Growing risks of liquidity trap

By Kim Jae-kyoung

The Bank of Korea (BOK) has lowered its key interest rate to a record low of 2 percent, which is equivalent to the level when the global financial crisis shook the Korean economy in 2008.

The central bank wants to reinvigorate the economy through the rate reduction. At the same time, it aims to prevent the Korean won from becoming a lone currency that remains strong against the U.S. dollar in the midst of a global currency war.

The move indicates that BOK Governor Lee Ju-yeol and other monetary policy committee members might have focused more on the positive side of rate cuts.

The decision seems reasonable in that it can give new vigor to the economy in the short-term. It can boost asset markets, such as real estate and equity, which can, in turn, reduce household debt and bolster domestic demand.

However, a series of rate cuts by the BOK in August and October are considered a very risky bet.

Some critics argue that aggressive credit-easing campaign will only increase consumer debt without achieving its intended goal of stimulating the economy. In the worst case, households’ income will drop, leading to a fall in earnings of financial firms and an expanding asset bubble.

What is more worrisome is that our key interest rate could fall below the U.S. policy rate as the Fed is expected to hike interest rates in the coming quarters. It is set to complete its financial tapering in line with a rebound of the world's largest economy.

If the United States raises interest rates amid the weakening yen, it is highly probable that foreign capital will leave us for the U.S. market. Given that we are a small, open economy, a little change in interest rate differential can trigger sudden capital outflow and shake the entire economy.

Because of a mixture of a prolonged slump and rate cuts, there are growing concerns that the economy is exposed to the risk of falling into a “liquidity trap” in which the liquidity created by lower rates does not stimulate the economy.

In this situation, consumers and firms start to hoard money rather than spend it, making a downturn even more severe.

In fact, the August rate cut aimed at supplying more liquidity to the market has had only a limited impact on the economy.

According to the BOK, the velocity of money, or how fast money changes hands in the economy, stood at 0.74 in the second quarter, down 0.22 from 0.96 in the second quarter of 2004.

The velocity of money is the figure defined by dividing the nominal gross domestic product (GDP) by M2, a narrow measure of money supply. A fall in the figure, thus, indicates that credit-easing policy does not contribute to the economic growth.

Given that M2 rose sharply in August, the velocity of money is estimated to have continued its downward trend in the third quarter. In August, M2 grew 7.6 percent year-on-year, the fastest pace in four years.

BOK governor Lee downplayed concerns over a liquidity trap, claiming that the rate reduction had made its way through the economy. He said that rate cuts will eventually improve consumption and investment.

However, in a recent report, the International Monetary Fund (IMF) warned of the risks of the low interest rate policies of the U.S., Japan and eurozone. Although our rates are not as low as those of advanced economies, it is worthy paying attention to such warnings.

“Accommodative policies aimed at supporting the recovery and promoting economic risk taking have facilitated greater financial risk taking,” the IMF said..

Of course, the government and BOK should join forces to employ all possible options to revive the economy. However, they should not ignore the negative effect of short-term pump-priming measures just to jumpstart the economy.

They must take a lesson from Japan that had to go through a long, dark tunnel of a “liquidity trap” as a result of reckless low rate policies.

The writer is a business columnist for The Korea Times. He is a former business editor. He can be reached at jayrain@naver.com or jayrain.kim@gmail.com