Suh Kyoung-ho
The author is a columnist for JoongAng Ilbo.

Central banks in the United States, Europe, South Korea and elsewhere are raising interest rates to contain runaway inflation. The US Federal Reserve last month raised the base rate by 75 basis points, the biggest hike in 28 years. Late last month, the Bank for International Settlements (BIS), dubbed the central bank of central banks, released an annual economic report advising central banks to act “swiftly and decisively” to prevent the entrenchment of inflation and stagflation. He stressed that the priority should be to fight inflation, even if these measures lead to short-term suffering and economic slowdown. In its latest report in 2021, the BIS warned of “a bumpy pandexit”. The exit from a pandemic of unprecedented duration has done a lot of damage.

I spoke to Shin Hyun-song, economic adviser and head of research at the BIS to find out the details of the report. The interview was conducted through video chat and emails.

Q. In this year’s annual report, the BIS highlighted the danger of entrenched inflation as employers and workers react differently to inflation. In Korea, wage increases have been strong at large corporations and big tech companies.
A. Wages and prices can flatten each other as part of the mechanism of worsening inflation. When the economy enters a phase of high inflation, the wage-price spiral begins. In this case, the cost of reducing inflation can be high. Central banks must first prevent inflation from rising from low to high levels. Since the transition is happening rapidly, prompt and decisive action by central banks is important.

Yet the BIS did not forecast 1970s-style stagflation, saying the environment was more “benign” than in the aftermath of the 1970s oil shocks.
The international financial system was destabilized during the 1973 oil crisis shortly after the fall of the Bretton Woods system. Today, each country’s monetary policy systems and the global financial order are strong enough to fend off stagflation 1970s-style – and each country has more policy space. Soaring oil prices have also been less threatening than in the 1970s. Energy efficiency in the global economic structure has also improved. Energy consumption in relation to GDP has been reduced by around 40% compared to 1973. Dependence on oil has been reduced significantly thanks to renewable energy prices, which have fallen faster than expected.

That doesn’t mean everything is safe, does it?
Of course not. High volatility in commodity prices can stifle growth in the global economy and fuel inflation. The path to a soft landing is narrowing. As the BIS mentioned in the report, central banks need to get inflation under control quickly before household and corporate decisions affect inflation. In short, we cannot exclude the possibility of a prolonged stagflation like in the 1970s, but this probability is slim.

Shin Hyun-song, a former professor of economics at Princeton University and current economic adviser and research director at the Bank for International Settlements (BIS), delivers a speech in Basel, Switzerland. [BIS]

Developed economies have rolled back or normalized their loose fiscal policies during the pandemic. South Korea has handed out billions of dollars to the self-employed through supplementary budgets. Will this help curb inflation?

I cannot comment on any specific country based on BRI rules. Generally speaking, a government needs to establish a medium-term roadmap to rebuild fiscal ammunition after its large-scale spending to fight an economic crisis or recession. To normalize fiscal and monetary policy, growth-enhancing investments and supply-side restructuring can help. Such measures can increase growth potential and reduce reliance on macroeconomic policy.

Growth-enhancing investments and supply-side restructuring were also highlighted in South Korea.

Growth-friendly spending such as business investment and supply-side restructuring policies can raise economic growth rates and put fiscal and monetary policy on a normal long-term path. When a means of budgetary expenditure is restricted, the growth-inducing tax code can be a useful tool. Building human capital through education and a sustainable energy mix can also be good policy examples for supply-side restructuring.

But developed and developing economies can differ when it comes to budget integrity.

Maintaining fiscal integrity is important for all countries, but it becomes a critical issue for countries tempted to leverage central bank authority in money printing to reduce public debt. Historically, countries whose central banks bought government debt by printing money have suffered currency crashes. Latin American countries faced default in the 1980s. These are cases where central banks failed in their duty to defend the value of their currency.

Explain in more detail.

It is wrong to claim that fiscal and monetary policies are separate. When the economy is working well, this doctrine can hold. But when a country’s public finances are managed recklessly – and budget deficits are covered by central bank printing of money – fiscal and monetary policies become one. Due to the adverse interaction of the two, the value of a currency can be altered by changes in inflation and exchange rates. Therefore, fiscal integrity is crucial for price stability, and the central bank should pay more attention to it.

Household debt is a big concern for South Korea. It reached 1,859 trillion won ($1.41 trillion) in March, which is 104.3% of GDP.

Again, I will speak in general terms. Developed economies have grappled with household debt problems since the global financial crisis, but debt has continued to rise in countries that were less affected by the financial crisis. To stimulate the economy, future spending was brought forward. The policy has less impact when the debt has already increased. Countries with a high ratio of floating rate mortgages would be vulnerable to interest rate hikes. There is also a generational gap in household debt. While the older generation may benefit from rising house prices, the younger generation will have to take on more debt to buy a home. Such a generational conflict can cause not only economic problems but also social problems.

Do you agree with the argument that foreign exchange reserves have become less important than in the past due to the increase in offshore assets held by the private sector?

We must not only look at the current account, but at the overall portfolio of foreign assets. If institutions invest heavily in foreign-currency-denominated bonds, such hedging demand for short-term debt will be created. There should be no mismatch between short and long-term assets in capital markets. This kind of mismatch caused a default crisis for South Korea. To avoid disruptions due to mismatches in debt maturities, foreign exchange reserves need to provide a strong backstop.

What do you think of the simultaneous collapse of prices of financial assets – stocks, bonds and digital coins?

The synchronized fall in stock and bond prices was unusual, given the decoupling trend since 2000. This was caused by inflation, which has become a critical macroeconomic hazard. The bond market is sensitive to inflation and rate hikes by the central bank. The strength of the US dollar also added to the liquidity crunch in international capital markets. A BIS study found that a strong US dollar tends to invite a tightening environment in international markets. Crypto investors are facing a triple whammy following the crashes in stocks, bonds and digital assets. The downward spiral of stocks and bonds can only be stopped when inflation is contained.

If the freefall of digital coins deepens, will it not turn into a risk for the financial system of chain bankruptcies of institutions that have invested in digital coins?

From today’s perspective, the collapse of cryptocurrencies is unlikely to cause a subprime mortgage crisis like the global financial meltdown of 2008. But when decentralized finance (DeFi) becomes mainstream, its fragility could one day undermine the stability of the financial system.