Note: This article is an abridged version of an in-depth country study produced as part of the Prosperity Index project of the Legatum Institute. Complete versions of all 12 are available on the Institute's website.
By any broad measure, the Turkish economy is successful. Turkey has almost doubled average incomes since the turn of the century, even as it reduced poverty and narrowed income equality. What's more, the economy has shown remarkable vigor in bouncing back from the recession in spite of the ongoing malaise in its European trade partners.
But Turkey's evolution since World War II suggests that the transition to upper-income status will require difficult political and socioeconomic adaptations. Indeed, to understand Turkey's strengths and vulnerabilities, one must understand how the country has imperfectly bridged gaps between democracy and authoritarianism, free markets and crony capitalism, secular nationalism and Islamic conservatism.
The urgent need for cooperative security in the face of Soviet expansionism after the Second World War brought Europe and America closer in many ways, leading them to build liberal institutions that matched their converging cultural outlook. However, rapid growth and common security concerns have not produced a parallel convergence between Turkey and the West.
Strong property rights do exist in Turkey, but they are not buttressed by an impartial judiciary to enforce contracts and ensure due process. Civil society is dominated by business and the religious orders, which have close ties to the state. Big business is far more influential than small business or trade unions, while citizen groups defending causes ranging from environmentalism to consumer rights have little traction. Indeed, Turkey's failure to adopt Western political values is forcing analysts to reconsider the near-consensus view that global economic integration will lead to a more liberal world order.
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In the first few decades following World War II, by contrast, Turkey's inclination toward crony capitalism only grew stronger. Wealth was increasingly concentrated in a cluster of well-connected firms and families. So-called "strategic" companies were nurtured with a host of subsidies and protected from import competition, while consumers were forced to accept shoddy goods at high prices. Barriers to market entry stifled enterprise and economic mobility.
Turkey's financial system similarly diverged from the liberal ideal, suffering from inefficiency and chronic instability. Hyperinflation and balance of payment crises (in which the central bank ran out of foreign exchange) occurred in every decade of the second half of the 20th century. Turkey became a frequent visitor to the International Monetary Fund's emergency room. But being a frontline state in the battle against communism afforded Turkey considerable forbearance.
That began to crack in 1980. A severe balance of payment crisis forced Turkey to devalue the lira. And this time around, under pressure from international lenders, the government embarked on the gradual deregulation of trade, investment, and finance. But the bad fiscal habits that had been treated so discreetly by Turkey's Cold War patrons proved hard to unlearn: Budget deficits persisted and the economy ran on unsustainable inflows of capital. Inflation went untamed, averaging 50 percent during the 1980s and 80 percent in the 1990s.
Finally in 2001, the government committed to a more prudent fiscal stance and to end dependence on foreign loans. The central bank was granted greater autonomy, and the bank's new charter made price stability the first priority, barring it from making direct loans to the government to finance budget deficits.
While it remained legal to hold financial assets in foreign currencies, the "dollarization" of the Turkish economy swung into reverse as confidence in the stability of the lira grew. Households and corporations now hold roughly 30 percent of their liquid assets in dollars, compared to 60 percent at the turn of the century.
Much has thus changed since the early 1980s -- but too much hasn't. Corruption in places high and low remains a serious problem: Turkey ranks 61st on Transparency International's Corruption Perceptions Index -- better than in the emerging-markets of Asia and Latin America, but far behind Europe and North America. A legacy of arbitrary authority and discretionary law enforcement has permitted a large, corrupt bureaucracy to thrive, petty bribery is still customary.
Until very recently, moreover, whenever political stability was threatened by clashes between the right and the left, or secularists and religious Muslims, the military stepped in. A rapid return to civilian rule did occur after each of the three post-war coups. But the threat of intervention defined the limits of Turkish democracy.
The Islamic government of Prime Minister Recep Tayyip Erdogan, elected in 2003, has promised to tighten civilian oversight of the security forces; to this end, a civilian-controlled Supreme Military Council was established in 2011. But the Council of Ministers (a sort of "super cabinet" in the Turkish government) has yet to adopt measures assuring that the military would remain in its barracks until summoned by elected administrations.
The initial steps towards opening the economy in the 1980s created opportunities for business start-ups -- specifically, Islamic businesses -- challenging the secular/nationalist "old boy" network. These businesses flourished, increasing the voice of religious Muslims in national politics. By no coincidence, newly-empowered interest groups formed networks that challenged the center-right coalition -- and the secular-republican synthesis that had allowed a Turkish nation to emerge from the ruins of the Ottoman Empire.
To understand why society and culture have not followed the economy in converging with Western institutions, one must know a bit of the history of the Turkish conservative movement. The clash between conservatives and republican nationalists resulted from the divergence between rural religious conservatism, and the values of the urbanized elite that flourished under Mustafa Kemal Atatürk, who established the modern Turkish republic as a secular state in 1923.
Yet while republican nationalists dominated Turkish politics from 1923 to 2001, they offered no easy transition to a secular democracy. Indeed, they blocked the formation of left-center social democratic parties, like those of Western Europe that championed the welfare state. Politicized Islam filled the vacuum, offering a way out of the impasse.
