The Logic of Erdogan's Wager

Notes on the Lira Crisis

The so-called Obama doctrine is a useful rule of thumb for historical actors, who, as it were, ‘don’t do stupid shit’. By that I mean that if you think that historical actors are doing something utterly irrational, you’ve probably not understood the logic on which they are operating.

If you read the financial press, you’d have noticed that elite Western scolds are united in their condemnation of Erdogan’s economic policy. ‘The Turkish president is at war with the markets,’ the anonymous Oxbridge grads of The Economist write. ‘The two-decade economic boom that lifted millions of Turks into the middle class is beginning to unravel’, the Wall Street Journal notes; thanks to ‘a currency crisis’ that ‘stems from President Recep Tayyip Erdogan’s own economic policies, say economists both inside and outside Turkey.’

The New York Times too, found no disagreement among the technocrats it apparently interviewed for the occasion: ‘Erdogan’s insistence on directing monetary policy and sticking with low interest rates is draining confidence, economists say.’ Ominously, Bloomberg reported that Fitch Ratings has downgraded the outlook on Turkey’s credit rating from stable to negative, saying that interest rate cuts by the no-longer-independent central bank of Turkey ‘create risks to macroeconomic and financial stability and could potentially re-ignite external financing pressures.’

The perception that the lira crisis is due to the president’s incompetence is widespread in the professional class, including within Turkey. Like other plebiscitary democracies run by one man, there is an obvious class politics of working class support for the strongman matched by jaundiced perceptions of the same in the urban intelligentsia. This class politics must be kept in mind in order to understand the scolding tone of the prestige press. Of course, no one works the class scold quite as well as the 24-year-old Oxbridge grads of The Economist: ‘“The competitive force of the exchange rate leads to increase in investment, production and employment,” Mr Erdogan said on November 22nd. He got what he bargained for the next day, when unnerved investors began dumping the lira.’

In order to understand the so-called lira crisis, you have to understand the basic mechanics of currency and bond markets. The most important fact about currency and bond markets is that interest rates and exchange rates are jointly determined. The Turkish central bank can control either the exchange rate or the interest rate — it cannot control both in a world of free capital flows.

The lira has been falling gradually since 2014, before plunging precipitously this year.

In order to understand why the Turkish lira had been gradually falling for years before collapsing more recently, we have to look at the interest rates offered by lira bonds and inflation in Turkey, both relative to the advanced economies.

Now, the interest rates on lira bonds are determined to first order by the policy rate of the Turkish central bank — the level of the yield curve is sufficient for our purposes. This is what the policy rate looks like over the past decade:

Inflation in Turkey had been running well above mean AE inflation, while the Turkish central bank was holding the interest rates roughly constant between 2015 and 2019. So the lira had to fall gradually to maintain the real rate of interest on Turkish bonds at the global equilibrium rate maintained by instantaneous financial flows.

A year before the covid panic, in response to rapidly accelerating inflation and running low on hard currency reserves, the Turkish central bank dramatically increased interest rates. This stemmed the flow out of lira assets. Turkish inflation responded promptly. In light of rapidly falling inflation, the bank then began cutting rates until it was back at previous levels by the middle of last year. But inflation picked up again, leading to another hiking cycle later in 2020. It was this hiking cycle that prompted Erdogan to stamp out the independence of the Turkish central bank and force it to reverse course.

The no-longer-independent central bank began cutting rates in August 2021. By December, it had cut the rate offered on lira-denominated bonds down from 19 percent to 15 percent, well below the rate of inflation which has climbed to 21 percent. The falling real interest rate prompted a dramatic outflow of capital from lira bonds, in turn leading to a collapse in the price of the lira.

This is the mechanics of the falling lira but what is the controlling logic? Is the lira falling despite the will of Ankara? or is a weaker lira the desired outcome?

Erdogan has repeatedly made it clear that the latter is the case. Financial newspapers do report this, only to brush it aside. ‘There is some method to the president’s madness’, The Economist explains. ‘A weak currency and negative real interest rates may help borrowers who do not have foreign-currency debt, exporters who do not have to rely on foreign suppliers, and the construction sector, says Selva Demiralp of Koc University.’

The Economist should know better. It’s the newspaper’s old nemesis: mercantilism. Erdogan has sought and achieved a permanent devaluation of the lira, effectively lowering unit labor costs in Turkey thereby making Turkish workers more competitive relative to Germans. It’s what economists call a ‘beggar thy neighbor’ policy. Don’t expect the newspaper to champion it. But you cannot understand what Erdogan is up to unless you appreciate the governing logic. Financial investors may be dumping lira assets but, with a weaker lira, Turkish products do become more competitive at home and in European markets, and Turkey does become a more attractive destination for FDI by global production firms looking to harvest lower unit labor costs.

The logic is hardly new. Americans have long claimed that China was intervening in currency markets to make Chinese products more competitive. The same allegation was made against the Japanese when Japan was threatening to become ‘number one’. Serious economists know too that the euro has been too weak for Germany (after the wages there were frozen with the Hartz reforms in the mid-2000s) and too strong for the Mediterranean members of the eurozone, leading to large and growing current account surpluses in Germany—the largest in the world—and an unprecedented buildup of Germany’s net investment position.

So, there is nothing new about a medium-sized country pursuing a weaker currency to become more competitive. As a matter of doctrine, economists are loath to say that such a policy could ever be effective. But the proof of the pudding is in the eating. Countries pursue competitive devaluations because they work. Indeed, Turkish exports have responded enthusiastically.

Of course, Erdogan’s wager is not without risk. The main risk is that inflation may get out of hand. Some of the recent spike is simply ‘pass-through’ of the higher price of imported commodities as a result of the weaker lira. That’s by definition transitory. The real risk is an expectations spiral. If economic actors expect higher and higher inflation, things may well get out of hand. In order to contain that threat, the Turkish central bank will eventually have to raise interest rates, which would also stabilize the lira. Paradoxically, we will know Erdogan’s wager has succeeded precisely when he capitulates. By allowing the policy rate to rise, thereby stabilizing the lira and containing inflation, he would have secured a permanent devaluation and restored macroeconomic stability. The key is knowing when to fold.

Erdogan has shown himself capable of such tactical flexibility. As the FT notes, he’s ‘a wily pragmatist’ who let the central bank ‘raise interest rates during previous episodes of currency volatility’. This time, however, he ‘appears determined to follow through on his ideological commitment to low interest rates.’ Guess we’ll see. Only time will tell who is being ideological here. Is it Erdogan or the editors of the world’s most prestigious financial newspaper?