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Chapter 1: The Economic Crisis in South Korea as a Transformation Crisis of its Political and Economic Culture

1.1 Competing explanations for the economic crisis and the role of transformation theory

The reasons for the economic and financial crisis in East Asia in general and South Korea in particular are subject of intense debate. This is all the more true because economists completely failed to predict the crisis. No consensus was reached on the ultimate reasons for the economic meltdown, and often reasons and symptoms of the event were not clearly distinguished. For instance, the finan- cial upheaval was described as a crisis of trust in the economic viability of the East Asian economies, which is clearly a symptom rather than an underlying cause. Ob- servers have offered two broad competing groups of explanations for the crisis, namely the fundamental explanations and the financial architecture explanations. The fundamental explanations focus generally on ‘bad governance’ in East Asian countries and South Korea, based on factors such as: an unsustainable cur- rency peg; growing trade deficits; ‘crony capitalism’ (corruption and lack of trans- parency); credit decisions driven by politics rather than economics; a lack of com- petition in domestic markets; orientation of chaebol toward market share instead of profit; and generally the impossibility of maintaining the government-led, interven- tionist developmental models in the more global economy (The Economist, March 7, 1998; Seliger, 1999a). Financial architecture explanations focus on the growing instability of global capital markets, the moral hazard due to implicit bailout expectations, herding behavior, and financial contagion. Many authors also favor an explanation made up of a combination of these theories, putting more or less stress on the elements they think to be most plausible. The policy implications of the two explanations are quite different. According to the funda- mental explanation, the economic systems of East Asian countries are mainly culpable and should be the main target for reform. According to the financial architecture explanation, international capital markets have to be reformed. Both factions favor either a more interventionist approach, including capital controls or Tobin taxes to fight market failure, or an approach favoring the dissolution of international financial institutions hampering the functioning of the market.1

1 A Tobin tax (named after the economic Nobel laureate James Tobin, who first proposed the tax) is a tax on currency trade to discourage short-term capital movements. 24 Chapter 1: The Economic Crisis in South Korea

While both explanations of the crisis have their merits, from the point of view of economic theory they remain incomplete. Fundamental explanations raise two objections: First of all, the fundamentals as they were described in pre-crisis times, namely growth rates, inflation rates, investment and savings rates, budget deficits, but also other figures like investment in education, had been extraordi- narily healthy and always been seen as conducive to the ‘East Asian miracle’ (World Bank, 1993). Second, those fundamental weaknesses blamed for the crisis – like crony capitalism, the unhealthy expansion of business or the lack of competition in domestic markets – have existed for years. Especially in the case of collusion of big business and government, the weaknesses have even been previously understood as part of a successful East Asian economic development model. Why did they suddenly become liabilities instead of assets? Financial architecture explanations of the crisis also face skepticism: If fun- damentals did not play an important role in the crisis, why was Taiwan – the one country not exhibiting the fundamental weaknesses of its neighbors – the country least affected by the crisis by far? More importantly, why did the post-crisis paths of the countries of East Asia diverge so markedly, from a market-oriented reform in Korea, to a temporary retreat from openness in Malaysia, to a grave political crisis in Indonesia? If the crisis was contagious and the underlying cause international, not national, then one would also expect the recovery from the crisis to be more uniform. The divergent paths seem to imply that fundamen- tals cannot be neglected when explaining the crisis.

