FRBSF Economic Letter
2005-07; April 15, 2005
A Tale of Two Monetary Policies: Korea and Japan
In most countries' experience, the
course of financial liberalization—much like the course
of true love in Shakespeare—"never
did run smooth." The process of reforming an economy
from one where the government takes the lead in allocating
financial and real resources to one where market forces
determine economic outcomes can involve choices and consequences
that are painful and costly.
This Economic Letter focuses
on recent developments in two major economies in Asia—South
Korea and Japan—to
highlight some of the differences in their progress and
to suggest that the differences might be due in part to
different monetary policy outcomes. Both countries have
had to negotiate two stumbling blocks to financial liberalization,
with differing outcomes. The first stumbling block is switching
from a regime that limits bankruptcy to one that permits
it; such a shift can involve high costs in terms of lost
output, and therefore it is likely to lead policymakers
to put it off as long as possible. It appears, however,
that South Korea has moved more aggressively since 1998
than Japan to liberalize and resolve nonperforming loan
problems. The second stumbling block is a failure to achieve
price stability through the conduct of monetary policy.
Here again, South Korea appears to have performed better
and, as a result, has exhibited better macroeconomic performance
(Cargill and Patrick 2005 review a number of economic and
noneconomic factors that account for the difference in
macroeconomic performance). Better macroeconomic performance
makes it easier to shift toward a system that permits greater
bankruptcy and resolves nonperforming loans. Though the
Bank of Korea (BoK) operates with less formal independence
than the Bank of Japan (BoJ), the BoK's inflation-targeting
regime appears to have contributed to better price stability
and, hence, to better macroeconomic performance.
The role of bankruptcy
The role of bankruptcy, which obviously
reflects a country's attitudes, cultural values, and historical
experiences,
is critically important in the process of financial liberalization.
The reason is that bankruptcy, more than any other characteristic,
reflects a country's willingness to allow market forces
to ration capital. For example, the U.S., even before it
began to move toward liberalization some 30 years ago,
had a market-directed financial regime that was designed
to evaluate credit, to monitor credit, and most importantly,
to impose bankruptcy as a penalty for the inefficient use
of credit. Specifically, the concept of "creative
destruction" (Schumpeter 1975) was at the center of
the financial system to ensure that old technology would
be replaced by new technology. Schumpeterian creative destruction
requires a well-developed and transparent financial system
able to impose bankruptcy in the context of a well-developed
legal system capable of enforcing transparent property
rights contracts.
In contrast, Korean and Japanese regimes
were founded on state-directed institutions designed to
limit bankruptcy
and avoid the perceived instability of the creative destruction
process—that is, they were designed to be "patient." These
institutions included complete government deposit guarantees,
nontransparency, limits on open money and capital markets,
and most important, the use of bank finance in the context
of close bank-firm relationships, a key characteristic
of Korean and Japanese finance. "Company groups," referred
to in Korea as chaebol and in Japan as keiretsu,
represent vertically and horizontally related companies
organized
around one or more financial institutions, usually banks.
In Korea the banks have played a passive role, while in
Japan the banks have played a leadership role. (Note that
these types of industrial organizations would not be permitted
in the U.S. legal system.)
The problem with basing economic
and financial development on limiting bankruptcy is that
it is subject to "time
inconsistency." Specifically, although limiting bankruptcy
generates rapid capital accumulation and economic growth
in the short run, in the long run the approach is unsustainable
because of the accumulated costs of letting inefficient
enterprises continue to operate.
Cargill and Parker (2002)
illustrate this point in a three-sector (agriculture, manufacturing,
and finance) development model.
The financial regime is bifurcated into a market-directed
version that permits bankruptcy and a state-directed version
that limits bankruptcy. The state-directed path results
in faster capital accumulation at first, but eventually
capital accumulation declines relative to the market-directed
path. The market-directed path destroys inefficient capital
in the initial stages of development and hence ends up
with more efficient capital in the latter stages. The state-directed
path accumulates more capital, but the capital stock is
weighted down by an increasing proportion of inefficient
capital. Much like the albatross around the mariner's neck
in Rime of the Ancient Mariner, limiting bankruptcy ultimately
slows economic growth. Moreover, the costs in terms of
lost output of shifting from a state-directed to a market-directed
path increase over time. This may help explain why financial
liberalization has been so difficult for Korea and Japan.
