Turkey

Every semester I do this class, a country comes up in the macroeconomic news that I could not have anticipated at the start of the semester.

This year it's Turkey, which is in a crisis of its own creation right now. It's not clear how big this one will get.

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In aggregate, Turkey is well into the 90th percentile as far as size goes (it's a tad smaller than Italy, which is one of the big 4 in western Europe).

It is further down in per capita real GDP — around the 60th percentile.

Want a comparable? Think Mexico.

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Historically, predominantly Sunni Moslem Turkey (where they speak a language that is not Indo-European or Arab) was the mortal enemy of Russia and Austria. Up until 3 centuries ago, Turkey was the aggressor. In short, Turkey was a player. As it became weaker, it became the victim, and no longer was considered a Great Power. Imperial Germany cultivated Ottoman Turkey before World War I, while Austria-Hungary, Russia, and later Italy fomented unrest and then wars of independence inside its borders. The Ottomans made a bad move joining the Central Powers in World War I. 

After the war, revolution overthrew the sultans, and Turkey turned secular and increasingly western (you know ... The Orient Express and all that). Nazi Germany cultivated them to join the Axis powers in World War II, and Turkey rightly declined to get involved. After that, Turkey became one of the major non-American military powers in NATO. By the 90's, Turkey was looking like a developed country.

And then, in my opinion, the Europeans blew it. Turkey had been attempting to join western European economic organizations going back to 1959. They met all the qualifications. Easily. But the process has been repeatedly stalled (there is a huge Wikipedia site on this, because the process has been so sordid). Over the last 30 years, the EU has repeatedly admitted smaller, poorer countries, including Greece which systematically lied about its macroeconomic data to get in. While they still go through the diplomatic motions, in my opinion, Turkey as a culture has given up on the EU.

Since 2003, Turkey has been ruled by a dictator named Recep Erdogan. It hasn't been pretty. But he's popular, and in many ways Turkey has been a successful country under his leadership. But the country is no longer secular, and is increasingly oriented towards the Middle East rather than Europe.

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So what's happened so far?

In principles, we usually stress that a central bank that is independent of the government and political forces is a good thing for reasonable monetary policy. The independence of Turkey's central bank has declined under Erdogan. Currently, the central bank of Turkey (hereafter TCMB) gets its objectives from the government, although it has been free to use

Last week Erdogan abruptly fired the Governor of the TCMB. He was already the 3rd in 2 years. He was an ally of Erdogan, as were the previous Governors. But that wasn't good enough. His transgression appears to have been fighting inflation by raising interest rates. 

“It is as complete a surprise as I can remember in 20-plus years of doing this job,” said Paul McNamara, an investment director at GAM Investments in London, who manages emerging-market debt funds.

In the wake of this, Turkey's exchange rate dropped by about 10%, as did its stock market. The thing to really pay attention to is how much holders of Turkey's government debt have to pay to insure against potential default. That popped up to about 5% since last week:

The cost of insuring Turkey’s government debt against default leapt sharply Monday, rising by the end of European trading to an annual cost equivalent of $442,000 for every $10 million of bonds over a five-year contract. That is up from $306,000 at Friday’s close...

The new Governor of the central bank appears to be more of a political hack:

The problem for Turkey is less that the central bank is under Mr. Ergogan’s control and more that he seems likely to misuse that control.

Contrary to the consensus view that higher interest rates tame inflation, the Turkish president believes they push it higher by increasing firms’ borrowing costs. This is probably why he dismissed Mr. Agbal, who tightened policy again last week. Mr. Kavcioglu’s articles in the local press suggest that he agrees with Mr. Erdogan and may lower rates again. He has also written that the lira has been kept too strong and undermined Turkey’s competitiveness.

This is wishful thinking. The textbook link between interest rates and inflation may not be strong in Western countries, but they don’t suffer from regular currency crises. In emerging markets, most inflation comes from precipitous falls in the exchange rate, which increases import costs, and so the main focus of the central bank must be the currency.

 But, of course, the 10% drop in the value of the Turkish Lira since last week probably means that worsening inflation is already a done deal.

So, keep an eye on the news and what is said about Turkey. The situation is very fluid.