1.2 Outline of the book

This book deals not with the causes of the crisis in retrospect, but rather with the implications for the development of a new economic model in the case of South Korea. It argues that the crisis and the following changes in South Korea can best be understood by applying the theory of economic transformation. The first part looks into the challenges the transformation in Central and Eastern Europe, as well as the later East Asian crisis, neither event foreseen by almost all economists, pose to economic theory. In Chapter 2 problems are discussed which cannot be solved with mainstream transformation theory. A reformulation of transformation theory is proposed, using the discussion of the Ordnungsproblem by German ordo- liberals, the Austrian tradition, especially the evolutionary competition process for institutionals, new institutional economics (NIE), and public choice as the main ingredients. Such a theory could also be applied to transformation processes apart from those in CEE, making it a general theory of transformation. In the economic transformation in Korea after the Asian crisis external choices loomed 1.2 Outline of the book 25 large; today many Koreans understand the crisis as an “IMF crisis” rather than a domestic crisis. Chapter 3 discusses the role of external initial conditions, institu- tional arrangements and policy choices in transformation in CEE. Based on a brief outline of the theory of institutional competition the strategies of institu- tional transfer in the former German Democratic Republic, institutional imitation in countries aiming at EU membership, and institutional innovation are dis- cussed. While closing the ‘window of opportunity’ in transformation, institu- tional transfer or imitation can considerably reduce uncertainties surrounding transformation for business and state. One of the problems of mainstream eco- nomics in understanding economic crises in CEE and East Asia was the lack of area-specific analysis in neoclassical formal models. Area studies and social sciences for some time now have lived in an ‘uneasy coexistence,’ as reviewed in Chapter 4. The debate between area specialists and social scientists is especially difficult in times of tight science and university budgets, but it has deeper, meth- odological roots. Area specialists accuse economists of economic imperialism, using mathematical tools in a ‘one size fits all’ way, and thereby loosing impor- tant information about the characteristics of a region and disregarding the cul- tural and environmental background of regional development. Social scientists blame area specialists for using a non-scientific approach, and point to important failures of area specialists to predict and interpret regional development. This chapter looks into the possibility of reconciling area studies with social sciences, in particular economics. NIE can be regarded as a ‘missing link’ between area and social science studies. This paper develops a research agenda for area studies applying NIE. The second part of the book looks into the Korean financial and economic crisis of 1997 and 1998. As Chapter 5 explores, while there has been an intense debate on the causes and implications of the East Asian economic crisis, it would add to the analysis to understand the crisis and its aftermath in South Korea, the five years dubbed as “DJnomics”, as a transformation process. This transforma- tion process changed the institutional structure of the Korean economic system, until a new expectation-equilibrium was reached. The intended and especially the unintended consequences of transformation changed the traditional economic system of Korea. This chapter deals less with the causes of the South Korean economic and financial crisis in retrospect, and more so with the implications for the development of a new economic model in the case of South Korea. Korea’s economic transformation did, however, not take place in isolation, but as part of the larger East Asian economic system. Chapter 6 looks into the changes in the economic systems of Malaysia, Indonesia and Korea, in particular focusing on the interdependence of economic orders; the interdependence of the economic order with the political, social and cultural order; the interdependence of external 26 Chapter 1: The Economic Crisis in South Korea and internal institutions; and finally the interdependence of the national and international order. The debate about “Asian values” back in the early 90s sug- gested that that any desired mix of elements could exist. Authoritarian states (like Singapore, Malaysia and Indonesia) in varying degrees restricted the politi- cal freedom of their citizens. At the same time their generally open economies were in a varying degree mixed with more or less strong elements of central planning (like investment plans for selected export industries). The crisis, insofar it was not only a financial crisis, but also a structural crisis of East Asian economic orders, brought the interdependence of order back to light. One of the out- standing features of the Korean economy, in particular during the Korean crisis, is the role of large conglomerates (chaebol), which is reviewed in Chapter 7. Chaebol played a major role in the economic rise of South Korea since the 1950s and 1960s. Their intimate relationship with the government made them ideal tools for developmental policies of the state. However, this relationship was far from smooth already, and in the 1980s, when the economy was liberalized and the chaebol grew, their guidance by the state became less and less feasible. The growth- (not profit-) oriented businesses and their overinvestment in new busi- ness fields became more and more a liability for the Korean economic model. The East Asian financial and economic crisis of 1997 and 1998 was a turning point for the chaebol. A number of large companies (among them Hanbo Iron & Steel, Kia Motors, and later Daewoo) failed and others (like Hyundai Group) barely escaped bankruptcy. The new policies, beginning with the conditions of the IMF credits and elaborated by the “four plus one” policy of the Kim Dae- Jung government, put certain restrictions on the chaebol. However, decades-old business practices lived on and were difficult to erase in a couple of years. Therefore, old patterns of quantitative growth were reproduced (e.g., in the credit