Rationality behind the veil: the communist world looks at inflation in South Korea – evidence from the Wilson Center archives

Looking at North Korea’s foreign policy, it is often tempting to discard Pyongyang’s behavior as irrational. However, it is important to keep in mind that our inability to decipher the North Korean state’s decision-making process does not equate to there not being a set of rational costs and benefits that policymakers in Pyongyang utilize to determine the country’s next move.

In line with this idea, Ruediger Frank suggested that analysts should approach North Korea with the assumption that it is “a well defined nation-state with a national economy and inhabited by individuals that bear the same basic economic and social characteristics as individuals elsewhere.” Frank’s argument rests on his contention that North Korea’s economic crash in the 1990s can be understood within the context of many different conventional economic theories, thereby proving that North Korea is not a unique case operating outside standard Western economic models.

However, what is missing from Dr. Frank’s assessment is whether North Korean policymakers and policy analysts themselves look at the economic issues through the same theoretical lens as the rest of the world. It is only after ascertaining this fact that we can begin to assess how the North Korean leadership weighs the various costs and benefits of their economic policies. For instance, if the North Korean state does not recognize the over-issuance of currency as the core contributing factor to inflation, then we cannot build inflation into the ex ante cost-benefit analysis of the decision making process.

Since we have been examining monetary policy over the past few months, we will continue to examine inflation in this post.

Historical documents obtained by the Wilson Center’s North Korea International Documentation Project (NKIDP) provide evidence that communist bloc countries shared the West’s methodology of studying inflation in the 1950s. During North Korea’s “Big Push” towards reconstruction and industrialization after the Korean War, diplomatic officials from communist bloc countries were closely examining what was then the basketcase economy of Northeast Asia: the Republic of Korea. The reports on South Korea’s inflation and associated industrial problems reveal interesting insights on how communist states during the early years of the Cold War analyzed economic distortions. While these reports were not filed directly by North Korean officials, since it is highly likely that the Eastern European officials either acquired these analyses directly from the North Korean state or shared the information with their North Korean counterparts, it is reasonable to believe that the contents of the reports were known to the North Korean state.

A report from the Polish embassy on February 28, 1953 assessed President Syngman Rhee’s policy measures against rising inflation in South Korea and its consequences:

Inflation in South Korea, which has been advancing for seven years, forced the puppet government of Syngman Rhee on [February 15, 1953] to implement a so-called monetary reform, which is allegedly supposed to put an end to the phenomenon of inflation. According to data from the Syngman Rhee-ite side, the total number of monetary units in circulation has grown from 2,600 million won (as of [August 15, 1945]) to 10 billion won (as of [February 14, 1953]). The new unit of money is called the “hwan” and is exchanged at 1 hwan to 100 won. As a result of this reform, instead of the stabilization of the currency, which was expected by the Syngman Rhee-ites, one can observed its ongoing drop.

The prices of basic food items grew over the 2 days since the reform more than threefold. Profiteering is growing. An inhabitant of South Korea is allowed to exchange only the small amount of 50,000 won, for which he can buy only 2.5 kgs. of rice. The remainder of the money has been deposited in banks. Following the monetary reform, shops were closed for several days. The people did not trust the new monetary unit, and products were rarely exchanged for the new money. The Syngman Rhee police forced merchants to open their shops and arrested everyone who did not want to take the new currency. [1]

Here, the Polish official recognized the following factors as the key issues behind South Korea’s economic malaise

  • Overissuance of banknotes led to inflation
  • Monetary reform via arbitrary revaluation did not stabilize prices because it further undermined the public’s confidence in the value of the legal tender

These are interesting retrospectives if you consider how the North Korean state repeated Syngman Rhee’s exact error in the 2009 currency revaluation (if curbing inflation was truly the intended objective of the currency reforms).

