Turkey's Inflationary Woes
For example, using evidence from Germany’s 1920-23 hyperinflation, my long-time friend, distinguished economist, former Governor of the Bank of Israel, and Chairman of J.P. Morgan Chase International, Jacob Frenkel confirmed the accuracy of PPP during hyperinflations. In the July 1976 issue of the Scandinavian Journal of Economics, Frenkel plotted the Deutschmark/U.S. dollar exchange rate against both the German wholesale price index and the consumer price index. The correlations between Germany’s exchange rate and the two price indices were very close to unity throughout the episode of hyperinflation, indicating that changes in the inflation rate mirrored changes in the exchange rate.
I have expanded on the PPP insights presented by Frenkel. One article, which I co-authored with Charles Bushnell in the Fall 2017 issue of World Economics, “On Measuring Hyperinflation: Venezuela’s Episode,” lays out how the PPP approach can be used to accurately measure inflation in cases in which the annual inflation rate exceeds 30 percent, as it presently does in Turkey. Beyond the theory of PPP, the intuition of why PPP represents the ‘gold standard’ for measuring elevated rates of inflation is clear. For example, during episodes of hyperinflation, virtually all goods and services are either priced in a stable foreign currency (the U.S. dollar) or a local currency. In Venezuela, for example, bolivar prices are determined by referring to the dollar prices of goods, and then converting them to local bolivar prices after observing the black market exchange rate. When the price level is increasing rapidly and erratically on a day-by-day, hour-by-hour, or even minute-by-minute basis, exchange rate quotations are the only source of information on how fast inflation is actually proceeding. That is why PPP holds and why I can use high-frequency data to calculate elevated inflation rates.
It is clear that Turkey’s number one problem is inflation. So, the first order of business for President Recep Tayyip Erdogan and the Turkish government is to stomp out Turkey’s inflation. To do that, the lira’s exchange-rate must be stabilized. The best way to do that is with a gold-backed currency board.
A currency board issues notes and coins convertible on demand into a foreign anchor currency at a fixed rate of exchange. As reserves, it holds low-risk, interest-bearing bonds denominated in the anchor currency. The reserve levels (both floors and ceilings) are set by law and are equal to 100 percent, or slightly more, of its monetary liabilities. So, the domestic currency issued via a currency board is nothing more than a clone of its anchor currency. A currency board generates profits (seigniorage) from the difference between the interest it earns on its reserve assets and the expense of maintaining its liabilities.
By design, a currency board, unlike a central bank, has no discretionary monetary powers and can’t engage in the fiduciary issue of money. It has an exchange rate policy (the exchange rate is fixed) but no monetary policy. A currency board’s operations are passive and automatic. The sole function of a currency board is to exchange the domestic currency it issues for an anchor currency at a fixed rate. Consequently, the quantity of domestic currency in circulation is determined solely by market forces, namely the demand for domestic currency. A currency board can’t issue credit. Accordingly, a currency board imposes a hard budget constraint and discipline on the government. This is an under-appreciated feature of currency boards. Unlike central banks, a currency board can’t be used as a means to finance government budgets.
Currency boards have existed in about 70 countries, and none have failed. The first one was installed in the British Indian Ocean colony of Mauritius in 1849. By the 1930s, currency boards were widespread among the British colonies in Africa, Asia, the Caribbean, and the Pacific Islands. They have also existed in a number of independent countries and city-states, such as Danzig and Singapore. One of the more interesting currency boards was installed in North Russia on November 11, 1918, during the civil war. Its architect was none other than John Maynard Keynes, who was a British Treasury official at the time.
Countries that have employed currency boards have delivered lower inflation rates, smaller fiscal deficits, lower debt levels relative to the gross domestic product, fewer banking crises, and higher real growth rates than comparable countries that have employed central banks. To smash inflation and establish stability, a currency board for Turkey would do the trick. Indeed, that’s why I first proposed a Turkish currency board during the lira crisis of 2000-2001. The details of what I proposed then, and now, are contained in a book I co-authored with Kurt Schuler, Gelişmekte Olan Ülkeler İçin Para Kurullari El Kitabi (2001).
I know that currency boards work from, among other things, a great deal of personal experience in stopping hyperinflations—stopping them with the introduction of currency boards. One such case was in Bulgaria, when I served as President Petar Stoyanov’s adviser from 1997-2002.
After Bulgaria took the exit from Communism in 1990, Bulgarians encountered some potholes. The economy plunged, there were debt defaults, and that Balkan paradise experienced an episode of hyperinflation. This episode peaked at an astounding 242 percent per month in February 1997. Yes, that’s per month. With the expectation that a currency board would be the best system to crush Bulgaria’s hyperinflation, I wrote a book with Kurt Schuler that was translated into Bulgarian. In late 1996, it reached the top of the best-seller list in Sofia. In January 1997, I became President Stoyanov’s adviser. My primary tasks were to draft a currency board law for Bulgaria and to explain to Bulgarian politicians and the public how such a system would halt the episode of hyperinflation.
Things moved rapidly. There’s nothing like a crisis to move the ball down the field. The currency board was installed on July 1, 1997, and inflation and interest rates plunged immediately. Much later, President Stoyanov confided that, without the stability created by the currency board system, Bulgaria would have had much more difficulty entering the North Atlantic Treaty Organization (NATO) in 2004 and the European Union in 2007.
Today, Turkey should do exactly what Bulgaria did in 1997. A currency board would make the lira sound. Indeed, if gold was the lira’s anchor, the lira would be a clone of gold, which is a stable currency that is not issued by a sovereign. With that, inflation would be smashed within 24 hours, interest rates would plunge, and stability would be established. And, while stability might not be everything, everything is nothing without stability.