Damon H. Grande*
President Trump promises to be the biggest wild card for markets in 2017 and probably beyond. So far, fund managers used a smorgasbord approach to Trump’s intentions, picking the delicious tid-bits like the promise of cuts tax cuts, ample infrastructure spending and wholesale deregulation. His other promises concerning levying taxes on Chinese and Mexican imports have been shrugged off, because achieving the goals implied in these promulgations “would be irrational”. Lately, Trump’s advisors doubled up the ante, promising to re-shore the supply chain and talking down the dollar.
What will Trump do? What can’t he do because it would be “irrational” or “against national interest”? I propose an empirical simulation using the experience of Turkey’s president Mr. Erdogan. The similarities between two leaders are fascinating; meaning the past behavior of Erdogan can be used to generate meaningful predictions about Trump’s future actions.
Let’s establish these similarities.
If you are satisfied with the similarities, Erdogan’s past should scare you, because his economic policies are neither “rational” in the sense you and I would define it, nor have they served the “national interest” well. Moreover, Mr. Erdogan doesn’t learn from mistakes, he keeps repeating them.
Allow me to make my case with recent examples. Erdogan and the AKP administration blame the weakness of the TL on “foreign powers” waging economic war on Turkey. There is not one shred of evidence that there is a coordinated effort or an international conspiracy behind the currency weakness. It is simply a reaction to low carry yield, murky politics, high F/X borrowing requirements and the-then dollar strength.
Intriguingly, Mr. Erdogan doesn’t even see how irrational his allegations against foreign powers are. Most wealth in Turkey is in the hands of secular Turks who vote for the opposition. If they were to truly believe that the Mighty West decided to get rid of Erdogan, the reaction would be wide-spread capital flight and a run on F/X deposits in the banking system, because Turkey would have no hope of winning such a battle with the puny F/X reserves of CBRT.
Mr. Erdogan firmly believes that high interest rates cause high inflation. He never bothered to prove this assertion, and I’m yet to see any empirical study from his camp to justify it. To the contrary, CBRT had years ago published a study showing that financing expenses are only a small part of firms’ cost structure, meaning that the level of interest rates can’t possibly lead to cost-push inflation, the only channel I can think of through which interest rates effect inflation.
Year after year, Erdogan badgered CBRT to keep interest rates lower than warranted by the trend of inflation, condemning Turkey to sporadic currency shocks, such as the one we are currently witnessing and concomitant high inflation, which ranged at about 7% over the last five years, at a time when the world was battling dis-inflation. It is worth emphasizing that even though his insistence on low rates brought Turkey to the precipice of balance of payments crisis at least three times since Bernanke’s taper tantrum, he shows no signs of having learned from his error.
Finally, Erdogan claims that Turkey needs low interest rates to increase its rate of fixed business investment. This is only a half-truth. Given a stable political climate, a sufficient pool of financial funds and profitable investment opportunities, it would be true that the lower the interest rate, the higher would be the tendency to invest in plant and equipment. In Turkey these “other” conditions usually don’t hold. Most importantly, recent Turkstat GNP revisions reveal that when real interest rates are low, Turks switch their savings from the financial system to real estate. Since 2015, there has been no correlation between interest rates and fixed investment.
Overall, according to Turkstat, Turkey did in fact enjoy higher-than-average (EM ex-China and India) growth rates thanks to Erdogan’s economic policies since 2009, but growth was concentrated in construction. It led to a massive accumulation of private debt, mostly in F/X, the repayment of which is doubtful. This is one of the reasons why all three major rating agencies downgraded Turkey in the last six months. Moreover the price for faster-than average growth was very high current account deficits and inflation. Today, most global investment bank research singles out Turkey (along with South Africa) as the most vulnerable country to Fed or Trump related shocks.
If Trump were to behave like Erdogan, he would ignore friendly advice or constructive criticism and carry out all of his election promises plus what his advisors have been saying in recent days. Deep corporate tax cuts, massive infrastructure spending, high tariffs for imports and economy-wide deregulation leading to wild risk talking and moral hazard will be the signature of his presidency. America will indeed grow faster, but it will also generate much higher inflation than Fed projects, triggering hasty monetary tightening and higher long-yields than the market currently anticipates. The probability of trade wars or sudden “risk reversal episodes” in EMs would be much higher than priced today.
Trump will not stop. His idea of rationality and national interest differs substantially from the run-of-the-mill fund manager. Markets should stop cherry picking his agenda for positives and should instead focus on the relevant question: Are the checks and balances in the American system robust enough to tame Mr. Trump. For your information, in Turkey these completely failed.
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