From The Economist Article
How has Turkey’s economy kept growing despite raging inflation?Many Turkish businesses are struggling to cope
Jul 21st 2022 | GAZIANTEP AND ISTANBUL
On the wall of Savas Mahsereci’s office is a black-and-white photograph of his father and grandfather making shoe soles from recycled tractor tyres. The room is upstairs from his factory on the outskirts of Gaziantep, a city of 2m people in south-eastern Turkey, close to the border with Syria. Like his forebears, Mr Mahsereci is in the recycling business. His family firm, mtm Plastik, makes refuse bags, disposable gloves and pellets for use in moulded products. The business has grown rapidly. It now occupies 20 times as much factory space as it did in 2004, and started exporting in 2016. Supply bottlenecks in China are “a big opportunity for us”, he says. Other industrial firms in Gaziantep are benefiting. The city enjoyed record exports last year, says Mr Mahsereci
than 72 hours, says Mr Mahsereci, compared with a minimum of a month from China. And supply is more reliable. Turkey can also export via the Aegean or the Black Sea.
Yet accelerating inflation poses big challenges for even the most agile business. One is pricing strategy. It is tricky to judge where to pitch prices. Too high, and you risk losing market share to rivals; too low, and you may find you do not cover replacement cost. Hard decisions seem to multiply. “You have to be ready to negotiate with all of your customers and all of your suppliers all of the time,” says a businessman. “It is very, very tiring.” Some prices are slow to adjust. A large share of mobile-phone subscribers have 12-month contracts. Many are still on last year’s prices.
Businesses must protect themselves from inflation to survive. This often means that the cost is pushed onto others. That creates tensions—between landlords and tenants, shops and customers, and firms and their suppliers. No business can afford to defer the settlement of its customers’ bills for very long. “Payment terms of three to six months are down to zero to three months,” says an Istanbul-based investor. And there are other pressure points. Turkey’s external deficit has not gone away. In principle, devaluation is a remedy. It works by stimulating exports and crushing demand for imports. The export fillip is working, but strong consumer demand has kept imports high.
Against the flow
Turkey must either attract fresh foreign capital or draw on its existing reserves of foreign currency. Both are becoming harder. The quality of capital inflows to Turkey has steadily degraded over the past 20 years. Foreign direct investment (fdi), the “stickiest” form of capital inflow, has not matched the levels of the mid-2000s, when Turkey followed more orthodox policies (see chart 5).
Some European bosses now see Turkey as a potential alternative to China as they seek to shorten and diversify their supply chains. Last year ikea said it would move production of some of its furniture from Asia to Turkey. Hugo Boss, a clothing firm, said it would add capacity to its factory in Izmir to reduce reliance on Asia. But Turkey’s monetary instability—and a deterioration in governance and the rule of law—is a bar to another fdi boom. Portfolio flows into Turkish bonds and shares have evaporated. That leaves Turkey ever more reliant on short-term syndicated loans extended to local banks. As interest rates go up worldwide, these are harder to come by.
The situation for reserves is also perilous. Turkey’s central bank has burned through tens of billions of dollars trying to prop up the lira. Official reserves of foreign currency are negative if swaps with local banks are taken into account. (The central bank still has holdings of gold.) Meanwhile private-sector demand for dollars and euros has risen. At their peak last year, two-thirds of bank deposits were held in foreign currency. The growing illiquidity in currency markets means exporters have every incentive to hoard dollars and euros from their overseas sales.
The authorities are striving to curb this creeping dollarisation and to stop the lira from falling further. A scheme has been in place since December which indemnifies deposits switched out of dollars or euros and into lira from exchange-rate losses. In January Turkish exporters were ordered to hand over 25% of their hard-currency earnings to the central bank. That figure was raised to 40% in April. Complaints from corporate treasurers that they needed a float of dollars and euros to pay for vital imports or to service debts had no effect.
In a sign of growing desperation, the authorities went further. On June 24th Turkey’s bank regulator said it would ban loans to firms that cling to significant hard-currency holdings. This measure was to stop companies borrowing lira on the cheap to speculate in dollars. The initial reaction in Istanbul was shock. Suddenly the main concern of corporate Turkey was not inflation but a potential credit crunch.
