The Korea Times Articles - 2012+
Tale of Prichard pension program
January 20, 2013
By Chang Se-moon
On December 22, 2010, the New York Times reported that “Prichard did something that pension experts say they have never seen before: it stopped sending monthly pension checks to its 150 retired workers.” The Prichard pension dilemma has also been reported in the Huffington Post on December 23, 2010, and by the Canadian Broadcasting Company on January 26, 2011. Prichard is located in Alabama with the population of about 28,000 of which 85 percent are African-Americans. Thirty-five percent of Prichard residents live below the poverty level as defined by the U.S. government.
The pension plan for retirees of the City of Prichard was established in 1956. The 1956 pension plan was amended by the Legislature more than 15 times. Importantly, a 1963 amendment required the City to pay the losses, if the pension board makes mistakes in granting pension benefits, or if the bank invests unwisely, or if the stock market collapses.
In 1975, control of the pension plan was taken away by the state legislature from the City and given to the new Pension Board to oversee retirement benefits. The Mayor of Prichard has no control over selection of the members of the Pension Board. In 1983, pension payments increased by 50 percent with no increase in contributions. In 1991, employees with 25 or more years were allowed to receive pensions at age 55, lowered from 60. No one knows when, but the Pension Board began adding the accumulated unused sick, vacation and compensatory hours (times the current rate of pay) to the pension calculation, effectively increasing pension benefits by 26 percent, with no offsetting contribution or revenues to pay for it.
The burden of pension payments led Prichard to file for bankruptcy on Oct. 5, 1999. Only two years after the city paid off its creditors from the 1999 bankruptcy, the City of Prichard again filed for bankruptcy on Oct. 27, 2009 in an attempt to cope with the debt in pension funds. The City, not the Pension Board, filed these bankruptcies because the Prichard pension program made the City responsible for any shortfalls in pension funds. The City was not able to bail out its pension debt because it was barely meeting daily financial obligations. Pension payments to all retirees stopped in September 2009 when the great recession hit and the entire balance of the pension fund decreased to $26,908, from the high $8,279,710 in 2001.
On Aug. 31, 2010, U.S. Bankruptcy Judge William Shulman dismissed Prichard's bankruptcy case, stating that the City was not eligible for Chapter 9 under Alabama law. On May 19, 2011, the Prichard City Council approved an agreement that would allow partial payment of pensions. On May 25, 2011, Mobile County Circuit Court Judge Michael Youngpeter approved the May 19 agreement. U.S. District Court Judge
Kristi Dubose in Mobile asked the Alabama Supreme Court during the week of May 15, 2011 to determine whether Prichard has the right under state law to seek Chapter 9 bankruptcy protection over pension funds. The May 19 agreement led to the resumption of a partial payment in June 2011.
The June 10, 2011, 8 p.m. Hannity Show on Fox News commented that the Prichard pension problem was the fault of “politicians.” Reality is not that simple. Real causes of the Prichard pension problems are many and include, but are not limited to, state constitution that does not allow home rule, past members of the pension board who pushed for increased pay without an increase in contributions, state legislatures that allowed changes in calculation methods that led to higher pension benefits, and the predominantly poor African-American composition of the City’s race mix that led to a benign neglect by leaders at all levels of the government. Life would have been simpler if the pension system were a defined contribution, not defined benefit, in its very beginning.
The case would be quite a big lesson for Korea whose national pension system is also feared to face balance problems in decades to come.
Open letter to President-elect Park Geun-hye
December 23, 2012
By Chang Se-moon
While so many pressing issues are swarming toward you as president, your time will fly by. You need to set aside time for yourself, so that you can think through all the important facts and make decisions. Please make decisions that will make Korea grow stronger and many years from now, not make you popular today. Do not pay attention to critics. Some people will always criticize you, no matter what you do.
In economic affairs, please remember that the key driving force of the Korean economy has been, and will continue to be, exports. I remember the days when Hyundai and Kia cars were a joke among the American public. Those brands are now the envy of the world. I remember the days when a billboard advertising Samsung products was a mere attraction. These days, Samsung is the envy of the world, even attracting lawsuits from Apple. Please consider that all Koreans lose if Korea’s export industry suffers. Clearly, the tax system, labor-management, and multinational free trade issues rank high in influencing the future course of Korea’s export industry.
