The Turkish lira crash: a story of (hyper)inflation

Explaining the difference between inflation causes in Turkey and the US

You might have noticed that the Turkish lira lost 15% against the dollar in a single day this week. This is merely a continuation of a year-long trend, as the lira already lost about 45% of its value against most major foreign currencies.

Inflation in Turkey is already at 20%, expected to be at 25% for the year.

Now THAT’s what galloping inflation looks like. The american 6% and European average of 4% don’t seem that big now, do they? Well, that’s because two different things are causing these two inflationary outcomes.

The US and the EU are faced with supply chain shocks that cannot adapt to huge post-COVID demand. Nassim Taleb had an excellent explanation the other day on how this works in a 2:30 min video. To sum up: buying 50 things in 2020 and 50 things in 2021 isn’t the same as buying 0 things in 2020 and 100 things in 2021 - the second scenario involves convexity to which the supply chain system cannot easily adapt. It’s also like having 100 people walk into a restaurant over the course of the entire day, and 100 people walking in all at once. The second case implies a kitchen collapse and very long waiting times.

Turkey is facing a similar supply chain issue, but it also has a much more damaging problem - a despotic ruler who’s lost touch with reality.

Let’s start with that.

Erdogan, Turkey’s Putin wannabe, thinks that the best way to combat rising prices is to make money cheaper. So he fired his central bank governor, his two deputies, and ordered the central bank to cut interest rates several times this year. The last rate cut triggered the 15% lira decline this week, pushing inflation even higher, where many goods and services are going up in double digits.

Also, Erdogan wants to monetize his country’s debt – printing A LOT of money to pay off the debt. Pretty much like what Weinmar Germany did in the 1920s.

Weinmar marks being used to start a fire

Let’s unpack this.

Combating inflation by making money cheaper is ludicrous

Why?

Simple supply and demand really. Abundance of pieces of paper (call it money) means that paper is worth less.

On money and scarcity

Think of it this way. The reason money is valuable is because it’s scarce. This is why people used gold and silver as money before – scarcity. Giving someone a scarce item or piece of paper, so that the same person can use that item to give to others implies that people: (1) trust this scarce item, and (2) find it valuable and hard to get.

If money “grew on trees”, it would be worth as much as the actual leaves growing on trees - nothing, as everyone would have easy access to it, meaning that no one would want it. Why would I accept a leaf for something I want to sell, when I can easily pick another leaf off a tree? I want something more valuable (and more scarce) that I can exchange for other stuff. Something other people want too.

So when you make money abundant, no one wants it anymore. It’s become worthless.

This is exactly why money does not, in fact, grow on trees.

How does a currency reflect this?

Remember that each country’s currency is valued in relative terms, compared to other currencies. So when you devalue a currency (or let it depreciate too much - devaluation is a CB decision, depreciation is led by market forces), it makes your currency worth LESS than a foreign currency. Revaluation & appreciation imply the opposite.

So a depreciation of the lira means you need more lira for the same amount of dollars.

If one dollar is worth 6 lira, this means you need 6,000 lira to buy an iPhone. But when the value drops to 12 liras for 1 dollar, you need 12,000 lira to buy an iPhone.

That’s how inflation kicks in.

The many new printed liras in the system make them worth less compared to foreign currencies. You can now buy less stuff with the same amount of liras.

Imagine how this hurts people (or firms) who have foreign currency-denominated loans (e.g. in euros). Your interest payment is 500€, but now instead of 3,000 liras, you need 6,000 liras to pay it. And your monthly salary is 7,000 liras (average salary in Turkey). Bit of a stretch, isn’t it?

So when you try to make money cheaper by devaluing your currency - following the Erdoganomics textbook - you do end up making it cheaper, and worth LESS than foreign currencies.

And since Turkey trades with other countries, it needs to exchange its liras for dollars in order to buy and sell things. But foreigners don’t want lira when it’s cheap. Sure, your exports may be cheaper, so you might sell more stuff there, but with a devalued currency, you’re still faced with spending all that lira on goods and services whose prices have gone up.

In real terms, you’re losing a lot. That’s why everyone hates inflation. It’s not just nominal prices going up, it’s your money becoming worth less and less each day.

