Turkey: autopsy of a debacle

This country got lost in grandiose real estate projects that have turned out to be barely profitable. Instead of progressing from its economy’s developmental stage by prioritising and banking on the traditional path– which is also enticing for foreign investors –, a path that is characterised by gradual industrialisation, Turkey has preferred to enrich the powerful construction sector that is itself financed by banks. This artificial monetary creation – artificial because it is based on an unproductive sector – nevertheless allowed the upper echelons of the public and executive administration to butter up their electoral base, to establish a business elite indebted to them, and finally to consolidate their power and influence over the Turkish state.

Of course, as always, the structural weakness of this kind of arrangement is that the country in question finances its investments with foreign capital by way of high interest rates. Such capital is very quick to take flight as soon as the cost of money falls, or when political instability manifests itself. The prosperity of the Turkish economy at the start of the 2000s was in fact due to its addiction to foreign capital that of course led to an overvaluation of its currency, the lira. Invested mainly in sectors of low growth like real estate and barely in industrial activities that would have boosted the country’s productivity, this influx of liquidities created an enormous deficit on the balance of payments as it was not balanced out by an equivalent private and public rate of saving in the country. 

Foreign investors grew wary of the country’s political precarity and the relative sterility of their investments, which in 2018 caused what is generally accepted in the jargon as a “sudden stop”, that happens when the infusion of foreign capital dries up and the tide goes out. From that point on, the Turkish central bank had to quickly up its interest rates to ensure that this outflux of liquidities from the country didn’t leave it in ruins, but also to curb the high inflation rate due to the lira freefall. It’s at this moment that the Turkish president, Recep Tayyip Erdoğan, publicly intervened in his country’s monetary policy for the first time by forcing rates downwards, on the basis of a theory (inspired by the American economist Irving Fisher) that claims that low interest rates can combat inflation. 

How can Erdoğan be blamed when a whole fringe of economists insist that it’s high interest rates that cause inflation, and that deflation is the result of low interest rates? For this, they resort to Fisher’s formula that teaches that the sum of inflation and real interest rates together gives the nominal interest rate of an economy. The verdict of these naïve “neo-Fisherians” is that inflation will end up falling if the interest rate set by the central bank is kept under pressure for a long enough time. It is diametrically opposed to what is generally accepted and has been verified by the discipline over recent decades, which has clearly shown that interest rates staying low for too long is a fundamental cause of inflation and that it must be combatted with a tightening of monetary policy.

But this did nothing to stop Erdoğan from forging on and getting rid of all the central bankers and ministers who opposed him and who tried to fight the inflationary spiral and collapse of the lira by raising interest rates in Turkey. Listening only to the voice of his master, the new head of the country’s central bank further lowered interest rates, which decimated its currency and caused inflation to explode, now at 75%! Whether the neo-Fisherians are right or wrong is a technical debate. However, what is not a technical debate is an obvious point to identify: that hyperinflation pretty much always happens when the same person is pulling the levers of both monetary policy and the fiscal and budgetary policy.