While in prison in 2001, Erdogan, the founder of the Islamic Freedom and Development Party (AKP), who had been jailed as a threat to the secular republic, realized that mainstream Turkish society could only be won over if the conservative Islamic movement aligned itself with the West, even at the price of alienating the AKP's core constituents. And to avoid the fate of earlier Islamist parties suppressed by the military, Erdogan broadened his base to include the restless, economically-frustrated middle class.
The AKP's electoral victory in 2002, capturing nearly two-thirds of the seats in Parliament, proved that religion could replace nationalism as a tool to mobilize alienated Turks. Erdogan understood that to deepen Turks' commitment to Islam, his party first had to deliver a chicken in every pot. Thus he sought to bridge a rupture between traditional grassroots religious conservatives and Turkey's other key constituency, big business. And he spread the economic benefits of liberalism to other groups -- notably, the Kurdish minority.
Does democracy represent the "end of history" for AKP's followers, or just a means to an Islamic end? This question weighs heavily on analysts' minds because Erdogan seems ever less inclined to respect human rights or religious freedom. His government has charged opponents -- journalists, generals, and student activists -- with treason. And critics allege that the lists of new candidates for state offices and academic professorships are being vetted for their religious affinities. Indeed many worry he meant what he said when he quipped, "democracy is like a bus -- once we reach our stop, we'll get off."
Nonetheless, the AKP's verbal (if not always practiced) commitment to democracy and its geopolitical alignment with NATO seem to support the liberal internationalist thesis, that open trade will produce open regimes. But the process seems more tactical than organic: Not deviating far from Western institutions allows Erdogan to pursue his larger goal of combining Islam with modern management and wealth creation to make Turkey the center of a revitalized Middle East.
Turkey's puzzling mix of cultural, religious, and political institutions helps explain its near-term economic successes and problematic long-term prospects:
Growth and stability. Turkey rebounded briskly from the global recession, but all is far from well. Turkish business is highly leveraged, thus highly dependent on the availability of capital. The unemployment rate only dipped below double digits in 2012.
The country's macroeconomic weaknesses are largely due to a competitiveness gap: Foreign investment, which supplies a lot of foreign exchange, disguises the reality that the Turkish lira is overvalued. That makes Turkey especially vulnerable to the increased volatility of global trade and capital movements. And it has led domestic producers to adapt by using capital-intensive technologies that undermine prospects for creating employment.
The flipside of dependence on foreign capital is low domestic savings. In theory, countries can grow indefinitely on the strength of foreign investment. But it's rarely worked this way: The growth miracle in Asia was largely funded by domestic savings, and many analysts attribute Latin America's spotty record to dependence on volatile global capital markets.
Industrial Structure. The technological and managerial sophistication of Turkey's large industrial conglomerates -- notably, the family-controlled Koc Holdings and Sabanci Holdings -- goes a long way in explaining Turkey's success on the global-economic stage in the last decade. However, operating cheek by jowl with these globally competitive businesses are traditional companies with low productivity. This is a legacy of a dysfunctional political system in which rich insiders got preferential treatment from the government. But it is also a symptom of serious under-investment in education.
Moreover, although Turkey has been a star performer in the last decade, global competition from low-cost producers is growing. The only way to finesse this competition is to move upscale products and services that require highly skilled labor and R&D. The government is encouraging collaboration between universities and business, but private-sector R&D still lags.
Human Capital. Turkey's less-than-impressive commitment in the past to higher education and training in part explains low-labor productivity. But other factors ranging from health to income inequality also affect the fitness of the labor force. Perhaps most significant here is discrimination against women in both higher education and the workplace, which are especially problematic in a country attempting to reconcile Islam with modernity.
Regulation. Trade protectionism is minimal; foreign direct investment has been welcomed since the early 1980s. By contrast, entrepreneurship is hindered by erratic and often corrupt enforcement of other regulation. This means monumental headaches for business owners -- unless they are insiders. It takes an average of 70 days to plow through the red tape to obtain an electricity hookup and more than three years to distribute assets in a bankruptcy.
Foreign Trade. The share of Turkish exports going to Europe fell from 55 percent in 2001 to 48 percent in 2008 -- a consequence of global supply and demand, as trade between emerging-market countries grows disproportionately to traditional north-south trade. Turkey's efforts to maintain a cultural distance with the West could prove an asset here, especially if it gives the economy an advantage in the Middle East. But this is a tricky line to walk: Turkey needs close economic ties with the West as a source of technology and as a spur to innovation.
Once the Cold War ended, Turkey's divergence regarding minority rights, free speech, and judicial independence, among other issues, became too obvious for the West to ignore. One critical consequence was that is produced stiffer European opposition to Turkey's accession to the EU, along with a mutual souring of relations. If these tensions are not managed wisely, a populist, nativist backlash in both the West and in Turkey could magnify mistrust and frustrate reconciliation.
Equally important, Turkey's third way may be a harbinger of a new reality -- one in which emerging economies adopt the methods of growth used in the West without adopting its values or foreign policy goals. Indeed, Turkey's experience only reinforces growing doubts that the regime changes forced by the Arab Spring will lead to a liberal convergence. Democratic Islam offers the Middle East a path to cultural values that are likely to be as alien to the West as those exhibited by the previous generation of unelected autocrats.