Economic illiteracy vs. Turkish inflation

The Turkish economy is in real trouble. As news.com.au reported yesterday:

While the rest of the world has tightened monetary policy to deal with the global surge in inflation, Turkey’s central bank has kept its cash rate stubbornly unchanged since January.

In fact it actually cut the rate significantly in the final third of 2021, lowering it from 19 per cent to the 14 per cent at which it now remains.

The central bank has adopted this approach under sustained pressure from Turkey’s President, Recep Tayyip Erdogan, who believes higher interest rates actually fuel inflation.

The conventional economic wisdom is the other way around. It holds that high interest rates restrain inflation, and looser monetary policy inflames it.

Speaking in May, the President defended his gamble and branded those who were concerned about Turkey’s monetary policy “illiterates”.

“Those who try to impose on us a link between the benchmark rate and inflation are either illiterates or traitors,” he said.

Unfortunately, it is the Turkish leader who is the economic illiterate. Low interest rates fuel inflation. That's because when interest rates are low, borrowers need to spend less on interest payments, so that leaves them with more money to spend on other goods and services. Also, businesses can borrow more cheaply to spend on investment goods. Being able to spend more sounds like a good thing, but increasing investment spending, and increasing consumption spending, both increase demand for goods and services. Without a corresponding increase in production, there is essentially more money chasing the same number of goods, and prices start to go up. In other words, inflation increases when interest rates are low. And so, you end up with this:

A year ago, Turkey’s inflation rate was an already troubling 19 per cent. By the end of last month, it had risen to a staggering 79 per cent, the highest it has been in 24 years, and 16 times the central bank’s inflation target of 5 per cent.

Turkey isn't alone in facing high inflation. But it is a substantial outlier:

Incidentally, those viewing the world from London are currently experiencing an inflation rate of 9.4 per cent. Over in New York it is 9.1 per cent.

That’s far more inflation than either country would like – hence, the US Federal Reserve is poised to announce a fresh interest rate hike this week – but it’s preferable to 80 per cent...

According to data released by the Bureau of Statistics this morning, Australia’s consumer price index (CPI) rose by 1.8 per cent in the June quarter, with our annual inflation rate increasing to 6.1 per cent...

For comparison, New Zealand's inflation rate for the year to June 2022 was 7.3 percent, which was the highest level since 1990. That has both economists and lay people worried, but nowhere near as much as inflation of 80 percent would! Those worries arise because there are a bunch of costs associated with high inflation, including:

• Shoe leather costs - the costs to consumers of holding less cash so that they are not exposed to their cash losing value, as well as the cost of time spent searching for the lowest current prices (they are called shoe leather costs because consumers would make frequent trips to the bank to get money, and spend a lot of time searching around for prices, thereby wearing out their shoes);
• Menu costs - the costs to firms of having to constantly adjust prices (they are called menu costs because if your firm is a restaurant, you have to print all new menus when you change prices);
• Arbitrary redistributions of wealth - such as from lenders (who are being paid back in money that is worth less than before) to borrowers;
• Tax distortions - as taxpayers get pushed into higher tax brackets due to their increasing nominal wages; and
• Confusion and inconvenience - since it makes it difficult for anyone to figure out what the current prices are.

Those costs all tend to reduce economic activity, and those costs are going to be far higher in Turkey now than they were before. And all because Turkey's President followed his own (incorrect) ideas about how interest rates affect inflation. I guess we can see who the real economic illiterate is.

There is one small benefit to the current high inflation. Economics teachers will now have students who have actually seen some appreciable inflation, which hasn't been the case for many years. We'll now be able to point to recent experience in our classroom examples.