A tale of inflation

view tells it all. Turkish inflation THE LONG was high & chronic in the 1990s, but it never got out of hand and turned into hyperinflation. This is because budget deficits were mainly financed through debt issuance, not money printing. As macroeconomics has demonstrated, if you finance the deficit via printing money, you quickly end up with hyperinflation. On the contrary, if government securities finance the deficit, it takes time to hit the wall and inflation becomes high & chronic. Turkey hit the wall in 1999. In the end, after the 2001 crisis, inflation was nearly conquered and by the end of 2003 it became subdued. Single-digit inflation lasted for almost 15 years.

THE FIRST YEARS OF AKP

There were risks and the growth strategy, if any there was, didn’t look sustainable but at least inflation was contained. Too much real estate investments, too little total factor productivity growth, and very little R&D investments characterized this long period. However, Turkey attracted foreign capital of all sorts, and the Lira became sporadically overvalued, encouraging imports. The economy became fully depended on capital and intermediate goods imports, and the current account deficit soared. The current account deficit took the place of the budget deficit; contrary to the 1990s the latter was small but the former was large. Still, there has been no sudden stop, no serious crisis except 2008-09, and inflation remained subdued throughout. Real interest rates were low but positive. Anyway, the first 15 years of AKP rule was in stark contrast with the 1990s, first thanks to the IMF-Derviş programme, second thanks to the global savings glut. Also, the economic administration made no serious mistakes. Things quickly changed after 2018.

WHAT HAS REALLY HAPPENED BACK THEN?

In the last two decades the world was awash with money more than ever. After 2001 and even after 2004 when the Fed had finally increased its funds rate, dollars were abundant everywhere. Already in 2010 global capital had swollen to some USD 600 trillion, tripling over the past two decades. In 2013 total financial assets were nearly 10 times the value of the global output of all goods and services, and that multiple still stands. As the world economy recovered, financial assets trended up to USD 1540 trillion by 2020 just as the pandemic erupted. Net worth has tripled since 2000, but the increase mainly reflects valuation gains in real assets, especially real estate, rather than investment in productive assets that drive our economies. Today one-third of net worth comes from real estate re-valuations. Turkey is no exception. This is a global trend, a trend only new technologies and AI can change.

THE CREDIT GUARANTEE FUND OF 2017

That helped by postponing the inevitable cooling off of the Turkish economy. For political and also economic reasons incumbent governments don’t like to stop, think and re-route. They simply keep on triggering domestic demand at all costs, and when they clumsily try to change the sources of growth by relying on exports, they do that hastily and the wrong way. The Credit Guarantee Fund changed the risk assessments of banks and helped zombification of SMEs endure. Of course, there was the referendum in April 2017 and as Turkey passed to the presidential system –an Alla Turca one, coupled with Alla Turca economics- everything had to look good. The old idea of a fund-guaranteed credit device has been re-taken from the shelf and put to use.

THE INTERIM: 2018 TO 2021

The USD/TL exchange rate stood at 3.95 in the beginning of April 2018. On May 23, 2018 it was 4.85. In the meantime, during the London road show it was declared to investors and bankers that interest was the cause of inflation. Therefore the rate of interest had to be cut if one wants a lower inflation. People had a hard time to understand that. So, Turkish assets were quickly sold. Mr. Şimşek was minister at that time too. He rushed to London and told investors he was in charge. A couple of weeks later, he was no longer in charge. Then the pastor Brunson crisis erupted. The exchange rate jumped again, from 4.76 on July 23, 2018 to 6.88 on August 13. People thought that was purely political. In a sense yes, but was it purely political indeed? Anyway, the case is solved and the Lira ended the year at 5.28. This was deemed a success but the exchange rate was 3.77 on December 31, 2017. From 3.77 to 5.28 and with a lot of volatility, there is a long way. Hence, inflation was triggered from 11.9 in December 2017 to 20.3 in December 2018 after jumping to 25.4 in October 2018. At that time that was a first. As to wholesale inflation, it headed north even more and reached 46.1 in September 2018. A scissors was formed between the two inflations. In October 2022, DPPI would reach 157.9%.

This is official by the way.

2021, THE YEAR WHEN THINGS GOT OUT OF HAND

In the meantime CBRT reserves were sold. For the first time ever net reserves excluding swaps fell to c. USD 60 billon negative. Today it is c. USD 56 billion negative. Nobody could have foreseen that with that kind of negative reserves one could run a central bank. Indeed, I remember myself having written “for whom the bell tolls” after the CBRT had intervened and lost USD 10-12 billion of its reserves. Indeed, two weeks later it raised the policy rate by a hefty 550 basis points (effectively 300 because the funding rate was already higher than the head-on rate). In September 2021 it would be correct to raise the rate by 100 basis points but instead a cutting cycle has been initiated and things got out of hand in just three months. In December 2021 the advent of the exchange rate-protected accounts was announced. It indexed savings to FX and this way at a high cost the depreciation cycle could have been stopped. Inflation got out of hand. Now nobody knows exactly what inflation do we face because independent research points at more than double the official inflation rate. If you ask people on the street, they will surely tell you that inflation is something like 120-130% rather than 60%. Even if we consider only the official print, we observe that after the infamous 2001 crisis the peak was at 73% in February 2002 but in October 2022 it hit 85.5%. The long view does indeed tell it all. After two decades, we came back to square one, and in fact the situation is far worse because (a) nobody believes the official print ( b) there is now financial repression because real interest rates have been negative over the last couple of years. Savings eroded unless they were invested in protected accounts, but even they fail to preserve the purchasing power of savers’ money.

THE CAR AND HOME RUSH

So, people rushed to buy homes, cars and companies hoarded inputs. This has created cycles within the business cycle. Mortgage rates were around 18% on average in March 2023 –lower in public banks, like 12% per annum. Now they stand at c. 43% on average and credit volumes have dropped down. You can’t buy a home by relaying on credit: it is supplied in low quantity and is expensive. Same with cars, and probably after the last couple of months’ campaigns because demand is already satisfied, cars sales will fall in 2024. The second-hand car market can still function but first-hand cars will simply be too expensive to buy. SMEs will also struggle because they expect a hefty rise in minimum wages. Then, ahead of elections, there will be other venues like selective cheap commercial loans etc. in order to keep small businesses happy. The cycle will go on and on, perhaps until H2 2024. This is business as usual: because the economy is in kind of make-believe equilibrium or a surrogate state there will have to be non-economic interventions to keep people afloat. This applies to wages also because they have little or no relationship whatsoever with productivity. Clearly, a high minimum wage can only provide an incentive to employ refugees that accept to work at sub-par wages. Again, the disparities in the cost of living between provinces and big cities are so pervasive that unless there are regional variations in the minimum wage many people can’t continue to work in big cities.

WAS ALL THAT A MISTAKE?

Was it all a policy error, a mistake? Many good economists, some of them are my friends, tend to think so. I tend to think otherwise. The new course was probably a drive to help the FX-indebted sectors (which explains why reserves were sold at low exchange rates), to render wages cheap in dollar terms so as to promote export competitiveness (which explains why the exchange rate jumped predictably in a few months as the rate of interest was unduly cut at a critical juncture), and help reduce the real burden of government debt (which is what financial repression is). At deeply negative real rates, all debt became incredibly cheap and that too helped businesses to thrive. Those that can’t raise the price of their products (fixed income and wage & salary earners) lose in this game but they are compensated from time to time with wage hikes that have no relationship with productivity. However, equilibrium is lost and the government had to revert back to normal. We are in this process now. Inflation will of course fall at some point at least due to favourable base effects but inflation is only a speed. Past inflation has already done its work.