In dire situations, when countries go too far and devalue a currency beyond repair by printing so much of it (like they did most recently in Venezuela), people resort back to barter on black markets, use other things for currency (flour, cigarettes, toilet paper), or, for those who can access it - buy stuff with foreign currencies.

Venezuelans resort to barter after their currency becomes worthless. Payments are made in flour, rice, toilet paper and cigarettes.

To sum up, making money cheaper does the OPPOSITE of what Turkey’s despotic ruler thinks - it CAUSES inflation.

What about monetizing debt?

Other side of the same coin. As I’ve said, no country is an isolated island, every country trades with others (even N. Korea). When you buy stuff from abroad you need to exchange your currency for foreign currency to pay for the stuff. Same goes with debt.

Turkey decides to print billions of liras to pay off its debt. Before it can do this, it needs to exchange those liras into dollars. But again, a foreign creditor would need a lot more liras as they are becoming more and more worthless with every new printed edition. Even if you print it “secretly” (a fun suggestion that laymen sometimes have), it’s gonna become “visible” at one point, when you try to exchange it for dollars, meaning you will disturb the current balance. It’s like when a huge buy or sell order comes to the market - it becomes obvious almost immediately.

Before you know it, the more currency you print, the less valuable it is to foreigners, and the less valuable it becomes to natives (as described above). So you descend into hyperinflation. A practice familiar to many countries in history (Germany in the 1920s, Hungary in 1945, Yugoslavia in 1992, Zimbabwe in 2008, Venezuela in 2019, etc).

The daily inflation rate in Zimbabwe in 2008 was 98%.

How is this different from what the Fed is doing?

Now, some of you might think, how is all this money printing different to what the Fed is doing, while pointing to the US M1 money supply graph below, shooting up ever since the pandemic.

Why isn’t the same hyper-inflationary pressure happening in the US?

Because the Fed is not doing the same thing. Even though there is a huge, unprecedented level of money supply on the Fed's balance sheet, very little of that newly created money is circulating in the real economy. That’s the main difference.

The best proof of this is the velocity of money indicator, which is still at its all-time low. Velocity of money measures the rate of circulation of money in the economy (nominal GDP divided by money supply). When it’s high, there is a lot of money circulating relative to the money supply, when it’s low there is less money circulating in the economy relative to the money supply.

Furthermore, ever since the previous crisis & recovery the velocity of money is no longer correlated with the employment-population ratio. Typically these two indicators move in unison since more people having jobs means more spending, and more spending means that more money is circulating in the economy. However, ever since the Fed's QE policies of the past decade, that mechanism no longer seems to apply. The expansion of the money supply grew much stronger than nominal GDP, meaning that nominal GDP was not driven by excess money supply, or in other words: all this new money created is not being spent. It is sitting in between banks and the central bank, as the following figure indicates:

Note that this trend looks exactly like the Monetary base (M0) of the Fed

Excess reserves of all depository institutions - the money held by banks in excess of what is required by regulators - are also at an all time high, even bigger than during the previous decade. Banks are hoarding cash on a massive scale, and this money is simply not present in the real economy.

That’s why there is NO hyperinflation or galloping inflation in the US. What we see is inflation driven by supply chain issues due to huge demand.

Note also that the dollar, despite all this money creation is not subject to a decline in value, right? The dollar’s trend (against all major currencies) in 2021 is that it’s actually growing stronger, not weaker.

The lessons

To sum up, US inflation is mainly due to supply chain disruptions unable to cope with huge demand. It’s worrying, it’s causing pain, but it will pass.

Turkey’s inflation is much more problematic. It is caused by a method that’s a goal in itself - making money cheaper. Erdogan succeeded. Congratulations.

There are two lessons here.

(1) Hyperinflation becomes a threat only when you actually print a lot money and throw it into the system, or when you use all that printed money to pay off your national debt.

(2) When your country has a highly volatile currency, this can only lead to an economic disaster. It’s one thing to use, Bitcoin, for example, as an alternative form of payment. That’s perfectly fine. But beware of using it as an official currency in which you denominate your country’s debt (which is an idea that has been thrown around). That is a very dangerous game you do not want to play.

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