WHAT ACCOUNTS FOR THE KOREAN ECONOMIC MIRACLE?ECONOMIC MIRACLE?

Anne O. Krueger

Stanford Center for International DevelopmentAndSchool for Advanced International Studies, Johns Hopkins UniversityUniversity

For presentation at Conference on The Korean Economy: Six Decades of Growth and Development

Seoul, KoreaAugust 30, 2010

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INTRODUCTIONINTRODUCTION

It is a great pleasure to be here to help celebrate the stellar performance It is a great pleasure to be here, to help celebrate the stellar performance of the Korean economy. Over the past 60 years, Korea’s economic performance has been truly phenomenal by any standard.

It is hard to imagine the dire condition of the Korean economy in the l950s. From having one of the lowest per capita incomes in the world in the l950s, Korea has progressed all the way to industrial country status. Few remember how bad things were.

No one questions Korea’s stellar performance. Because success was so great, many try to ask what the secrets of success were. Was it that there was a laissez-faire economy? Or was it that government officials were very wise and doing the right things? Or was Korea just lucky?

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OUTLINE OF REMARKSOUTLINE OF REMARKS

First a reminder of just how bad things were in the l950s It is First, a reminder of just how bad things were in the l950s. It is easy to forget (and hard to imagine) how bad things were then.

Next a quick review of the policy changes of the l960s and Next, a quick review of the policy changes of the l960s and their effects.

Then focus on policies and issues that were important for the Then, focus on policies and issues that were important for the Korean economy from the l970s to today that shed light on our question.

Finally, I will try to use all that to assess how much was market orientation, how much was clever government intervention, and how much was luckhow much was luck.

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THE 1950S THE 1950S

Everyone knows about the chaotic state of the Korean economy Everyone knows about the chaotic state of the Korean economy immediately after the end of the Second World War. High inflation, disruption of ownership patterns as the Japanese left, and partition all were traumatic.

Before those problems were completely resolved came the devastation of the Korean War. After the war, postwar reconstruction began. But it proceeded very slowly, with less than 5 percent average annual growth, from 1953 to 1960 1960.

There were multiple exchange rates, and by any standard there was significant overvaluation. Trade policy was highly protectionist, with quantitative restrictions, import licensing, and high tariffs. Even in l960, exports were only 3 percent of GDP (and 88 percent of exports were primary commodities) while imports were 13 percent of GDP. The Korean economy was dependent on foreign aid for imports and for financing investment Most foreign aid came foreign aid for imports and for financing investment. Most foreign aid came from the United States.

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THE 1950S THE 1950S CON’T

Investment was not much more than 10 percent of GDP and domestic Investment was not much more than 10 percent of GDP and domestic savings were close to zero (and even negative in some years). The inflation rate was very close to the highest in the world.

By the mid 1950s, American officials became so pessimistic about Korea’s economic prospects that the U.S. Congress voted to shift Korea from being a recipient of development aid to being a recipient of “supporting assistance”, and the Koreans were notified that aid flows would start diminishingand the Koreans were notified that aid flows would start diminishing.

The rate of population growth was well over 2 percent, so that the increase in per capita incomes in the 1950s was very slow. Even in 1960, per capita incomes are estimated to have been the third lowest in Asia (and well below the levels of most African countries), and less than $100 in nominal terms. More than 70 percent of the population was rural and mostly dependent on farming.

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POLICY CHANGES AND THE 1960SPOLICY CHANGES AND THE 1960S

The first real change in policy came in l958, with an IMF stabilization program. The exchange rate was largely unified and moved to a more realistic level; there was some rationalization of realistic level; there was some rationalization of the import regime; and monetary and fiscal policy became less expansionarybecame less expansionary.

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POLICY CHANGES AND THE 1960S POLICY CHANGES AND THE 1960S (CON’T)

This was followed in 1960 by a series of measures to promote This was followed in 1960 by a series of measures to promote exports. These included tax credits per dollar of exports, access to subsidized credits per dollar of exports, and a “wastage allowance”. This last was the value of imports (of needed inputs for purchases of exports) last was the value of imports (of needed inputs for purchases of exports) that would be allowed automatic entrance duty-free per dollar of exports. These “export incentives” were uniform for almost all exports. They were not industry specific. Some of the goods that were initially exported y p g y p(ladies’ wigs, plywood, etc.) were far from the “industries” that planners thought about. In 1964, a celebration was held when exports for the year topped $100 million (up from $30 million in l960), and, as you know, there is still “export day” each year to remember the event. It is difficult even to imagine exports of $30 million 50 years ago, contrasted with about $373 billion in 2009, one of many data which demonstrate h f th K h how far the Korean economy has come.

