Friday, March 26, 2021

Erdoğan's alternative "science" on interest rates

Turkish Rondo by Wolfgang Amadeus Mozart, edition by Mrs Eva Pillarová. Note that the shabada lyrics coincides with that of Nohavica's song about the Arab who is touching Nohavica's wife.

The Turkish economy has displayed some high, 15% or so inflation rate. It would be unacceptable in almost all standard Western countries (and some others). In November, when the U.S. dollar was already worth some 8.40 Turkish liras (see USD-TRY charts), the Turkish president Recep Tayyip Erdoğan appointed a respected hawk Naci Ağdal to the central bank who has apparently tamed the inflation when he raised the interest rates from 10% to 19%. The lira appreciated up to 5.95 per dollar in mid February 2021.

However, one week ago, the dissatisfied president fired him and replaced him with an unknown dove and the lira instantly went from 7.2 to 8.0 (now) per dollar. What is remarkable is the the president's maneuvers are built on his "science" whose basic tenets are
The interests are the root of all evil.
High interest rates also cause high inflation.
Amusing and cute but dangerous.

When I was 7 or so, I actually believed the second statement by the president, too. The inflation X percent means that the price of the "basket of products" – which is some amount of money – increases by a factor of 1.0X (well, it is 1.XY in Turkey LOL) in a year; the banknotes are getting less potent. Seemingly similarly, interest rates of X percent mean that your savings – another amount of money – increases by a factor of 1.0X. So it is a similar "shrinking of the unit of money" so these two things are probably roughly the same, and the higher interest rates you prescribe, the higher inflation you will see etc.

Well, there is something true about this fundamentally invalid argument: countries with a high inflation rate end up being countries with high interest rates, too. At the end, the "real interest rates" (the nominal interest rates minus the inflation rate) end up being similar (and close to 0% in recent years; in the healthy times, those were always decisively positive) in all countries which is why the interest rates and inflation rates end up being similar. However, the causal relationship behind this proximity is completely different than Erdoğan says.

The two rates are similar because to fight high and especially accelerating inflation that already exists, central banks increase the interest rates. So a high or accelerating inflation causes high or increasing interest rates because the central banks think that this is the right reaction because the central banks want to counteract against the high or accelerating inflation; I will explain why it is the right reaction momentarily. But the opposite causal relationship doesn't hold. High interest rates don't cause high inflation. On the contrary, high interest rates cause a low or decreasing inflation.

The reason is simple. When the interest rates are low [or dropping], or even negative, people and companies have a high [or growing] tendency to borrow the money because the borrowing is cheaper: they only return what they have borrowed plus a small [or smaller] interest. If the people borrow the money, there is more cash that is circulating and competing to buy products and services, and that's why the products and services get (and may get) more expensive, and inflation is high [or accelerating]. On the contrary, higher [or increased] interest rates discourage the people and companies from borrowing (and also encourage the savers to hoard and protect their money in the least risky saving accounts etc.), the money supply grows less quickly (or decreases), the demand goes down, products and services must get cheaper to be sold, and the inflation is low [or decelerating].

The understanding of the mechanism in the previous paragraph is among the most important things that a central banker has to understand and most of them may have understood it from their childhood. The president doesn't understand it even as a grownup man and it may lead to very bad consequences. Of course, if you have a 15% inflation rate and you send interest rates back towards 0%, the savers are screwed (all people in Turkey should fully go into some investments, stocks or real estate or at least foreign currencies to be safer! The Czech crown and stocks are safe enough) but there are other consequences, too. The inflation will probably accelerate to hyperinflation because the borrowing is encouraged (minus 15% real interest rates, you know...). Unless the president is tamed, Turkey might be on its path to Zimbabwe and Venezuela.

Well, the first dogma of the president is that "the interest is the root of all evil". It's not just a reflection of some general financial illiteracy. This idiotic comment is also a "wisdom" written in the Quran (the Quran bans the lending with a nonzero interest rate because it's not halal or whatever). I know many people who are parttime allies of mine, in the fight against the identity politics, perhaps global warming, and other things. But they also believe that "the interest is the root of all evil" (and they often say that the lenders are parasites etc.). Most of these people end up being some sort of anti-Semites and conspiracy theorists – and they are generally far left economically. Sorry, I am obviously not one of them at all.

The interest is a totally necessary condition for a loan to be fair – and economically effective. The zero-interest loan would typically be very bad for the lender because of the following reasons (among some others):
  1. the inflation will increase the price of products so the lender will be able to buy "less products" when the money is returned, so this should be compensated
  2. the lender faces the risk that the borrower will go bankrupt or die or become a criminal-aßhole-robber and won't return the money, so this has to be compensated by some higher returns in the case that the loan is repaid
  3. even if the inflation were zero and the risk of failure were zero, the lender gives up the opportunity to use the money earlier while the borrower gains it, and this difference (it's better to be rich already now than in the future) is imprinted to the discount rates
Roughly speaking, the fair interest rate is the sum of three terms sketched above: the inflation rate, the probability of failure \(P\), and some extra discount rate. Now, the lenders and borrowers don't really need to learn the basic theory that I have sketched. They "feel it" even without the theoretical training. And if they "don't feel the fair interest rates" individually, the markets with many possible lenders and borrowers will "feel it". So you will only be able to lend or borrow at a certain interest rate (the other side must agree with the transaction and if you are too demanding, you won't find a counterparty!). The central banks influence the interest rates because they determine the interest rates that the commercial banks get for some spare money. In this "storage of the spare money of the commercial banks", the central banks have no competition, they have a monopoly, so they can determine these rates according to their own policies.

