TThe economy of Türkiye obviously does not encourage imitation. For the past five years, it has been plagued by skyrocketing annual inflation, which reached 86% in October. The central bank has run out of foreign exchange reserves, having spent most of them to support the lira, but to no avail: the currency plummeted to all-time lows against the dollar last month. To make matters worse, Turkish President Recep Tayyip Erdogan is set to deliver on some expensive promises after an unexpected election victory in May. The draft law will probably plunge the government, which has been reasonably reasonable from a fiscal point of view, deep into the red.
This chaos reflects the wrong monetary policy pursued by Mr. Erdogan. He insists that cutting interest rates is the key to fighting inflation, not tightening the screws, which is the solution favored by generations of orthodox economists. To explain how this could be the case, Turkish officials invoke names ranging from Irving Fisher (an economist and the Finance Ministry’s favorite guru) to Gott (Mr Erdogan’s favorite politician).
Since the election, Turkey’s monetary policy has become somewhat more prudent as interest rates have been raised. However, this has not prevented Mr Erdogan’s ideas from gaining traction in the finance ministries of developing countries. “I really wonder if classical theories are the way to go,” muses Ken Ofori-Atta, Ghana’s finance minister, who is one of several African ministers pondering such ideas. “We need to cut interest rates and start growth,” shrugged another, speaking at a recent green finance summit in Paris. Last month, officials in Brazil and Pakistan expressed similar views. Instead of looking to rampant inflation, a faltering currency, or fleeing investors, these ministers are focused on Turkey GDP Growth has been remarkably resilient, reaching 5.6% over the past year. They are wary of warnings that such a state of affairs is unsustainable given stagnant productivity, which ultimately determines long-term growth, and depleted foreign exchange reserves.
Some reasons for supporting ultra-loose policies when inflation spirals out of control predate Turkey’s experiment. Inflation is eating up the value of government debt, which weighs on developing countries. When a government has borrowed too much, letting prices run wild is a tempting option, although it’s also the surest route to hyperinflation and a currency crash.
Other reasons are newer and come from Mr Erdogan. Turkey’s president insists loose policies in emerging markets will help curb inflation. For countries that want companies to have access to cheap credit to boost industrial growth, this is an attractive idea. One argument is that cheaper borrowing leads to lower consumer prices. Another reason is that it will boost exports, potentially replenishing foreign exchange reserves. The problem with both arguments is that the economic activity boosted by low interest rates also pushes up wages and makes companies optimistic about future prices, which supports inflation. Low interest rates on government bonds also cause foreign investors to flee and the currency suffers.
However, it is true that monetary policy works differently in emerging markets. Foreign investment is more important for market interest rates; Aggregate demand is less important. In a recent article, Gita Gopinath writes IMFThe chief economist von ‘s and co-authors conclude that the key interest rates of the emerging countries have almost no influence on their real economy. Looking at 77 developing countries since 1990, the researchers find that just as in advanced economies, central banks increase the domestic interest rate at which they lend to local banks when inflation picks up steam. Unlike in advanced economies, banks do not pass interest rate changes on to government and private borrowers.
To understand why, consider how banks make loans. Financial institutions in emerging markets are struggling to find money domestically because few households save and there aren’t many large corporations. Instead, they turn to international markets. Contrary to intuition, the risk premium required by foreign financiers tends to decrease when inflation rises, as economic growth tends to be strong at such times. This will offset the effects of central bank rate hikes.
Nor are international markets the only force that politicians have to contend with. Poor countries also have large informal sectors where companies do not borrow from banks. The U.N And IMF It is estimated that over 60% of the labor force in developing countries is employed, and more than a third of that GDP, is from the books. Although informal lenders eventually match banks’ interest rates, it takes time. And informal labor markets are flexible, meaning that as wages rise, workers’ wages adjust, not employment. According to the Bank for International Settlements, a club of central banks, this means emerging markets are taking longer to feel the strain of higher interest rates.
Gloomy markets
Informal finance offers people a way out of the banking system. Her columnist was recently in Ghana, where she was told by an informal lender who accepts luxury cars as collateral that business has been booming since the country’s recent debt restructuring, which wiped out much of the government’s domestic borrowing and almost took its banking sector with it . Not surprisingly, trust in formal banks is low. The head of one of Accra’s largest banks says other firms are protecting themselves from the consequences of another similar episode by hoarding dollars off the books.
The problem lies in the assumption that Mr Erdogan’s policies will help. If high interest rates are diluted by foreign lenders and informal borrowers, so are low interest rates. Ms Gopinath’s research casts doubt on the fact that ultra-accommodative monetary policy can produce growth, but neither does it support the idea that it can bring down inflation, much as Erdogan did. If she’s right, officials need to focus on lowering the foreign credit risk premium to increase the impact of monetary policy on the economy. To do that, they need to convince investors to take them seriously, which means keeping deficits under control and finances stable, rather than jumping on the bandwagon of outlandish theories. It would be best to leave Mr. Erdogan’s experiment in the test phase. ■
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Read more from Free Exchange, our economics column:
The illusion of working from home is fading (June 28th)
Can the West build up its armed forces cheaply? (June 22)
Wage-price spirals are far more frightening in theory than in practice (15th June)
Also: What the “Free Exchange” column looks like got his name