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POLICY CHANGES AND THE 1960S CON’T

Initially the subsidies per dollar of exports for subsidized Initially, the subsidies per dollar of exports for subsidized credit, tax credits, and the exchange rate itself, were adjusted fairly frequently so that the real value of export proceeds per dollar remained fairly constant in won. But, over time, the real exchange rate was depreciated and the subsidies were phased out by the mid-1970s out by the mid-1970s.

In the mid 1960s, the import regime was substantially liberali ed as the “positi e list” of those goods hich co ld be liberalized, as the “positive list” of those goods which could be imported was replaced with a “negative list” of goods which could not be imported. Simultaneously, tariffs were lowered (and the p y (wastage allowance also reduced the degree of restrictiveness of the regime).

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POLICY CHANGES AND THE 1960S CON’T

Also in the mid 1960s monetary fiscal and tax policy were Also in the mid-1960s, monetary, fiscal, and tax policy were reformed and after 1964, the exchange rate was adjusted for inflation. The nominal interest rate, while not market determined, was at least set at a level where the real interest rate was not was at least set at a level where the real interest rate was not negative, which is important. The tax structure was adjusted and fiscal policy changed so that the inflation rate fell below 10 percentpercent.

The economic success of the l960s was phenomenal. The average annual growth rate for the decade 1963 1973 was average annual growth rate for the decade 1963-1973 was estimated (in constant l963 prices) to have been well over 10 percent for real GDP, and over 40 percent for the dollar value of e ports (at a time hen orld prices ere fairl stable)exports (at a time when world prices were fairly stable).

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THE CHALLENGES OF THE 1970S AND EARLY 1980S

The 1970s and early 1980s were turbulent years for The 1970s and early 1980s were turbulent years for the world economy and many countries, especially developing ones, were hard hit. The Korean economy p g , ywas certainly hurt by world conditions: the commodity price boom of the early 1970s hurt the terms of trade, and Korea was hurt more than most by the oil price and Korea was hurt more than most by the oil price increases of 1973-74 and l979. The worldwide recessions of 1974-5 and l980-83 were also difficult. And the huge increase in nominal interest rates (as the American economy was disinflating) greatly raised debt-servicing costsservicing costs.

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THE CHALLENGES OF THE 1970S AND EARLY 1980S CON’T

These events posed significant challenges at a time when These events posed significant challenges at a time when growth, while successful, was not yet sufficiently robust to be assured of sustainability. Policy responses were, by and large, appropriate The exchange rate was allowed to depreciate in real appropriate. The exchange rate was allowed to depreciate in real terms in response to the deterioration in the terms of trade; new exports (such as construction activities) sprang up in response; the oil price was allowed to increase domestically and prudent the oil price was allowed to increase domestically, and prudent monetary and fiscal policies contained inflation and enabled the continued servicing of Korea’s debt. (It should be remembered th t d i g th l h d g th d th i g t that during the early heady growth days, the savings rate was rising but still well below the desirable rate of investment; the difference was financed by foreign borrowing, equaling about 10

f GDP)percent of GDP).

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THE CHALLENGES OF THE 1970S AND EARLY 1980S CON’T

Another policy response was to support the “heavy and chemical Another policy response was to support the heavy and chemical industry” (HCI) drive. Some policy makers thought Korea had grown enough so that these industries would have comparative advantage, and their establishment was encouraged. Heavy machinery (electrical especially), g y y ( p y),shipbuilding, and other new capital-intensive industries were established, starting around 1974. By l978, it was evident that there were problems: the salaries of engineers had almost tripled and traditional export industries

bl t t i th i lit t l t ff t th b t were unable to retain their quality control staff; export growth began to falter, and exports even fell in one year (the only time during the rapid growth years that that happened). Meanwhile, the anticipated comparative advantage of the new industries did not materialize (except partially in advantage of the new industries did not materialize (except partially in shipbuilding) at the time. By 1979, it was recognized that development of most of these industries was premature and further investments in them were postponed or canceled. (later, many of these industries did acquire p p ( , y qcomparative advantage).

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THE LATE 1980S TO 1997 THE LATE 1980S TO 1997

By the late 1980s it seemed that all was well for the Korean By the late 1980s, it seemed that all was well for the Korean economy. Growth had been sustained, employment had increased, and real wages had risen rapidly. Korea had become a recognized rapidly growing country and was invited to join the OECD one rapidly growing country, and was invited to join the OECD, one symbol of success.

