Turkey’s Next Move

This article appeared in Forbes Global on March 19, 2001.

Chalk up another victim of the International Monetary Fund's currency policy. On Feb. 21, Turkey gave up on its IMFimposedcurrency peg and allowed the lira to float. Instead, it sank—down about 30% against the dollar and the eurobetween Feb. 21 and Feb. 27.

No one should have been surprised. Turkey's pegged-exchange-rate regime was fatally flawed. These regimesrequire 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 offsetthis by pumping up domestic liquidity. Anticipating troubles, additional capital takes flight and the contradictionbetween exchange-rate policy and domestic-liquidity policy grows. That's when the speculators start betting that thepeg will soon blow up. Turkey's currency collapse—like similar events in Mexico, Thailand, Korea, Indonesia, Russiaand 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 onTurkey and its floating lira setup. He was quickly echoed by Paul O'Neill, the U.S. secretary of the Treasury. Thissurprised many observers. After all, just two weeks before Turkey's fiasco, O'Neill had hammered the IMF, going sofar 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 floatingexchange rate is doomed. Floating exchange rates are fine in principle. They don't lead to contradictions betweenexchange-rate and domestic-liquidity policies because a central bank doesn't have an exchange-rate policy: Thecurrency market sets the rate.

The problem is that in emerging markets like Turkey, floating rates are unsustainable. Either the central bank will nothave the muscle to control domestic liquidity, so the exchange rate will float downward, creating more inflation, or thecentral bank will impose ultrahigh real interest rates, which will send the economy into a nosedive. Either way thecentral bank loses—which probably explains why Gazi Ercel, the governor of the Central Bank of Turkey, resignedfrom 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 isto do what its neighbor Bulgaria did in July 1997: adopt a currency board. Under a currency board, a country with aweak currency backs it one-for-one with a strong currency—dollars, euros or yen—and guarantees that its notes canbe freely converted to the stronger notes at a fixed rate. Contradictions between exchange-rate policy and domesticliquidityconcerns 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 adeutsche mark—backed currency board. It is forecast to be 3.9% this year. A currency board, backing liras witheuros, would do the same for Turkey.

To support the currency board and other necessary reforms, the Turkish government should lift a page from theGerman economist Wilhelm Ropke (1899—1966). After Hitler ran him out of Germany in 1933, he went into exile inTurkey, where he was a professor at the University of Istanbul from 1933 until 1937. He later gained fame as LudwigErhard'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 acurrency 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 extendcredit to the fiscal authorities. Consequently, for the economy to grow, the government has been forced to introduceliberal economic reforms and move toward European standards. Even though Bulgaria has a long way to go, it is atleast 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 domesticsupport for economic reforms aimed at modernization. The first line of attack should be once and for all to stabilizethe Turkish lira by means of a currency board. This would rapidly unify the lira with the euro and put in place a strongfoundation for other liberal reforms.