Korea turned from saver to debtor

By Matthew Smith

The first thing I noticed when I returned to Korea in 2009 after an eight-year hiatus was how prevalent credit cards have become. Korea was not the country I had left.

Koreans used to save prodigiously. When I first arrived in 1995, the personal net savings rate was 17.5 percent. This investment gave Korean banks a real money supply from which to lend to entrepreneurs, fueling economic growth.

It was a simple process. Korean consumers saved. The banks loaned the savings to firms. Firms spent those loans to produce capital and consumer goods. The capital goods were used to lengthen the production process, thus creating more and better jobs. The consumer goods raised the standard of living. Firms repaid their loans; the banks in turn paid interest to the savers. The savers then used that earned interest, not their principal, to buy consumer goods. They could also reinvest their earned interest, continuing the real growth of wealth in this country. Yet, by 2005, personal net savings was only 4.7 percent.

Now instead of spending from savings, Koreans are spending with debt. In 1998, credit card use totaled approximately 700 billion won. In 2008, credit card purchases reached nearly 4.5 trillion won, and the household debt-to-savings ratio reached nearly 123 percent. That is, despite wealthy appearances, there are many households in Korea with a negative net worth.

This growth in indebtedness is due to artificially low interest rates. Low interest rates create a disincentive to save and create an incentive to engage in debt-financed spending.

There is nothing wrong with low interest rates if the market has determined the low rate. A market determines an interest rate based on the relationship between the supply of money (deposits) and the demand for money (loans). In a fundamentally sound economy, lending and growth comes from savings and investment. In an unsound economy, it comes from the central bank manipulating the interest rates.

Central banks create artificially low interest rates. Artificially low interest rates create a boom. During boom periods savers and investors engage in mal-investment ― that is, they invest in bad ideas that never would have been considered under fundamentally sound economic conditions. They do so to get a rate of return that they could have gotten from more traditional investment vehicles had the interest rates not been artificially low. At some point, the lenders realize that they are financing fundamentally unsound projects, and that by over-extending loans they have become fundamentally unsound themselves. They then seek to recall outstanding loans to get themselves back on a firmer footing. If their borrowers can make repayments, this is not a problem. The problem is that over-leveraged borrowers can rarely repay the loans and the lenders find themselves in deep trouble.

Currently the central bank is using all of its force to keep interest rates low. The natural market forces need interest rates to rise. The dam will burst, and when it does, those Koreans with excessive credit card debt and with floating-rate mortgages may drown in debt. The 1997-98 currency crisis will seem like a sunny day by comparison.

Douglas Kim has written what may be the most important book of the year, ``The Vortex of the Korean Financial Crisis." While I do not agree with his faith in Keynesian economics and central banks, his advice to his fellow Koreans is 100 percent sound: pay off your credit cards and refinance your house into a long-term fixed mortgage now, or else you may go bankrupt when the necessary rise in interest rates push your payments beyond your earnings.

Matthew Smith is a teacher and graduate student of Applied Economics. He can be reached at mattvsmith@yahoo.com.