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The Predicament of Turkey's Monetary Policy

Image by Meric Dagli on Unsplash

Turkey was once known as an “investment darling” by investors around the globe. Between 2002 – 2007 the Turkish economy grew rapidly at an annual rate of around 7.2% and was one of the fastest-growing economies in the G20. Much of this growth was financed through cheap credit as the country took advantage of low interest rates globally and quantitative easing. But a house built on sand doesn’t take a lot to fall, and Turkey’s currency has taken a mighty fall.

The Turkish lira has lost as much as 45% of its value this year. Its economy has struggled with rising inflation and recessions since 2018 resulting in rapidly growing prices for food and other necessary products. This has made it harder than ever for everyday Turks to make ends meet. As hardships for Turks increase, their consumption of non-essential products has decreased leading to a fall in aggregate demand similar to the Turkish President Recep Tayyip Erdogan’s ratings. This is not the only thing harming the economy, increasing inflation means increasing prices of imports. Many of Turkey’s industries that rely on imports, such as raw meat, have been crippled.

As inflation rises other skeletons in the economy’s proverbial closet have come out from hiding. Turkey’s economic rise was driven heavily through cheap credit, but it is now time to pay up. They borrowed mainly in dollars so as inflation rises, the debt is increasing as more Turkish Lira will be needed to pay off the debt in dollars. But how did the country get into this predicament?

There is the obvious culprit; the pandemic, which required substantial quantitative easing thereby increasing inflation. In addition, Turkey was struggling with mountainous debt even before the pandemic. Considering this you would expect inflation to rise, but not to take off like a rocket and surge past 20 percent. Why has this happened then?

Evidence points towards the Turkish President’s unconventional monetary policy stance. Firstly, the national bank in Turkey is not independent from the government as President Erdogan’s unconventional policy stance has had a tight hold on monetary policy. For instance, his reluctance to raise interest rates no matter how unpleasant the inflation becomes. In addition, he has even gone as far as calling interest rates the “mother and father of all evil”.

To better understand how low-interest rates directly affect inflation you must consider the quantitative theory of money. Essentially it linked the supply of money to inflation, proposing that as the supply of money increased, with other variables remaining constant, inflation will also increase. Having a low-interest rate means more people borrow and this credit finds its way into deposits eventually and is then sent out as more credit, acting as a money multiplier and increasing the supply of money. Which in turn, increases inflation. But what is the Turkish government doing about this?

The central bank has been buying up the lira on the open market, but this is a short-term plan and relies on the central bank’s reserves which can’t last forever. Erdogan is still adamant about keeping interest rates low to give the people access to cheap credit, attempting to borrow his way out of a crisis and raise consumption. But are there any other solutions other than raising interest rates?

The central bank could buy back government bonds which would decrease the money supply or try the Keynesian solution of decreasing demand by increasing taxes which in turn should decrease prices. However, neither of these solutions would be as popular with the Turkish people as simply raising interest rates.

Knowing this, it will be interesting to see whether Erdogan sticks to his guns or caves into popular opinion. Either way, sadly for the people of Turkey, things are likely to get worse before they get better.


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