Not much room to maneuver

The answer to the question of “What should be right policy mix?” which was discussed in my Sept. 24 column “Looking for the right policy mix,” has become, indeed, a very critical issue about not only the future of the current adjustment process but also the future of the consensus on the economic regime put in place in the aftermath of the 2001 crisis and adopted by the AK Party during its years in government.

When Zafer Çağlayan, the minister of economy, opened the economic policy debate following the publication of the second quarter gross domestic product (GDP) figures that confirmed the low growth of the economy, I wrote in my column “Second quarter confirms worries about low growth” (Sept. 10) that “there is a serious risk of abandoning the adjustment process too early,” and I ended my article by saying that it would not be “easy to decide for the great referee”.

I do not know if it was easy or not for the prime minister to decide, but it seems that that he took a decision: He backs the fiscal discipline but insists on the loosening of Turkey's monetary policy. Recep Tayyip Erdoğan, coming from the business world like Deputy Prime Minister Ali Babacan and like many other AK Party managers and supporters, believes in the virtues of a balanced budget. Accumulation of debt frightens him. On every occasion you can hear him relating gladly the pitiful situation in which Greece and other southern European countries found themselves because of long-lasting budget deficits that caused colossal mountains of debt.

Moreover, fiscal discipline is not just a moral attitude but is a decisive piece in the economic stabilization of the Turkish economy under AK Party rule. I fully agree with Mehmet Şimşek, the finance minister, and with Durmuş Yılmaz, the previous governor of the central bank, who each explained last Friday that decreasing budget deficits decreased both inflation expectations and inflation itself, as well as real interest rates, dramatically decreasing in turn interest expenditures. They restated that in 2002, more than 80 percent of tax revenue was allocated to interest payments, while today this has decreased to around 15 percent. In this achievement, the decisive role of fiscal discipline is obvious, but let me note that the global crisis, nowadays called the “Great Recession,” pushed down further the real interest rates of public debt and they currently remain at 1-2 percent. The debt burden relief permitted the AK Party to increase public expenditures without jeopardizing the budget balance so that an impressive improvement of public services were made possible which, in turn, filled the ballot boxes with AK Party votes.

So far, so good. Nevertheless, I have a caveat about the fiscal policy. I support the continuation of fiscal discipline but I have two objections. The first one is about the size of the deficit. The government should not insist on the planned 1.5 percent deficit, which is related to 4 percent growth. For a lower growth, which seems to be the case today, a higher deficit is desirable as long as the debt burden does not increase. Concretely, this means that a 2.5 percent deficit is quite acceptable. My second objection is about the quality of the fiscal policy. Limiting public expenditures must be preferred rather than increasing indirect taxes, which push inflation up and narrow the space for maneuvering by the central bank for a controlled relaxing of monetary policy. Of course, it is much easier to increase indirect taxes than to freeze expenditures, particularly when elections are in sight.

Currently, the central bank faces increasing pressures pushing it to loosen monetary policy. Erdoğan made clear that he wants to see lower interest rates, backing Çağlayan in his battle for stepping on the gas pedal. But the problem is that by law, the central bank conducts its monetary policy independently to reach the inflation target, which is set together with the government. This target is already set at 5 percent, and we are still far from this level. Getting inflation down obliges the central bank to avoid either an abrupt depreciation of the Turkish lira or a new boom in domestic demand. To do this it has to keep the real interest rates low but positive. This is exactly the case right now. Further attempts at loosening can easily provoke adverse effects on inflation expectations, causing an exchange rate shock, as well as increasing market interest rates. If the disinflation process goes well in the coming months, I am sure the central bank will envisage relaxing the interest rates.

But I am afraid that the show of strength engaged in by Çağlayan with the central bank risks questioning the consensus on the current economic regime based on the low inflation-low budget deficit. Çağlayan made a dangerous step ahead in the debate by declaring that the central bank is a bank of the country and thus if it insists on keeping its foot on the brake, its independence should be discussed. I hope that the aim of Çağlayan is not questioning the consensus on the economic regime but just the dosage of the monetary policy.