North Korean issues will continue to threaten Korea in many different ways. Belligerent behavior by North Korean leaders will recur like clockwork. This is where your policy can really make a difference for the long-term benefits of Korea. There are three developments that will determine the future relationship between the two Koreas. First of all, because of spreading wireless technology, it is only a matter of time before serious unrest begins to surface in North Korea. We do not know when, but it will come. Secondly, because of the dominant trade relations between China and South Korea, especially in the area of intra-industry trade, North Korea will become increasingly dispensable to China. Chinese officials have expressed an opinion that China may not continue to support North Korea unless the Stalinist state reforms its economic system which relies heavily on exports of depleting raw materials. Finally, economic sanctions will have no impact on North Korean leaders. What then should you do as president?
Needless to say, the military alliance with the United States and other Asian nations against North Korea has to be strengthened. Underlying policy toward North Korea, however, has to be to educate the general public there. You should expand economic and cultural exchanges even when North Korea behaves badly. You should establish a meaningful unification fund because when the time for unification comes, it will be fast beyond the control of any future president. You should also call a special meeting of military leaders and the brains of Korea’s world-class businesses to have an open discussion on how Korea should develop a cutting-edge defense industry to counter the missile build-up in North Korea. You will be surprised at the creative ideas of those brains.
Finally, to create jobs and raise the income of all Koreans, the only realistic thing you can do as president is to promote an environment in which businesses can compete and grow. Jobs should be created by the private sector, not by the government. In many instances, good intentions of policymakers have led to opposite results. For example, when the U.S. Congress passed a law expanding benefits to mentally ill schoolchildren, more parents wanted their children classified as mentally ill.
Before closing, I have a confession or two to make. One is that there is one group of Koreans I truly admire. They are middle-aged females working on micro-businesses. I do not know what you can do but I sure hope you can do something for these hard-working women. The other is the surviving “comfort women” who are still protesting in front of the Japanese Embassy. Next time I visit Seoul, I am determined to buy lunch for every one of them.
Dynamics of economic impact studies
November 25, 2012
By Chang Se-moon
Let us assume that the city of Cheonan, my hometown, pursues its bid to host a Summer Olympics or an Asian Games. There is no way it can pay for the expensive event. To ask South Chungcheong Province or the Korean government for financial assistance, Cheonan may want to prepare a statement to show that the events will have a significant impact on the economy of South Chungcheong Province and Korea as a whole.
Turning to the United States, many companies, large or small, prepare impact studies, especially when they want incentives for its relocation or expansion. If the calculated positive impact is large, the assistance in say, preparing an access road or a water-sewer line, that they ask could also be large. When Hyundai opened a plant in Alabama, the media widely reported the large economic impact it would have on the state’s economy. Alabama provided a incentives package that totaled nearly $250 million.
Private businesses are not the only ones interested in preparing impact studies. Non-profit organizations are also interested in impact studies that they can present to funding agencies for continued or increasing support. Economic impacts included in these studies usually include the effect on new jobs, wages, retail expenditure and tax revenue.
One important question relates to who can prepare economic impact studies? In the U.S., there are three reliable places that can prepare accurate, not exaggerated, impact studies. They are IMPLAN, REMI, and RIMS II that are all based on regional input-output models. IMPLAN and REMI are private companies that have many customers. RIMS II multipliers are prepared by the U.S. Bureau of Economic Analysis, and impact studies based on them are usually prepared by consulting economists and AUBER research centers that are familiar with such estimations. AUBER stands for the Association for University Business and Economic Research.
All impact studies employ what is known as a multiplier. Multiplier effects arise when initial expenditures are re-spent on such items as groceries by those who are paid during initial expenditure. The process of re-spending generates multiplier effects until finally the initial dollars leak out of the study area. The reason why I listed the three is that there are many people who prepare impact studies for money. Many of these studies, however, tend to overestimate the real impact to make their clients happy. In the long run, corporations and other organizations interested in having impact studies prepared may want to consider working with one of the three that I recommended. Let me give you examples of how impacts can easily be over-estimated.
