A the­o­ret­i­cal over­view of Er­doğan’s re­marks: The is­sue of in­ter­est-in­fla­tion

Daily Sabah (Turkey) - - Business -

ments in all the Jus­tice and De­vel­op­ment Party (AK Party) pe­ri­ods. For in­stance, the float­ing ex­change rate and full fi­nan­cial open­ness are two achieve­ments that will fur­ther deepen in the new sys­tem. We will also make them func­tion in a health­ier way. Even though we have em­pha­sized this again and again, some de­lib­er­ate mis­giv­ings about the is­sue per­sist.

Like­wise, the state­ments made by Er­doğan on in­ter­est-in­fla­tion re­la­tions were also dis­torted by a re­duc­tion­ist ap­proach. A lot of non­sense is cir­cu­lat­ing, go­ing as far as to say that the pres­i­dent’s eco­nomic state­ments have no place in eco­nomic the­ory and they are what they call non-mar­ket. Let me first clar­ify this is­sue: Treat­ing these state­ments as ap­proaches which di­rectly ex­plain the daily, cur­rent mone­tary pol­icy with a re­duc­tion­ist ap­proach is di­rect eco­nomic ig­no­rance, even if it is not badly in­tended. Er­doğan’s state­ments are based on two ba­sic facts.

First, de­vel­op­ments that took place in the global econ­omy with the 2008 cri­sis have laid bare the short­com­ings of tra­di­tional the­ory. Sec­ond, in­fla­tion is a con­se­quence that does not emerge on the de­mand side alone in de­vel­op­ing coun­tries like Turkey, but in­fla­tion, which is a struc­tural prob­lem, is a cost-based con­se­quence.

Irv­ing Fisher (1867-1947) is the fa­ther of the ba­sic ap­proach that ex­plains the in­ter­est in­fla­tion re­la­tion of the tra­di­tional the­ory I men­tioned above. Fisher ex­plains the equa­tion be­tween the nom­i­nal in­ter­est rate, or real in­ter­est, and in­fla­tion with this for­mula. i t= r t+ E t t+1

Here, i t and r t re­fer to nom­i­nal and real in­ter­est rates, re­spec­tively, for a cer­tain t pe­riod. Et t+1 means the ex­pected in­fla­tion in the next pe­riod.

As seen in the equa­tion, the sum of the real in­ter­est rate and the ex­pected in­fla­tion in an econ­omy pro­duces the nom­i­nal in­ter­est rate. Ac­cord­ingly, an in­crease in the nom­i­nal in­ter­est rate un­der the as­sump­tion that the real in­ter­est rate is con­stant in the long run means an in­crease in the ex­pec­ta­tion of in­fla­tion in the econ­omy. In short, there is a clear pos­i­tive cor­re­la­tion be­tween in­ter­est rates and in­fla­tion in the long run, ac­cord­ing to the Fisher equa­tion.

So, let me ask the fol­low­ing ques­tion: De­spite this most ba­sic equa­tion of the macro econ­omy — i.e., when the in­ter­est rate and in­fla­tion move in the same direc­tion — why has the ba­sic mone­tary pol­icy of cen­tral banks been do­ing the ex­act op­po­site for many years? In other words, why do cen­tral banks fol­low the path of hik­ing in­ter­est rates to lower in­fla­tion? The rea­son and the an­swer for this is very clear: From the 1970s on­ward, the U.S. has been launch­ing the fiat dol­lar, the ba­sic re­serve cur­rency, to the mar­ket. Hence, since then, in­fla­tion has been de­scribed as a mone­tary phe­nom­e­non alone, and cen­tral banks have be­gun act­ing out­side the ba­sic Fisher equa­tion. In­ter­est­ingly, mon­e­tarist and Key­ne­sian ap­proaches, the two en­emy sisters of main­stream eco­nom­ics, both make the Fisher eq­ui­tation a fun­da­men­tal com­po­nent of their the­o­ries and all ar­gue that it is un­sta­ble.

For in­stance, let us as­sume that the cen­tral bank keeps the nom­i­nal in­ter­est rate fixed at a cer­tain level. Ac­cord­ing to Key­ne­sian and mon­e­tarist views, in this case, fol­low­ing a small de­crease or in­crease in in­fla­tion, a de­fla­tion­ary spi­ral or in­fla­tion­ary spi­ral emerges over time. There­fore, the cen­tral bank must ac­tively man­age the in­ter­est rate in or­der to avoid these scary sce­nar­ios. This prac­tice is fun­da­men­tally based on the Tay­lor prin­ci­ple in mod­ern mone­tary pol­icy. The Tay­lor prin­ci­ple says that the cen­tral bank should raise in- ter­est rates by more than 1 per­cent if in­fla­tion rises by 1 per­cent. Ac­cord­ingly, when in­fla­tion starts to rise, the cen­tral bank should in­crease in­ter­est rates rapidly and steadily, and if it starts fall­ing, it should re­duce it again.

