Wednesday, June 15, 2011

On Turkish Monetary and Fiscal Policy

Turkey has a problem the U.S. (and Europe) very much wishes it had-- rapid growth and high inflation. This month's inflation rate came in higher than expected, now at an annualized rate of 7.2%. This is after a decade of incredible economic growth-- GDP in Turkey has more than doubled since 2002. Real GDP growth in 2010 alone is estimated at 8.2%. With this growth, it's no surprise that the majority AK Party won a whopping 50% of the vote in Sunday's elections.

Turkish politicians also have adopted the opposite position of U.S. policymakers-- they want their currency, the lira, to weaken, as opposed to the "strong dollar" rhetoric you hear from the U.S. Treasury Secretary and others. They want exports to grow in order to shrink their increasing current account deficit. So, the central bank has kept interest rates low. But as the invisible hand works, prices rise which causes a real appreciation of the currency anyway. The concern from Western watchers is that Turkey's central bank has waited too long to raise interest rates and has let inflation get out of hand. So, now the government is "hinting" at fiscal tightening.

The problem is the same as it's always been since Bretton Woods was abandoned in the 1970s-- Turkey has decided to keep independent monetary policy and free capital flows, so it has given up an anchor for its exchange rate. I'd consider this policy a blessing as Turkey takes one look at its rival Greece and is thankful it's not part of the EU debacle right now. Even as Erdogan keeps pushing negotiations for EU membership, Turkey could and should never adopt the euro as its currency. (My guess from the geography and income dispersion in Turkey is that it's not an optimal currency area even just for the lira.) But Turkey fears a 1990s Asian-style bubble where the currency appreciates as "hot money" flows in to fund increasingly questionable investments, Turkish consumers' spend their increased incomes on imports, and all is fantastic until some crisis occurs. For example, a Greek default sets off a flight to safety, and the money quickly flows out of Turkey, the currency crashes, interest rates rise, and the economy plunges into a 1990s Asian-style post-bubble recession.

So, Turkey's central bank is in a quandary-- it needs to raise interest rates to cool off the economy but this would also attract much more foreign capital that appreciates the lira as the U.S. and others keep interest rates low.

In the midst of this, Turkey's Prime Minister Tayyip Erdogan has made some interesting comments about his economic preferences. Erdogan wants to "decrease both inflation and interest rates,"aiming for a long-run real interest rate of zero, or one where the nominal rate is equal to the rate of inflation. His stated reason is "so people will increase their incomes through working, not through interest.” While this reminded me of Keynes' apparent disdain for the "rentier class" or seemed akin to some type of mercantilist or Marxist philosophy, someone reminded me that this is very Islamic--interest is forbidden in Islam.

Remember that real interest rate = nominal rate - rate of inflation. But what can ultimately drive down the nominal and real rates? Only an increase in national saving, the sum of saving done by households and the government, regardless of what the interest rate is. You'd need a massive increase in the desire to accumulate capital rather than goods of consumption.

In the Econ 101 loanable funds model, the increase in national saving causes the real interest rate to fall. This causes net capital outflow to increase, the currency to depreciate, and net exports to increase. (If C, I, and/or G decrease autonomously then income decreases and unemployment increases unless NX increases and/or wages and prices fall together).

The problem for Turkey is that much of the rest of the world isn't growing, so Turkey has become the engine for importing the goods those slow-growing countries are desperate to sell. While it wants to reverse that position, the central bank can't hold down the value of the currency very long-- the inflation is causing a de facto appreciation. As outlined above, foreign inflows of capital also cause the real interest rate to fall, but this would also cause the lira to appreciate and the current account deficit to widen (see the U.S. and the "global savings glut" theory) and the risk of a capital flight bust in the future to increase.

So, it appears that Erdogan's preferred world is one in which Turks consume less and save more as a nation, acquiring a greater value of assets abroad than foreigners acquire of Turkish assets (running a trade surplus). While I was in Turkey, I saw a lot of AKP campaign promises on billboards-- e-readers for every student, extended metro lines, nuclear power plants, greater sea access for Istanbul, etc. It seems hard to square those promises with the increase in public saving likely required to increase national saving and drive the long-run interest rate down to zero.

The next decade will be interesting. Turkey still has plenty of "low-hanging fruit" to encourage domestic investment since it ranks just 65th in the World Bank's Ease of Doing Business indicators. Ending some of the red-tape and figuring out how to expand the tax base without increasing items like the already high payroll tax would potentially help encourage new business that could help unemployment fall below its current rate of 10.8%. It's going to take some creativity to boost saving and avoid an Asia-like boom/bust. But like this article RT'd by Tyler Cowen today (who is visiting the country) indicates, creativity seems to be on the rise in Turkey (see the Eskisehir description).

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