One assumption underlying impact estimation is that there are no constraints in local supplies of input. If everyone is already employed in the impact area, for instance, there will be no employment multiplier effect. Another assumption is that new expenditure by one firm does not lower expenditure at another firm in the study area. For instance, if a new Wal-Mart or an H-Mart leads to the closing of smaller firms in the area, the impact of their opening needs to be reduced proportionately.
Another assumption underlying multipliers is that the event or project is permanent such as a new Hyundai or Samsung plant, not a short-term event such as a sporting event or a festival. This is because the length of time that it takes for the economy to settle at its new equilibrium after an initial change in economic activity is unknown. If the initial event or project is a one-time event, firms in the local area may increase output without hiring as many additional employees as the multiplier suggests. Although impact studies utilizing multipliers can be a powerful tool in business decisions, they can just as easily be abused.
2016 Barack Obama's America
October 7, 2012
By Chang Se-moon
I admit that I went to see the movie called “2016: Obama’s America.” It is an anti-Obama documentary based on a book by Dinesh D’Souza and directed by Gerald Molen, who won an Academy Award for co-producing Schindler’s List. I was thinking that those, except me, who had seen the movie were Romney supporters, while Obama supporters would simply ignore the movie. Therein lies the problem of American politics.
Traditionally, I believe that 40 percent of American voters will always vote for the Democratic candidate, while the other 40 percent will always vote for the Republican.
When I say always, I really mean always, no matter what. In this year’s presidential election, the percentage appears to have increased to 45 percent each. Only about 10 percent of voters appear to be objective enough to evaluate the two candidates on their merits before they vote. Does it matter? Yes, it does.
Many years back, I was chatting with one of my graduate school friends about how to recruit faculty to our departments. This is what my friend told me.
Democracy is not necessarily a good system because if the majority of existing faculty members of a department were incompetent, they would recruit a faculty who will not make them look any worse.
No one knows exactly what percentage of the American public receive government assistance such as medicare, medicaid, social security, student loans, housing subsidy, unemployment insurance, loan guarantees, price subsidies, investment incentives, and more.
The percentage is likely to hover around 50 percent, if not more. Just like the incompetent faculty, there is a good possibility that about half of the American voters will vote for the presidential candidate who promises to secure, if not increase, government assistance that they receive, even if the government has to borrow every penny of it.
Many Americans, including voters and political leaders, act as if they have never heard Milton Friedman’s famous words: There is no such thing as free lunch. They never understand that somebody has to pay one way or another. Let me give you an example.
On February 16, this year, Sandra Kay Fluke, a Georgetown Law School graduate and women’s rights activist, testified at the U.S. House Oversight and Government Reform Committee on the importance of requiring insurance plans to cover birth control pills, including those at Catholic churches and universities that are against birth control: “Without insurance coverage, contraception, as you know, can cost a
woman over $3,000 during law school. For a lot of students who, like me, are on public interest scholarships, that’s practically an entire summer’s salary. Forty percent of the female students at Georgetown Law reported to us that they struggle financially as a result of this policy.”
She did not mention who would pay for the pills, as if these pills would be made available free of costs to anyone including religious people who are opposed to the use of contraceptives as well as gays and lesbians who may not need the pills.
I do not necessarily agree with the underlying theme made in movie 2016, because both Obama and Romney will have to make adjustments once they are elected.
However, the global trend toward greater entitlement will eventually have to be paid for as it is now in Greece, Italy, Spain, and beyond. At least in the United States, the rich are just as guilty as the poor in expanding the entitlement mentality.
The poor like Sandra Flukes want more of something so long as it is paid for by everyone except themselves, while the rich like General Motors and Solyndra want a huge amount of something so long as it can be justified under the deceptive banners of saving jobs or developing a clean industry.
Is outsourcing so bad?
August 19, 2012
By Chang Se-moon
One presidential candidate in the United States has repeatedly attacked the other candidate for outsourcing jobs when he worked in the private sector. Remember that the same criticism can also be directed to Korea’s booming multi-national corporations that have operations outside Korea. Let us take a close look at the issue to determine whether outsourcing is really as bad as politicians claim it to be. Let me tell you a story, first.
