Growing with inflation or getting poorer with inflation?

How to start writing this article? The Minister of Treasury and Finance said, “at a crossroads, we have chosen to grow with inflation. Otherwise, we could have taken very drastic measures to reduce inflation.”

Alternatively, I would begin with this: “The dollar exchange rate, which had been 9.5 liras at the beginning of November 2021, closed 20 December at 17.5 liras. The Exchange Rate Protected Lira Deposits (KKM) system was made-up to lower the rate, and then “back door” currency interventions started. As six months passed, it is estimated that around $40 billion has been sold with the backdoor interventions. KKM placed a significant burden on the government budget, and the load is increasing. The dollar exchange rate rose to 17.2 liras on 8 June. Accordingly, why did we go through all this?

Principles of economics

There could be other ways to start this article. No worries. They all come down to this: The principles of economics are not to be ridiculed. If ridiculed, what we have experienced in the last months happens. Inflation soars. The living conditions of the minimum wage earners, civil servants, retirees, in short, those with fixed income, deteriorate. Poverty increases. The resulting growth becomes neither sustainable nor is felt by most of the society.

Let us look at the inflation-growth relationship first. Is this relationship as the way the Minister of Treasury and Finance recently expressed and many analysts argue? In other words, were they right in their objection, “but what about growth?” without even giving a chance to set out what needs to be done after it is stated that “inflation ought to be reduced even when it is just at 10 percent.” So, is it required to forego growth to reduce inflation?

Inflation – growth relationship

Sorry for those who do not like figures since this article has four of them. The first one exhibits an inflation-growth relationship between the first quarters of 1999 and 2022. Annual consumer inflation is on the vertical axis, while the annual growth rate is on the horizontal axis.

If the stated relationship were valid, that is, if we had to forgo high growth to reduce inflation, we would have to observe a low inflation-low growth, high inflation-high growth relationship. A trend curve running through the circles -each showing a quarter’s inflation-growth relationship- should have run from the southwest to the northeast (should go up). However, there is no such relationship. Conversely, there is a reverse situation to this ‘ought to be’ relationship, albeit not statistically substantial. The downward-sloping red line represents it.

Why is it so?

It is neither the first time I have commented on the subject, nor am I the only one pointing this out. Nevertheless, it does not matter: No matter how hard tried, one cannot counter this “urban myth”: If a program to reduce inflation were implemented, the growth would also decrease.

Come on.

It depends on the conditions. There is a significant reason why the said relationship is neither observed in Turkey nor in most emerging market economies that experienced high inflation. It is associated with risk, interest rates, exchange rates, and inflation.

An example

Let me give an example before discussing the risk. Examine the results of the Transition to a Strong Economy Program, implemented right after the 2001 crisis, when Turkey’s risk was very high. Inflation dropped from 72 percent to 7 percent, roughly from the second half of 2001 to the end of 2007. At that time, the Turkish economy’s average growth rate was relatively high, and the growth volatility was low.

Of course, one example is not enough. Then, here is another figure. This time, I take the country’s risk into account. I consider the inflation-growth relationship by excluding periods when Turkey’s risk (CDS) is 200 basis points or less from the analysis. The period in question is the same as in the first figure.

It is crystal clear: In high-risk periods, the opposite of the relationship expressed in the “urban myth” emerges and is statistically robust: Low inflation-high growth or vice versa-high inflation-low growth is observed. In other words, there is no such choice as “growing with inflation,” overwhelmingly. There are a few observations contrary to what I argue, unsurprisingly, since there are other factors that determine the inflation-growth relationship. Nonetheless, the overwhelming number of observations wipes away the “urban myth.”

Bizarre policies, debt, and risk

I have mentioned that the direction of the inflation-growth relationship depends on other factors too. How?

One of the conditions in which there is no need to consent to less growth to reduce inflation is about risk. Clearly, the risk of a country that implements absurd economic policies will jump. If such an economy also depends on foreign borrowing, demand for foreign currency increases and supply for foreign currency decreases as risk rises. The exchange rate hikes instantly, and so does inflation after a while. As the irrational policies continue, an exchange rate-inflation spiral occurs. Trying to control the exchange rate by selling foreign currency causes tremendous volatility in the exchange rate; however, it does not prevent the inevitable–an upward trend. Also, tumult persists if the dose of unsound policies is increased and various unorthodox measures are introduced. The planning horizon gets narrower. It is clear that there will not be a healthy decision-making environment in such an economy, and the conditions will not be investment-friendly.

Alternatively, consider an economy with high foreign currency debt. The debt can be the liability of the public sector, banks, or non-financial companies. If doubts arise that these debts cannot be rolled over, so does risk. For a while, the economy struggles along. Growth is rising and falling sharply. Volatility is increasing. The economy is getting more fragile every day. When a triggering factor comes into play, the already high risk jumps up, with it the exchange rate and, after a while, inflation. It is explicit that this economy will not be investment-friendly either.

Repentance

In this type of economy, risk is reduced if ‘repentance’ is expressed and a sound economic program is implemented. In particular, as the program’s positive results begin to be observed, the risk goes downward, meaning a sharp drop in interest rates. Consequently, the domestic currency appreciates, and inflation decreases. Volatility decreases in the variables that economic units consider when making decisions, and there is more confidence in economic targets. Therefore, the country becomes a much more investable country. If that sound economic program can also convey institutional transformation, it will be possible to increase the potential growth rate over time.

The 2001-2007 example is given on purpose because a sound economic program was in effect. Indeed, external conditions and what you do in areas other than the economy are also essential. It is worth noting that the European Union accession process was on track in the period I mentioned.

If only the sole thing that falls was the value of our money…

When you turn your back on economics, not only exchange rate jumps and inflation upsurges but also the living conditions of the majority of the public start to become unbearable. I am giving two more figures, asking for your indulgence. The first one (the third of the article) shows the workforce’s share of the total income (GDP) created in the country. It has been going downward in recent years. Free fall: The workers are losing. Who is the winner? Capital owners.

The last figure of the article illustrates the course of the minimum wage adjusted for food inflation. Let us say the value of the minimum wage, free from food inflation, in January 2020 is 1. In other words, let the amount of food purchased with the minimum wage be one basket in January 2020. The figure shows how many baskets of food goods the minimum wage earner can buy in the remaining period. Months are on the horizontal axis. In 2022, the situation is dreadful: purchasing power is below both 2020 and 2021 levels. Moreover, with the minimum wage, in May 2022, only 0.75 baskets of goods can be purchased, not one basket of goods that could be bought two and a half years ago.

So, did we choose to “grow with inflation” or “to become impoverished with inflation”?