Eğilmez: The public has been dragged into a consumption vortex

In an article titled "Consumption Explosion" published on his blog, Mahfi Eğilmez stated that the inflation that began to rise after interest rates were lowered starting in September 2021 created anxiety among the public that 'everything will become even more expensive,' leading to increased purchasing, which in turn effectively caused high inflation to explode.

Stating that the government's KKM (FX-protected deposit) move dragged the economy into a vortex and caused a vicious cycle of inflation and demand growth, Mahfi Eğilmez noted that interest rate hikes alone will no longer solve the problem.

Eğilmez included the following views in his article:

"In September 2021, when inflation and interest rates were equal at 19 percent, we turned high inflation into very high inflation by once again implementing the 'lowering inflation by lowering interest rates' approach, which we had tried several times in the past and which only exacerbated inflation. We have been dealing with inflation ever since that day. Yet, if we had increased interest rates by, say, 2 points instead of starting to lower them in September 2021, most of the economic problems we are in today would not exist.

The graph below was prepared by me using the data in the table I shared as an appendix to the article.

According to the graph, when the years between 1999 and 2021 are taken as a basis, a correlation coefficient[ii] of 0.92 can be seen between the increases in GDP and consumption expenditures compared to the previous year. In other words, consumption expenditures followed a path parallel and very close to the increase in income, rising along with it. On the other hand, when we add the year 2022 to this series, the outlook changes; while the growth rate of GDP shows a serious decline compared to the previous year, the growth rate of consumption expenditures shows a significant increase compared to the previous year. With the effect of adding only the year 2022 to the series, the correlation coefficient between the GDP growth rate and the consumption expenditure growth rate drops to 0.80.

Turkey experienced a consumption explosion in 2022

To put it in the simplest terms, the graph tells us that Turkey experienced a consumption explosion in 2022. The main reason for this is the interest rate cut I mentioned in the introduction of the article. In a country where the national currency is not recognized globally (not accepted as a reserve currency), everything falls apart when you set interest rates below inflation. Because in the capitalist system, the two most important determinants of consumption expenditures, savings, and investments are income level and interest rates.

When interest rates are negative in real terms, people stop saving and turn to spending the money they have as soon as possible before they lose even more purchasing power (flight from currency). With this behavior, they are actually trying to buy goods they think they will need in the future, even if not at that moment, by using credit (pulled-forward demand). As a result, these two behaviors create a demand that exceeds supply, and prices rise (demand-pull inflation). At the same time, the TL is experiencing external depreciation due to both the effect of inflation and the high risks created in many areas (exchange rate increase). Under normal conditions, price increases should create a drop in demand, but when people see that prices are constantly rising, they increase their demand even more in order to stock up on goods as soon as possible before prices rise further. Thus, in an interesting way, inflation becomes the cause of demand growth, and demand growth becomes the cause of inflation (a vicious cycle).

The burden of KKM was paid by the public

With this wrong economic policy, the government dragged the economy into a vortex that encourages consumption rather than savings, and to solve this mistake, it made another mistake by introducing the FX-protected deposit account, this time loading the cost that banks should have paid onto the Treasury and the Central Bank, leading to an increase in the budget deficit. And in the end, it turned to making the public pay the bill for all these mistakes, on one hand with inflation and on the other with tax increases.

This is the picture we are in today. And it is no longer possible to get out of this by raising interest rates. Temporary improvements to be achieved through interest rate hikes and temporary recoveries that will emerge due to the base effect may be seen, but for a permanent and real solution, it is absolutely necessary to initiate a structural reform package in which the rule of law is put into effect at the first stage.

[i] The most well-known of these attempts is the one made by Tansu Çiller in early 1994, which ended in a crisis.

[ii] The correlation coefficient is a coefficient used to measure the degree of the relationship between two variables. It varies between -1 and 1: As the coefficient approaches 0, the relationship weakens; positive values indicate a relationship in the same direction, and negative values indicate a relationship in the opposite direction. As it approaches -1, the inverse relationship strengthens, and as it approaches +1, the relationship in the same direction strengthens.

Supplementary Table: Percentage Changes in GDP and Consumption Expenditures Compared to the Previous Year

(Source: TURKSTAT, November 30, 2023 News Bulletin: Periodic Gross Domestic Product, Q3: July – September, 2023