Turkey's lira crisis may be down to Erdogan's fundamental misunderstanding of how 'evil' interest rates work

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• The Turkish lira collapsed by over 35% in value versus the US dollar this year - a dramatic and sudden fall.
• Yet the Turkish economy is growing strongly.
• The trigger for the crisis may be investors' realisation that President Recep Tayyip Erdogan doesn't understand, or doesn't believe in, the role central banks play in setting interest rates that control inflation.
• Erdogan has called interest rates "evil" in the past, and it's an attitude that may be spooking markets.

LONDON - Turkey's economy went from being rocky-but-fixable into a full-blown currency crisis today as the Turkish lira collapsed, losing more than 7% of its value against the US dollar on Firiday, totaling a drop of over 35% since the same date last year. The crisis may potentially spread beyond Turkey and Italy's already troubled banks are particularly exposed to the lira.

The immediate trigger for the decline was US President Trump's threat of sanctions against two senior Turkish ministers, in protest at the country's imprisonment of Andrew Brunson, an American Christian pastor jailed on accusations that he is linked to the Gulen movement, which opposes Turkey's current government.

But the actual sanctions imposed - freezing assets of a handful of Turkish officials - are not enough to tank an entire currency. GDP growth in Turkey is robust - it was 7.4% in the first quarter of 2018 and 7% in 2017. (For comparison, annual GDP was only 2.3% in the US and 1.8% in the UK).

So what is really going on?

XE.com

The collapse of the lira.

Recep Tayyip Erdogan fundamentally misunderstands the role of central banks

The track record suggests that President Recep Tayyip Erdogan fundamentally misunderstands the role of central banks in setting interest rates to combat inflation, and it is this error that is fuelling the bonfire of lira right now.

In basic terms, if you have rising inflation then a country's central bank needs to increase interest rates to drive price increases down again. The higher your inflation, the higher rates need to go to combat it.

But in Turkey, inflation is currently running at 16% - an astonishingly high level for a modern European country. Most Western free-market countries aim to keep inflation at or below 2% per year.

With inflation rampant, Turkey's central bank had been expected to raise interest rates again. But in July it held them, at 17.75% (which must, admittedly, seem already punishingly high for Turks grappling with raging consumer price increases).

That was the exact opposite move the markets wanted to see - it signalled that Erdogan's central bank is not serious about controlling inflation and thus the price of the lira.

'Because my belief is: interest rates are the mother and father of all evil'

The reason the bank lacks that seriousness is chilling: Erdogan fundamentally does not understand how interest rates work. Back in May he said, according to Reuters (emphasis added):

"If my people say continue on this path in the elections, I say I will emerge with victory in the fight against this curse of interest rates," Erdogan said in a speech to business people in Ankara, referring to snap elections on June 24.

"Because my belief is: interest rates are the mother and father of all evil."

In July he appointed his son-in-law, Berat Albayrak, to run the central bank. Albayrak told Turkish TV, "We will see inflation and interest rates decline in the coming period," but then he did nothing with interest rates. As the Financial Times put it, "Many see this as a sign that Erdogan's takeover of the country's monetary policy is complete."

Erdogan is a conservative Muslim intent on turning his country away from the West and back toward Islam. In that religion, charging interest on debts is regarded as "riba," or usury, which is therefore "haraam" (sinful or prohibited). Thus it may well be that when Erdogan describes interest rates as "evil" he is speaking literally not figuratively.

By leaving the interest rate alone they have signalled to the market that the exchange price of lira won't stabilise anytime soon

The problem for Turkey is that its economy has grown at a fast pace in recent years. This, generally, is a good thing and one of the reasons Erdogan won re-election this summer. But a fast-growing economy tends to drive prices higher, as demand outstrips supply. High inflation can kill an economy by making its currency worthless - no one wants to use it if its value tomorrow is a fraction of its value today. Currencies only tend to hold their value when prices are stable. The only way to maintain the value of the lira is for the Turkish central bank to sell government bonds and increase the rate of interest it offers for anyone who wants to hold them. In so doing, the bank would take in lots more lira - thus removing currency from the market. Like any commodity, a reduced supply of lira would increase its value and stabilise its price.

Unfortunately, Erdogan and his son-in-law are doing the opposite: By leaving the interest rate alone they have signalled to the market that the exchange price of lira won't stabilise anytime soon. In July, when the bank failed to act, Albayrak said, "We will see inflation and interest rates decline in the coming period." Either Erdogan and Albayrak don't understand what they need to do to get the crisis under control, or they regard interest-rate setting as so evil they would rather live with the consequences.

Either way, it's bad.

There have been two infamous occasions in history when governments attempted a similar miracle to what Erdogan and Albayrak are hoping for. One was the Weimar Republic of 1919 to 1933, when the German government printed money to pay its debts, with disastrous consequences. The other was the US in the 1970s, when US Federal Reserve chairs Arthur Burns and William Miller kept interest rates low because, as businessmen, they just liked low interest rates. The US economy went through a 10-year period of "stagflation" - high inflation and repeated recessions - as a result.