It appears that there are many good doctors who can cure cancers of all types so long as they are discovered during their very early stages. The doctors are really saving lives, and thus deserve to be paid well. Assume that the cancer doctor is paid $500 per hour. Doctors are notoriously poor hand-writers, and need a typist to help them out. The cancer doctor thus hires a typist, paying him (the typist) $10 per hour. Let us make an assumption that the doctor is a better typist than the typist she (the doctor) just hired. Stated in simple terms, the doctor hires a typist, but can type better than the typist. In this story, the doctor has an absolute advantage not only in treating cancer patients, but also in taking care of typing duties. Should the doctor take care of both patients and typing duties, and not hire the typist?
Clearly, the answer is no. If the doctor takes care of typing as well as patients, the doctor will lose $500 to save $10. In this case, the doctor is said to have a comparative advantage in taking care of patients, while the typist has a comparative advantage in taking care of typing. Both benefit from specialization and trade. Keep in mind that the same explanation applies just as well if the doctor is one country and the typist is another country. This theory of comparative advantages has been the basis for promoting free trade for about 200 years.
Outsourcing may take place in many different forms. A Korean company may contract a firm in India for service calls for the company’s products. A U.S. company may open manufacturing plants in other countries through a partnership agreement. A Korean or U.S. company may hire a distributor in other countries to sell the products that the company produces. No matter what shape an outsourcing may take, it is all based on comparative advantages. Outsourcing is usually a calculating act of a company to lower costs so that it can survive the competition.
Let me give you another example that shows the importance of outsourcing. Note that any opposition to outsourcing is a two-way street. If we want our businesses to open plants and hire our people in our country, people in other countries will want to do exactly the same. In the county where I live, the number of employed persons is about 180,000 and the rate of unemployment is around 10 percent. The county is also the home of many well-known foreign companies such as ThyssenKrupp, Airbus, Degussa, Mitsubishi, Austal Shipbuilding, and more. The number of workers hired directly by these foreign companies is approximately 10,000. Through the multiplier effect, these 10,000 direct employees have created roughly another 10,000 jobs in such supporting industries as accountants, janitors, clothing stores, restaurants, and the like.
If we assume that these companies are forced to close because they feel so much pressure from short-sighted political leaders of their countries, about 20,000 of well-paying jobs out of 180,000 jobs will disappear and the rate of unemployment will increase to well over 20 percent from the current 10 percent. If these companies have to close their doors, it is highly unlikely that they will be able to open comparable plants in their own countries. Everyone loses.
If a country is prosperous, the country will have healthy domestic industries and many successful operations in other countries that easily translate into global power beyond jobs. Dr. Chang is a panelist of the CESifo World Economic Survey.
Dr. Chang is a panelist of the CESifo World Economic Survey.
July 29, 2012
By Chang Se-moon
You probably have never heard of the Hyundai Expressway. That is because I coined the name. Hyundai Motor America is located in Montgomery, Alabama, while Kia Motors America is located in West Point, Georgia. The distance between these two plants is approximately 100 miles (around 160 kilometers) along Interstate 85. If you look around carefully while you are driving along this interstate highway, you will notice almost 10 plants with names that I am sure are Korean, such as Ajin and Mando.
Combined, the total number of employees hired directly by Hyundai in Alabama, Kia in Georgia, and their supplier firms between the two is about 6,000. Including the multiplier effect, the total number of employees of the Hyundai complex along I-85 easily exceeds 10,000. This is the reason why I call the portion of I-85 between Montgomery, Alabama and West Point, Georgia, the Hyundai Expressway.
Hyundai is not the only Korean company making news in Alabama. The June 5, 2012 issue of the Mobile’s daily newspaper, Press-Register, had a lead article in the business section titled, “Koreans deny interest in TK plant.” TK refers to the ThyssenKrupp Group of Germany. I was particularly interested in the article because POSCO is one of my favorite companies in Korea and I worked as an economic consultant to TK in Mobile. ThyssenKrupp is one of the world's largest technology groups with more than 190,000 employees in about 700 companies. On May 11, 2007, TK selected the 3,700-acre site in Mobile as the location of its new plant. It was completed in 2011. The TK mill in Mobile produces high-grade carbon steel and stainless steel for sale largely to the North American car industry. The total cost of building the Mobile plant was $5 billion.
