Lira Crash

No, a currency board won’t save the Lira, contra Steve Hanke’s oped in the Wall Street Journal. Steve:

Turkey should adopt a currency board. A currency board issues notes and coins convertible on demand into a foreign anchor currency at a fixed rate of exchange. It is required to hold anchor-currency reserves equal to 100% of its monetary liabilities,…

Well, that sounds reasonable no? If 100% of the country’s currency and bank reserves are backed by US dollars, and the currency is pegged to the dollar, what could go wrong? Don’t want Lira? The central bank promises to exchange 1 Lira for 1 dollar and always has enough dollars to make good on the promise. It sounds like an ironclad peg.

Government debt is the problem. Turkey may still have the resources to back its currency 100% with dollar assets. But what about the looming debt? Turkey does not have the resources to back all its government debt with dollar assets! If it did, it would not have borrowed in the first place.

So what happens when the debt comes due? If the government cannot raise enough in taxes to pay it off, or convince investors it can raise future taxes enough to borrow new money to roll it over, it must either default on the debt or print unbacked Lira.

I.e. a currency board run by an insolvent government will fail. The government will eventually grab the foreign reserves.

The Argentinian currency board did fail, and this is basically why.


It’s worse in many countries including Turkey for two reasons. One, the government borrows in dollars. It cannot devalue this debt by inflation, so the inflation required to devalue the rest of the debt is higher. From the WSJ editorial, 

A country borrows too much to spur growth in an era of low interest rates and easily available credit. Much of that debt is in U.S. dollars, but the cash flow to finance it is earned by local companies in local currency. By some estimates about half of all Turkish debt is owed in hard currencies.

WSJ is mixing government and private debt here, but they are entwined. When companies borrow in dollars against local currency revenues, they become vulnerable to devaluation. When that happens, the government either bails them out or watches the country collapse. So private debt in dollars becomes government debt, also in dollars.

The currency board can work, if it is part of a package by which the government commits to solve its fiscal problems, either by tax increases (usually, not likely as if there was that much tax revenue around, the government would have already grabbed it), spending cuts, defaults, or some means other than inflation.  But it is the fiscal package, not the currency board, doing the work.

This really is where we differ:

Government finances, state-owned enterprises and trade need not be reformed before a currency board can issue money.

Oh yes they do. Otherwise everyone knows the board will fail. The board can only succeed if it is part of a reform of all the above.

You can see a foundational difference. Steve thinks of inflation as coming from money alone. Control money creation, you control inflation. I think in terms of fiscal theory of the price level. You have to control all government debt to control inflation, sooner or later.

Turkey right now is also a good example to keep in mind for the vast majority of the economic establishment that thought it awful that Greece didn’t have its own currency, so that in its fiscal troubles it could do exactly what Turkey is doing now. And, like pre-euro Greece did many times before.

This is nothing new. Inflation has ravaged Turkey for decades. The average annual inflation rates for the 1970s, 1980s, 1990s and 2000s were 22.4%, 49.6%, 76.7%, and 22.3%, respectively.

Those horrendous numbers mask the periodic lira routs. In 1994, 2000-01 and the past few months, the lira has been torn to shreds.

None of this brought great prosperity.