Your economics textbook got it all wrong. At least that’s what Prime Minister Recep Tayyip Erdogan says.
The Turkish leader, 60, is emerging as a global pioneer of putting an untested theory of economics into action. While central bankers around the world, including Turkey’s, have made interest rate decisions based on the textbook assumption that higher rates will work to slow inflation, Erdogan and his administration argue the opposite.
“High interest rates are not the result of a high inflation rate, they’re its cause,” Yasin Aktay, head of the foreign relations committee of Erdogan’s ruling Justice and Development Party, or AKP, said by phone from Ankara on June 7. “The premier is talking about the relationship between the two based on scientific facts,” he said, without explaining how Erdogan reached that conclusion.
Backed by an economic administration loyal to his ideas and a pro-government press fixated on Turkey’s interest rates, the third-highest among major emerging markets, Erdogan is taking the fight to the nation’s central bank. In an era of experimental global monetary policy, he joins a faction of economists seeking alternatives to conventional theory.
The argument that low interest rates cause low inflation has been dubbed the “neo-Fisherite Rebellion” by Noah Smith, an assistant professor of finance at Stony Brook University in New York and a contributor to Bloomberg View. It’s named for Yale University economist Irving Fisher’s equation on the relationship between nominal and real interest rates.
Nobel Prize winner Paul Krugman, in a May 17 posting on his blog, said the neo-Fisherite view probably emerged when “some economists said something silly, not out of deep conviction, but because they weren’t really thinking about what their equations meant.” He concluded by saying, “there’s no reason to take this stuff seriously.”
Still, Erdogan does, even as some economists say the theory may not apply to a country like Turkey. Pressure from the premier, who called the current rates an “oppression” yesterday, has put Central Bank Governor Erdem Basci in the uncomfortable position of having to justify orthodox economics and his interest rate policies from a full governmental assault.
Basci, with advanced degrees in economics from Ankara’s Bilkent University and Johns Hopkins in Baltimore, raised Turkey’s benchmark interest rate by 550 basis points in January to stem losses in the lira that have pushed the inflation rate toward 10 percent. Basci has since lowered the benchmark by 125 basis points, most recently to 8.75 percent on June 24.
Erdogan, whose parliament biography lists his profession as economist, publicly berated Basci for the initial increase, saying it hasn’t helped slow inflation and rates should be immediately cut back to spur Turkey’s $800 billion economy. On May 26, Erdogan asked Basci whether he was joking with a 50 basis-point cut. Inflation that month was 9.7 percent.
The neo-Fisherite thesis rests on the argument that the nominal interest rate includes two components: a real interest rate demanded by investors, which is largely independent of monetary policy in the long run, plus expected inflation.
When nominal interest rates are elevated for a long time, prices also rise to make up the difference, said Martin Uribe, a professor of economics at Columbia University and a backer of the theory. As evidence, he points to economies that have brought interest rates to record lows and are still struggling to push inflation higher.
“Japan has kept the interest rate low now for 15-20 years. Do you know what the inflation rate in Japan is? It’s negative,” Uribe said. “Europe has kept the inflation rate at zero now for five years. What are they facing? Deflation.”
The arguments among academics have focused on examples like those, or the U.S., where inflation and interest rates aren’t far from zero. They may not apply to Turkey, according to Murat Ucer, an economist for New York-based consultancy GlobalSource Partners in Istanbul.
Reducing interest rates in Turkey typically leads to depreciation of the lira and a surge in consumer borrowing, which push the prices of goods in lira up, Ucer said by phone on June 12.
“The biggest danger is that we are trying to implement something that is completely irrelevant to our situation,” he said. “This is a country that never fixed its inflation problem. We never had price stability and the expectations are not anchored.”
Another distinction is that Japan and those other developed economies have huge demand for their government bonds, and “that demand itself is deflationary,” said David Andolfatto, vice president of the Federal Reserve Bank of St. Louis, by phone on June 5.
Radical rate cuts would probably not have the same impact on emerging economies, he said. “If you’re in Turkey and you were to try this, who knows?”
Asked about the Turkish central bank’s view of the neo-Fisherite debate, bank spokesman Yucel Yazar said on June 20 that Basci has repeatedly explained it since April, including in a presentation to the government earlier this month. Basci used a chart to explain that the inflation rate would fall after the bank’s emergency rate increase in January, and interest rates could then be brought down.
In short, Turkey’s central bank doesn’t buy the neo-Fisherite argument. It may still be fighting a losing battle against Erdogan, though.
The premier, who took office in 2003 after one of the deepest financial crises in Turkey’s history, has presided over growth averaging 5 percent a year since then. It’s been central to his appeal to voters, most recently in March 30 municipal elections which his party won. Erdogan’s party is widely expected to announce tomorrow that he’ll contest August elections for president.
While government interventions into monetary policy have unsettled investors, Erdogan has the support of the public and Basci may find it difficult to resist, Tim Ash, chief emerging-market economist at Standard Bank Group Ltd. in London, said by e-mail on June 18.
“The temptation from the market has been to discount Erdogan’s unorthodox views on monetary policy as simply aimed at a particular domestic audience,” said Ash. Turkey’s central bankers “have a difficult enough job fighting inflation, and figuring out a monetary policy stance, without trying to second guess the prime minister,” he said.