Turkey flies in the face of economic orthodoxy

4 January، 2022

The value of the Turkish lira plummeted to record low levels at the beginning of last month. The main reason for this was Turkish President Recep Tayyip Erdogan’s insistence on a theory that claims “the interest rate is the cause and inflation is the result.” He has emphasized on more than one occasion that interest is forbidden in Islam. “Therefore,” he said, “I am committed to bringing it down. It is a divine order and we have no choice but to abide by it.”

To stop this volatile trend, Erdogan has introduced a mechanism that was tested decades ago and notoriously failed. In 1967, Turkey, in order to meet its foreign currency needs, wanted to attract the savings deposited by Turkish workers in the banks of the European countries where they were working. So it encouraged them to transfer these savings to “convertible deposit accounts” in Turkish banks. This served as a life jacket for the country’s ailing economy in the early 1970s, bringing in $3.5 billion-worth of foreign currency. However, despite this temporary relief, the mechanism had a devastating effect on the economy.

When late-Turkish President Turgut Ozal was set to terminate the mechanism in 1989, he harshly criticized it and said that, if Turkey were to let the value of the Turkish lira float according to free market economy rules, it could save billions in foreign currencies. “With this money,” he continued, “we could donate 1 million Turkish lira to every single family in the country. We could build 9,000 additional schools, 900 middle-scale factories, 500 hospitals, 4,000 kilometers of highways and create jobs for 100,000 workers. This was the invention of those who believed they were intelligent and clever.”

The scheme introduced two weeks ago by Erdogan is called the “foreign exchange-protected Turkish lira deposit.” Its name differs slightly from the original, probably to claim that it is not the same mechanism as the one used decades ago. However, both the strategy and its effects are almost identical. Basically, it aims at encouraging the holders of foreign currency to convert it into Turkish lira and keep it in a lira account as a time deposit.

Erdogan’s government is producing a carbon copy of what was done decades ago. The backbone of the mechanism is to compensate for the loss in the value of the lira due to subsidies from the Treasury.

A closer look at the mechanism reveals several discrepancies.

Erdogan’s new mechanism is basically subsidizing relatively wealthy account holders with money from the poorest taxpayers.

Yasar Yakis

First, the official interest rate, as recognized by the central bank, is still 14 percent. The interest rate that the state-owned banks charge when they give credit is 20 percent and those of the private banks vary between 25 and 30 percent. This indicates that there is a major discrepancy in the system.

Second, if a person puts their money in a fixed-term account and has to access the funds early for any reason, they will not be entitled to receive compensation for the loss of the Turkish lira’s value. So they will lose money because of this transaction.

Third, many people will not be able to open a time deposit account because they do not have a stable income. This means the depreciation in their purchasing power will not be compensated either.

Fourth, many individuals close to the government obviously had insider information about the new mechanism. They sold their foreign currency on the evening of Dec. 20, when one US dollar was worth 18.40 lira, and bought it back after the lira’s value increased by more than 50 percent overnight. Opposition parties asked for a list of insiders who were involved in the manipulation that night, but the government preferred to remain silent.

Fifth, as most of the time account holders will increase their wealth at a level proportionate with the loss in the lira’s value, the real value of their asset will remain the same in terms of foreign currency. However, the government will have to finance the fictive increase by augmenting the volume of banknotes created. Consequently, the purchasing power of the lira will be reduced. In other words, this mechanism is basically subsidizing the relatively wealthy account holders with money from the poorest taxpayers.

Turkey must learn that measures to keep interest rates artificially low have only a limited effect. The real problem is the proper management of the economy in a competitive and transparent environment, in which the rule of law and an independent judiciary prevail. This will automatically attract investment. There is no need to reinvent the wheel.