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