The Turkish lira crisis: Erdogan misunderstands how interest rates work

(Photo
by Getty Images)

• 
  The Turkish lira collapsed by over 35% in value versus the
  US dollar this year — a dramatic and sudden
  fall. 
• Yet the Turkish economy is growing
  strongly. 
• The trigger for the crisis may be investors’
  realisation that President Recep Tayyip Erdogan doesn’t
  understand, or doesn’t believe in, the role central banks play
  in setting interest rates that control inflation.
• Erdogan has called interest rates “evil” in the past,
  and it’s an attitude that may be spooking markets.

LONDON — Turkey’s economy went from being rocky-but-fixable into
a full-blown currency crisis today as the Turkish lira collapsed,
losing more than 7% of its value against the US dollar on Friday,
totaling a drop of over 35% since the same date last year. The
crisis may potentially spread beyond Turkey, as Italy’s
already troubled banks are particularly exposed to the lira.

The immediate trigger for the decline was US President Trump’s
threat of sanctions against two senior Turkish ministers, in
protest at the country’s imprisonment of Andrew Brunson, an
American Christian pastor jailed on accusations that he is linked
to the Gulen movement, which opposes Turkey’s current government.

But the actual sanctions imposed — freezing
assets of a handful of Turkish officials — are not
enough to tank an entire currency. GDP growth in Turkey is robust
— it was 7.4% in the first quarter of 2018 and 7% in 2017. (For
comparison, annual GDP was only 2.3% in the US and 1.8% in the
UK).

So what is really going on?

The
collapse of the lira.

XE.com

Recep Tayyip Erdogan fundamentally misunderstands the
role of central banks

The track record suggests that President Recep Tayyip
Erdogan fundamentally misunderstands the role of
central banks in setting interest rates to combat inflation,
and it is this error that is fuelling the bonfire of lira right
now.

In basic terms, if you have rising inflation then a country’s
central bank needs to increase interest rates to drive prices
down again. The higher your inflation, the higher rates need to
go to combat it.

But in Turkey,
inflation is currently running at 16% — an astonishingly high
level for a modern European country. Most Western free-market
countries aim to keep inflation at or below 2% per
year.  

With inflation rampant, Turkey’s central bank had been expected
to raise interest rates again. But in July it held them,
at 17.75% (which must, admittedly, seem already punishingly
high for Turks grappling with raging consumer price increases).

That was the exact opposite move the markets wanted to see — it
signalled that Erdogan’s central bank is not serious about
controlling inflation and thus the price of the lira.

‘Because my belief is: interest rates are the mother and father
of all evil’

The reason the bank lacks that seriousness is chilling: Erdogan
fundamentally does not understand how interest rates work.

Back in May he said, according to Reuters (emphasis
added):

“If my people say continue on this path in the elections, I say I
will emerge with victory in the fight against this curse
of interest rates,” Erdogan said in a speech to business
people in Ankara, referring to snap elections on June 24.

“Because my belief is: interest rates are the mother and
father of all evil.”

In July he appointed his son-in-law, Berat Albayrak, to run
the central bank. Albayrak told Turkish TV, “We will see
inflation and interest rates decline in the coming period,” but
then he did nothing with interest rates. As the Financial Times
put it, “Many
see this as a sign that Erdogan’s takeover of the country’s
monetary policy is complete.”

Erdogan is a conservative Muslim intent on turning his country
away from the West and back toward Islam. In that religion,
charging interest on debts is regarded as “riba,” or usury, which
is therefore “haraam” (sinful or prohibited). Thus it may well be
that when Erdogan describes interest rates as “evil” he is
speaking literally not figuratively. 

By leaving the interest rate alone they have signalled to the
market that the exchange price of lira won’t stabilise anytime
soon

The problem for Turkey is that its economy has grown at a fast
pace in recent years. This, generally, is a good thing and one of
the reasons Erdogan won re-election this summer. But a
fast-growing economy tends to drive prices higher, as demand
outstrips supply. High inflation can kill an economy by making
its currency worthless — no one wants to use it if its value
tomorrow is a fraction of its value today. Currencies only tend
to hold their value when prices are stable. The only way to
maintain the value of the lira is for the Turkish central bank to
sell government bonds and increase the rate of interest it offers
for anyone who wants to hold them. In so doing, the bank would
take in lots more lira — thus removing currency from the
market. Like any commodity, a reduced supply of lira would
increase its value and stabilise its price.

Unfortunately, Erdogan and his son-in-law are doing the opposite:
By leaving the interest rate alone they have signalled to the
market that the exchange price of lira won’t stabilise anytime
soon. In July, when the bank failed to act, Albayrak
said, “We
will see inflation and interest rates decline in the coming
period.” Either Erdogan and Albayrak don’t understand
what they need to do to get the crisis under control, or they
regard interest-rate setting as so evil they would rather live
with the consequences.

Either way, it’s bad.

There have been two infamous occasions in history when
governments attempted a similar miracle to what Erdogan
and Albayrak are hoping for today. One was the Weimar
Republic of 1919 to 1933, when the German government printed
money to pay its debts, with disastrous consequences. The other
was the US in the 1970s, when US Federal Reserve chairs Arthur
Burns and William Miller kept interest rates low because, as
businessmen, they just liked low interest rates. The US economy
went through a 10-year period of “stagflation” — high inflation
and repeated recessions — as a result.