[Expert Diagnosis] How to Escape a Recession Caused by Easy Money

What I Ask of the Choo Kyung-ho Team I

Major countries are now raising interest rates sharply over a short period of time. They are doing so to rein in surging prices. In the United States, the year-on-year consumer price inflation rate was 9.1% in June, 8.5% in July, and 8.3% in August. The trend appears to be moderating somewhat, but it remains extremely high. Korea as well saw rates of 5.7% in June, 6.3% in July, and 5.7% in August. The upward trend appears to have eased somewhat, but it too remains very high.

The current stagflation is a phenomenon caused by the severe distortion of the economic structure as a result of the enormous amounts of money released globally around the time of the 2008 financial crisis in the United States, and then again on a massive scale in response to the COVID-19 outbreak in 2019.

The United States began releasing money from 2000 in order to raise the homeownership rate, and this led to the 2008 financial crisis. Afterwards, to overcome the recession, it again released massive amounts of money through quantitative easing. Other major countries, which could not help but be affected by the U.S. economy, which accounts for about 25% of the world economy, did the same.

Korea was no exception. Thus, the current stagflation is a recessionary phase brought about by monetary expansion. It is true that the supply disruptions caused by the Russia-Ukraine war and the conflict between the United States and China have played an additional role, but they are not the fundamental cause.

To raise interest rates, stop monetary expansion, and withdraw excess money in order to tame inflation is an appropriate course of action. What is ridiculous, however, is that central banks, together with financial institutions, now step forward again as the agents of resolution—talking about “big steps” or “giant steps”—in order to clean up the stagflation they themselves caused.

Central banks will continue to alternate between monetary loosening and tightening, like the fool in the shower who abruptly turns the hot and cold water on and off. This is because mainstream economics, on which central banks mainly rely, lacks an interest rate theory and the theory of the structure of production built upon it.

Let us look at the process by which money printing wrecks the economy by dividing it into the cases of the financial crisis and COVID-19. In the case of the financial crisis, when money released through a prolonged low-interest-rate policy is loaned through financial institutions to entrepreneurs, they mistakenly believe that people have reduced present consumption and increased savings for future consumption, and they increase investment in the capital goods industries in preparation for greater future consumption.

This is because the lower interest rate makes possible investments that were previously not feasible. The problem is that this increased investment is not supported by savings backed by production left over after consumption, but is instead malinvestment made with newly released money.

For example, with materials and equipment such as steel secured through genuine savings, only a 20-story building can be constructed. But entrepreneurs holding newly released money mistakenly act as though the materials and equipment needed for a 50-story building have been secured and begin construction.

But since people only wanted a 20-story building and saved only enough materials and equipment for that, the 50-story building cannot be completed and, moreover, is not what people want. That is why it is malinvestment.

As malinvestment increases, the capital goods industries immediately become lively, and because the invested money returns to consumers as workers’ wages and landowners’ rents, consumption also rises, bringing the economy into a boom phase.

The Harmful Effects of Quantitative Easing on the Economy

As such, during a boom, investment and consumption increase simultaneously, and this is entirely because newly released money is fueling the fire.

Later, when the central bank, worried about inflation, stops monetary expansion and raises interest rates, the 50-story building project—revealed to be malinvestment—is halted. As a result, consumers’ incomes also decline, and the bubble created during the boom bursts.

In short, the financial crisis is the very phenomenon of the economy melting down because a prolonged low-interest-rate policy creates a mismatch between the consumption structure people want (a 20-story building) and the production structure producers undertake (a 50-story building).

That is what happened in the Great Depression of 1929, in Japan in 1991, and in the financial crisis that occurred in the United States in 2008. In the case of COVID-19, by contrast, when money released through a prolonged low-interest-rate policy flows to consumers, factors of production move into the consumer goods industries and investment in the capital goods industries declines. As a result, the multilayered structure of production based on the division of labor is simplified, and output decreases.

In other words, the capital goods industries are damaged, and the quantity of consumer goods produced in a given period declines. Recall that capital goods embody stored time that makes it possible to produce many consumer goods in a short period.

Accordingly, in this case, the structure of production is damaged in such a way that it can no longer meet the increased consumer demand brought about by the expansion of consumer credit. In other words, building a 20-story building may take much longer than before—or it may not be built at all.

Taken together, the current stagflation is a recessionary phenomenon caused by the destruction of the structure of production that can produce the consumer goods people want at the time they want them, due to the enormous amount of money released under a prolonged low-interest-rate policy. That is why a recession begins in the damaged capital goods industries.

Money has been released and the structure of production has been damaged, so output falls and prices rise. Of course, the degree of stagflation resulting from monetary expansion can be affected by other variables such as technological progress, so its presence cannot be judged solely on the basis of economic indicators.

Recession is often regarded as an evil that must be overcome, but it performs a beneficial function. A recession is a signal that the economy cannot operate in its current damaged state and must be repaired through market adjustment; it is a period during which the economy recovers so that the consumption structure and the production structure mesh once again like gears.

It is a period in which malinvestment is liquidated and capital that was spent under the illusion of having become wealthier because of monetary expansion is restored. The pain of falling income and rising unemployment during this period is unavoidable.

The beginning of clearing away the monetary garbage(?) that has piled up in the economy under a low-interest-rate policy is to raise interest rates, stop monetary expansion, and withdraw the excess money. To obtain the full effect, the process of market adjustment that takes place during the recession must not be obstructed by other government policies as the structure of production is repaired and the economy returns to a normal track.

Policies that release even more money, policies that expand lending to firms that lack the ability to survive on their own, policies that prop up falling wages and prices, policies that talk about “smart consumption” while encouraging higher consumption and lower savings, policies that raise taxes and expand fiscal spending, and various subsidy programs all obstruct market adjustment.

What must be emphasized is that any policy by which the government greatly increases the money supply in the name of promoting economic growth or stability will inevitably bring about a recession, and that the way out of recession is not to obstruct the market adjustment that takes place during this period.

Youngyong Kim

Professor Emeritus of Economics, Chonnam National University

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Original title: [전문가 진단] 돈 풀어 생긴 불황에서 벗어나려면

Author: Young-yong Kim

Date: 2022-09-29

Source: https://www.cfe.org/bbs/bbsDetail.php?cid=press&idx=24987