The Need for Expansionary Macroeconomic Policies

An Article by Mr. Ajai Chopra
Assistant Director, Asian Pacific Department
International Monetary Fund

Donga Ilbo
November 18, 2001

The global economy is currently experiencing a rare combination of synchronized weak growth in all three major markets—the United States, Europe and Japan. Korea is not immune to this development: growth will fall sharply to 2-2½ percent this year from almost 9 percent last year. Korea has so far weathered the global slowdown better than most of its peers, but growth remains well below potential. Moreover, given the dependence of Korea on exports, a return to healthy growth is unlikely until the global economy picks up. Forecasting global economic activity is always an uncertain exercise, and now particularly so in light of the events of September 11. It seems clear, however, that the prospects for a global recovery have been pushed back to late 2002 at the earliest.

In view of the weak global growth outlook, what should Korea's policy response be? Although monetary policy has been eased and the government has passed two supplementary budgets to boost fiscal spending, there is a good case for more expansionary policies in both areas. Such policies would help to support domestic demand and help to offset the negative impact on growth of Korea's weak exports. This is important not only for Korea, but also from a regional and global perspective. To complement these efforts and strengthen the recovery when it does come, progress should also be maintained in the area of structural reform.

Fiscal policy

Korea has an admirable tradition of fiscal conservatism—there has been no history of running large and persistent budget deficits. This was again demonstrated in the period following the Asian crisis, when the government achieved a return to budget balance in 2000, three years ahead of schedule. As a result of this fiscal conservatism, government debt remains relatively low and debt sustainability is not a concern.

Indeed, Korea's situation is different from a number of other emerging market economies—Argentina being the most prominent example—where the financing of deficits is a major concern. Such countries have been forced to tighten fiscal policy in the current global environment. By contrast, Korea enjoys greater flexibility in its policy making: it can afford to ease fiscal policy to help support domestic demand and cushion the impact of the global downturn. This extra room to maneuver should be more fully utilized in 2002.

The budget in 2001 provided virtually no stimulus to the economy even though growth is running well below potential. Looking ahead to 2002, growth is expected again to be below potential and there is a strong case to loosen fiscal policy to provide stimulus to domestic demand. The proposed 2002 budget, which projects a 1 percent of GDP surplus and has been clearly overtaken by events, would not achieve this aim. A revised budget that targets a modest deficit would be much more appropriate. The way to achieve a more expansionary fiscal stance would be to introduce temporary measures that could be reversed once evidence of a pick-up in growth becomes solid. Possibilities include, but are not limited to: (i) a one-time income tax rebate; (ii) support for low income households (including those highly dependent on interest income) and the unemployed; and (iii) acceleration of infrastructure projects already in train.

We are not advocating irresponsible fiscal policy. At the same time, however, there is a danger if fiscal conservatism is carried too far as it could exacerbate the downturn in the economy. What is needed, therefore, is a less rigid policy that does not require the government to balance its books in every year. Rather, the objective should be to aim at broad balance in the fiscal accounts on average over the business cycle—that is, deficits in bad years that are offset by surpluses in good years. Indeed, a modest surplus over the medium term may even be appropriate given future retirement spending needs. It is encouraging that the government has already begun to address this last issue through recent reforms of the National Pension Fund.

Monetary policy

Because of slowing economic growth and a weakening outlook, monetary policy has been eased through interest rate reductions in all industrial countries this year. The Bank of Korea (BOK) lowered interest rates by 1 percentage point in the third quarter of 2001, which was entirely appropriate. There is, nevertheless, room for more cuts in the months ahead. Why? Inflation is subdued and not an immediate threat, so it is not an obstacle to further easing of monetary policy. In addition, the economy remains weak with considerable slack, and there are still downside risks to the growth outlook for 2002 because of global conditions. Under these circumstances, further monetary easing could support the economy and provide insurance against weaker outcomes.

Lower interest rates will help to spur growth through reducing the cost of borrowing to both firms and consumers. For firms, lower interest rates will increase investment and employment. For consumers, borrowing will become less expensive, boosting consumption. Higher investment and consumption will increase domestic demand, and hence, economic growth. To ensure that borrowing is not excessive in an environment of lower interest rates, bank supervision should be especially vigilant.

What about the effect of lower interest rates on savers, who receive a large share of their income from interest payments? Although lower interest rates would mean lower interest income for these households, it is important to remember that savers and producers are linked by the labor market. Thus, when lower interest rates spur investment and employment, households benefit through job creation. The only group not enjoying this link is pensioners, and there is a case to compensate this group through appropriate fiscal policy measures.

Structural policy

The global slowdown has shifted the policy focus to monetary and fiscal issues, but it will also be important for Korea to press ahead on the remaining agenda for structural reforms. The main elements of the agenda are as follows. Priority should be given to the privatization of nationalized banks following their rehabilitation. In addition, the insolvency system needs to be strengthened and corporate governance should be improved, including through measures that establish appropriate checks and balances for decision making, particularly for the chaebol. It would also be important to bring to resolve the large, headline firms in distress to bolster market confidence.

A successful structural reform effort will allow market forces to play a greater role in allocating economic resources and thus increase investor sentiment toward Korea and result in increased valuations for Korean companies. It will also result in more efficient and competitive firms, which will make the entire economy better positioned to return to rapid and sustainable growth once the world economy recovers.