by Serban V.C. Enache
Last month, Turkey’s president fired the head of the country’s Central Bank, Murat Cetinkaya. “We told him several times to cut interest rates at meetings on the economy […] We said that if rates fall, inflation will fall. He didn’t do what was necessary.” His view on monetary policy was mocked by mainstream economists, who are either incompetent or just playing dumb. Sure enough, the CB did what Erdogan desired. That being said, Turkey’s key lending rate and interbank rate remain in the double digits. Meanwhile, private debt to GDP has stabilized at around 170 percent and the public’s desire now is to slowly unwind.
Here’s why Erdogan’s unorthodox view on monetary policy is correct. The CB’s lending rate is the cost of borrowing reserves; reserves are used by banks for accounting and settlement purposes. Banks DO NOT lend out reserves to their debtor customers. The ability of banks to approve loans is contingent on their capital and the actual demand for loans: the presence of credit-worthy customers willing to borrow money. Banks first approve the loans, and later acquire the reserves if they need them. So long as a bank meets the capital requirement, it can always borrow reserves [in case it’s short on reserves] from the interbank market [from banks with a surplus of reserves] or from the Central Bank itself. The lending rate is a cost on liquidity. During a period of deleveraging, which the Turkish private sector wants to do, it’s not wise to increase this cost. At the same time, higher interest on reserves and on Government bonds translates into larger financial flows into the economy through the CB & Treasury interest payments channel.
A counter-argument can be made that, with a lower lending rate, speculators could borrow Liras more easily and use them to buy foreign currency. This is a legitimate concern, however, since Turkish private sector debt has peaked, fewer economic agents have a good balance sheet to engage in such activities, and at the same time, given the overall situation, banks are more prudent now, since their equity positions are shaky. This particular concern wouldn’t exist if the country’s laws ensured asset side discipline for the banking sector. Contrary to conventional beliefs, you don’t discipline banks on the liability side, but on the asset side. A bank’s liabilities are stable in value, but its assets [loans made] oscillate in value. The riskier the loans, the riskier the spread between assets and liabilities, endangering the bank’s equity position. Erdogan’s desire to have the Central Bank lower rates is beneficial in two ways for the Turkish economy. First, it allows for a smoother deleveraging phase. Second, it minimizes the volume of funds entering the economy via the CB & Treasury interest payments channel, easing inflationary pressures.
Here’s what Erdogan’s Government should do with regard to asset side regulations. Banks shouldn’t have subsidiaries of any kind, since keeping assets off balance sheet doesn’t serve public purpose and it makes it harder in real terms for Government regulators to monitor them. Banks shouldn’t be allowed to accept financial assets as collateral for loans, because leverage serves no public purpose. Banks shouldn’t be allowed to lend off-shore [for foreign purposes]; bilateral agreements between states should cover that type of activity. Banks shouldn’t be allowed to engage in proprietary trading or any profit making venture beyond basic lending. Banks would issue loans based on credit analysis, not market valuation; they would not be allowed to mark their assets to market prices. Banks shouldn’t be allowed to buy or sell credit default insurance. Banks shouldn’t be allowed to contract in an interest rate set in a foreign country. Banks would only be allowed to lend directly to customers, service and keep those loans on their own balance sheet. No public purpose is served by selling assets to third parties. The interbank market should be abolished as well, since it serves absolutely no public purpose. The CB should lend directly to its member banks. The reserve requirement should also be removed, since banks can provision themselves with enough liquidity [from the State] by simply looking at the behavior of their customers. And under all these rules in place, limited Government deposit insurance can be upgraded to full insurance. Last but not least, in order to improve the ability of banks to manage risk and lower overall speculation, a principle from the Islamic banking model should be adopted. It works as follows – when a customer comes in to get a loan to acquire a piece of property [a house, an apartment, a vehicle etc], the bank buys that property and gives it to the customer for use, but the bank retains ownership over it, until the debt is squared. This provision serves another great purpose… it facilitates an easy transition from mainstream taxation to the Single Tax [Georgist] framework. With this rule in place, the responsibility for paying the land-value tax [LVT] falls upon the bank, not the debtor. The debtor makes the debt payments to the bank, and the bank uses those funds to pay the LVT.
Here are two examples:
Phasing in Land-Value Taxation. I bought land through a bank loan, and now the Government has eliminated the property tax and instead introduced a 10 percent LVT. I’m stuck with paying the LVT and the debt I owe to the bank, which is not fair. Therefore, the Government introduces the Islamic banking rule retroactively, and the ownership of the land goes to my creditor, who can’t kick me out, as long as I honor my debt payments. With this change in ownership, the bank accepts a loss of 10 percent [the LVT]. It’s much easier for Government to deal with financial firms in an orderly, institutional manner, than directly with every household faced with this double-burden. The State can temporarily relax capital requirements, should it be necessary in the transition from the antiquated, regressive and perverse tax code to the new, fair and efficient one. The boys and girls at the Bank of International Settlements will, of course, grimace at such a bold and informed move.
Full Land-Value Taxation is in place. Banks won’t be happy to accept land as collateral, given the fact land has a 100 percent tax liability on it. And those that do will have to hope for a near zero profit at best. So gaining access to land will be possible in most cases without any upfront cost. A citizen will simply pledge to pay LVT to the State, and he or she gets the respective plot.
Going back to the issue at hand… mainstream commentators can mock Erdogan as much as they want, but they’re the ones who are wrong about interest rates. The ‘natural’ interest rate on fiat money is zero! Anything below zero is a tax. Anything above zero is a subsidy. Those who claim that higher interest rates lower the volume of ‘malinvestment’ are arguing for a regressive and inefficient way to combat it. According to their logic, all pharmaceuticals should be sold at a premium, to make it more expensive for those seeking to buy the drugs for recreational use, instead of treating illnesses. Why should everyone pay more because a few abuse these products? Why should the cost of money be higher, just because some use it for speculation, rather than wealth creation? The correct logic is to distinguish between productive and unproductive economic activity. Encourage the former and discourage the latter. Higher interest rates across the board [levied irrespective of the type of economic activity] is as regressive as it gets and it hardly does anything to contain malinvestment. Those who blame the real estate bubble on low interest rates [so-called artificially low rates] are wholly missing the root cause: privatized land rents – landlords and money lenders appropriating the value of location [value which they did not create]. Without this phenomenon, asset price inflation wouldn’t occur. Under full land-value capture, property prices would be kept stable. If Erdogan wants to escape the looming recession and secure his power, instead of engaging in damage control, his Administration should push in the Georgist direction, even if that means completely pissing off the vested interests within and without Turkey.