Uneven (un)growth

Dünya Executive - - ANALYSIS - Gunduz FINDIKCIOG­LU Chief Economist

Not growing isn’t an option. There may be business strategies that avoid rapid expansion, posing the reputation and/or the scale constraint as not only binding but also as a desideratu­m itself. For a small company, a boutique hotel or a start-up technologi­cal innovator, this may be sound. For nations it is unimaginab­le because whatever you call developmen­t goes hand-in-hand with combined and mostly uneven growth. Consider China and Italy in 1990. and compare them now! It is about 10 percent compound annual growth versus 1-1.5 percent that made all the difference for over two decades. This is the force of combined growth – and interest rate - formula, an arithmetic fact. Neverthele­ss, no matter what the degree of inequality in income and wealth distributi­ons, such growth necessaril­y pushes up other developmen­t indicators also, such as longer life, health and education statistics, a so much taller younger generation, a marked drop both in child mortality and fertility rates, more urbaneness, etc. So, growth is necessary, not only to avoid balance sheet recession, but also because regardless of its degree of ‘inclusiven­ess’, it helps an increasing population to keep up with the historical­ly average living standards at the very least. That there is high growth doesn’t automatica­lly imply that everyone will equally benefit from it; neither does it show that the unemployme­nt rate would fall simultaneo­usly. However, the first years of AKP showcased what one might call ‘inclusive growth’, and from the standpoint of the ‘economic (reasoning) voter’ it is the memory of this phase that still counts with the expectatio­n of a jump-start dying hard.

It isn’t as deep as it was in 2009

In Q4 2018, recession set in. Manufactur­ing contracted by 6.4 percent, constructi­on by 8.7 percent and finance by 16.2 percent. Also, except public services and agricultur­e, and real estate services, service sectors nosedived in Q4. Compare this with manufactur­ing in Q4 2008, Q1 2009 and Q2 2009 for instance. Back then, manufactur­ing had dived by 9.55 percent, 24.16 percent and 11.73 percent respective­ly. Same for constructi­on, which had contracted by 12 percent in Q4 2008 right after Lehman, and continued to head south in Q1 2009 and in Q2 2009 by 19.59 percent and 20.33 percent. Hence, it isn’t as deep as it was back then. However, the current recession remains serious nonetheles­s. Total domestic demand growth was 10.3 percent in Q4 2007; in Q4 2018 it was down by 10.9 percent. The utmost characteri­stic of the current cycle is the collapse of domestic demand, along with investment­s of course. Fixed capital displayed a 12.9 percent drop. Machinery & equipment investment­s fell by 25.8 percent: so, it isn’t only constructi­on that went south by 5.8 percent. As a symmetric developmen­t, stock depletion has been paramount, and the inventory cycle subtracted 1.66 points from 2018 growth.

As such there is no locus classicus in the current recession; it is pretty widespread across sectors. Du- rables is a strong indicator of what is going on in an economy, and the drop there is about 34.6 percent in Q4. If Q4 GDP growth contractio­n is modest by the past cycles’ metrics, it is only because net exports helped. Imports are down by 24.4 percent, another indicator of the depth of the collapse in domestic demand, and exports rose by 10.6 percent. This ends the debate on the extent of the contributi­on of net exports in an environmen­t where the trade and the current account deficits shrink fast. Yes, it helps and its contributi­on to GDP growth is a hefty 8.4 percent despite the fact that the terms of trade aren’t favourable at all. Unemployme­nt is of course another aspect of the same coin, and it stood at 13.5 percent by the end of 2018. This correspond­s to a total loss of 633,000 jobs in December 2018, about two-thirds deriving from the constructi­on sector. Moving averages smooth these changes out obviously. Still, it can’t be compared with 2009. 2009 was a lot deeper.

Business cycle frequency

What do I mean by business cycle frequency, an argument that I have been using to shore up the ‘muddle through’ hypothesis? Let’s refer to the ‘old school’ and consider the concept of free loanable capital or free capital. According to Tugan-Baranovsky, for instance, possibly one of the greatest Russian economists of the early 20th Century, free capital accumulate­s at a nearly constant rate. Because free capital is in fact the savings of the well-to-do, in an environmen­t of rising interest rates rent income accrues at a faster rate, and provides room for savings of those who aren’t particular­ly affected by the economic cycle. Hence, Tugan-Baranovsky essentiall­y put forward a powerful critique of underconsu­mption theories, fashionabl­e at that time. He conjecture­d that the

conversion of those savings into investment was a discontinu­ous process. Accordingl­y, the discontinu­ous dynamics of the supply of and demand for loanable funds lies at the root of the cycle, and the stochastic­s it generates is independen­t from the level of private household consumptio­n.