I know that you are getting a little impatient and want to know what was in the Press-Register article. According to the article, “German weekly WirtschaftsWoche reported that South Korea’s POSCO has shown interest in ThyssenKrupp’s mill in Alabama.” The article also states that in response, “A South Korean steelmaker is denying interest in ThyssenKrupp’s carbon steel plant in Calvert (which is in Mobile) after a German newspaper named the firm as a potential suitor.” The plant has its own dock along the Alabama River that flows directly to the Port of Mobile that has regular shipping services to Incheon, Gunsan, and Masan in Korea and to potentially the rest of the world. The plant is only about 150 miles from Hyundai Motor America in Montgomery. The latest news is that TK hired Goldman Sachs and Morgan Stanley to review options for their plants in Mobile and also in Brazil.
Incidentally on July 2, Airbus, which is a subsidiary of the European Aeronautics Defense and Space Company (EADS) announced that they would manufacture the popular A320 airplanes in Mobile (Alabama), making Mobile only the second such plant outside France. The other plant is in Tianjin (China).
Let me go back to the Hyundai Expressway and make one suggestion to Hyundai, Korea Tourism Organization, or anyone who might be interested in this turn of events. I think we need a Hyundai Welcome Center on the Hyundai Expressway near the border of Alabama and Georgia. That spot is right in the middle between Montgomery, Alabama and Atlanta, Georgia with heavy traffic. The Hyundai Welcome Center should preferably be decorated in a classic Korean style, serve Korean food as well as American food, display many brochures for potential visitors to Korea, and hand out a $500 coupon for Hyundai and Kia cars subject to the condition that only one coupon can be applied for each car that coupon-holders may buy. If anyone with money in Korea is interested in the project but does not know how to go about it, all he or she has to do is to ask about the EB-5 visa program. Will the venture be successful? I have no doubt that it will.
Lawsuits on workplace injuries
July 1, 2012
By Chang Se-moon
Let us assume that Mr. Kim is injured while working. If the injury is minor, he will probably drink some “soju,” or other traditional Korean spirit, and forget about the injury. If the injury is serious enough to force him to quit his job, even temporarily, he may file a lawsuit against the company for what is known in forensic economics as “wrongful injury.” Lawsuits on wrongful injury are filed all the time in many countries including the United States in which many Korean companies operate. A lawsuit can be costly and be a source of headaches to both sides.
The person who files a lawsuit is called the plaintiff. As a plaintiff, Mr. Kim contacts plaintiff lawyers who specialize in wrongful injuries. These lawyers usually contact medical personnel to have a written assessment on the extent of Mr. Kim’s injury, hire a vocational expert to determine the extent of loss of Mr. Kim’s access to future employment, and hire an economist to put all the figures together and come up with a report showing the amount of monetary losses called the present value of the future stream of lost earning capacity. The company as defendant may rely on in-house attorneys or seek outside attorneys for defense. Defense attorneys usually follow the same procedures that plaintiff attorneys do; contact medical personnel, hire a vocational expert, and hire an economist.
The problem is that the so-called experts often generate vastly different assessments on the plaintiff’s loss in future employability and earnings. This is because several technical procedures require calculating various figures to determine the precise amount of lost earnings. Due to their complexity, they are also prone to abuse. The figures include work life that refers to how long the person would work if they were not injured, discount rate that is needed to convert future values into the present value and earning capacity indicating how much money the injured would be earning in the future without injury. Other figures that need to be determined are fringe benefits, such as the values of health and life insurance, vacation time, and retirement pay, and loss of household services especially if the injured person is a housewife.
Based on my experience of having worked on over 100 lawsuits as an economic expert, I have found that most attorneys agree that if the plaintiff is truly injured, he or she should be properly compensated. If I give a piece of advice to both sides involved in wrongful injury or death cases, it is that they need to hire experts who really, not just claim to, work for plaintiffs as well as defendants. Ideally, the loss estimation one expert calculates for the plaintiff is the same as one that the same expert may calculate for the defendant.