The commercial banks may decide which part of their cash is lent and to whom. They will only lend it to new private borrowers (people or companies) if the expectation value of the yields from these loans exceed what the commercial banks get from the central bank for the "excess cash". That is why the private, small borrowers (who want to buy a car before they have all the money, for example) compete against the central banks (to get the money collected by the commercial banks) and when the central bank increases the central interest rates, the private borrowers must increase what they pay as the interest rates, too. That is why the increased "central" interest rates generally increase all interest rates in the financial markets, almost by the same increment! (I wrote "almost" because after the central bank increases the interest rates, it partly wins in the competition fight against private borrowers, and that's why a greater fraction of the commercial reserves' will be parked in the central bank, and that's another reason why the economy will cool down because real subjects will borrow less when the central interest rates increase.)

As I said, the central banks may "dictate" the interest rates paid to the commercial banks for their spare money because the central banks are the only "borrowers" who are guaranteed not to go bust (and the commercial banks are legally required to be sufficiently safe and to hold a certain minimum fraction of their positive assets in the "very safe" forms, starting with the cash parked in the central banks). In practice, the central bankers are choosing interest rates to stabilize or help the economy in some way. Most central banks try to prescribe the future value of the currency by targeting an inflation rate (or the nominal GDP or something else). A low but predictable inflation makes it easier to plan, to have some idea what a crown or a dollar will mean in 2025, and that is a good thing, that is what makes the money usable and useful at many time scales including long ones (it is more meaningful to sign contracts involving money transfers in the future: we know what the amount will roughly mean). Some central banks, including the U.S. Federal Reserve, contaminate this rule by some extra activism: the U.S. central bank is "also" assumed to help to fight the unemployment or other non-monetary enemies. This is often confusing and potentially dangerous but has not led to a tragedy yet, mostly due to the reserve currency status of the U.S. dollar.

OK, kids or teenagers should be taught these things. Or maybe college students with any specialization should be taught similar basics of economics and monetary politics at the university. The president of Turkey should have learned those things before he became the president – or after he became the president. He failed to learn these basics. Too bad. But as I already wrote, the misunderstanding of the interest isn't "pure ignorance". It is mixed with some kind of "anti-Semitism" and "anti-elitism". The rich people in the financial markets (who are often Jewish, as the enemies of the interest rates may add) build their work on the interest rates and because "we" (they) dislike most of these people, the interest rates must be evil, too.

Sorry, the interest rates are not evil. They are essential for a healthy economy. Without an external pressure, most lenders won't lend their money at a zero interest rate because they will find some better ways to spend the money, invest the money, or get the nonzero yields for some de facto loans indirectly. But I think that those who repeat the Turkish president's (or Islamic) idiocy that "the interests are the root of all evil" completely misunderstand pretty much everything about capitalism and why it works, too (and when it doesn't work). They are just totally financially illiterate from every perspective.

In particular, they tend to believe that "demanding a nonzero interest rate is immoral" which is why coercion is considered fair by them – to force the people with money to lend their money at the zero interest rate. At this moment, the financial illiteracy of these anti-interest people becomes a moral defect, too. Coercion is never fair because coercion is equivalent to a robbery. The people who have the money and who may lend the money have (or at least some of them have) earned the money while doing nothing immoral whatsoever. On the contrary, they did some work which was helpful for others – and these others have paid for that work. So the people who already have the money shouldn't be treated as criminals and they shouldn't be subject to violence, coercion, or intimidation. To say "you have to lend the money at zero interest rate else" is the same as to punch someone on the street and say "give me Y percent of your money, otherwise you will be punched again". It is really the fudging same thing. And the societies that encourage zero-interest borrowing end up similarly to the societies that encourage the robbery on the street. In such societies, people won't be encouraged to do helpful things for others and earn the money (or at least the excess money) simply because the people who earn a lot of money are treated very badly. They are forced to lend under bad conditions; or they are punched into their face on the streets. Without the excess money and the concentration of capital, you just won't get industrial advances etc. because those totally depend on the concentration of capital.

So most of these anti-interest, often anti-Semite, people just don't understand the basic point of capitalism, namely that it is composed of consensually agreed transactions that are believed to be good for both sides, by these sides – transactions that prove that the economic life is not a zero-sum game, it is a positive-sum game instead. This is the magic principle that has led to the economic growth in a majority of the recent thousands of years. This is why we're doing other things than just eating the bananas in the jungle or starving in the colder climate zones. People do useful work not just for themselves but also for others – because they get a fair compensation for that (fair according to both sides). Yes, the Jews partly invented the interests or they have at least turned them into an industry. But the Jews – and many others – must be thanked for that. The world would be insanely worse for humans if those principles and mechanisms were denied (at some level, you can't really deny them; to some extent, these basic laws of economics govern the cooperative behavior even in the animal kingdom).

I don't know whether the president of Turkey is reading The Reference Frame and whether he will understand my explanation. Maybe he won't. But this piece of his "alternative economics" shows that Turkey still represents an incredible can of worms. The Turkish society is still controlled by decisions which are both authoritarian and financially illiterate and that show that Turkey still hasn't gotten the basic macroeconomic and monetary insights that have been understood in the West for a century or so. The EU membership of Turkey could dilute the central power in Brussels and make the EU integration shallower which would be a very good thing. But it would bring new risks (mostly related to the Islamic methods to manage whole nations). Truly uncivilized policies such as the Turkish president's upside-down decisions on the interest rates could spread to other countries. The world is a šitty place (thanks, Larry, for this summary) and we are facing threats that are coming from most directions.

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