Washington, DC, August 14, 2018 --  

Bad behavior and hothead posturing is to blame for Turkey's currency woes. Cooler heads must keep the crisis from spreading.

When the Turkish lira plunged nearly 8 percent on Monday¹, currency traders were on edge. The currency has lost nearly half its value since the beginning of the year, and it's not alone. Emerging markets around the world like India, Argentina, South Africa and Indonesia have felt the pinch of declining currencies relative to the dollar and euro. And this is to say nothing of the collapses in value of currencies in the world's most basket case countries like Venezuela and Iran.

Currency markets are becoming as volatile as during the Asian economic crises of the late 1990s.

Two key changes have upset the status quo, one natural, one man-made. The natural change comes from normal progress since the end of the 2008 global financial crisis. Everybody knew the era of interest rates near zero, ushered in after the crisis, could not last forever. Orthodox economics theory says that as growth increases and unemployment decreases, interest rates tend to rise. It took a surprisingly long 10 years for this to happen in the rich world, but after several rounds of interest rate rises by America's Federal Reserve, this era is finally over.

The man-made change to the order comes from the global trade war started by America's unorthodox leader. President Trump has rattled international markets with tariffs imposed on large markets like China and the European Union, but also on smaller markets like Turkey. And smaller markets have currencies that are much more vulnerable to external shocks.

In Turkey, macroeconomic problems have existed for years, but have been exacerbated by the fight between President Erdogan and the Trump administration. The volatile Turkish leader has been angry at the United States since a failed coup attempt two years ago, which Erdogan blames on an exiled political opponent living in Pennsylvania. In a draconian crackdown on opposition in the aftermath of the coup, Erdogan decided to arrest everybody and ask questions later. He has rightfully earned international ire with this behavior. He handed U.S. Vice President Pence -- a christian fundamentalist -- a cause celebre in the apparently arbitrary detention of an American evangelical minister.

Erdogan is a notorious hothead who refuses to fix his currency problem because of his ideological opposition to raising interest rates. But Erdogan has met his match in Donald Trump. His American hothead counterpart has decided to kick Turkey when it is down, raising tariffs in the midst of its currency crisis, and repeating public demands for the release of the American minister.

Just like in the currency crises of the late 1990s, there is plenty of talk now of contagion. Since the widespread abandonment of gold and silver standards in the last century, all world currencies (save tiny Lebanon) are what's known as fiat currencies. Their value is based entirely upon faith. As the status quo unravels in the most vulnerable markets like Turkey, investors worry this will make people question their faith in the currency of other countries, too.

When they start to hedge their bets by trading in local currency for relatively safer assets priced in dollars or euros, the value of the local currency begins to slide. This makes it all too easy for powerful hotheads like Donald Trump to directly undermine foreign currencies by threatening tariffs, or to indirectly undermine them by baiting his hothead counterparts (like Turkish President Erdogan) to make dumb moves of their own.

But the real problem of contagion is when it spreads beyond these small markets into big ones. China, for example, has long been pretending that billions of dollars in bad loans backed by overbuilt real estate don't exist. Banks pretend that vacant apartment blocks nobody wants are worth enough to secure loans that may never be repaid. And depositors leave their money in these banks, allowing the bad loans to ride indefinitely.

Should the Chinese people be nudged into a similar crisis of faith in their Yuan as the Turks have in their Lira, the Chinese financial system -- then the world's -- would be in serious trouble. Fortunately, Chinese President Xi Jinping is no hothead. Let us hope that when it comes to President Trump's goading with new tariffs, cooler heads will ultimately prevail.

Notes:

1. Telegraph, Turkey ‘On Verge of Meltdown' as Lira Plunges Again, August 13, 2018