One example of how complicated the issue can become in Korea relates to determining the lost earning capacity. Experts need income figures as reported in annual tax returns. In Korea, a large portion of earnings may be paid in bonuses and thus are not reported as earnings.
For another example, experts need a work life table that shows how many years a person is expected to work according to their gender and age. In the absence of a reliable work life table, the next best approach is to go over the retirement age. In Korea, in the private sector, the average retirement age is 57. However, many actually retire by 53. In the government sector, high-ranking employees retire before 60. The lower-ranking employees will also be able to retire at 60 by the year 2012. Effective retirement ages, by which time workers actually stop working, however, may be different from official retirement ages as mandated by law. According to the July 2009 issue of the Monthly Labor Review by the Korea Labor Institute, the effective retirement age is 71.2 for Korean males and 67.9 for Korean females.
Forensic economics has yet to be introduced in Korea, but Korean firms operating in Korea and other countries may have to deal with the problem every day.
Chang Se-moon is a professor of economics and the director for Center for Business and Economic Research at the Southern University of Southern Alabama.
Relations among Koreas and China
June 3, 2012
By Chang Se-moon
The trade relations between China and the two Koreas have been changing dramatically in recent years. It would be interesting to figure out how the changing trade relations would affect the future of the relation between South Korea and North Korea.
This is the issue that I will be addressing during my presentation at the KDI Journal of Economic Policy Conference that the Korea Development Institute is hosting later this month on June 22.
Let me, first, go over some trade figures. In 2009, total exports and imports were, respectively, $1.2 billion and $2.4 billion for North Korea, while they were $314 billion and $237 billion for South Korea. The combined amount of exports and imports during 2009 was about $551 billion for South Korea, which was more than 150 times the combined amount for North Korea which was $3.6 billion. In 2009, North Korea had a trade deficit of $1.2 billion, which was equal to the amount of the country’s entire exports, while South Korea enjoyed a trade surplus of $77 billion. During the same year, the percentage of exports to China relative to total exports was 64.7 percent for North Korea but 38.2 percent for South Korea, while the percentage of imports from China relative to total imports was 77.5 percent for North Korea but 25.2 percent for South Korea. In plain English, more than 3 out of 4 total imports of North Korea in 2009 came from China.
The high percentage of trade between any two countries does not necessarily mean that they are bad. Trade among advanced economies can be high, when these countries specialize in making complementary components of high-tech products and thus help each other in the process. This is exactly what is happening to the trade between South Korea and China, especially in high-tech electronic products. South Korea and China both benefit from close trade relations. This is not the case for North Korea, however.
I reviewed all 992 items traded between North Korea and China since 1995. The amount of trade between North Korea and China remained low until about 2000. When the volume of trade began to increase, the most popular exports from North Korea to China were resource-based products such as coal, ore concentrates, and agricultural products that do not require technology to produce. North Korea’s imports from China have also been dominated by resource-based products although imports of low to medium technology products began to increase since 2008. There were virtually no exports and imports of high technology products such as electronics, telecommunications, pharmaceuticals, and aerospace. Why does this matter? It matters because economic growth requires not only the growth of exports, but also “a move up the technology ladder” in export products. No matter how you look at it, North Korea is in bad shape.
Think about this. North Korea imports from China much more than it exports to China. North Korea will eventually be, if not already, under great pressure of having to pay for its imports of necessities. As China’s problem of being paid for its exports to North Korea worsens, it would be interesting to see what changes China will make in evaluating the relative importance of the two Koreas to China. At least from the view of economics, it is difficult to imagine that China would value North Korea ahead of South Korea. The changing trade triangle that predominantly favors South Korea over North Korea may tempt, if not force, the new generation of Chinese leaders to re-consider its continuing support of North Korea.
Global Debt Crisis
May 14, 2012
By Chang Se-moon
On April 13, 2011, Senators Carl Levin and Tom Coburn of the U.S. Senate Permanent Subcommittee on Investigations released their 635-page final report on their inquiry into key causes of the financial crisis.
