Erdogan Is Writing Checks the Turkish Economy Can’t Cash

After his party faced stinging defeats in mayoral elections in Ankara and Istanbul last month, Turkish President Recep Tayyip Erdogan promised a “strong economic program” to turn around his country’s sinking economy. He’s right that Turkey has serious economic problems. Unemployment is rising, and inflation is at nearly 20 percent, the highest level in well over a decade. But Erdogan faces a painful dilemma: The steps his government could take to improve the economy in the medium term would cause short-term suffering. And that is an unattractive prospect as he considers whether to announce a rerun of the Istanbul mayoral election in the hopes that his party might win a new vote. He’d much rather boost growth now, but the methods he’d use to do that will only exacerbate the country’s longer-term problems.

Turkey’s core problem is that the government keeps trying to stimulate the economy even as higher inflation suggests it should be doing the opposite. There is an obvious political logic behind the stimulus. Erdogan has faced a series of big votes in recent years, including a constitutional referendum in 2017, a presidential election in 2018, and this year’s regional elections. Since Erdogan’s Justice and Development Party made its reputation on delivering rapid economic growth, it had to keep stepping on the gas to halt the economy’s slide through each subsequent vote.

The strategy has worked, but with a cost. Thanks in part to these stimulus programs, Erdogan keeps winning elections—with much assistance, of course, from suppression of the opposition and ironclad control over the media. Yet each successive attempt to meddle with the economy has pushed inflation ever higher, from just above the central bank’s target of 5 percent for much of the past decade to 10 percent in 2017 and 20 percent today. As inflation has increased, the value of the lira has declined accordingly. Ten years ago, a dollar bought slightly under 2 liras. Today, with the lira again in a downward swoon, the exchange rate is closer to 6 liras per dollar.

The collapsing lira has made Turks substantially poorer. Compared to a decade ago, it takes roughly three times as many liras to buy a dollar’s worth of goods from abroad. And Turkey is a relatively trade-dependent economy, so the decline in the exchange rate hurts.

Turkey’s government is doing little to stop that slide. True, it has hiked its main interest rate from 8 percent a year ago to 24 percent today. That may sound high, but it is only barely above the inflation rate and is substantially below where it would need to be to stabilize the lira.

Why not increase interest rates further? For one, Erdogan himself has repeatedly argued that lira volatility is a “U.S.-led operation by the West to corner Turkey” and that “the inflation rate will drop as we lower interest rates.” The reality, nearly every economist agrees, is the opposite. But set aside Erdogan’s unorthodox musings on exchange rates, and he there is still a political logic for keeping interest rates relatively low.

The reason is that higher interest rates will reduce inflation by reducing economic growth. If the central bank increases the cost of borrowing liras, it would put immense pressure on Turkey’s banks. The banks fund themselves in part by borrowing billions of liras, in part from the central bank. They have to roll over a substantial portion of that debt on a weekly or monthly basis. (Details are in the Turkish central bank’s biannual Financial Stability Report.) When interest rates rise, it becomes more expensive for banks to fund themselves.

At the same time, almost all the loans Turkey’s banks hand out themselves—providing money for Turks to buy houses or cars, for example—are of longer duration and with fixed interest rates. Every time the central bank hikes interest rates, it thus raises the banks’ costs without increasing their revenue.

The result is a credit crunch. As banks cut back lending, consumers buy less, businesses invest less, and the economy slows—the exact opposite of what Erdogan needs to maintain political support. Thus the Turkish government has pressured the central bank to keep interest rates lower than they should be, even at the cost of letting inflation sail away while the lira sinks yet further.

For now, this strategy has worked well enough in political terms. It helped Erdogan win the 2017 referendum and the 2018 presidential election. But the bill is coming due. The sinking lira and rising prices were one reason that Erdogan’s party lost control of the mayoralties of Istanbul and Ankara in this year’s elections.

There is a long-term economic cost, too—though it is hidden, for now, in the country’s banking system. In addition to lending liras to Turkish consumers, Turkey’s banks have also lent dollars to Turkey’s firms. This made sense when the lira was stable, because Turkey’s banks have been flush with dollars, and because firms find it cheaper to borrow dollars than in liras.

The plummeting lira exchange rate, however, has set a time bomb ticking inside of Turkish banks. Many of the banks’ clients borrowed dollars when the exchange rate was half the current rate. Now these companies must make twice as many liras to pay back their bank loans. As the economy slows—most economists expect GDP to decline in 2019—their task will become ever more difficult.

For now, Turkey’s banks and their regulators insist there is no problem. The experience of other emerging markets facing slow-rolling financial crises suggests that they may have some time before the problems become too big to ignore. Yet if the lira sinks further, the day of reckoning may come sooner. The government is already bailing out the banking system. But the final bill is likely to be far bigger—and Turkey’s taxpayers will ultimately be stuck paying it.

There is, of course, an alternative path. The lira’s slump is caused by government policies intended to keep the economy humming. Yet each dose of stimulus brings ever-nastier side effects, including higher inflation and a weaker lira. The alternative—higher interest rates and a deeper recession—would be painful, too, but it would limit the long-term damage.

Each additional round of stimulus also brings forward the date at which the bill must be repaid. But Turkey’s government has more immediate problems, most notably a decision about whether to rerun the Istanbul mayoral race this summer. And so long as the next election is closer than the due date on his bills, Erdogan will always opt for one more jolt of credit-fueled stimulus.