If the regulation is strictly enforced, says one executive, banks will be unwilling to lend and firms will be forced to cut back on non-essential spending. Some may struggle even to get enough trade credit to finance their working capital. It may not come to that. Noises from Ankara are that the banks will not bear the burden of verifying whether borrowers are complying with the new regulation.
Still, companies are turning cautious and big investments are being put on hold. “Everybody is waiting for the elections,” says an investment banker. Mr Erdogan’s ak Party is clearly behind an alliance of six opposition parties in opinion polls. He trails in polls against the plausible opposition candidates for the presidency. His defeat would probably mean a return to monetary orthodoxy.
Taming inflation would be a big and painful job, but Turkey’s experience after 2001 shows that, with the right policies, it can be done. fdi could rebound to take advantage of Turkey’s position as a low-cost manufacturing hub on Europe’s doorstep. A rally in the stockmarket is plausible, given how cheap Turkish shares have become. Yet electoral defeat for Mr Erdogan is far from certain. He has jailed political opponents, bullied the media, sought to suppress free speech and could resort to all manner of chicanery to cling to office. Many of the people interviewed for this article did not want to be named.
And before then, the exchange-rate crisis might enter a new, more combustible phase. Once the summer is gone, and the boost to hard-currency earnings from tourism starts to fade, things could get dicey. A tranche of protected lira deposits matures at the end of August. The state has $6bn of external debt payments due in the second half of this year, according to Morgan Stanley, a bank; big companies and banks have $23bn coming due. It seems unlikely that all these debts will be fully rolled over. Yet somehow the diminishing stock of foreign exchange must be augmented—or husbanded. In a worst-case scenario, limits might be placed on withdrawals of householders’ dollar deposits.
Perhaps the economy will somehow muddle through until the elections. As strange as Mr Erdogan’s approach to monetary policy has been, his fiscal policy has been quite conservative. The public debt-to-gdp ratio was 41.6% of gdp last year. This is comfortably below the debt burden of Turkey’s emerging-market peers. Given the country’s low solvency risk, perhaps its friends in the Gulf might stump up some of their petrodollars.
Turkey has withstood some remarkable strains. Now, more than ever, Turkish businesses are focused on survival. Inflation breeds uncertainty and uncertainty breeds caution. The things you must do, you keep doing, says a businessman. The rest can wait. “You live another day.” ■
This article appeared in the Briefing section of the print edition under the headline "Inflation nation"
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Higher interest rates to tackle inflation
John H Cochrane - On Interest rates as a fiscal policy
A few days ago I gave a short talk on the subject. I was partly inspired by a little comment made at a seminar, roughly "of course we all know that if prices are sticky, higher nominal rates raise higher real rates, that lowers aggregate demand and lowers inflation." Maybe we "know" that, but it's not as readily present in our models as we think. This also crystallizes some work in the ongoing "Expectations and the neutrality of interest rates" project.
The equations are the utterly standard new-Keynesian model. The last equation tracks the evolution of the real value of the debt, which is usually in the footnotes of that model.
OK, top right, the standard result. There is a positive but temporary shock to the monetary policy rule, u. Interest rates go up and then slowly revert. Inflation goes down. Hooray. (Output also goes down, as the Phillips Curve insists.)
The next graph should give you pause on just how you interpreted the first one. What if the interest rate goes up persistently? Inflation rises, suddenly and completely matching the rise in interest rate! Yet prices are quite sticky -- k = 0.1 here. Here I drove the persistence all the way to 1, but that's not crucial. With any persistence above 0.75, higher interest rates give rise to higher inflation.
What's going on? Prices are sticky, but inflation is not sticky. In the Calvo model only a few firms can change price in any instant, but they change by a large amount, so the rate of inflation can jump up instantly just as it does. I think a lot of intuition wants inflation to be sticky, so that inflation can slowly pick up after a shock. That's how it seems to work in the world, but sticky prices do not deliver that result. Hence, the real interest rate doesn't change at all in response to this persistent rise in nominal interest rates. Now maybe inflation is sticky, costs apply to the derivative not the level, but absolutely none of the immense literature on price stickiness considers that possibility or how in the world it might be true, at least as far as I know. Let me know if I'm wrong. At a minimum, I hope I have started to undermine your faith that we all have easy textbook models in which higher interest rates reliably lower inflation.
