Erdogan's 40-Year-Old Theory of Inflation Scores a Win in Turkey

(Bloomberg) -- For years, Turkey’s President Recep Tayyip Erdogan has hawked an eccentric theory that challenged modern inflation-fighting methods: the key to containing prices was lower interest rates, he maintained. For weeks, he has pressured his own independent central bank not to lift borrowing costs. On Thursday, he chalked up a small victory.

The Turkish central bank’s decision to raise its key interest rate just 50 basis points to 12.75 percent, half the consensus forecast, sent the lira into a brief tailspin and confounded more traditionally inclined economists. “Is this a joke?” asked Tim Ash, senior emerging market strategist at BlueBay Asset Management LLC, in London, in a note minutes after the decision.

Ash believes that with inflation at 13 percent, well over double the bank’s target, the correct policy move would have been an increase of 4 percentage points -- eight times higher than what emerged.

“Either directly or subliminally,” Ash said later, policy makers had bowed to political pressure.

Erdogan's 40-Year-Old Theory of Inflation Scores a Win in Turkey

“It is not possible for inflation to slow down in a country where there are high interest rates,” Erdogan said as recently as Tuesday. Last month, he complained that the bank was on the wrong path with its inflation policy “because we haven’t interfered.” He also repeated his theory that the “interest rate lobby,” an international and ever-expanding alleged conspiracy of financiers, foreign powers and others is driving Turkish interest rates artificially high to damage the economy.

At one point, Erdogan accused the former central bank chief, Erdem Basci, of treason for not lowering rates fast enough.

Challenging Orthodoxy

Erdogan is far from alone in questioning monetary-policy orthodoxy. The idea that emerging economies are structured so differently from developed ones that fiddling with the money supply won’t work to control inflation goes back to 1960s and 70s Latin America. A group of economists argued then that the main impact of raising interest rates in such economies was to impose an additional cost on business, which is then passed to consumers in the form of higher prices. It’s a theory Erdogan promotes regularly.

Erinc Yeldan, a professor of economics at Ankara’s Bilkent University, wrote a paper in 1993, examining whether Turkey in the 1980s -- a period in which inflation gyrated between 25 percent and 135 percent -- structural issues (rather than just an oversupply of money) were to blame. He found they were.

Turkey, Yeldan explains, was a closed economy. But after a military coup in 1980, the government began to open up to international markets and the transition was brutal. Those extraordinary circumstances no longer apply, however. Erdogan’s theory “is no longer valid,” said Yeldan.

There’s a growing debate over conventional monetary policy in developed economies. Persistently slow inflation in the U.S. and Europe, despite a decade of record low rates has led some economists and even central bankers to ask whether inflation targeting policies remain appropriate in a deflationary, post crisis environment.

Whether the same argument can apply to higher-inflation, emerging economies such as Turkey is another question, according to Dani Rodrik, professor of international political economy at Harvard. “But there is a core element of truth to it; in a developing country you may have to live with an inflation rate in the high single digits and that’s OK, as opposed to 2-to-3 percent in a developed economy,” he said.

The problem with Erdogan’s inflation theory is less that it’s obviously wrong or even sincerely believed, but that it fails to recognize Turkey’s predicament, according to Rodrik.

‘Nonsensical Policies’

Turkey runs a $40 billion current account deficit and its companies have borrowed heavily abroad, making the economy vulnerable to a sudden change in global flows. In 2017, according to a November report by the European Bank for Reconstruction and Development, Turkey tapped a sum worth a quarter of its economy to finance those debts. If the foreign credits involved should suddenly dry up, Turkey would have to squeeze that money from its citizens, triggering a deep recession.

“You have to compete in global markets,” said Rodrik. “The more risky Turkey looks, because it’s engaging in threats and counter-threats and nonsensical economic policies, the more risk that money stops flowing -- and that would be very damaging regardless of the source.”

Some analysts see Erdogan’s stance as simply a ruse to assign blame to financiers and foreigners for any economic troubles to come. Both presidential and parliamentary elections are set for 2019.

Yet Erdogan’s desire to stimulate the economy regardless of inflation has been consistent. After last year’s failed coup, the government expanded a credit guarantee fund to provide what has so far been $57 billion of easy credit to companies. On Thursday, Erdogan urged Turkish employers to hire two extra workers each.

Cemil Ertem, an economic adviser to the president, has tried to set out the government’s thinking in a series of newspaper columns this year.

Jobs, Investment

Reducing unemployment, rather than inflation, must be the main target for Turkish fiscal and monetary policies, Ertem wrote in a September article for the daily Sabah. He said the Phillips curve -- an economic model that suggests inflation goes up when unemployment falls, and vice versa -- was now defunct. If Turkey boosts infrastructure spending and increases employment, the economy can grow at double-digit rates without sparking undue inflation, he said.

“The growth and development models that the West preached to both itself and others have failed,” Ertem wrote in another September column. Sovereign wealth funds were replacing global financial markets as sources of capital, allowing for more independence and state planning, he said. He pointed to the wealth fund Turkey is creating by leveraging state-owned companies, as well as the credit guarantee fund.

In response to requests for an interview or comment on this story, Ertem pointed instead to a column this week in which he argues that Turkey’s transformation to a more balanced business model is already taking place. That, he said, was evidenced by third quarter year-on-year growth of 11.1 percent, and a 14 percent rise in real exports.

“We have started overcoming the hot money flow problem in the first and second quarters of the year and that growth will continue in a healthier way by creating jobs and investments,” Ertem wrote, predicting a fall in both inflation and unemployment next year.

For now, though, inflation is rising at a double-digit rate and growth -- stripped of base effects from last year -- is slowing, to a quarter-on-quarter rate of 1.2 percent. Thursday’s minimalist central bank decision looks set to test Erdogan’s confidence that the global economy has transformed in Turkey’s favor.

©2017 Bloomberg L.P.