Asking the right questions about the Turkish economy

I was supposed to give a short talk on the Turkish economy in the Council on Foreign Relations (CFR) workshop, “Turkey: An Emerging Power in a Changing Middle East,” on June 18. Unfortunately, severe food poisoning kept me in bed the whole day. I would like to summarize my speech, which is based on two misplaced questions.

First of all, the question in everyone’s mind these days is whether Turkey could end up with another crisis if it is faced with a sudden stop in capital flows. I do not disregard that possibility. If the Turkish Lira were to depreciate sharply, firms with foreign currency open positions would face financial difficulties, if not bankruptcy. Due to the high exchange rate pass-through, inflation would rise. The Central Bank would respond with a large interest rate hike to control the lira, which would help some firms and stem inflationary effects, but would not spare the economy from recession.

The economy would eventually recover. But would Turkey be able to grow more than 2-3 percent per year in a world without ample capital flows to emerging markets? As Turkish growth is dependent on external financing, 2-3 percent growth would be more than enough for developed countries, but it would not be sufficient for Turkey.

For one thing, many economists believe that, given the country’s demographics, Turkey would need to grow more than 3 percent to keep the unemployment rate from rising. The same demographics also ensure Turkey would not be able to get into the league of high-income countries with 2-3 percent growth, getting stuck in the middle-income trap.

So what needs to be done to make sure Turkey can continue to grow at least 5 percent without capital flows to boost growth? I would again argue that...