(Yes, the shock is negative. Look at the Taylor rule. This happens a lot in these models, another reason you might worry. The shock can go in a different direction from observed interest rates.)
Panel 3 lowers the persistence of the shock to a cleverly chosen 0.75. Now (with sigma=1, kappa=0.1, phi= 1.2), inflation now moves with no change in interest rate at all. The Fed merely announces the shock and inflation jumps all on its own. I call this "equilibrium selection policy" or "open mouth policy." You can regard this as a feature or a bug. If you believe this model, the Fed can move inflation just by making speeches! You can regard this as powerful "forward guidance." Or you can regard it as nuts. In any case, if you thought that the Fed's mechanism for lowering inflation is to raise nominal interest rates, inflation is sticky, real rates rise, output falls and inflation falls, well here is another case in which the standard model says something else entirely.
Panel 4 is of course my main hobby horse these days. I tee up the question in Panel 1 with the red line. In that panel, the nominal interest are is higher than the expected inflation rate. The real interest rate is positive. The costs of servicing the debt have risen. That's a serious effect nowadays. With 100% debt/GDP each 1% higher real rate is 1% of GDP more deficit, $250 billion dollars per year. Somebody has to pay that sooner or later. This "monetary policy" comes with a fiscal tightening. You'll see that in the footnotes of good new-Keynesian models: lump sum taxes come along to pay higher interest costs on the debt.
Now imagine Jay Powell comes knocking to Congress in the middle of a knock-down drag-out fight over spending and the debt limit, and says "oh, we're going to raise rates 4 percentage points. We need you to raise taxes or cut spending by $1 trillion to pay those extra interest costs on the debt." A laugh might be the polite answer.
So, in the last graph, I ask, what happens if the Fed raises interest rates and fiscal policy refuses to raise taxes or cut spending? In the new-Keynesian model there is not a 1-1 mapping between the shock (u) process and interest rates. Many different u produce the same i. So, I ask the model, "choose a u process that produces exactly the same interest rate as in the top left panel, but needs no additional fiscal surpluses." Declines in interest costs of the debt (inflation above interest rates) and devaluation of debt by period 1 inflation must match rises in interest costs on the debt (inflation below interest rates). The bottom right panel gives the answer to this question.
Review: Same interest rate, no fiscal help? Inflation rises. In this very standard new-Keynesian model, higher interest rates without a concurrent fiscal tightening raise inflation, immediately and persistently.
Fans will know of the long-term debt extension that solves this problem, and I've plugged that solution before (see the "Expectations" paper above).
The point today: The statement that we have easy simple well understood textbook models, that capture the standard intuition -- higher nominal rates with sticky prices mean higher real rates, those lower output and lower inflation -- is simply not true. The standard model behaves very differently than you think it does. It's amazing how after 30 years of playing with these simple equations, verbal intuition and the equations remain so far apart.
The last two bullet points emphasize two other aspects of the intuition vs model separation. Notice that even in the top left graph, higher interest rates (and lower output) come with rising inflation. At best the higher rate causes a sudden jump down in inflation -- prices, not inflation, are sticky even in the top left graph -- but then inflation steadily rises. Not even in the top left graph do higher rates send future inflation lower than current inflation. Widespread intuition goes the other way.
In all this theorizing, the Phillips Curve strikes me as the weak link. The Fed and common intuition make the Phillips Curve causal: higher rates cause lower output cause lower inflation. The original Phillips Curve was just a correlation, and Lucas 1972 thought of causality the other way: higher inflation fools people temporarily to producing more.
Here is the Phillips curve (unemployment x axis, inflation y axis) from 2012 through last month. The dots on the lower branch are the pre-covid curve, "flat" as common wisdom proclaimed. Inflation was still 2% with unemployment 3.5% on the eve of the pandemic. The upper branch is the more recent experience.
