The new year did not start well for the Turkish economy. Its annual inflation rate now exceeds 36%, about twice as high as it has been for the past several years.
It is not surprising that Turkey would get caught in the global inflation trend. However, with a rate that is seven times higher than the euro zone and forecasts pointing to 40%, even 50% inflation in the new year, the government in Ankara needs to take drastic action to turn the trend around.
The situation is urgent. Financial capital has been flowing out of the country for some time, causing the Turkish lira to depreciate. High and rising inflation has put yet more pressure on the lira, but instead of making the hard choices to curb inflation, the response from President Erdogan’s government is likely to aggravate the situation.
In fact, Turkey is a textbook example of what not to do in the face of high inflation.
To begin with, the Turkish government does not seem to take its current inflation rates very seriously. There are no firm statements, let alone policy actions, from the Erdogan administration suggesting the issue is prioritized. On the contrary, in December President Erdogan claimed that his government will bring down inflation by keeping interest rates low.
The only way for a government to keep interest rates low is to print more money. However, the faster money supply grows, the higher inflation will be.
To Erdogan’s defense, it is entirely possible that his country’s history of high inflation has made him and his administration somewhat numb on the issue. In the past 50 years Turkish inflation has never been below 5% for one single calendar year. At the same time, the current situation is a significant aberration from more recent numbers: it has been approximately 20 years since the last time inflation in Turkey exceeded 30%.
In addition to its high level, the rapid rise in inflation should be a red flag. The break in trend, which is statistically obvious, is characteristic of monetary inflation. Trading Economics provides an overview of Turkish money supply,
It has taken about a year and a half for the acceleration of money supply to translate into inflation. The reason is that monetary inflation works like ketchup out of a glass bottle: first nothing comes, then nothing, then all of it at once.
When this monetary fuel for inflation reaches a critical mass, it replaces all other causes of inflation and changes the character of how price increases spread throughout the economy. Unlike all other causes of inflation, the one driven by monetary expansion becomes a self-perpetuating phenomenon, as in Venezuela.
Even without comparing Turkey’s inflation problems to the unmitigated Venezuelan disaster, the government in Ankara has every reason to immediately act in response to inflation. The apparent resistance to addressing runaway price increases will only exacerbate the problem and raise the bar for future policy responses.
It is understandable, but not excusable, that politicians balk at addressing monetary inflation. There is no painless way to do so. Other types of inflation can usually be brought down by means of gradual changes to fiscal policy or government regulations. By contrast, monetary inflation requires a rapid reversal of both the expansion of the money supply and other policy measures that help transmit the newly printed money into the economy.
Such measures are universally unpopular and often socially painful. Nevertheless, they are the only means available, once monetary inflation sets roots in the economy.
It is troubling to see how President Erdogan seems to want to move in the very opposite direction. Instead of letting his central bank tighten money supply, raise interest rates, and reverse the outflow of financial capital, Erdogan is pushing a new, highly inadvisable plan that would pour gasoline on the inflation fire. His idea, unveiled in December, is to discourage Turks from taking their savings out of the country. The outflow of money, driven by the decline in the lira’s value versus major currencies, has effectively perpetuated the deterioration of the lira. To stem the flow, Erdogan wants to compensate the owners of savings accounts in Turkish banks for the depreciation of the currency.
The plan, which is unique as far as economic policy goes, would work as follows. Suppose a person with 100 liras in a savings account earns, say, 10% interest per year with his Turkish bank. Suppose also that if he deposits the 100 liras in a euro-zone bank, he earns the same interest.
Over the course of a year, with a constant exchange rate between the lira and the euro, it does not matter where the person keeps his money. However, suppose that the lira falls versus the euro, so that after one year 100 liras can only buy 80 euros. The “mirror image” is that 100 euros now buys 125 liras.
With 10% interest on both accounts, the balance on the Turkish account is 110 liras at the end of the year. By contrast, with the new exchange rate the year-end balance in the euro-denominated account equals 137.50 liras.
According to President Erdogan’s plan, his government would now compensate the savings-account holder in Turkey by, in our hypothetical example, depositing 27.50 liras into it. This would bring its balance on par with the euro-zone account.
Economic theory brims with warning signs against this plan, and so does the fiscal reality of the Turkish government. It is in no position to pay for this program with tax revenue; it has run a consolidated budget deficit since 2016 and has recently raised income taxes for both individuals and corporations. Therefore, it is more than likely that funding for the savings compensation program would come in the form of newly printed money from the central bank.