Two years after the Polish report, the Soviet embassy reinvestigated inflation in South Korea and criticized how the Syngman Rhee government was financing its deficit spending by printing more money

The amount of banknotes in circulation tripled from June 1953 through November 1954 (from 13 billion to 40 billion hwan). As a result of galloping inflation and the devaluation of the Korean currency the hwan exchange rate changed from 60 hwan to the dollar in 1953 to 180 by the start of 1954, and to 250 by the end of the year. The market rate reached 600-700 hwan to a dollar. [2]

In this document, the Soviet embassy assessed the far reaching economic consequences of the South Korean hwan’s sliding exchange rate value vis-a-vis the U.S. dollar by utilizing the principles outlined in the Singer-Prebisch thesis.

Developed by economists Raul Prebisch and Hans Singer in the 1950s, the Singer-Prebish Thesis rested on the idea that in the long-run, the price of primary goods will fall faster than manufactured goods, eroding the terms of trade for countries that relied heavily on exporting raw materials. This concept was the basis for import-substitution industrialization (ISI) policy that advocated less-developed economies to build industries to reduce import of finished goods from developed economies – a plan of action not too distant from North Korea’s own pursuit of heavy industries to reduce reliance on imports from abroad.

Returning to the Soviet embassy’s critique of the South Korean economy, the report found the origins of the people’s hardship in the vicious burden imposed by inflation on South Korea’s ability to service foreign imports, which in turn diminished consumer purchasing power. Imported goods were becoming more expensive because the hwan was losing value to inflation while the price of grain, the sale of which rural peasantry (around 70% of South Korea’s population in the mid 1950s) relied on for income, remained stable. This meant that living standards were bound to fall. At the same time, South Korea could not fully engage in industrialization policies due to

  • shortage of money for capital investment in industry
  • industry’s lack of raw materials (which must be imported from abroad and serviced with exports) and electrical power
  • importation of large quantity of consumer goods into South Korea from the US and Japan when the population had low purchasing power

While a few prominent economic historians like Meredith Jung-En Woo(-Cumings) highlighted some positive aspects of Syngman Rhee’s economic policies (like the decisive land reform in 1952 and nascent pursuit of ISI), it is widely accepted that South Korea’s First Republic (1948-1960) presided over general economic stagnation. There was certainly 4.5% per annum GDP growth between 1953 and 1962, but much of its positive effects were neutralized by the rampant inflation that accompanied the developments.

To be fair, South Korea faced serious economic issues that could not be reversed overnight. As authoritarian and corrupt Syngman Rhee was, the ineffectual political order was probably not significantly holding down growth. After all, the Soviet embassy also criticized economic conditions under the democratic, albeit short-lived, Second Republic (1960-1961)

South Korea still cannot even minimally supply its needs in manufactured goods and food from domestic production. Inflation continues in the country, there is not enough food, and all the leading South Korean industrial sectors – textiles, food, and mining, and also transportation depend completely on getting raw material and equipment from American aid funds. South Korea lags considerably behind the DPRK in the production of all kinds of industrial products and especially per capita production. Whereas in 1959 451,000 tons of steel, 694,000 tons of cast iron, and 8.8 million tons of coal were produced in the DPRK, in South Korea only 38,200 tons of steel, 83,000 tons of cast iron, and 4,400 tons of coal were produced. In the DPRK 6.4 billion kilowatt-hours of electricity were produced in 1959, but in South Korea only 1.7 billion kilowatt-hours. [3]

Things have certainly turned around on the peninsula after fifty years.

It is interesting to note that the Soviet Union’s analysis that inflation critically hindered South Korea’s economic development paralleled the analysis of South Korea’s economic conditions by its key donor, the United States. Washington’s policies towards South Korea under both the Eisenhower and Kennedy administrations became increasingly focused on stabilizing the hwan, which American policy makers saw as the foundations for economic growth. According to Arthur Bloomfield of the New York Federal Reserve, inflation was growing out of control in South Korea because of over-issuance of currency to cover

large-scale, central-bank financed, deficit spending by the Korean government, chiefly reflecting heavy defense and security expenditures, subsidies to government-owned enterprises and public utilities operating on a deficit basis, inefficient budgetary accounting controls, and poor tax collection, coupled with an undue expansion of bank credit to government agencies operating outside the budget [4]

Following Bloomfield’s recommendations, the United States eventually made monetary stabilization programs, such as the independence of the Bank of Korea, a precondition for aid. Even after Syngman Rhee’s downfall in 1960, Washington’s commitment to upholding South Korea’s monetary stability was evident when the U.S. forcibly instituted realistic exchange rates in 1961 and again in 1963 when aid was withheld until Seoul implemented tax reforms to reduce the budget deficit.