I think this plot makes some sense of the Fed's colossal failure to see inflation coming, or to perceive it once the dragon was inside the outer wall and breathing fire at the inner gate. If you believe in a Phillips Curve, causal from unemployment (or "labor market conditions") to inflation, and you last saw 3.5% unemployment with 2% inflation in February 2021, the 6% unemployment of March 2021 is going to make you totally ignore any inflation blips that come along. Surely, until we get well past 3.5% unemployment again, there's nothing to worry about. Well, that was wrong. The curve "shifted" if there is a curve at all.
But what to put in its place? Good question.
Update:
Lots of commenters and correspondents want other Phillips Curves. I've been influenced by a number of papers, especially "New Pricing Models, Same Old Phillips Curves?" by Adrien Auclert, Rodolfo Rigato, Matthew Rognlie, and Ludwig Straub, and "Price Rigidity: Microeconomic Evidence and Macroeconomic Implications" by Emi Nakamura and Jón Steinsson, that lots of different micro foundations all end up looking about the same. Both are great papers. Adding lags seems easy, but it's not that simple unless you overturn the forward looking eigenvalues of the system; "Expectations and the neutrality of interest rates" goes on in that way. Adding a lag without changing the system eigenvalue doesn't work. John H. Cochrane at 5:17 PM
A few days ago I gave a short talk on the subject. I was partly inspired by a little comment made at a seminar, roughly "of course we all know that if prices are sticky, higher nominal rates raise higher real rates, that lowers aggregate demand and lowers inflation." Maybe we "know" that, but it's not as readily present in our models as we think. This also crystallizes some work in the ongoing "Expectations and the neutrality of interest rates" project.
The equations are the utterly standard new-Keynesian model. The last equation tracks the evolution of the real value of the debt, which is usually in the footnotes of that model.
OK, top right, the standard result. There is a positive but temporary shock to the monetary policy rule, u. Interest rates go up and then slowly revert. Inflation goes down. Hooray. (Output also goes down, as the Phillips Curve insists.)
The next graph should give you pause on just how you interpreted the first one. What if the interest rate goes up persistently? Inflation rises, suddenly and completely matching the rise in interest rate! Yet prices are quite sticky -- k = 0.1 here. Here I drove the persistence all the way to 1, but that's not crucial. With any persistence above 0.75, higher interest rates give rise to higher inflation.
What's going on? Prices are sticky, but inflation is not sticky. In the Calvo model only a few firms can change price in any instant, but they change by a large amount, so the rate of inflation can jump up instantly just as it does. I think a lot of intuition wants inflation to be sticky, so that inflation can slowly pick up after a shock. That's how it seems to work in the world, but sticky prices do not deliver that result. Hence, the real interest rate doesn't change at all in response to this persistent rise in nominal interest rates. Now maybe inflation is sticky, costs apply to the derivative not the level, but absolutely none of the immense literature on price stickiness considers that possibility or how in the world it might be true, at least as far as I know. Let me know if I'm wrong. At a minimum, I hope I have started to undermine your faith that we all have easy textbook models in which higher interest rates reliably lower inflation.
(Yes, the shock is negative. Look at the Taylor rule. This happens a lot in these models, another reason you might worry. The shock can go in a different direction from observed interest rates.)
Panel 3 lowers the persistence of the shock to a cleverly chosen 0.75. Now (with sigma=1, kappa=0.1, phi= 1.2), inflation now moves with no change in interest rate at all. The Fed merely announces the shock and inflation jumps all on its own. I call this "equilibrium selection policy" or "open mouth policy." You can regard this as a feature or a bug. If you believe this model, the Fed can move inflation just by making speeches! You can regard this as powerful "forward guidance." Or you can regard it as nuts. In any case, if you thought that the Fed's mechanism for lowering inflation is to raise nominal interest rates, inflation is sticky, real rates rise, output falls and inflation falls, well here is another case in which the standard model says something else entirely.
