Is there a way out of the impasse?

Although its origins can be traced back to Greek philosophers, the concept of structural stability has been formalized with the tools of modern topology only relatively recently, in a seminal contribution by Andronov & Pontryagin (1937). Unlike dynamic stability, which relates to a property of a state or an orbit of a dynamic system, structural stability relates to a property of a dynamic system itself. In other words, the topological definition of structural stability incorporates the intuitive idea that the features of the phase portrait do not change in an essential way if the system is slightly perturbed, by requiring that “nearby” dynamic systems have the same qualitative dynamics. Notice that there may be yet another approach that relates to nonlinearity and linearity: the dynamics of non-linear flow translate into that of the corresponding linearized flow, i.e. they are qualitatively (topologically) equivalent. If the system isn’t structurally stable at some point, anything can happen.


High inflation is a case in point. It signals that the monetary anchors of an open economy are lost. High inflation is one of the reasons why resource allocation is sub-optimal. Why is sub-optimality important? First, when resource allocation is sub-optimal, the potential growth rate of an economy falls over time: high inflation kills growth in the long-run. Second, it also kills productivity and technological innovation.

Why does inflation increase in a country like Turkey? There are various reasons but the most important cause is the exchange rate pass-through. As the exchange rate increases, so does inflation. When the exchange rate jumps from 1 USD = 7 TL to 1 USD = 14 TL in a short span, the inflationary impact will be 30-35%. Such large exchange rate movements cause high inflation because we import almost everything. Even if the exchange rate stabilizes, the impact multiplier generated by the previous shock lasts for 5-6 months. Also, as spending rises inflation rises in tandem. So either there won’t be much growth in 2022 after the base effects vanish or inflation will head north, further depressing the already negative real interest rate as if there were an inflationary surprise in the spirit of the classical Barro- Gordon model (1983). This invites all sorts of credibility problems. In short, problems abound, problems that may be rendered visible by a small perturbation if the whole eco-system itself is structurally unstable.


As demand picks up inflation goes up, other factors being equal. This general phenomenon is further strengthened if the budget deficit soars and if the deficit is financed through monetization. Furthermore, bank capital is continually shored up by TL injections, and TL credit creation outpaces core funding growth rates. All of these are happening currently. Governments are prone to thinking along Phillips-curve-type ideas: accordingly, high inflation is the price to be paid for high growth. This is obviously wrong, and it is likely wrong even for a closed economy.

What is problematic is that the exchange rate blurs this closed economy view. Turkey has an open economy. Because corporations are FX-indebted, any exchange rate increase doesn’t trigger exports but either deters imports and contracts the economy or it curtails investments and contracts the economy –or both. An out-of-equilibrium exchange rate can’t equilibrate the sources of growth through reallocation of resources across sectors; it simply tips the economy off balance. No small open economy can simultaneously control both the interest and the exchange rates unless it closes itself to cross-border capital movements. The government won’t go that far – I think.


A conservative central banker – this is a technical term inspired by the past deeds of the Bundesbank – is almost always preoccupied with inflation, even with the slightest possibility of a rise in the distant future. Typically, monetary policy through the commodities channel becomes effective in 6 to 9 months. So, central banks act in advance. Otherwise, they are either caught off guard or left “behind the curve”. With the exception of a few countries, all major central banks target inflation –whether they are “conservative” or not, and this is their only legally binding goal. True, there have been many changes over the last decade or so, and central banks expanded their balance sheets through ‘bad asset’ or sovereign debt purchases in an attempt to stage a rather large private sector bail out scheme. Yet, they still

target inflation or at least they are bound by the constraints their legally mandated task imposes upon them. There is no way a legitimate central bank acts arbitrarily, changes course all too often, and traces an erratic policy path. There is no way a central bank doesn’t care about inflation, either. There is also a simple stylized fact: by keeping the policy rate high for a sustained period, it is possible to lower long-term market interest rates. On the contrary, a low policy rate leads to higher market rates, as the experience ıf the last five months has demonstrated.


Time inconsistency of optimal policies basically means that an optimal policy computed at the beginning of a planning horizon does not remain optimal at a later date. Prior to certain choices made by the private sector, an optimal policy induces a response from that sector. However, ex post responses may be very different from ex ante responses. This implies that the government’s ex post constraints are different from its ex ante constraints. Under the existence of a certain form of imperfection which makes the expected optimal policy a second-best rather than a first-best, there is an ex post incentive to deviate from the expected optimal policy. The incentive to deviate ex post vanishes if the government is able to make a binding pre-commitment to an ex ante optimal policy. It is difficult to envision the enforcement of such binding commitments since the government is by definition the dominant player and a sovereign decision-maker. Hence, those policies that would be optimal if binding commitments could be enforced face a credibility problem due to the ex post incentives of the government not to perform as pretended. Should the central bank deviate from pre-announced policies all too often, then monetary policy becomes time-inconsistent. As a result, credibility is lost.


So, what does the economic management do now? What they do can best be described as dirty float. Dirty float – or managed float – was a middle-of-the-road device that some countries used in the 1990s. Emerging economies that adopted either pegged or fixed exchange rate regimes were reluctant to abandon them and switch to floating rates. This is called fear of floating. Dirty float – half freely-floating half managed exchange rates – provided the answer back then. By definition, dirty float should either be shortlived or it shouldn’t require central bank interventions too often. What we observe now is neither. We see an incessant flux of daily FX market interventions, possibly the worst kind of dirty float mechanism. A central bank shouldn’t sell foreign currencies through backdoor policies on a regular, day-to-day basis. It can sell FX if need be but it should announce the terms and conditions of its intervention via openly declared auctions. It is increasingly becoming difficult to understand what the central bank does and what it doesn’t. A central bank should by definition be transparent. Deciphering disguised moves isn’t or shouldn’t be the job of economists and financial analysts.


Does the risk premium of a country have anything to do with its exchange rate regime? Put another way, does switching to a flexible rate regime suffice to insulate the economy from an excessive risk premium shock? Is it true that the risk premium is unrelated to the choice of exchange rate regime? In conventional monetary macroeconomics, an expansionary monetary policy and the depreciation of the currency are optimal responses to an adverse exogenous shock. However, if the economy has a large stock of FX-denominated debt, a weaker currency can exacerbate debt service difficulties and damage the balance sheets of domestic firms and banks. Hence, devaluations may lead to contractions instead of booms. Central banks do not like devaluations, not only for fear of inflationary pressure. Yet, central banks can be constrained to act as if they were inviting currency shocks either because of political interference or because they face unsolvable dilemmas. In large and developed open economies where exchange rates don’t matter – like the U.S. or Germany – monetary policy faces only a small set of constraints. In Turkey, there are a lot of constraints, and they do bind even if the economic management team doesn’t realize it.

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