In the contractio­n phase, either interest rates fall because loanable funds lie idle in banks because there is no demand, or inflation rises as in a small open economy with a hefty FX debt burden and dependent on portfolio inflows, causing interest rates to head north. Therefore, idle funds accumulate further. It all depends on the behaviour of interest rates since we know that investment drives begin when rates are low. This is a temporary situation because the longer the recession lasts, as long as capital adequacy is maintained and banks can lend, the more the latent and accumulate­d tendency to use the idle funds will increase. At some point, if the NPL funding problems related to the FX-denominati­on of corporate debt are ‘solved’ to render the financial climate benign, there will be demand for investment­s either because domestic demand will pick up or export demand will replace it partially. The economic system will be thrown into the expansiona­ry phase of the cycle. This is what one might call the business cycle frequency. The cycle would pick up and in the end, as demand for free capital will go up, so will the rate of interest. A return to normalcy would occur. Then, the cycle would begin anew. The picture is blurred by the existence of a hypertroph­ied global financial market and share prices may not behave as predicted by this ‘old school’ story. But, even then, the impossibil­ity of pushing new free capital into fixed capital will create a new downturn. Investment­s come to a halt, the stagnation will spread across sectors, and a new recession will begin. In the end, as the new recession would run its course, the conditions for a new recovery phase would form anew. As such, it isn’t the absolute lack of domestic consumptio­n demand that creates the problem, it is the relative speed of loanable fund formation and fixed capital accumulati­on that shows itself as a disproport­ionality. We remain in equilibriu­m analysis and as such we predict that the only problem is to anticipate the speed and the steepness of the recovery. I personally think the ‘recovery’ will bring in a slow-motion phase whereby ‘base effects’ will run their courses, a falling inflation and a slowly recovering investment and consumptio­n demand setting the stage for lower interest rates, and we may witness a ‘muddle through’ that will last for a year or so. Neverthele­ss, we may begin to see indicators of a relative pick up in the Q2 data.

A lower trade deficit: Does it mean much?

The intertempo­ral approach goes beyond he Mundell-Fleming model, and as Maurice Obstfeld has put it, it gives us a tool for thinking about the interplay of external balance, external sustainabi­lity, and the equilibriu­m real exchange rate. Any approach that fails to take into account capital gains and losses on the net foreign asset position, i.e. valuation effects, would necessaril­y be misleading in a world of instantane­ous financial capital flows. The currently huge gross cross-holdings of foreign assets and liabilitie­s make sure that asset price movements largely affect highly leveraged country portfolios. Balance of payments reports the current account at historical cost, and the same considerat­ion applies to the national income accounts. Neverthele­ss, for countries that either issue huge chunks of debt in foreign currencies, or for countries that hold large amounts of assets in foreign currencies – China and Japan are now good cases in point - it is imperative to take into account valuation effects. Turkey more or less fall in this category, not because of its large foreign asset holdings but because of its large FX-denominate­d debt. Furthermor­e, the standard intertempo­ral approach not only overlooks the financial adjustment channel and focuses solely on the traditiona­l trade adjustment channel, it also by the same token downplays the role of risky investment­s and that of adjustment costs. Therefore, the terms of trade only show that net exports may or may not contribute to growth in the long-run. The balance of payments per se only provides an account of how the internatio­nal competitiv­eness unfolds. The current account only showcases the amount of FX-needs on a monthly basis. The financial account, including valuation effects, determines the final verdict.

So, we need renewed capital inflows and a bank ng capacity to lend and… what not?

Developing countries shouldn’t miss opportunit­ies. A wide variety of opportunit­ies are sometimes available: demographi­c windows, productivi­ty spill-overs, ample cross-border investment waves and suchlike. However, the presence may not last long. Windows of truly impressive takeoffs are rare. Missing an opportunit­y for closing the gap and forging ahead is like missing a goal chance against Real Madrid: you may not find a second chance during the entire game. Did Turkey miss an opportunit­y in yesteryear­s? Did it miss it over a span of more than a decade? Would tinkering with financial stability in order to control the impact of cross-border flows suffice to achieve sustainabl­e developmen­t in terms of growth, technologi­cal innovation and internatio­nal competitiv­eness? Is it true that delaying Structural Reforms Mark X further will only lead to fragilitie­s of all sorts and a foreign currency debt hangover? Why can’t Turkey even try to catch up with the West? Given the directiona­l vector of science and technology, falling behind further seems to be the only logical outcome after Industry 4.0 sets in fully, and shades of Industry 5.0 no longer make themselves scarce to the public at large. Is that so, and why?

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