Turkey’s economy does not obviously inspire emulation. Over the past five years it has been battered by soaring annual inflation, which hit 86% in October. The central bank is fresh out of foreign reserves, having spent most of them propping up the lira, also to little avail: last month the currency plummeted to an all-time low against the dollar. To make matters worse, Recep Tayyip Erdogan, Turkey’s president, is about to make good on some expensive promises following an unexpected election victory in May. The bill will probably plunge the government, which had been reasonably fiscally sensible until now, deep into the red.
This chaos reflects the upside-down monetary policy pursued by Mr Erdogan. He insists that lowering interest rates is the key to fighting inflation, rather than tightening the screws, which is the solution favoured by generations of orthodox economists. To explain how this could be the case, Turkish officials invoke names ranging from Irving Fisher (an economist, and the finance ministry’s preferred guru) to God (Mr Erdogan’s policymaker of choice).
Since the election Turkey’s monetary policy has become a little more reasonable, as interest rates have been raised. This has not stopped Mr Erdogan’s ideas catching on in the finance ministries of the developing world. “I truly wonder whether classical theories are the way to continue,” muses Ken Ofori-Atta, Ghana’s finance minister, who is one of several African ministers pondering such ideas. “We have to get rates low and growth going,” shrugged another at a recent summit on green finance in Paris. In the past month, officials in Brazil and Pakistan have expressed similar sentiments. Rather than looking at sky-high inflation, a floundering currency or fleeing investors, these ministers focus on Turkey’s GDP growth, which has been remarkably resilient, reaching 5.6% last year. They are skeptical of warnings that such a state of affairs is unsustainable, owing to stalling productivity, which ultimately determines long-run growth, and depleted foreign reserves.
Some reasons for supporting ultra-loose policy when inflation is out of control are much older than Turkey’s experiment. Inflation eats away at the value of official debts, which weigh down developing countries. Letting prices run wild is an appealing option when a government has borrowed too much, even if it is also the surest path to hyperinflation and a currency crash.
Other reasons are newer and come from Mr Erdogan. The Turkish president insists that in emerging markets, loose policy helps quell inflation. For countries that want firms to have access to cheap credit, in order to stimulate industrial growth, this is an appealing idea. One argument put forward is that less expensive borrowing will mean lower consumer prices. Another is that it will boost exports, which may replenish foreign reserves. The problem with both arguments is that the economic activity boosted by low rates also buoys wages and makes firms optimistic about future prices, entrenching inflation. Low rates on government bonds also send foreign investors fleeing, whacking the currency.
It is nevertheless true that monetary policy works differently in emerging economies. Foreign investment matters more for market rates; aggregate demand matters less. In a recent paper Gita Gopinath, the IMF’s chief economist, and co-authors find that emerging markets’ policy rates have next to no impact on their real economies. Looking at 77 developing countries since 1990, the researchers find that, just as in advanced economies, central banks raise the domestic rate at which they lend to local banks when inflation gets going. Unlike in advanced economies, banks do not pass the rate change on to government and household borrowers.
To understand why, consider how banks borrow. Emerging-market financial institutions struggle to find funds at home, since few households save and there are not many big firms. Instead, they turn to international markets. Counterintuitively, the risk premium demanded by foreign financiers tends to fall when inflation is rising, since at such times economic growth tends to be strong. This balances out the impact of central-bank rate rises.
Nor are international markets the only force with which policy must contend. Poor countries are also home to big informal sectors, where firms do not borrow from banks. The un and imf reckon that over 60% of the developing world’s workforce, and more than a third of its gdp, is off the books. Although informal lenders eventually match banks’ interest rates, this takes time. And informal labour markets are flexible, meaning workers’ pay rather than employment adjusts when rates rise. According to the Bank for International Settlements, a club of central banks, this means emerging economies take longer to feel the pinch of higher rates.
Informal finance gives people an escape from the banking system. Your columnist was recently in Ghana, where she was told by an informal lender, who takes luxury cars as collateral, that business has boomed since the country’s latest debt restructuring, which wiped out much of the government’s domestic borrowing and almost took the banking industry with it. Unsurprisingly, trust in formal banks is low. The boss of one of the Accra’s biggest banks says other firms are safeguarding against the fallout from another similar episode by stockpiling dollars off the books.
The problem comes with assuming Mr Erdogan’s policies will help. If high rates are diluted by foreign lenders and informal borrowers, so are low ones. Ms Gopinath’s research is reason to doubt ultra-doveish monetary policy can produce growth, but it does not support the idea that it can cut inflation, either, contra Mr Erdogan. If she is correct, officials need to focus on cutting the risk premium on foreign borrowing to strengthen the impact of monetary policy on the economy. To do this, they must convince investors to take them seriously, which means keeping deficits in check and finances stable, not jumping on the bandwagon of outlandish theories. Mr Erdogan’s experiment is best left in its trial phase.
This article was originally published by The Economist.
The views and opinions expressed above are the author’s and do not reflect those of the Free Turkish Press.