card market). This chapter analyzes the changing role of chaebol and the chang- ing relationship between chaebol with the government in the years after the East Asian crisis. The Korean crisis proper ended in 1998. By 1999, Korea made a spectacular V-shaped rebound. However, transformation issues lingered over Korea throughout the last decade. In Chapter 8, an overview of economic devel- opment and economic policy debates in the post-crisis decade is given. The interplay of external and internal institutions becomes visible, for exam- ple, in the formulation of Korean monetary policy after the Asian crisis, which is discussed in Part 3 of the book. Chapter 9 reviews monetary policy before and after the Asian crisis. Monetary policy was one of the most contested fields of economic policy during the financial and economic crisis of 1997 and 1998 in South Korea. After the plunge of the Southeast Asian currencies, beginning in Thailand in July 1997, the South Korean won came under pressure in the autumn of that year, leading to an IMF-led bailout in December 1997. The cooperation 1.2 Outline of the book 27 with the IMF led to a policy of temporarily high interest rates, which was heavily criticized as the cause of the deep recession of 1998. However, the goal of this policy, namely the restoration of trust in the South Korean currency, was achieved. Besides this change in monetary policy during the crisis and coopera- tion with the IMF, the institutional framework for monetary policy was thor- oughly revised as well. Specifically the central banking law, the Bank of Korea Act, was revised. In the end of December 1997, the BOK became an independent central bank. Chapter 10 looks into the development of monetary policy within the new framework. While East Asian central banks before the crisis earned a reputation as “gatekeepers of growth” (Maxfield 1997), the change in the Bank of Korea Act prescribed price stability, not growth, as the main target of mone- tary policy. In this chapter, the problem of the interaction of political and eco- nomic decisions embedded in a specific cultural context, resulting in decision- making in the ‘market for institutions’ not conforming to the rational decision- making processes usually modelled is discussed. Therefore, concepts (like cen- tral bank independence) developed in the context of Western market economies cannot simply be transferred to East Asian economies. In South Korea, the con- flicts between the Ministry of Finance and the Economy and the BOK show de facto central bank independence had to be earned as a reputation, rather than decreed by government. Part 4 of the book looks into cognitive models and changing perceptions of the economic model of Korea after the crisis, looking in particular at the chang- ing perception and role of foreign direct investment (FDI). To understand the background of these changes, Chapter 11 reviews the self-perception of Koreans stemming from ancient and recent history. In the self-perception of Koreans, three widely prevalent stereotypes can be found which are important to the po- litical and economic development and interaction with other nations: Korea as victim of foreign aggression, Korea as nation with a ‘pure,’ unique culture which resists foreign influences (“Hermit Kingdom”), as well as Korea as the nation of the East Asian economic miracle (“tiger economy”). The role of Korea as victim of foreign aggression is historically rooted in relations with China and especially Japan, but also in the later development of Korea as pawn in the hands of foreign powers, as a Japanese colony and finally as a country divided during the Cold War. Certainly, the biggest collective trauma developed through the colonization and Japanization of Korea from 1910 to 1945 as a Japanese colony. The role as a “Hermit Kingdom” (originally a term for the Chosŏn Dynasty in the 19th century, which refused all contact with foreign powers), refers to Korea’s long history as a homogenous kingdom. The preservation of this (racially and culturally founded) unity is an important paradigm in its economy, politics and cultural politics. The role as a prototype of a “tiger economy” refers to the experience of having the 28 Chapter 1: The Economic Crisis in South Korea highest economic growth rate worldwide since the 1960s, which was expressed metaphorically as the East Asian economic miracle or the “miracle on the Han River” (which passes through Seoul). This stereotype leads to a special, positive view of the role of the economy and to opposing trends with regards to the “Hermit Kingdom” view, because in this case globalization is perceived quite positively as Koreanization, for example through exports and Korean investments in other countries, as well as the success of Korean culture abroad (hallyu or the Korean Wave). Chapter 12 looks into Korea’s changes in FDI policy after the Asian crisis. The strong increase in FDI was one of the most obvious results of the Korean economic development after the economic and financial crisis of 1997 and 1998, and the policy to attract FDI was widely discussed. However, already in the time before the crisis there were changes in FDI policy, in particular dur- ing the Kim Young-Sam presidency (1993-1998) and his segewha (globaliza- tion) policy. In the Korean market for institutions, 1997 was a turning point re- garding FDI, since now explicit opening for FDI and wooing of investors be- came an institutional innovation. It was part of the answer to formerly disre- garded structural problems exhibited by the crisis, like the lack of competition in domestic markets, the lack of modern forms of corporate governance, and the inflow of short-term capital used for long-term investment projects. Second, in 1997 external influences in institutional competition were most obvious, as in the imitation of foreign policies regarding FDI as partly in liberalization conditions of external actors, namely the IMF. Thirdly, the new policy also can be seen as a change of perception based on cognitive schemata with regard to foreign capital no longer matching reality. To understand the resulting changes, an institutional economics viewpoint can be more fruitful than traditional theories of FDI like models of optimal regulation of FDI by host countries. South Korea has been a prototype of the developmental state in East Asia: long led by