Panel 4 is of course my main hobby horse these days. I tee up the question in Panel 1 with the red line. In that panel, the nominal interest are is higher than the expected inflation rate. The real interest rate is positive. The costs of servicing the debt have risen. That's a serious effect nowadays. With 100% debt/GDP each 1% higher real rate is 1% of GDP more deficit, $250 billion dollars per year. Somebody has to pay that sooner or later. This "monetary policy" comes with a fiscal tightening. You'll see that in the footnotes of good new-Keynesian models: lump sum taxes come along to pay higher interest costs on the debt.
Now imagine Jay Powell comes knocking to Congress in the middle of a knock-down drag-out fight over spending and the debt limit, and says "oh, we're going to raise rates 4 percentage points. We need you to raise taxes or cut spending by $1 trillion to pay those extra interest costs on the debt." A laugh might be the polite answer.
So, in the last graph, I ask, what happens if the Fed raises interest rates and fiscal policy refuses to raise taxes or cut spending? In the new-Keynesian model there is not a 1-1 mapping between the shock (u) process and interest rates. Many different u produce the same i. So, I ask the model, "choose a u process that produces exactly the same interest rate as in the top left panel, but needs no additional fiscal surpluses." Declines in interest costs of the debt (inflation above interest rates) and devaluation of debt by period 1 inflation must match rises in interest costs on the debt (inflation below interest rates). The bottom right panel gives the answer to this question.
Review: Same interest rate, no fiscal help? Inflation rises. In this very standard new-Keynesian model, higher interest rates without a concurrent fiscal tightening raise inflation, immediately and persistently.
Fans will know of the long-term debt extension that solves this problem, and I've plugged that solution before (see the "Expectations" paper above).
The point today: The statement that we have easy simple well understood textbook models, that capture the standard intuition -- higher nominal rates with sticky prices mean higher real rates, those lower output and lower inflation -- is simply not true. The standard model behaves very differently than you think it does. It's amazing how after 30 years of playing with these simple equations, verbal intuition and the equations remain so far apart.
The last two bullet points emphasize two other aspects of the intuition vs model separation. Notice that even in the top left graph, higher interest rates (and lower output) come with rising inflation. At best the higher rate causes a sudden jump down in inflation -- prices, not inflation, are sticky even in the top left graph -- but then inflation steadily rises. Not even in the top left graph do higher rates send future inflation lower than current inflation. Widespread intuition goes the other way.
In all this theorizing, the Phillips Curve strikes me as the weak link. The Fed and common intuition make the Phillips Curve causal: higher rates cause lower output cause lower inflation. The original Phillips Curve was just a correlation, and Lucas 1972 thought of causality the other way: higher inflation fools people temporarily to producing more.
Here is the Phillips curve (unemployment x axis, inflation y axis) from 2012 through last month. The dots on the lower branch are the pre-covid curve, "flat" as common wisdom proclaimed. Inflation was still 2% with unemployment 3.5% on the eve of the pandemic. The upper branch is the more recent experience.
I think this plot makes some sense of the Fed's colossal failure to see inflation coming, or to perceive it once the dragon was inside the outer wall and breathing fire at the inner gate. If you believe in a Phillips Curve, causal from unemployment (or "labor market conditions") to inflation, and you last saw 3.5% unemployment with 2% inflation in February 2021, the 6% unemployment of March 2021 is going to make you totally ignore any inflation blips that come along. Surely, until we get well past 3.5% unemployment again, there's nothing to worry about. Well, that was wrong. The curve "shifted" if there is a curve at all.
But what to put in its place? Good question.
Update:
Lots of commenters and correspondents want other Phillips Curves. I've been influenced by a number of papers, especially "New Pricing Models, Same Old Phillips Curves?" by Adrien Auclert, Rodolfo Rigato, Matthew Rognlie, and Ludwig Straub, and "Price Rigidity: Microeconomic Evidence and Macroeconomic Implications" by Emi Nakamura and Jón Steinsson, that lots of different micro foundations all end up looking about the same. Both are great papers. Adding lags seems easy, but it's not that simple unless you overturn the forward looking eigenvalues of the system; "Expectations and the neutrality of interest rates" goes on in that way. Adding a lag without changing the system eigenvalue doesn't work. John H. Cochrane at 5:17 PM
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