According to the report, mortgage companies knew at least five years before the crisis became public that lending standards were lowered and the bubble was building up, but they continued to securitize “hundreds of billions of dollars in high risk, poor quality” mortgages.
Investment banks “assembled and sold billions of dollars in mortgage-related investments that flooded financial markets with high-risk assets. Some of these securities were referred to by traders as “crap” and “pigs,” and rushed to sell it “before the market falls off a cliff.” We all know that the bubble burst into the financial crisis.
The financial crisis led to credit crunch, which in turn led to the 2007-09 recession in the U.S. and beyond. The recession lowered tax revenues while making it necessary for the government to increase its spending. This combination led to a dramatic increase in annual budget deficits and the cumulative debt of the public sector in many OECD countries.
Standing alone, public sector debt is not a problem. Too much debt is the problem. What constitutes too much debt? A debt of $5,000 can be an excessive burden to a family making $10,000 per year, but a debt of $100,000 would not be a problem for families making a million dollars per year. It all depends on the ability of the borrowing government to make payment on a timely basis. Economists use the ratio of government debt to nominal GDP as a measure of the ability of the government to pay.
How high should the debt to GDP ratios be for these ratios to reach a crisis level? Policymakers usually try to keep these ratios below 100 percent. When the ratios are deemed excessive, countries begin to experience difficulties in borrowing since investors such as buyers of the government securities, have less confidence in the government’s ability to pay back the loans.
This anxiety felt by investors leads them to demand higher yields. In other words, interest rates start rising. The debt to GDP ratios for Greece, Ireland, Portugal, and Italy are well above 100 percent and substantially higher than the average of the entire euro area which is rapidly approaching 100 percent. Greece, Ireland, and Portugal have already asked for assistance from the European Union and the IMF, and Italy has been widely reported as experiencing a serious debt problem. The four countries have also experienced a slower growth rate of GDP in recent years than the average of the euro countries.
Policymakers in the euro zone countries are deeply concerned that the high debt to GDP ratio is causing a slow economic growth in their countries, which in turn is lowering their imports from the rest of the global economy including Korea. Even in China, a growing number of exporters are believed to experience credit pressure and thus demand payment once they ship goods to buyers. No country experienced a greater increase in deficit than the U.S. government following the 2007-09 recession. The U.S. government had an annual budget deficit of only $161 billion in 2007. The government deficit exploded to over $1.4 trillion in 2009, $1.3 trillion in 2010, and to about of $1.6 trillion in 2011. Total cumulative debt of the U.S. government exceeded GDP in 2011.
Importantly, the debt problem is only a symbol of more deep-rooted problems, which may be branded as crippled capitalism. These days, capitalism is burdened with assignments that capitalism is simply not capable of handling. Capitalism has been crippled in many different ways, which include numerous financial innovations that may make money managers rich while adding nothing to the economy, and new rules and regulations that take flexibility away from the market system.
One example of useless financial innovations that fueled debt frenzy is short sales. Suppose that shares in Korea Inc. currently sell for $10 a share. An investor believes that the stock is overvalued and would like to profit from this by selling the stock short. The investor borrows 100 shares and then immediately sells them for a total of $1000. This transaction is usually handled through the investor’s brokerage house, which buys and sells the securities on his behalf and also often arranges the loan of the shares. If the investor is correct and the price later falls to $8 a share, the investor would then buy 100 shares back for $800, return the shares to their original owner, and make a $200 profit minus transaction fees. Holland banned short sales in 1610, while England banned them in 1733. The U.S. still allows short sales.
Clearly, it is important to reduce the public sector debt, especially in countries where the debt to GDP ratios are approaching or exceeding the 100 percent level. If not, these countries may reach a crisis in which investors refuse to buy their securities, and a sudden cut in government spending leads to massive lay-offs spiraling the economy into a deep recession.
It is also important to make the economy more flexible as one of long-term strategies to lower the public sector debt. Although Korea’s debt to GDP ratio is well below the 100 percent, the Korean economy will still experience slowing exports because the current debt crisis in many OECD countries will cause the global economy to grow slowly for many years to come.