In our last article we completed the theoretical basis on which to carry this, now continuous, column. In the current article we present an independent assessment of the nature of what the news media is calling “the Lira crisis”.
The Lira crisis is a central bank crisis
Back in July it was reported that President Erdogan had been granted the authority to appoint the governor of Turkey’s central bank. This development comes toward the end of an eight year process of inflating Turkey’s money supply (M2) from 500 Billion Lira in 2010 to almost 2 Trillion Lira in 2018.
The supposed reason for this policy of money supply inflation was to “boost” the economy. Regular readers of this series will understand the nature of what this money supply inflation causes. Rather than a sustainable increase in economic activity and production, what is wrought by this policy is rampant malinvestment and capital consumption.
The nature of some of this malinvestment in this case is seen in the balance sheet of Turkey’s government, which has run a deficit for as long as we can source data (back to 2001). At present the government debt is reported to be around 970 Billion Lira. This reflects multiple years of policies of increased spending financed by “cheap debt” created by expanding the money supply. This money was funnelled toward industries and projects that might not have been that productive, such as subsidising tourism at a time when people perceived the Region to not be as safe to travel to.
Turkey’s situation mirrors the Greek crisis after 2007-2008. The devaluation of the Lira means loans denominated in Euros continue to increase.
What’s the risk to other countries?
“Cheap money” or “cheap debt” entices banks in other countries (particularly those in the euro-zone as they are geographically close and are looking at this debt market) to purchase Turkish debt. Since the debt comes at a time of rampant money supply inflation much of it represents malinvestment. This will eventually show up as “non-performing” loans which will require writing off and large losses.
The theories we built up earlier in this series explain this process well – entrepreneurs use the price of money and the interest rate as signals for what consumers want. When it is revealed that this signal was tampered with and does not reflect what consumers want, the structural errors in investment are revealed. The risk to Europe is that not bailing out Turkey implies excessive risk of their banks suffering large losses. But bailing Turkey out only means the current policies will continue. “Capital flight” could be expected to increase from Turkey and capital controls to be erected.
A really interesting fact of the world at present is that emerging markets (such as Turkey) tend to exhibit similar market risk patterns. So at a time when there are very real risks in a particular market (i.e. Turkey) savers and investors may also decide to begin liquidating in other emerging markets where the risk isn’t so real.
Does this affect New Zealand?
The banks that operate in New Zealand are not in the same position as those in the Eurozone. Turkish debt does not account for large portions of their balance sheets (if any). So, as far as the immediate crisis is concerned, New Zealand will not be affected.
At present the Reserve Bank of New Zealand is also engaged in a policy of money supply inflation. This has led to malinvestment here. The risk that the situation in turkey represents is that the process of liquidating assets affected by Turkey’s data reveals the malinvestments in the New Zealand economy. These will then also be liquidated, spiking unemployment and beginning a depression.
We estimate this risk to be small at present.