I don’t read the newspapers much anymore. But the other day it seemed to me that if I wanted to participate in the lunch-table conversation at my office, I would have to learn something about Korea. So I clipped all the articles about Korea in the three daily newspapers that had accumulated in my apartment over 10 days, and I read them.
I was greatly impressed by the volume of the reporting, the diligence of the reporters, the number of new facts recounted every day, and the number of experts who had been interviewed and quoted. But when I had read it all, I was left unsatisfied. I felt I didn’t know what was going on, and I thought that many readers would have the same feeling, perhaps even more so than I did. Perhaps I was expecting more than should have been expected or could have been provided. I don’t think so, but even if I’m wrong, it makes one wonder what all the reporting is for.
One can read a perfectly accurate and detailed, play-by-play description of a baseball game and still not understand what happened unless one knows the rules of baseball and something about what is ordinary and what extraordinary in any particular game. One has to have a mental model of the sport into which one places the facts of a particular game if one is to create a comprehensible story. Probably most people who read the sports pages have such a model in mind, and the sports reporter can assume that and not have to reiterate it.
But it is equally probable that few people who read the daily paper, even those who read the financial pages, have a model of the international financial system in mind. Without that, they cannot be expected to understand the connection between the bankruptcy of some Korean firms and the decline of the value of the Korean currency (the won) relative to the dollar, why the Korean population in general is suffering, why unemployment should rise, or why the trade deficit should decline. Most importantly, they will not understand the function of the external funds being provided by the International Monetary Fund and some countries, or where the whole process is heading. What would the end of the “crisis” be?
Iknow about Korea only what I read in the papers. But I would like to illustrate what I mean by the missing model by telling a Korea story within the context of a simple model of the international financial system–a model I learned at school decades ago.
We start with the proposition that in any country, the excess of domestic investment (mainly expenditure on new plants, equipment, and housing) over domestic saving (the part of the national income not spent on consumption, private or public) is equal to the inflow of capital from abroad. This excess, in turn, is equal to the excess of imports of goods and services over exports of goods and services. This excess of imports over exports is the “current-account deficit,” a term that reporters use but rarely define.
These equalities are maintained by variations of the exchange rate, interest rates, inflation rates, and real incomes. Thus, if there are insufficient domestic savings to satisfy all highly profitable investment opportunities, foreign capital will be attracted into the country. Foreign investors will want to buy the local currency, in order to invest in the country, and that will raise that currency’s exchange value. With a higher value of the local currency, exports from the country will be less competitive and the export volume will decline, creating or increasing the current-account deficit.
The government may try to keep the value of the local currency from rising by buying foreign currencies with it. To do that, the government will increase the domestic money supply (in simple parlance, it will print more money). This, in turn, will either raise real (inflation-adjusted) incomes (if domestic production increases to meet the increased buying power of citizens), or raise the price level (if more money ends up chasing the same amount of goods). Either of these effects will attract imports and discourage exports, increasing the current-account deficit. Rising real incomes enable citizens to buy more imports and more of the domestic product that would have been exported, or attract domestic resources into producing for the home market rather than for export. A rising price level will make the country’s exports less competitive.
B efore the crisis, in 1996, Korea had an extremely high rate of domestic saving–about 35 percent of total Korean income, compared with about 16 percent for the United States. But it had an even higher rate of internal investment, thanks to an inflow of foreign capital. So large was that inflow that Korea ran a current-account deficit equal to almost 5 percent of gross domestic product, higher than in any other industrialized country except Poland and the Czech Republic. As noted above, this deficit was made possible by a high exchange rate for the won. The exchange rate would have been higher, and the deficit larger, if the government had not been buying dollars with won, and in the process accumulating a reserve of dollars.
Toward the end of 1997, investment in Korea suddenly became less attractive to both Korean savers and foreigners. A number of Korean businesses went bankrupt, either because of dishonest practices or because the possible Korean share of world markets for some products, like automobiles, had been overestimated. Foreigners wanted not only to stop investing in Korea but also to get their money out. The effort to convert won into dollars and other foreign currencies depressed the value of the won, despite the Korean government’s efforts to sustain it by using its reserves. The decline in the won caused further bankruptcies. Companies that could pay their foreign debts when a dollar cost 900 won could not pay when a dollar cost 1,400 won.
The decline in the won, by making imports more expensive and exports more competitive, would help bring about the decline in the current-account deficit, or the generation of a surplus. So, one could visualize a postcrisis situation in which total output was unaffected; investment was smaller; the capital inflow was smaller or negative; and the won would reach an equilibrium level, lower than it had been before the crisis.
But the transition to that situation would be painful. The decline in the won would not immediately raise exports or limit imports. The cut in output and employment in the investment sector would not be immediately offset by a rise in output and employment in industries that produce for export or that compete with imports. The decline of the Korean economy would cause more bankruptcies, increase investors’ efforts to get out of won assets into other currencies, and force the won down further. So there could be a cumulative, speculative process in which the won fell far below what might be its long-term equilibrium value and the Korean economy was depressed far beyond what its postcrisis situation would be.
T he purpose of assistance by the IMF and foreign governments is to cushion that transition and help Korea get to its postcrisis condition. The objective is to keep the won from falling much more than is necessary for the long-run adjustment of the Korean economy, and thereby to prevent unnecessary bankruptcies and unnecessary depression of Korean income and employment. The goal is not to bail out failing Korean enterprises but to keep enterprises from failing only because of a panicky flight from the won and the fall in its value. The assumption is that private investors who buy and sell won are depressing its value below its equilibrium rate. That assumption may or may not be correct.
This may not be the only possible story of the Korean economy. But it is a story that fits into standard economic analysis, is coherent and understandable, and reveals the interaction among the forces at work–the kind of story I miss when I read the daily reports.