When the central bank injects new money into the economy, inflation accelerates in short order. Higher inflation provokes yet more capital outflows, and quickly. As more money leaves the country, the currency is depreciated further; by the logic of the savings compensation program, this mandates the central bank to print even more money.
Given the Erdogan administration’s apparent lack of interest in the inflation problem, they will probably press on with this program regardless of the dangers. Therefore, it is very important to understand just how dangerous the situation is, and how different monetary inflation is from other types of inflation.
Technically, the mechanics of monetary inflation consist of an imbalance between the value that individuals and businesses add to the economy, and the value they take out of it. When a central bank mints new cash and puts it in the hands of the general public, it allows individuals (and businesses, if the cash is handed out to them) to take value out of the economy without putting corresponding value into it. By contrast, when we pay for our expenses with money earned from work or investments, the value we take out is proportionate to the value we produce.
A free-market economy equates the total value of productive activity (work and investments) with the total value of consumption and savings. At full employment and strong demand in the economy, the forces of the free market mitigate excess demand by raising prices on all types of economic activity. The price increases are moderate and reasonably paced, allowing consumers and investors to adapt. The economy cools off and inflation subsides.
No such mitigating mechanisms apply when a central bank prints cash and injects it into the economy. On the contrary, this type of policy upsets the value-in/value-out balance. The more money that is printed and handed out this way, the larger the imbalance becomes; the larger the imbalance, the faster inflation accelerates.
As if to add yet more insult to injury, the Erdogan government has steadfastly maintained that it wants the Turkish central bank to keep interest rates low. This means, plainly, that inflation exceeds interest rates, which is a classic disincentive toward savings. Among other things, it motivates people who want to save to take their money out of the country, which is exactly what is happening in Turkey right now.
Turkey cannot afford higher inflation, nor can it afford sustained capital outflows. The balance of trade has been negative since 2010, which has put the lira under steady depreciation pressure. This, in turn, has led to a situation where Turks choose to invest their savings abroad.
The only way a country can stabilize its currency when the balance of trade is in deficit, is to have a positive financial balance (or capital balance). This means, in practice, that foreigners invest more money in Turkey than Turks invest abroad. If the positive financial balance is big enough to compensate for the trade deficit, then–all other things equal–the exchange rate is stable.
When, though,Turks take more money out of the country than foreigners bring in, there is a financial deficit in the country’s balance of payments. This deficit compounds the downward pressure on the Turkish lira.
When a currency comes under long-term depreciation pressure, investors look to the central bank for signals as to whether it will support the currency or not. If the central bank supports its currency (usually by buying its own currency and reducing its foreign currency reserve) then the downward pressure from the financial balance will gradually subside.
If, on the other hand, the central bank sends out signals that it is indifferent to the depreciating currency, investors will continue to take money out of the economy. Turkey has put itself in this very situation, which—again, according to standard economic theory—sets in motion a vicious downward spiral of currency depreciation and higher inflation.
It is important to keep in mind that in this situation, inflation is not only driven by money printing, but also by currency depreciation. When the lira weakens, it becomes more expensive to import to Turkey, and higher import prices transmit throughout the economy. A classic example is oil prices, which rise fast in countries with no domestic oil production. This causes fuel prices to rise, immediately hitting the bottom line for consumers.
The only positive side of a weaker currency is that exports become cheaper. This advantage, however, erodes rapidly when inflation is high and costs rise for production and inputs. To further compound the problem, a sizable part of Turkey’s exports-oriented industry relies heavily on imported components, the prices of which obviously rise with a deteriorating currency.
At this juncture, the Turkish government really has no option but to forcefully reverse the course of its monetary policy. Higher interest rates are a necessary evil in this situation, but if coupled with lower taxes on individual and corporate income, i.e., a reversal of the tax hikes enacted over the past few years, the short-term pain for the economy would be weighed up by a brighter outlook for the long term. Higher interest rates would attract foreign investors to the Turkish government’s bonds, cutting its cost of deficit funding.
As a logical consequence of monetary conservatism, the Turkish government would have to scrap its plans for a savings compensation program. Last but not least, in order to have a chance at restoring confidence with international investors, it must firmly declare that the proposals for capital controls will never become reality.
With these policies, the Turkish government would be able to steer the economy back on the road again. Without them, on the present course, it could easily turn Turkey into a macroeconomic disaster zone.