an authoritarian government, with close business-government relations, an export-oriented growth strategy and a selective import liberalization policy. In the last two decades, South Korea underwent not only a process of democratisation, but also a pro- found change of its economic paradigm, triggered by the East Asian economic crisis. South Korea entered the WTO and the OECD, opened its markets and formed in 2004 its first free trade agreement with Chile. Economic nationalism seems to be receding. The cultural sphere and cultural businesses have been to some extent the core of economic nationalism in Korea, since the justification for protec- tion of Korean markets have been cultural rather than economic. The experience of Japanese colonization (1910-1945), as well as the contested identity of the “true” Korea through the division and Korean War, are equally responsible for this as the neo-Confucian heritage of the “Hermit Kingdom”, when Korea (Chosŏn) was the last country in East Asia to open up to Western influences. Therefore, it 1.2 Outline of the book 29 is no wonder that the cultural markets have been especially highly protected, as well against the dominant Japanese market as against the U.S.-dominated Western influences. In the decade after the Korean economic and financial crisis, however, this has been fundamentally changed. While in the beginning of this new era, open- ing was still the result of outside pressure, more and more Korea became confident of the attractiveness of its cultural content industries and now enjoys the status of an important exporter of culture to other countries in the region and worldwide. The change from protectionism to opening is reviewed in Chapter 13 of the book. The fifth part of the book looks into the interaction between Korea and the world economy after the Asian crisis. As in the fields of monetary policy and FDI policy, here again important changes took place. Here, in particular interna- tional institutional competition plays an important role in explaining the changes. In Chapter 14, trajectories of economic integration that were discussed during and immediately after the Asian crisis are analyzed. When in November 2001, the leaders of the Southeast Asian and Northeast Asian states met for the ASEAN Plus Three (China, Japan and Korea), President Kim Dae-Jung of South Korea proposed the exploration of an East Asian Free Trade Area and thereby opened a new chapter in East Asian integration. The special Northeast Asian perspective on regional cooperation became clear from the simultaneous decision to hold annual meetings of finance and trade ministers of China, Japan and Ko- rea. At the same time, bilateral agreements like an FTA between Japan and Sin- gapore, the tentative large FTA between ASEAN and China, and the beginning of work on a Japan-Korea FTA showed a new-found interest in regional trade agreements, which was diametrically opposed to the pre-crisis policy. The chap- ter reviews what triggered these changes and which factors shape economic integration in the region. As Chapter 15 shows, regional economic integration has been widely discussed in Korea and its neighboring states after the Asian crisis, but progress has been most pronounced elsewhere, namely in bilateral trade integration, and here not with neighbors, but rather with distant but impor- tant trading partners. This result could not have been expected after the crisis. Not all FTA negotiations were successful, but in 2011 Korea successfully en- tered a high-profile FTA with the European Union and finally ratified, after a four-year stalemate, the FTA with the U.S., thereby achieving free trade with an area representing 60 percent of world GDP. In this chapter, the unsuccessful attempt to negotiate an FTA with Japan is juxtaposed with the successful conclu- sion of an FTA with the European Union. The change in the external economic environment after the crisis resulted not only in a run to form FTAs by Korea and its neighbors and more cautious discussions of comprehensive regional inte- gration, but also in more marketing efforts to position Korea in a pivotal role in Northeast Asia. Already since 2002 the administration of Kim Dae-Jung propa- 30 Chapter 1: The Economic Crisis in South Korea gated the aim of making Korea the “hub of East Asia”, which seemed quite am- bitious given the still low (though increasing) level of FDI and the rather low rankings in various measures of locational competition in the region. Under the Roh Moo-Hyun administration, the goal was even more pronounced, namely by introducing Korea as a “balancer in Northeast Asia”. While this idea understanda- bly found no echo among the larger neighbors, the implemented reforms, in the sectors of logistics, finance and services, among others, had a positive impact on the Korean economy. Comprehensive economic integration in East Asia gained new momentum with the summit meeting in Kuala Lumpur in December 2005, when the ASEAN Plus Three states met, together with India, New Zealand and Australia, and decided to form a new economic integration area. However, the size of the new integration area has been a source of dispute: The number of states participating is of concern, as well as the regional implications of certain participants, due to the danger of overstretching, as in the case of APEC. At the same time, bilateral integration through FTAs flourishes in the region, but due to their frequent exceptions these FTA are barely able to be combined into a larger integration area (a “spaghetti bowl effect”). For the region, but in particular for South Korea, the question remains how economic integration can strike a bal- ance between the large and small states. This question is reconsidered in Chapter 17. Given an appropriate integration area, South Korea can fully exert its role as a catalyst of integration. In this case, even Korea’s goal of national unification can benefit from international economic integration. The last chapter, Chapter 18, again takes up the main theme of the preceding analysis: An understanding of economic crises from the point of view of institu- tional economics can enhance the understanding of these crises and thereby help to analyze policies, in the areas of the interplay between external and internal institutions, the role of cognitive models of the economy, as well as institutional competition.