a bad, old horror movie, a specter is haunting the South Korean economy. This ghost is stagflation and is the embodiment of the outcome of discredited policies from the 1960s and 1970s. If stagflation in the form of inflation, slower economic growth and rising unemployment does raise its ugly head again, it will be for the same reasons.
Stagflation poses a situation that renders most conventional economic policy adjustments ineffective. Attempts to boost economic growth through interest rates are likely to spark higher inflation. Lower interest rates also contribute to depreciation in the currency that can contribute to inflation. And attempts to stimulate the economy through deficit financing also contribute to inflation and retard growth as private-sector investments are "crowded out" by government borrowing.
According to the National Statistical Office (NSO), the economy is entering into a downturn phase. Evidence of this is that business sentiment has been declining for over a year and production growth is down for the last four months of 2000 as well as a decline in consumer spending. In addition, manufacturing plants were operating at a 20-month low of 74.7 percent, with inventory hitting a 22-month high.
At the same time, consumer prices rose by 1.1 percent in January over the levels of December, a 4.2 percent rise from a year ago and exceeding a government projection of 3 percent for the year.
In a nutshell, stagflation is a condition that confounds government policymakers who mistakenly believe they can fine-tune economies by lowering the cost of credit through higher monetary growth rates or spending more taxpayers' money. During the 1970s, a combination of loose monetary policy and financing increased government expenditures through running public-sector budget deficits condemned many of the industrialized economy to the ravages of stagflation.
Despite this sorry record, many analysts have begun to expound discredited interpretations of economic events and supporting policies based upon Keynesian economic theory. Yet most are probably not aware they are assisting in the revival of a moribund doctrine concerning what governments can do to impact growth.
There are also policy indicators that signal stagflation might be on the horizon. Instead of allowing the private sector to liquidate its excess capacity and move capital to more productive and profitable activities, the government seems prepared to embark on a jobs creation scheme to be financed by deficit spending.
Korea's government is counting on a spending package to assist in reviving its economy. One proposal for spending 21.8 trillion won on building or renovating physical infrastructure would involve about 60 percent of the budget for the entire year. Instead of revitalizing private consumption and corporate investment, such a step may be more likely to create inflationary pressures while impeding the momentum for necessary reform and restructuring. Even though some of the funds may be earmarked for venture start-ups, this is an activity that could be provided by the private sector.
In assessing the condition of the labor market, President Kim Dae-jung acknowledged that unemployment would rise to one million from 800,000 during the second phase of restructuring. Seasonally adjusted unemployment is now over 4 percent and the Labor Ministry expects it to continue to rise.
In hopes of halting this rise in the number of jobless, the government is poised to "create" 400,000 jobs following the steps outlined above. Unfortunately, this is an illusion. Spending by governments cannot lead to a net increase in jobs.
By providing employment, governments create an offsetting tax liability to pay wages, salaries and perks. This removes funds for paying public employees from the private sector, which is where jobs and wealth are created through entrepreneurial actions.
This means that the net effect of government spending to provide jobs is likely to have a zero impact on overall employment. Indeed, it might even be negative if workers employed by governments have lower relative productivity when compared to their private sector counterparts. Even if it were granted that the effect could be positive today, throwing taxpayer money at a problem shifts the burden to future generations whose opportunities will be diminished since repayment of government debt will diminish economic growth.
The key to escaping the trap of inappropriate policy responses is to understand that spending is the not the driving force in an economy.
Instead, investment spending guided by interest rates that reflect the long-term potentials of the real sector of an economy. In particular, sustainable changes in consumption are made possible when the levels of output match the purchasing power of workers.
Interest rates are the mechanism by which consumption and production are coordinated. When governments and central banks play games with the money supply and lower interest rates artificially, they distort this process and encourage a misallocation of spending that is unsustainable.
Because the future is unknown, mistakes by investors in a competitive market economy may lead to business cycles. Yet these ups and downs tend to be moderated because there is usually an offsetting number of bulls and bears.
When there are extreme conditions of boom and bust, these are inevitably caused by credit policies that induce most economic decision makers to commit resources to activities that cannot be supported in the long run. These effects are evident in Japan's "bubble" economy of the 1980s, East Asia's real estate and asset inflation or the dot.com bubble of the late 1990s.
The resolution of the vast pool of bad debts in the banking sector requires that insolvent companies be closed and their assets sold off to the highest bidder. It appears that instead of focusing upon forcing debt-stricken banks and firms to restructure, taxpayer money will be pumped into the economy to keep insolvent banks and firms from going bankrupt.
Another step that the government might take is to force public corporations to set an example by undergoing rapid reform, including privatization and deregulation. Yet, public sector restructuring has occurred more slowly than in the private sector.
Perhaps the most effective remedy for stagflation is tax reform by reducing marginal rates and removing distortion effects. It was just these steps during the Reagan Administration that set the stage for America's longest peacetime recovery.
Christopher Lingle is Global Strategist for the company eConoLytics.com.
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