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Getting normal

It is dangerous to keep driving over the speed limit when road conditions change.
Nov 24,2017
Investors must always be wary of bubbles forming in assets like stocks and properties. They can get wiped out when the bubbles burst.

“There is nothing so disturbing to one’s well-being and judgment as to see a friend get rich,” said Charles Kindleberger, an economist who was devoted to studying asset bubbles. When you see others make easy money, one is tempted to take out loans in order to invest. But bubbles always burst.

In the early 18th century, France set up an entity called the Mississippi Company with a monopoly on trade and the mineral wealth of French colonies in North America and the West Indies. Because its shares were widely circulated, their value soared over 3,000 percent in just a year. The word “millionaire” was born at the time to refer to overnight riches. After the speculative fever cooled off, the stock price nosedived. That bubble is still recorded as one of the three biggest economic bubbles in European modern history. In more recent years, the global economy suffered from three U.S.-triggered bubbles in the stock market in 1987, technology stocks in 2000, and housing in 2008.

But it is not easy to discern real value in inflated prices — or exactly when the tide will turn. Alan Greenspan, who served as chairman of the U.S. Federal Reserve for 18 years, said that you know when the bubbles burst only after they do. But if bubbles are left unattended until they pop, the financial system could be wrecked and the economy hit with a crisis.

There have been warnings about overheating in global financial markets from years of cheap and fulsome liquidity. Yale University professor and Nobel economics laureate Robert Schiller pointed to the cyclically adjusted price-earnings (CAPE) ratio of U.S. stocks, which has been rising at a pace as dangerous as in the 2000 dotcom bubble. Chinese central bank governor Zhou Xiaochuan recently warned of increasing risks of a Chinese financial crisis from a so-called “Minsky moment” — a crash in prices due to rapid rises of private-sector debt.

In many countries, prices of stocks and real estate rose faster than long-term average levels, raising concerns about bubbles building up. In Korea, stock prices have rallied by double digits and home prices shot up despite a series of regulations meant to cool the real estate market. Total household debt now hovers above 1,400 trillion won ($1.3 trillion), weighing heavily on the Korean economy.

Stock prices have gained sharply because of an accelerated recovery in the global economy and a brighter outlook for corporate earnings. Benignly low interest rates fuelled the bullishness. Cheap loans allow debt-financed investment and lead to an appreciation of the value of the assets when calculated at current rates. Speculative sentiment fans investment in riskier assets.

To combat the 2007-2008 global financial crisis, central banks around the world pushed down their short-term interest rates to the near-zero range, and when that didn’t do the trick, they resorted to the unconventional measure called quantitative easing by purchasing bonds to pump up liquidity. Since the 2008 crisis, the base interest rate in Korea went down from 5.25 percent to 1.25 percent in June last year and has stayed at that record low.

Central banks in the United States, Canada and the U.K. have begun winding up their quantitative easing and lifting interest rates to respond to recoveries in their economies and cooling in overheated capital markets. The normalization of monetary policies is likely to be incremental, as wage gains have been stagnant due to structural changes in the labor market and inflation has been suppressed by things like lower oil prices.

The Bank of Korea has also indicated a lift-off coming soon in interest rates. BOK Governor Lee Ju-yeol said in October that economic conditions have become ripe for moderation of its loose monetary policy. Raising interest rates in line with economic recovery and global policy trends can help stabilize the financial and currency markets. Although there isn’t much inflationary pressure from the demand end, the bank cannot keep the base rate at a record low further in fear of a building up of bubbles in asset prices and distortion in capital distribution which could end up hurting the financial system and economy.

The International Monetary Fund said that Korea’s monetary policy would be deemed “relaxed” even after two benchmark rate hikes this and next year. Raising interest rates is not like stepping on the brakes. Rather, it is more like a move to moderate the pace. It is dangerous to keep driving over the speed limit when road conditions change.

The BOK has warned of a shift in monetary policy since the summer and is expected to lift the policy rate at a Nov. 30 meeting. We need to see “normalizing” in action, not just words.

Translation by the Korea JoongAng Daily staff.

JoongAng Ilbo, Nov. 23, Page 31

*The author, a former chief economist at the Asian Development Bank, is a professor of economics at Korea University.

Lee Jong-wha