The Political Economy of Turkish Inflation.

• Author: AKAT, ASAF SAVAS
• Position: Statistical Data Included

"Recent Turkish macroeconomic history, including the crisis of 1999 and the current disinflation program, can only be presented and analyzed adequately by understanding Turkish inflation, whence it came and to where it is going."

After the Second World War, its geo-strategic position between Europe, Asia, the Middle East and the Soviet Union propelled Turkey into the founding membership of the OECD. As a byproduct of the Cold War, Turkey, despite the fact that all quantitative and qualitative indicators would have placed the country in a category of third world underdevelopment, enjoyed membership in the exclusive club of developed economies. Despite this fortunate beginning, the performance of the Turkish economy in the last half century has not been breathtaking: average GNP growth at 4.7 percent was substantial but well below the 6 to 9 percent range attained by other more successful economies with similar, if not worse, initial conditions. Relatively high population growth at 2.7 percent during the same period further reduced Turkey's rank in per capita income growth tables. Yet simply because it was not a miracle economy, it would be unjust to call the Turkish post-war experience in economic development a failure; rather, it was somewhere in between the two extremes, what I call "mediocre" for lack of another satisfactory adjective.

The indicator that singles out Turkey from its peers in the newly industrialized economies, particularly over the last two decades, is the behavior of its inflation. Turkey is the only middle-income and sizeable open economy with relatively developed market structures that has managed to sustain average annual inflation rates around 60 percent for a long period of time without either falling into hyperinflation or successfully reducing it to reasonable levels.(1) Recent Turkish macroeconomic history, including the crisis of 1999 and the current disinflation program, can only be presented and analyzed adequately by understanding Turkish inflation, whence it came and where it is going.

THE ECONOMY OPENS TO THE WORLD

In the first three decades following the Second World War, Turkey, like many other developing economies, adopted an inward looking import substitution and industrialization strategy An overvalued currency and strict import controls, often involving full bans on the importation of foreign goods competing with goods produced domestically, resulted in a complex structure of administrative intervention. Bureaucratic controls extended to all important prices and markets, including the financial markets; however, the private sector dominated in Turkey. Private firms undertook all production in agriculture, trade and services and a substantial part of industry. The contradictions inherent in a system that tries to combine a command economy with a dominant private sector made the economy extremely rigid and vulnerable to external shocks, especially those that affected external deficits. The five-fold increase in oil prices in 1974, combined with the political isolation resulting from Turkey's military intervention in Cyprus the same year, proved fatal. By the end of the 1970s, structural deficits in the current account had brought production to a standstill and pushed consumer inflation to three-digit levels. As a result, Turkey suffered from falling real wages, black markets, shortages of basic goods and other typical signs of a failing economic system. The depth and intensity of the crisis and the need for international support convinced both policymakers and the public that undertaking the necessary reforms to create a more market-friendly and export-oriented development strategy was imperative.

We can divide the last two decades of the 20th century into four distinct sub-periods, each associated with an important event:

1980-83: A stabilization program was implemented under a standby agreement with the IMF and continued under a military government. The program entailed a massive devaluation of the Turkish Lira and substantial hikes in indirect taxes.(2) Foreign exchange was made available by a large infusion of funds both from international institutions and NATO allies.

1983-89: Market reforms undertaken by Prime Minister Turgut Ozal were aimed at breaking the administrative structures of the command economy by lifting quantitative restrictions on imports, liberalizing interest rates, simplifying the procedures for foreign direct investment and promoting exports of goods and services (tourism), while strengthening the basic infrastructure of the economy, especially in telecommunications and transport.

1989-96: The liberalization of the capital account and the design of a program for the reduction of import tariffs helped to finance a politically motivated "populist cycle," which exploded in 1994 when GNP shrank by 6.2 percent. The convertibility of Turkish Lira resulted in the dollarization of the economy and large, short-term capital inflows ("hot money").

1996-99: The Customs Union Agreement with the European Union signaled the end of the transition from a closed command economy to an open market economy However, high inflation, and the resulting macroeconomic instability and volatility, persisted, and Turkey entered the new millennium with the most serious economic crisis it has ever faced. GNP growth was negative for the last six quarters of the century, turning 1999, with a growth rate of -6.4 percent, into the worst year since the early 1940s.

Table 1, comparing the last year of three separate decades, 1979, 1989 and 1999, in terms of GDP and indicators of the relative openness of the economy, presents some interesting results. In a relatively short period of 20 years, the structure of the economy was transformed with remarkable success from near autarky to a fully integrated open economy. In 1979, Turkey was an exporter of primary commodities, and its heavily protected industries had no chance of competing in either international or domestic markets. In 1999, Turkish firms competed effectively in the single EU market. This increased integration into the world economy is also reflected in the steady decrease of the percentage contribution of workers' remittances to the foreign exchange earnings.

Table 1

1979 1989 1999 (in Millions of US$) GDP 92,774 107,012 183,755 Exports 2,261 1,178 29,326 FX Revenues 4,798 22,472 53,249 Imports 5,069 15,792 40,692 FX Spending 6,271 21,511 54,613 Current Account+ Net Errors -762 1,932 535 Gross FX Reserves 1,726 9,3 I4 34,133 (in Percentages) Industrial Exports/ Total Export 34.7 78.9 90 Workers Remittances/ FX Revenues 35.3 13.5 8.5 FX Revenues/ GDP 5.2 21 29 FX Spending/ GDP 6.8 20.1 29.7 (Cur. Acc. + Net Errors)/ GDP -0.8 1.8 0.3 Gross FX Reserves/ GDP 1.9 8.7 18.6 Source: Central Bank, State Planning Organization. Table 2 summarizes the overall development of the key economic indicators during the last three decades. The contrast between the variables of real economy, which all show definite signs of improvement, and the behavior of prices, which only seem to increase, justifies the contention that high persistent inflation is the puzzle of the Turkish economy. Comparing the 1990s with the 1980s, it is evident that inflation caused the fall in the growth rate, from 5.22 percent to 3.96 percent, and the increase in output volatility, demonstrated in the increase in the standard deviation of GDP growth, from 3.33 to 5.64 in the 1990s.

Table 2

Average annual change 1970-79 1980-89 1990-99 GDP 5.03 5.22 3.96 St. Dev. of GDP growth 2.99 3.33 5.64 CPI Inflation 24.8 39.9 78.9 TL Depreciation 9.2 44.1 78.7 Exports (shuttle trade incl.) 16.5 14.8 12.5 Imports 23 7.9 10.3 FX revenues/GNP -3.4 8.8 9 FX expenditures/GNP 2 2.2 7 Source: Central Bank, State Planning Organization.

Recurrent foreign exchange shortages prior to 1980 and the currency crisis of 1994 left an important mark on Turkey's collective memory, resulting in a disproportionate focus on the dangers of (imaginary) current account deficits. As the figures clearly demonstrate, foreign exchange earnings and current account balances constitute the healthiest parts of the economy. Thus, the causes of high inflation and poor growth performance must be sought elsewhere.

PUBLIC SECTOR DEFICITS AND HIGH INFLATION

The consensus on the causes of inflation points to the large deficits in the public finances. However, this may not be the case. Economic theory and empirical evidence prove that the monetization of the often large public deficits is always the "original sin" from which high inflation emerges, as it did in Turkey in the 1980s and...