The years from l986 to l988 were especially remarkable with The years from l986 to l988 were especially remarkable with rapid growth, a sizeable current account surplus, and stable prices.

Much of the success in exporting was attributable to the chaebol, which had become heroes of Korean economic growth. Their share of industry had increased remarkably and their export Their share of industry had increased remarkably and their export success was recognized globally.

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THE LATE 1980S TO 1997 THE LATE 1980S TO 1997 CON’T

However one sector remained relatively backward: However, one sector remained relatively backward: finance. Although real interest rates had been allowed to rise enough so they were no longer negative, and credit g y g g ,rationing had diminished in importance, financial markets were not truly liberalized.

Equity markets had developed somewhat, but most business was still dependent upon debt financing, and l i i hi h f h b l M leveraging ratios were very high for most chaebol. Many chaebol even owned the banks that were lending to themthem.

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THE LATE 1980S TO 1997 THE LATE 1980S TO 1997 CON’T

D it th d fi i l k t i th l Despite the repressed financial market, in the early 1990s the authorities opened up their short term capital account as one of their needed actions in joining the account as one of their needed actions in joining the OECD.

By the early 1990s, the return on investments was falling markedly, and the policy response was to instruct th b k t l th i i t t t B l996 97 th the banks to lower their interest rates. By l996-97, the return on bank assets was negative and, as is well known the financial crisis of l997 98 ensuedknown, the financial crisis of l997-98 ensued.

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THE 1997 FINANCIAL CRISIS AND ITS AFTERMATH

There is no need to review the financial crisis here There is no need to review the financial crisis here. The memories are still painful for everyone. But for my purposes, two things should be pointed out.p p , g p

First, policy makers recognized the weaknesses in the financial system and rapidly changed policies to the financial system, and rapidly changed policies to strengthen it going forward. Corporate governance was strengthened, connected lending made illegal, and banks’ balance sheets were cleaned up and strengthened, as nonperforming loans were taken off their bookstheir books.

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THE 1997 FINANCIAL CRISIS AND ITS AFTERMATH CON’T

Second, the result was that Korean economic growth resumed much more quickly than anyone anticipated at the time. Despite difficulties since, including the credit card crisis, difficulties since, including the credit card crisis, growth has proceeded well (although, of course, not at the rates of the catch up years) and even not at the rates of the catch-up years), and even during the recent global financial crisis, the K ’ f h b ll Korean economy’s performance has been well above average.

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THE 1997 FINANCIAL CRISIS AND ITS AFTERMATH CON’T

Th K i g th 20 The Korean economy is now among the 20 largest in the world, and Korea is one of the ten l t t P it i i ti t d largest exporters. Per capita income is estimated to be around $28,000 in purchasing power parity

f fterms. Inflation is low, the country’s financial system is much strengthened, and external debt is relatively low. Many future challenges remain, of course, but success to date is unquestionable.

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WHAT ACCOUNTS FOR THE KOREAN ECONOMIC MIRACLE?

Th i di h h K There is no disagreement that the Korean economy has been phenomenally successful. Given its success, h i i i h f Th there is great interest in the reasons for success. There

are three possibilities: l) it was a market-led economy, d h k bl d h i l 2) h and the market enabled the miracle; 2) the government

intervened extensively, and it was government wisdom, th t d d i “ i ki i ” d ti that succeeded in “picking winners” and supporting them, that led to success; and 3) Korea was just plain l klucky.

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WHAT ACCOUNTS FOR THE KOREAN ECONOMIC MIRACLE? CON’T

Of it i t th t f th Of course, it is not necessary that one of these explanations is the whole truth and that there is

l t i th th It i ht b no explanatory power in the others. It might be that a market-oriented program failed because of

f Opoor luck, or succeeded because of good luck. Or policy makers might pick the “wrong” winners, but be lucky in that the world changed in ways that reduced or eliminated the costs of their mistake.

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WHY EXPORT ORIENTATION WAS SO IMPORTANT

From my viewpoint, a central anchor of success was the export orientation of the Korean government during the high-growth years. It is not that all decisions were made by the market: that all decisions were made by the market: indeed, they were not. But, when mistakes were made the fact that the authorities used a virtual made, the fact that the authorities used a virtual export performance test meant that the mistakes

f i l dil hwere fairly readily apparent to them.

