Meeting with economy officials

Fiscal discipline plus flexible monetary policy Last Friday Deputy Prime Minister Ali Babacan invited some economic commentators to a working lunch. I was among the participants. Babacan was accompanied by the governor of the Central Bank of Turkey, Erdem Başçı, and Treasury Undersecretary İbrahim Çanakçı, who made very instructive presentations followed by question-and-answer sessions that were even more instructive.
I left the lunch feeling that what I have been arguing in this column for a while had been confirmed: The Turkish economy is doing rather well, but still faces serious challenges. Başçı seems quite confident in the new monetary approach the central bank implemented almost two years ago, which is still, nonetheless, under severe criticism. This new approach consists of the implementation of new instruments besides the central bank's interest rate policy, and aims to tackle a standard dilemma: How can inflation be curbed without overvaluing the local currency? Fighting inflation requires control of aggregate demand through high real interest rates, which can be induced by raising the policy rate. At the same time, rapid appreciation of the local currency provoked by the massive inflows of capital that high interest rates attract must be avoided if one doesn't want to widen the current account deficit. From the beginning I supported the new monetary approach not because I am an expert in monetary policy but simply because I know one of the rules of thumb of economics well: If you have two goals to achieve, you have to use two instruments. Başçı recalled the standard dilemma and the necessity of using alternative instruments, like the interest corridor, which makes interest rate policy more flexible; and the reserve option mechanism, which stabilizes the exchange rate. Macroprudential measures aiming to control credit expansion, which are under the aegis of the Banking Regulation and Supervision Agency (BDDK) are added to this panoply. It is worth noting at this point the sentiments of Babacan, who underlined the importance of regular meetings of the Financial Stability Committee, which is in charge of coordinating macroprudential measures. The fitness of all economic policies, of course, must be tested by their results. Well, the results seem to be rather convincing. Turkey's exchange rate volatility became the lowest among emerging markets in recent months despite the turmoil caused by the US Federal Reserve's announcements of a possible tightening of monetary policy. Başçı continues to think that the Turkish lira is actually slightly undervalued, so there is room for limited appreciation without jeopardizing the current account deficit, and disinflation is under way thanks to tighter interest rate policy. Furthermore, Başçı underlined the return of long-term US Treasury bonds' real interest rates to positive, around 1 percent -- a level higher than Fed Chairman Ben Bernanke desired. This means that in the near future massive capital outflows should not be expected; hence, there is no need to further increase interest rates. The central bank's reserves, which are growing once again, should be sufficient to avoid exchange-rate shocks. Of course, one cannot yet claim definitive success for the new monetary approach, but I believe that it has already passed its midterm exam. As for fiscal policy, there is no hesitation: Turkey is among the best performers regarding budget deficit. Çanakçı estimates this year's budget deficit-to-GDP ratio at 1.5 percent, well below the target. The public debt-to-GDP ratio will continue to fall; by the end of 2016 it is expected to be around 30 percent. A colleague asked Babacan if the government would relax fiscal discipline ahead of upcoming elections. While Babacan was trying to convince this colleague that the Justice and Development Party (AK Party) government had never set aside fiscal discipline in any electoral season, I intervened, saying, “Don't worry, we can criticize Mr. [Prime Minister Recep Tayyip] Erdoğan on many economic issues, but one thing is certain: He believes firmly in fiscal discipline.” I have no more space in this column to talk about the challenges facing the economy. However, I would like to add that my comments during the debate were particularly focused on the lack of political will for economic reforms, and I gave as an example the abandoning of severance pay reform. I had written in this column that since Erdoğan says that all parties involved must compromise on the reform project, my bet would be against compromise and thus against reform. Unfortunately, I won the bet.

Are the brakes burning?

Zafer Çağlayan, Minister of Economy The expected reaction from the “growth lobby” to an increasing trend in unemployment was not delayed. Economy Minister Zafer Çağlayan, soon after the publication of December employment figures last Friday, reminded us how the rise in unemployment is unacceptable, for him and probably for the government as well. In his statement he once again used his favorite metaphor of burning brakes: “The brakes have begun to smell. Four or five months ago, I had warned to not push too much on the brakes. Unfortunately, the brakes have finally started to burn. But we have not been demoralized by this. I still hope to see better figures.”
Mr. Çağlayan then expressed his approach to economic policies: “From now on, we must step on the accelerator. … Each year we must grow by 6 percent. The way to reach this target is through expansion, not contraction. There is no need to be cautious on interest rates. They should be lowered.” In my column of Feb. 11 (“Worries on economic growth”), I wrote: “… I think the available information summarized above is enough to allow me to express some reflections on an important consequence of low growth. Further loosening monetary policy would risk jeopardizing the 5 percent inflation target. If the Central Bank maintains its actual stance, the already existing signals of an upturn in unemployment would become more perceptible. This will increase, for sure, the political pressures on the central bank's management.” I was not mistaken. Economic policies have arrived at a crossroad. The soft landing that was desired did not occur. The landing was rather hard, as the 2012 growth rate is expected to certainly fall below 3 percent. That said, Mr. Çağlayan is mistaken in believing that low growth is responsible for increasing unemployment. As I explained in my column on Saturday, despite the low growth rate, Turkish corporations and the state created lots of jobs last year, to the degree that the growth rate of employment exceeded that of gross domestic product (GDP). Unemployment is rising not because of insufficient employment but because of a strong growth of the labor force, particularly in the numbers of women. I believe these anomalies cannot maintain themselves, at least if economic theory and common sense prevail. I am afraid that Mr. Çağlayan, who hopes to see better figures in the coming months, risks being disappointed. If GDP growth maintains its pace at around 3 percent, rising employment will unavoidably decelerate. Even in the case of a deceleration in the growth of the labor force, I believe we should still expect rising unemployment. Unemployment is indeed the main threat to economic stability. I agree with Mr. Çağlayan that growth should be accelerated. The 6 percent target announced by the economy minister is out of range, but 4 percent is achievable. This could also be just enough to calm the worries regarding rising unemployment. But how? This is the critical question economists are asking themselves nowadays. The answers vary. The central bank and Treasury are confident that the 4 percent growth will come partly from external demand and partly from domestic demand. Let me remind you that last year domestic demand did not contribute at all to growth. However, the central bank and some economists do not think that radical changes in economic policies are needed. Some others, like Mr. Çağlayan, defend the argument that further loosening in monetary policy and the depreciation of the Turkish lira are necessary. At the moment, no one defends the loosening of fiscal discipline; Mehmet Şimşek, the minister of finance, announced last Friday that budget performance for the first two months is better than that of last year. This is good news. But if the state of the budget is revealed to be insufficient to revive domestic demand and/or exports fall further behind imports, what will happen to the moderately expansionist monetary policy and to the moderately tight fiscal policy? Personally, I think that there is no room for further lowering interest rates. The real interest rate has already come down to as low 1 percent, and the central bank is neither able nor willing to lower it. A limited depreciation of the Turkish lira will certainly aid growth, but the way to realize that process is not evident in the slightest. Thus it remains in the hands of fiscal policy. Let's hope that growth will resume in the coming months, just enough to stop the rise of unemployment and just enough to limit the unavoidable increase of the current account deficit.