The fact that both Washington and Moscow interpreted South Korea’s economic woes through the same lens reveal how the communist bloc analyzed the phenomenon of inflation and its consequences on industrial development in a manner that can be rationally understood by the West.

Wider implications of the communist bloc’s approach to inflation also reveal the rationale for North Korea’s developmental patterns. Case study of South Korea’s slow growth in the 1950s despite the acquisition of substantial financial and material assistance from the United States may have persuaded North Korea to pursue industrialization to bolster its terms-of-trade. This explains the apparent dissonance between Pyongyang’s espoused principles of self-sufficiency and its high degree of dependence on the acquisition of subsidized raw materials from China and the Soviet Union – Taken to its logical end, the Singer-Prebisch thesis would support high reliance on the import of raw materials over the alternative of depending on the import of finished goods from abroad. After all, these documents reveal that the communist states saw less-developed states that relied on primary goods exports as being more vulnerable to the consequences of inflation (the burden it imposed on the development of industries and increasing dependence on states that exported manufactured goods due to the erosion of the currency’s value).

These particular set of documents suggest that North Korea can not only be analyzed using conventional economic models, but also that the North Korean leadership in the 1950s considered certain economic issues through the Western perspective. By eliminating the element of genuine ignorance, we can then begin to assess what costs and risks were incorporated in Pyongyang’s economic policies.

However this is merely one small peek at North Korea’s economic outlook at a very particular moment in time. More robust research should continue to examine the extent to which Pyongyang/communist bloc’s analyses of economic phenomenons paralleled those of Western states. The findings from such investigation will help the analyst community better understand how North Korea came to where it is and how to best help it overcome the mitigating factors to their growth and development.

More to come.

Notes

[1] “Report No. 1 of the Embassy of the People’s Republic of Poland In the Democratic People’s Republic of Korea for the Period of 1 January 1953 to 28 February 1953” February 28, 1953, History and Public Policy Program Digital Archive, Polish Foreign Ministry Archive. Obtained for NKIDP by Jakub Poprocki and translated for NKIDP by Maya Latynski.

[2] “Memo about the Situation in the DPRK” January 17, 1955, History and Public Policy Program Digital Archive, AVPRF F. 0102 Op. 11 P. 65 D. 45. Translated for NKIDP by Gary Goldberg.

[3] “The Korean People’s Democratic Republic (A Brief Memorandum)” September 18, 1960, History and Public Policy Program Digital Archive, AVPRF fond 0102, opis 16, papka 87, delo 27. Translated for NKIDP by Gary Goldberg.

[4] Michele Alacevich and Pier Francesco Asso. “Money Doctoring after World War II: Arthur I. Bloomfield and the Federal Reserve Missions to South Korea.” History of Political Economy, Summer 2009, 41(2): 249-270.

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About Yong Kwon

Analyst of international relations, writer of history, observer of North Korea's food and monetary policies, and Korea blogger for the Diplomat
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3 Responses to Rationality behind the veil: the communist world looks at inflation in South Korea – evidence from the Wilson Center archives

  1. Pingback: A witness to North Korea’s economic downfall: Swedish diplomat Erik Cornell | Rice and Iron

  2. Pingback: A Crude Relationship | Rice and Iron

  3. prkralex says:

    Keen to diversify its supply to secure energy for its 50 million plus inhabitants and its $1 trillion trade industry, the country has relied significantly on nuclear power, refined oil products, LNG and coal to boost its energy mix.

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