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WHY EXPORT ORIENTATION WAS SO IMPORTANT CON’T

F th i li k t l ( d For the economic policy makers, a central (and obviously correct) starting point when reforms b th t th t h d h t began was that the country had a huge current account deficit and was confronted with the

f f fprospect of further decreases in foreign aid, the main source of finance for the large import surplus. That imports were necessary was self-evident to all. That led to the determination to open up the economy to encourage exports.

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WHY EXPORT ORIENTATION WAS SO IMPORTANT CON’T

I h b l k f h d i i k It may have been lucky for the decision-makers that Taiwan had begun its successful outer oriented

i h id 1950 d i h strategy in the mid-1950s and met with great success. That may have given confidence that the strategy might

k O i b h h d d b work. Or it may be that they were persuaded by economists’ arguments, as some histories of the period

t B t h th d t d th t t i t suggest. But why they adopted the strategy is not as important as the fact that, once it was adopted, it served

id d lit t t t lias a guide and a litmus test to policy.

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WHY EXPORT ORIENTATION WAS SO IMPORTANT CON’T

You could not have an export-oriented strategy and prevent exporters from importing freely. That already cut down the degree to which imports could be restricted. The wastage allowance could be restricted. The wastage allowance turned out to be important for exporters and for reducing the wall of protection import competing reducing the wall of protection import competing firms had.

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WHY EXPORT ORIENTATION WAS SO IMPORTANT CON’T

You could not have an export oriented strategy and a highly unrealistic exchange rate. Even the schedule of incentives for exports could not last very long in a successful strategy, because the very long in a successful strategy, because the cost to the Treasury was too high –hence the (important) unification of the exchange rate(important) unification of the exchange rate.

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WHY EXPORT ORIENTATION WAS SO IMPORTANT CON’T

Y ld t h t i t d t t g d You could not have an export oriented strategy and very expansionary monetary and fiscal policy, as domestic demand for products would divert sales to the domestic demand for products would divert sales to the domestic market.

And, as for example with the heavy and chemical industry drive, the export test could show when a

i t k d I th f HCI t did t mistake was made. In the case of HCI, exports did not materialize in most of the lines that were encouraged. The feedback spurred the authorities to alter courseThe feedback spurred the authorities to alter course.

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WHY EXPORT ORIENTATION WAS SO IMPORTANT CON’T

The outer orientation also would have given policy makers a The outer orientation also would have given policy makers a sense of the limits of their authority to a much greater degree than happens in an inner-oriented economy. In the latter, most domestic producers have virtual monopoly positions which they owe to the government; they must, therefore, acquiesce in the “plans” and mandates emanating from the bureaucrats on whose plans and mandates emanating from the bureaucrats on whose decisions their fortunes depended. But no bureaucrat can realistically assume that he can order foreigners to buy particular

fproducts, and individual producers have a much better idea of needed quality and specifications than government officials possibly can. possibly can.

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WHY EXPORT ORIENTATION WAS SO IMPORTANT CON’T

Fi ll b t h ibl th t i t t Finally, but perhaps possibly the most important consideration of all, the Korean economy was sufficiently small in the late l950s that it is difficult to sufficiently small in the late l950s that it is difficult to imagine rapid growth not based on an outer orientation. Exports were the way to go because they would finance Exports were the way to go because they would finance needed imports; but they were also the way to go to employ unskilled labor far more productively than it was employed in the countryside, and to employ far more workers than could have been absorbed by much more

it l i i t ti i d t icapital-using import-competing industries.

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WHY EXPORT ORIENTATION WAS SO IMPORTANT CON’T

So in an important sense the outer orientation provided the So, in an important sense, the outer orientation provided the discipline (prices being given in the international market to small producers such as the Korean companies were then) that would have taken place in perfectly competitive markets when the Korean economy taken place in perfectly competitive markets when the Korean economy itself could not provide enough producers for domestic perfectly competitive markets. Of course, there may have been learning from foreigners by domestic producers, and other benefits as well. But I lean g y p ,to the view that “export-orientation as market discipline” was the single most important factor underlying the Korean economy’s success. Of course, as the economy grew, there was more competition possible within the domestic market, but the fact that even today almost 40 percent of Korean output is exported makes the international economy vitally important for almost all Korean producers.

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DID THE AUTHORITIES MAKE ALL THE DECISIONS RIGHT?

What then of arguments that the authorities were What, then, of arguments that the authorities were interventionist? I have already mentioned the most visible case, that of HCI. Here, there is no question but that the government , q gtried to pick winners. There is also no question that they were wrong, and the fact that there was an export market test enabled the authorities to retreat before it was too late To be enabled the authorities to retreat before it was too late. To be sure, some of the HCI industries have since become highly competitive, but that is because Korean comparative p , padvantage shifted toward them with economic growth, not because comparative advantage was there in the early 1980s.

