No one should have been surprised. Turkey’s pegged‐exchange‐rate regime was fatally flawed. These regimes require a central bank to manage simultaneously the exchange rate and domestic liquidity. This is an impossible task. When foreign reserves begin leaving a country, domestic liquidity is squeezed. The central bank attempts to offset this by pumping up domestic liquidity. Anticipating troubles, additional capital takes flight and the contradiction between exchange‐rate policy and domestic‐liquidity policy grows. That’s when the speculators start betting that the peg will soon blow up. Turkey’s currency collapse—like similar events in Mexico, Thailand, Korea, Indonesia, Russia and Brazil—was yet another textbook case of the inherent instability of currency pegs.
In an attempt to snatch victory from the jaws of defeat, Horst Koehler, the IMF’s managing director, heaped praise on Turkey and its floating lira setup. He was quickly echoed by Paul O’Neill, the U.S. secretary of the Treasury. This surprised many observers. After all, just two weeks before Turkey’s fiasco, O’Neill had hammered the IMF, going so far as to suggest that some of its programs were “crazy.”
What’s next for Turkey? Burdened with a shaky form of governance and a weak rule of law, Turkey’s floating exchange rate is doomed. Floating exchange rates are fine in principle. They don’t lead to contradictions between exchange‐rate and domestic‐liquidity policies because a central bank doesn’t have an exchange‐rate policy: The currency market sets the rate.
The problem is that in emerging markets like Turkey, floating rates are unsustainable. Either the central bank will not have the muscle to control domestic liquidity, so the exchange rate will float downward, creating more inflation, or the central bank will impose ultrahigh real interest rates, which will send the economy into a nosedive. Either way the central bank loses—which probably explains why Gazi Ercel, the governor of the Central Bank of Turkey, resigned from the bank on the weekend of Feb. 24.
The only way for a country in Turkey’s predicament to control inflation and converge with European inflation rates is to do what its neighbor Bulgaria did in July 1997: adopt a currency board. Under a currency board, a country with a weak currency backs it one‐for‐one with a strong currency—dollars, euros or yen—and guarantees that its notes can be freely converted to the stronger notes at a fixed rate. Contradictions between exchange‐rate policy and domesticliquidity concerns don’t arise, because a currency board doesn’t have a domestic‐liquidity policy.
In Bulgaria the year‐over‐year inflation rate was 1,527% in June 1997, a month before the government adopted a deutsche mark—backed currency board. It is forecast to be 3.9% this year. A currency board, backing liras with euros, would do the same for Turkey.
To support the currency board and other necessary reforms, the Turkish government should lift a page from the German economist Wilhelm Ropke (1899—1966). After Hitler ran him out of Germany in 1933, he went into exile in Turkey, where he was a professor at the University of Istanbul from 1933 until 1937. He later gained fame as Ludwig Erhard’s adviser, the brains behind Germany’s postwar economic miracle.
Unlike most economic liberals of his day, Ropke was highly suspicious of liberal solutions imposed from above. Indeed, he believed that liberalization and modernization imposed by such outfits as the IMF were not sustainable. Instead, he argued that reforms, “like charity, should begin at home.”
The power of Ropke’s thinking is clear in Argentina, where former president Carlos Menem built political support for a currency board in 1991 and where the board still enjoys the voters’ near‐unanimous support. Likewise in Bulgaria. Thanks to this system, the Bulgarian economy faces a hard budget constraint because the central bank can’t extend credit to the fiscal authorities. Consequently, for the economy to grow, the government has been forced to introduce liberal economic reforms and move toward European standards. Even though Bulgaria has a long way to go, it is at least on the right track and far from the basket case it was in 1997.
If Turkey seriously hopes to converge economically with Europe and join the EU, it must begin to build domestic support for economic reforms aimed at modernization. The first line of attack should be once and for all to stabilize the Turkish lira by means of a currency board. This would rapidly unify the lira with the euro and put in place a strong foundation for other liberal reforms.