Korea
appears to have achieved better policy outcomes
 Korean and
Japanese finance share many common elements, especially
in regard to limiting the role of bankruptcy,
and, as such, both are subject to the same constraints
in shifting to a more market-directed regime. Despite this
commonality, however, Korea appears to have progressed
further than Japan since the Asian financial crises of
1997-1998. In response to the crises and the IMF-imposed
austerity program, Korea recapitalized its banking system,
reduced nonperforming loans, and initiated corporate governance
reforms. While not all observers believe Korea has effectively
dealt with its structural problems (e.g., Kim and Lee 2004
and World Bank 2003), compared to Japan, Korea appears
to have moved further in a shorter period of time. Only
in the last year or so has Japan been able to reduce the
large amounts of nonperforming loans and borrowers that
plagued the economy since the early 1990s, and only since
2003 has the economy showed signs of recovery. Even this
positive development is tempered by news about consumer
spending and GDP in the latter part of 2004 indicating
that recovery is still not firmly in place after almost
14 years of declining, stagnant, or low growth. The better
macroeconomic performance in Korea relative to Japan with
the exception of the crisis in 1997/98 (see Figure 1) makes
it easier to implement structural reform and may be one
among many economic and noneconomic reasons for the better
policy outcomes.
The importance of price stability
For most of the post-war
period, discussions about price stability have been cast
in terms of avoiding inflation.
But price stability means not only avoiding
inflation, but also avoiding deflation. Japan's recent experience represents
a modern example of a deflationary environment, though it is nowhere near the
scale experienced in the U.S. in the 1930s.
Economic theory suggests that, like
anticipated inflation, anticipated deflation should have
minimal real effects as long as economic contracts can
be adjusted.
This may not be correct, however. First, deflation increases the cost of servicing
fixed or quasi-fixed interest debt. Second, deflation increases the real interest
rate if the nominal rate is close to or equal to zero and thus offers an incentive
to postpone spending. Third, deflation can increase the demand for money by encouraging
the substitution of cash balances for commodities. Fourth, deflation reduces
the value of the money multiplier because banks become more averse to lending
as borrowers encounter greater difficulty servicing the existing debt. Fifth,
the longer the deflation process, the more aggressive monetary policy needs to
be to reverse the process and establish positive price expectations.
 With respect
to the fifth point, it has become common to refer to deflation
as
creating a "liquidity trap" in which monetary policy loses its ability
to stimulate demand through lowering interest rates. However, Cargill and Parker
(2004) argue that the current situation in Japan is better described as presenting
a "monetary policy discontinuity," because monetary policy is still
capable of raising inflationary expectations. The argument instead is that the
longer the deflation, the more difficult it is to reverse, because deflation
reduces aggregate demand, reduces the money multiplier, and increases the demand
for money.
Korea has avoided long periods of declining prices while
Japan experienced disinflation in the first half of the
1990s and deflation from 1994 through 2004
(see Figure
2). The increase in CPI inflation in 1997 was due to an increase in the consumption
tax from 3% to 5%.
Why the different monetary policy outcomes?
Although the
BoK and the BoJ share common structural characteristics
in terms of their formal relationships with their governments,
there are subtle and
important differences. Prior to 1998, the BoK and BoJ were considered to be
among the world's
most dependent central banks. Both were legally administered by their respective
ministries of finance. Despite the BoJ's legal dependence on the Ministry of
Finance however, it had achieved a degree of political independence understated
by any independence index. This was not the case with the BoK.
The BoK and BoJ
received enhanced legal independence in June 1997 and December
1997, respectively. The reasons ranged from a desire to bring the institutional
design of the BoK and BoJ in line with international developments to specific
political economy issues in Korea and Japan. The BoK did not achieve the same
increase in formal independence as the BoJ. Based on one well-known method
of measuring independence that attaches subjective weights to various parts
of the
enabling central bank legislation, the BoK's index increased from 0.27 to 0.33
while the BoJ's index increased from 0.17 to 0.38. By comparison, the Federal
Reserve's index was 0.69. In addition, the BoK's independence was constrained
by an inflation-target framework, while the BoJ was only required to achieve "price
stability" without an explicit definition of it.
It is debatable whether
the inflation-target framework in Korea versus the absence of a similar framework
in Japan accounts entirely for the difference
in monetary
policy outcomes; however, the advantage of a target is that it represents
an explicit anchor on which the public can base its price
expectations. It should
be noted that it was only when the BoJ came under pressure from Prime Minister
Koizumi and the Diet in 2002, with the implied threat of imposing an inflation
target, that the BoJ significantly changed operating policy, shifting to
quantitative easing and becoming more vocal about reversing
the decline in prices. The outcome
was an improvement in the economy in 2004 and a deceleration of deflation
with projections of positive price movements in 2005.
Thomas
F. Cargill,
Visiting Scholar
Professor of Economics, University of Nevada, Reno
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