Credit boom in a high and sticky inflation environment

the following set of propositions. CONSIDER Currency substitution increases, perhaps not by leaps and bounds, but by drastic upward movements with each and every jump in the exchange rate. Then, it stabilises at a new mean level until the next new shock. We can call this a new “plateau”. Should this happen, the exchange rate passthrough coefficient would almost automatically rise again, and induce an inflationary self-generating spiral. This is exactly what has happened over and over since May 2018. The old inertia coefficient (Hurst coefficient) representing currency (asset) substitution stood at over 0.60 in 2001, and the FX deposits/M2 ratio was slightly below 60%. In December 2021 those ratios were almost the same. After that, with the advent of the exchange-rate-protected TL deposit scheme and CBRT’s never ending foreign currency sales, we currently stand 5 percentage points below that peak level. Despite the recent relative stabilization of the exchange rate, inflation has become persistent largely because TL depreciated more than inflation against the basket for many months. This has been going on for the last 4.5 years. The USD/TL exchange rate was only 3.8 in January 2018. Therefore, inflation is basically cost-push as the D -PPI testifies – 115% versus 61% CPI. This has already had a bearing on pricing behaviour. The recent inflationary surge that might shift the CPI up to 70% is not due to the buoyancy of demand, but to those two factors. Obviously, energy prices also contributed to that outcome. However, inflation had already skyrocketed before that happened.

STICKY INFLATION

Is inflation becoming sticky? This is in a sense awkward because what is going on is reminiscent of the olden days when the exchange rate pass-through determined everything. Does anyone remember the infamous 2000 programme, the last of the Tablitas? It didn’t work, but the reason why it was implemented in the first place was the dominance of the exchange rate over everything: inflation, interest rates, currency substitution and all that. Although the consumer doesn’t seem particularly happy these days and can’t spend because real earnings are low, inflation is still skyrocketing. Is the problem completely supply-side? After the end of the Credit Guarantee Fund in 2017, inflation wasn’t really demand-pull. It is worrisome. Is the main culprit the exchange rate like in the (very) olden days, the 1990s? If yes, is it realistic to expect inflation to fall on the basis of exchange rate stabilization and favourable base effects? If yes, will there be a complete divorce between the consumer – who can’t spend and therefore trigger demand-pull inflation – and the producer, who can nonetheless invest because incentives are offered to him? As we approach an essential remake of the 2017 Credit Guarantee Fund, and because banks have been offered a lot of lending space at 14% CBRT funding, the natural outcome may well be a pronounced difference between consumers and businessmen. Why should they invest if demand is weak? Well, first, they can export, and second they can buy capital goods and intermediate goods and hoard them because they don’t know when prices could increase again. Buying cheap machinery and equipment while it is relatively cheap – compared to a hypothetical tomorrow – can be a good strategy. If there is cheap credit at 9% annual interest and if producer’s inflation is 115%, why not get the credit and do whatever it takes to support operating incomes?

ASSET SUBSTITUTION AND THE EXCHANGE̞ RATE ̞PROTECTED TL DEPOSIT SCHEME

The unlikelihood of a strong currency (asset) substitution clearly indicates that convergence to a “good” equilibrium out of a multiplicity of expectational equilibria won’t be easily achieved through the “smoothing” of expectations alone, which remain subject to cascades and reversals. Not only is reverse asset substitution on a large scale difficult to obtain unless a radical transformation looms on horizon and unless huge FDI influxes look probable, but also it may be true that such a substitution isn’t the best way to induce sustainable growth. Growth comes in many forms. What we need most is growth based on human capital and capital itself, meaning a substantial source of growth should emanate from productivity. True capital is scarce. But endowing the economy with enough capital to ensure a new take-off is only the beginning of a somewhat complicated and possibly long story.

A NEW CREDIT GUARANTEE FUND?