This ba­sic but faulty ap­proach was al­ready fal­si­fied with the 2008 cri­sis.

With the cri­sis, cen­tral banks of de­vel­oped coun­tries rapidly low­ered in­ter­est rates and zero in­ter­est was put into ef­fect. The pur­pose here is to de­lay a re­ces­sion. Now, ac­cord­ing to Fisher, if the nom­i­nal in­ter­est rate falls and re­mains sta­ble there, the ex­pected in­fla­tion will be low and the real in­ter­est rate will go up. In­deed, neg­a­tive in­ter­est has long been in de­vel­op­ing coun­tries. In this case, since the high real in­ter­est rate will fur­ther de­crease the to­tal de­mand, re­ces­sion will be in­evitable. This is a vi­cious cy­cle and means the fail­ure of tra­di­tional the­ory. As a mat­ter of fact, Er­doğan gave in­di­vid­ual ex­am­ples of coun­tries in his speech in the U.K. and com­pared the nom­i­nal in­ter­est-in­fla­tion rates in these coun­tries to ques­tion the real in­ter­est rate. At this very point, we are ask­ing why de­vel­oped economies, es­pe­cially in the U.S., can­not es­cape the re­ces­sion de­spite the quan­ti­ta­tive eas­ing (QE). They can­not es­cape be­cause they are in a vi­cious cir­cle where mone­tary solutions are in­valid. How­ever, the ex­act op­po­site ap­plies to de­vel­op­ing coun­tries.

How­ever, there have also been de­vel­oped dy­namic mod­els, called Neo-Fish­e­rian, which say in­ter­est rate hikes will im­me­di­ately lead to in­fla­tion or quite op­po­site con­se­quences. For in­stance, among new-gen­er­a­tion stud­ies, Be­lay­gorod & Dueker (2009) and Castel­n­uovo & Surico (2010) pre­dicted new-Key­ne­sian dy­namic prob­a­bilis­tic equilib­rium mod­els and found that in­fla­tion will rise im­me­di­ately as a re­sult of an in­crease in in­ter­est rates. Later, Sch­mitt-Grohe & Uribe (2012) from Columbia Univer­sity de­vel­oped a model based on down­ward rigid wages and Tay­lor-type in­ter­est rate rule, show­ing that in­fla­tion could be raised by rais­ing the in­ter­est rate if the nom­i­nal in­ter­est rate is zero. The idea that the in­ter­est rate-in­fla­tion re­la­tion­ship is sta­ble has also been in­creas­ingly ex­pressed among cen­tral bankers in re­cent years.

For in­stance, Fed­eral Re­serve Bank of Minneapolis Pres­i­dent Narayana Kocher­lakota (2010) said dur­ing an im­por­tant speech that a low overnight in­ter­est rate would lead to sus­tained and low-level de­fla­tion. Again, Fed­eral Re­serve of St. Louis Pres­i­dent James Bullard (2015) stated that a fixed in­ter­est rate pol­icy is a re­al­is­tic pos­si­bil­ity and that, if the low in­ter­est rate-low in­fla­tion sit­u­a­tion per­sists, as­sump­tions re­gard­ing the func­tion­ing of the mone­tary pol­icy in the U.S. may need to be re­vised.

One of the most ad­vanced and com­pre­hen­sive of the Neo-Fish­e­rian stud­ies was con­ducted by John Cochrane (2016) from Stan­ford Univer­sity. In this study, Cochrane first started out from the stan­dard Neo-Key­ne­sian macroe­co­nomic model and found that the most ba­sic model in mod­ern macro­eco­nomics shows a pos­i­tive re­la­tion­ship be­tween nom­i­nal in­ter­est rate and in­fla­tion.

I know that all of this is far beyond the bounds of a col­umn. But I had to. It was nec­es­sary to say, “Stop first and think” to those who dis­tort the pres­i­dent’s state­ments about the in­ter­est-in­fla­tion re­la­tion­ship and say “Where on earth did this come from now? It is against eco­nomic the­ory.” Con­se­quently, Er­doğan’s re­marks are the sub­ject of con­tem­po­rary sci­en­tific eco­nomic the­ory to­day whereas those who ad­vo­cate the op­po­site are the vic­tims of a rot­ten and un­sci­en­tific fal­lacy.

Cemil Ertem

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