Reflections on Turkey’s Economy

Stability might not be everything, but everything is nothing without it. Turkey’s current government has learned this lesson and delivered stability and growth. These welcome developments, coupled with large privatizations and an international investment climate that has encouraged risk taking, have produced a record surge in foreign direct investment (FDI) inflows to Turkey. This is good news, but it has to be put into perspective. Turkey hasn’t been alone: FDI has increased dramatically on a global basis over the past 3 years. For example, while FDI inflows to Turkey increased by 76.3% in 2006, those going to the U.S. during the same period increased by 78.2%. Even more sobering news comes when one digs into the details of what makes an economy competitive, an important metric in the eyes of foreign investors. It is clear that, while Turkey has great potential, its businesses and workers are burdened by a sub-standard legal system, a heavy bureaucracy that produces a lot of government red tape and a tax system that discourages work in the formal economy. These negative factors result in Turkey’s relatively low rankings in studies that measure competitiveness. For example, Turkey ranks 83rd (just below Moldova and Kenya) in the Heritage Foundation–Wall Street Journal 2007 Index of Economic Freedom.

Allow me to stress just how important an indicator a country’s competitiveness ranking is: In studies conducted for the Joint Economic Committee of the US Congress, I found that there is a roughly one-to-one correspondence between changes in measures for economic freedom (“competitiveness”) and economic growth. If Turkey wants to foster stable, rapid growth, it must continue on a much more accelerated path of liberal economic reform.

Estonia took that path, so let’s look at its accomplishments. Since the fall of the Soviet Union, Estonia got rid of the Russian ruble and started issuing its own money (the kroon) in 1992 via a currency board, which is a monetary institution that issues kroons that are fully backed by foreign reserves and freely convertible at a fixed rate of 15.65 per euro. Estonia also enacted a wide range of free-market reforms, including the introduction of a simple, flat-rate tax system. Not surprisingly, over the last15 years Estonia has become the 12th freest economy in the world (the highest ranking for any former communist country) and its GDP per capita has increased tenfold since 1992, to a projected $12,900 per capita this year.

Turkey-given its people, location and history-has great economic potential and could make dramatic improvements in its competitiveness. The problem is that this potential isn’t realized because of its history of questionable economic policies and unstable money. As an illustration, consider that the Turkish public sector is less than one-half as productive as the public sector in Singapore. Also, according to the World Bank’s Doing Business 2007 report, which evaluates 175 countries, Turkey’s labor market ranks 146th in terms of the difficulties businesses face in hiring and firing workers. The burdensome laws and regulations affecting Turkey’s labor market are unfriendly to both workers and businesses. At present, it is difficult to hire new workers and costly to fire them. As a result, the labor market is rigid and unable to respond to competitive pressures and to create an adequate number of jobs. The weight of Turkey’s labor laws and regulations should be dramatically reduced to make the labor market flexible and competitive.

Punishingly high taxes on wages add to that dysfunction. The Organization for Economic Cooperation and Development in Paris has calculated the “tax wedge” for OECD member countries. The tax wedge is the share of employee earnings taken by the government. It is equal to the difference between labor costs to the employer and the net take-home pay of the employee, including any cash benefits received from government welfare programs. For a family with two children and one working parent, Turkey’s 42.8% tax wedge was larger than that of any other OECD country in 2006, and over 15 percentage points higher than the OECD average of 27.5%. Turkey’s high taxes push Turks out of the formal labor market, forcing them to work in the relatively unproductive gray economy or to seek employment abroad. Taxes on wages in Turkey should be reduced by 75%-90%. Such a reduction would shrink Turkey’s tax wedge on wages to roughly the same level as that of Ireland, the latest tiger economy.

The best way for Turkey to modernize and improve competitiveness is to unilaterally implement its own “Made in Turkey” set of liberal economic reforms. Since the time of Adam Smith, liberal economists have advocated that countries unilaterally adopt free market and free trade policies for the simple reason that those policies are correct in both principle and practice. They argued against the principle of reciprocity, which requires a country to only reduce trade barriers if other countries do so as well. In practice, the unilateral adoption of the rule of law and free market policies is popular and works well. There is no better example than the Republic of Singapore.

In 1965, Singapore gained its independence-actually, Singapore was expelled from a two-year federation with Malaysia. At that time, Singapore was very backward, poor, and had only one important asset-its strategic location. Singapore was a speck on the map in a dangerous part of the world, and its population was made up of a diverse range of immigrants with a history of communal tensions. However, Singapore had a strong leader with a clear vision of how to modernize his country.

Lee Kuan Yew explicitly ruled out passing the begging bowl and accepting foreign assistance of any kind. His central principle for organizing the government was to run a tight ship with no waste or corruption. To implement that principle, Lee Kuan Yew appointed only first-class civil servants and paid them first-class wages. Another principle he embraced was first-world competition, which he attained through light taxation, minimal regulation of business and free trade. Lastly, Lee Kuan Yew insisted on personal security, public order and the protection of private property. It’s no surprise that today Singapore is one of the richest and most competitive countries in the world.

Although stability is a necessary condition for prosperity, it comes at a price in a country with a long history of unstable money. That is why Turkey’s real interest rates are some of the highest in the world-indeed, they are punishingly high and unsustainable. An orthodox currency board-along the lines of Estonia’s-would not only credibly fix the lira’s exchange rate (to the euro or the dollar, for example) but it would also fix Turkey’s real interest rate problem. Reforms are necessary for Turkey to attain big league status. Assuming that the Justice and Development Party retains its majority, its challenge will be to appoint top-quality people to key positions and firmly point the way. This challenge shouldn’t be taken lightly. Indeed, if history is a guide, reform momentum erodes with time.

Author Steve H. Hanke