Loans and government spending have been the two pillars on which consumer demand was built. Because household debt is high, and because the real estate sector’s cash flow doesn’t flow easily, real sector confidence is based on exports and stock depletion – along with other sweeteners, such as cheap credit. That cannot continue forever. Making the Credit Guarantee Fund (almost) permanent may look attractive at first glance, but it is only a means of delaying the inevitable. Exports help, but they can’t

provide the answer because the domestic market is large, and domestic consumption accounts for at least 70% of GDP. Moreover, the value-added that comes from exports doesn’t exactly square with the contribution of exports to GDP, given the terms of trade, which are declining. Furthermore, the global economy is slowing down. We know that the Credit Guarantee Fund did a good job five years ago as a temporary relief mechanism. Admittedly, such shock therapy could only have been transient. It can’t and shouldn’t be built into the system. It distorts banks’ risk assessment profiles. It also distorts prices. In 2017 it helped SMEs to roll over their debt. It also helped them to secure working capital loans. It may have led to loan hoarding because it was cheap, an opportunity firms couldn’t miss even if they didn’t need the credit. If it becomes permanent, it would invite moral hazard and could even lead to ‘zombie protectionism’ of some sort. Protecting jobs is a good aim in and of itself, but extending the life of inefficient firms comes as a by-product, delaying therefore much-needed restructuring of small-scale enterprises.

THE ‘LONG VIEW’

What about the global economy and international politics? Let’s take the ‘long view’. Pre-1715 financial data, especially interest rates, are perhaps unreliable, but they have at least the merit of being in line with historical land prices, which are better known. By the end of the Early Modern period, longterm interest rates hovered around 11%, but they fell to 3% in the 18th Century. In reality, global interest rates were never very high if we take the long view. Rates were exceptionally high through the mid-1970s – after the first oil shock of 1973 – and this is what most people remember. They have heard that there was a time when interest rates were very high, possibly when they were children. True, the Fed’s policy rate was c. 20% in 1980. This year it will rise and possibly reach 1.75-2% by the end of the year. This is what we call high interest rates today. Half a century ago people wouldn’t believe they could be so low – even when they are said to be “high.” However, this situation isn’t unheard of: for the best part of the last 300 years real interest rates were low, and that helped trigger the first industrial revolution.

In the 1970s, things were different. That decade was also the beginning of over-financialization and a new era of changing attitudes towards social conflict. The New Deal died off, for instance. And the European communist parties began to fade just before 1980. The Old Left lost its appeal. As a result, not only did income and wealth distribution tilt in favour of high income groups, but also the nature of work changed.

GOOD WEATHER AFTER 2025?

It is clear that low rates for a decade is a good recipe for innovation. Such a period occurred just before the First Industrial Revolution and it is probably happening again now in the form of Industry 4.0 – or 5.0 for that matter. In fact, real interest rates have been decreasing for the last 30 years. Since 1990, real rates have fallen by 2 percentage points every decade, and global real interest rates have stood at (near) zero for the last fourteen years. Hence, the “new neutral” was put is being put to the test: zero real interest rates for years to come. Monetary policy is only beginning to normalize now because inflation is back, but will relatively high rates endure? I think real rates in the advanced world will never be truly high for the foreseeable future. Truly high real rates don’t trigger innovation and growth. Just as the future belongs to electrical cars it belongs to low rates. This is not the end of the story obviously – it could in fact only be the beginning. If you don’t do anything innovative, no matter what interest rates are, you will achieve nothing. Temporary breaches of sparkling consumption-based growth episodes can occur if rates are low enough, or if there are other trigger mechanisms put to work, but the quality of your life and your work won’t change.

THE ‘NOT SO LONG’ VIEW

The global economy will slow down visibly in 2022 and in 2023. This is the ‘not so long ’ view. What started with Ukraine won’t go away. There will be kind of a new cold war, with armed conflicts around the globe. Europe will struggle to remain ideologically unshaken and will tilt towards the far right, but also will it struggle to grow and remain as prosperous as before. China is also slowing down, and it may not be a temporary setback this time. This time things are different.