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DID THE AUTHORITIES MAKE ALL THE DECISIONS RIGHT? CON’T

Th h i i h K f There are other instances in the Koreans story of successful “picking of winners”. But in those cases, “ i ” d h h i b f ll “winners” proved that they were winners by successfully competing on international markets. While the winners

d h d h were encouraged, they were expected to export so the initial period in which they received more than standard

t t b t li it d Th k t t t i kl support was at best very limited. The market test quickly showed whether, and to what extent, the appropriate h i h d b dchoices had been made.

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DID THE AUTHORITIES MAKE ALL THE DECISIONS RIGHT? CON’T

On macroeconomc policy more generally the economic policy On macroeconomc policy more generally, the economic policy makers in Korea generally did very well until their failure to bring about financial liberalization sufficiently and early enough to avoid the 1997 crisis It can be argued that over any 30 year period the the 1997 crisis. It can be argued that over any 30 year period, the authorities in any country are confronted with many opportunities to make major mistakes. In Korea’s case, they avoided all those opportunities until 1997 a very good record indeed Korea’s opportunities until 1997 – a very good record indeed. Korea’s macroeconomic stability has continued to serve the country and the economy well during the recent global recession. Inflation has b k t l fi l li h i t i d ffi i t di i li t been kept low, fiscal policy has maintained sufficient discipline to avoid large build ups of debt in good times and to leave room for expansionary policies during downturns.

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HOW IMPORTANT WAS LUCK?HOW IMPORTANT WAS LUCK?

Finally there is the question of luck It is imaginable that Finally, there is the question of luck. It is imaginable that the authorities might have embarked on their outer oriented strategy just as the world economy was plunging into deep gy j y p g g precession (or at the same time as a much larger economy, such as China, with much the same comparative advantage). Clearly, they were fortunate in that the first decade of the exportthey were fortunate in that the first decade of the export-oriented strategy coincided with buoyant economic conditions on international markets (although it does not seem to be true ( gthat American demand for goods to support the Vietnam War had much to do with it).

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HOW IMPORTANT WAS LUCK? HOW IMPORTANT WAS LUCK? CON’T

Th h l f l k I l k h There were other elements of luck. It was lucky that Taiwan, Hong Kong, and Singapore were also growing

idl i i d id h i ld rapidly: competition and evidence that economies could perform well certainly served as a prod to good decision

ki I d b ib d h K ’ making. It no doubt contributed to success that Korea’s educational system was so productive and that

d ti l t d d b hi h B t th t f educational standards became so high. But that, of course, was partly the result of policy as well as partly l kluck.

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HOW IMPORTANT WAS LUCK? HOW IMPORTANT WAS LUCK? CON’T

Korea was also fortunate in that the decision to retreat from HCI was made in l979, before the oil price increase and the worldwide recession of the l980s. Had the HCI drive still been absorbing the l980s. Had the HCI drive still been absorbing so many resources (with exports faltering) as the recession hit it is quite likely that Korea might recession hit, it is quite likely that Korea might have had to restructure its debt, along with many

h iother countries.

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HOW IMPORTANT WAS LUCK? HOW IMPORTANT WAS LUCK? CON’T

While these were lucky, there was bad luck, too. The oil price increases of the 1970s are a major case in point. Korea’s terms of trade were adversely affected almost more than any other adversely affected almost more than any other country’s. The fact that Korea felt compelled to spend a large sum on defense was also a drain spend a large sum on defense was also a drain on resources and unlucky.

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CONCLUSIONS CONCLUSIONS

Overall, it seems reasonable to conclude that luck was on balance not a major factor. The critical issues were policy choice, the ability to recognize mistakes, and the reliance on the recognize mistakes, and the reliance on the international market as a discipline for policy makers and businesses alikemakers and businesses alike.

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CONCLUSIONS CONCLUSIONS CON’T

I conclude, therefore, that Korea was lucky to have very smart policy makers, who made the important decisions largely correctly, and who were able (because of the choice of an outer were able (because of the choice of an outer orientation) to reverse course when there were mistakes mistakes.

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CONCLUSIONS CONCLUSIONS CON’T

While growth was rapid, it probably could have been even a bit more so had policy been perfect. But there is no such thing, and one must give Korean economic policy overall a very high mark. Korean economic policy overall a very high mark. If policy makers can do as well over the next sixty years Korea will be the envy of the worldyears, Korea will be the envy of the world.

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