Turkey’s lira crisis may be down to Erdogan’s fundamental misunderstanding of how ‘evil’ interest rates work


The Turkish lira collapsed by over 35% in value versus the US dollar this year — a dramatic and sudden fall.
Yet the Turkish economy is growing strongly.
The trigger for the crisis may be investors’ realisation that President Recep Tayyip Erdogan doesn’t understand, or doesn’t believe in, the role central banks play in setting interest rates that control inflation.
Erdogan has called interest rates “evil” in the past, and it’s an attitude that may be spooking markets.

LONDON — Turkey’s economy went from being rocky-but-fixable into a full-blown currency crisis today as the Turkish lira collapsed, losing more than 7% of its value against the US dollar on Friday, totaling a drop of over 35% since the same date last year. The crisis may potentially spread beyond Turkey, as Italy’s already troubled banks are particularly exposed to the lira.

The immediate trigger for the decline was US President Trump’s threat of sanctions against two senior Turkish ministers, in protest at the country’s imprisonment of Andrew Brunson, an American Christian pastor jailed on accusations that he is linked to the Gulen movement, which opposes Turkey’s current government.

But the actual sanctions imposed — freezing assets of a handful of Turkish officials — are not enough to tank an entire currency. GDP growth in Turkey is robust — it was 7.4% in the first quarter of 2018 and 7% in 2017. (For comparison, annual GDP was only 2.3% in the US and 1.8% in the UK).

So what is really going on?

Recep Tayyip Erdogan fundamentally misunderstands the role of central banks

The track record suggests that President Recep Tayyip Erdogan fundamentally misunderstands the role of central banks in setting interest rates to combat inflation, and it is this error that is fuelling the bonfire of lira right now.

In basic terms, if you have rising inflation then a country’s central bank needs to increase interest rates to drive price increases down again. The higher your inflation, the higher rates need to go to combat it.

But in Turkey, inflation is currently running at 16% — an astonishingly high level for a modern European country. Most Western free-market countries aim to keep inflation at or below 2% per year.

With inflation rampant, Turkey’s central bank had been expected to raise interest rates again. But in July it held them, at 17.75% (which must, admittedly, seem already punishingly high for Turks grappling with raging consumer price increases).

That was the exact opposite move the markets wanted to see — it signalled that Erdogan’s central bank is not serious about controlling inflation and thus the price of the lira.

‘Because my belief is: interest rates are the mother and father of all evil’

The reason the bank lacks that seriousness is chilling: Erdogan fundamentally does not understand how interest rates work. Back in May he said, according to Reuters (emphasis added):

“If my people say continue on this path in the elections, I say I will emerge with victory in the fight against this curse of interest rates,” Erdogan said …read more

Source:: Business Insider


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