by Bill O’Grady | PDF

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The Turkish economy is being roiled by spiking inflation and a sharp decline in the Turkish lira (TRY).  The orthodox response to such a macroeconomic crisis is austerity.  Fiscal and monetary policy become tight; taxes are raised, or spending is cut, or both occur and interest rates are increased.  The goal is to depress domestic demand because the root cause of these problems is usually a persistent current account deficit.  Reducing domestic demand usually leads to a reduction in the current account deficit.

Turkish President Erdogan has adopted a heterodox response to the current crisis.  He has fired numerous officials of the Central Bank of the Republic of Turkey (CBRT) over the past two years who insisted on raising interest rates to address the aforementioned problems.  Since July 2019, when Erdogan relieved Murat Cetinkaya of the governorship of the CBRT, he has installed three governors in less than three years.  Erdogan believes that increasing interest rates leads to higher inflation on the idea that increased borrowing costs will be applied to prices.  This position is at odds with the normal prescription for addressing an inflation and currency crisis.

In this report, we will begin with a review of the basic economics of savings balances and how current account deficits are created and funded.  From there, we will provide an examination of Turkey’s current economic situation.  The next section will deal with the government’s response.  We will close with market ramifications.

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