Our guest columnist this week is Fulya Apaydin, one of the leading writers on Islamic finance and a well-informed observer of the Turkish political scene.

A long-standing position of this website is that government produces a useful function in society – and that deregulation can often have perverse and unintended consequences.

In the 1990’s worldwide, institutions such as the World Bank promoted financial deregulation and a reduction of local laws regulating local banks. The primary purpose of this was to promote economic growth. (A more cynical interpretation is that the purpose was to facilitate foreign acquisition of local banks.)

A secondary purpose was that financial deregulation would lead to better governance and more robust democracy. The argument, which sounded good in 1989, was that when credit is limited, one needs to have political connections in order to get loans. There would be corruption and cronyism in the lending process. This would help to promote bad governance and semi-dictatorial control. Making money more generally available would reduce the linkage between credit and supporting the regime in power – leading to more economic growth and more freedom.

It did not work out this way.

There is genuine debate among scholars about whether financial liberalization produced economic growth. My own read of the record is that it helped in some places, hurt in other places, and overall had few dramatic effects.

Did financial deregulation help to produce democracy? Just the opposite.

For evidence of same, consider Fulya Apaydin’s grim story about Turkey.

I disagree with her about whether financial liberalization led to a crushing of worker’s unions. I think labor repression would have happened anyway. The rest of her story is compelling. It is a story that needs telling.

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For the second year in a row, Turkey is classified as “not free” by the Freedom House in 2019. For a long time, the country was a beacon of hope with its democratization saga in a troublesome Middle East, a region that has been predominantly ruled under authoritarian governments. However, since 2017, the formal concentration of power in the hands of the executive, systematic harassment of the opposition, frequent electoral fraud and curbing of civil rights and freedoms all suggest that Turkey now ticks all the boxes to qualify as a competitive authoritarian regime. To explain why Turkish democratization capsized under the current AKP regime, the Justice and Development Party,, most experts highlight the regressive agenda of political Islam, ongoing ethnic conflict and regional instabilities. However, these explanations tell only part of the story. I argue that the key mechanism that pushed the country onto the path of democratic backsliding—which eventually took an authoritarian turn—lies in the type of financial liberalization reforms adopted by conservative governments since 1980.

The financial liberalization in Turkey has focused on encouraging the growth of a bank-based financing model since its initiation. This went hand-in-hand with the state policy to create domestically owned capital groups. In line with this orientation, the number of private investors increased during the first phase between 1980 and 2002, and banks that were wholly or partially owned by domestic investors emerged as key providers of access to credit for investment and consumption. These new players also held a substantial share of the domestic public debt in return for the political support that enabled them to own banks.

At the same time, as the owners of these banks expanded their business operations in other industries, much of the credit extended by these institutions went into financing the production of goods and services—often to the companies owned by the same holding groups—at below the market rates. In fact, due to very high interest rates in the 1980s and 1990s, many small and medium sized enterprises were unable to borrow on affordable terms. Additionally, because banks were very reluctant to finance consumption during this period, credit extended to retail customers was modest, and overall household debt to GDP ratio remained rather low. Initially, the financial liberalization program aimed to jump-start the state-sponsored export-led industrialization program by providing easier access to credit via multiple banks while squeezing wages to increase profit margins. Therefore, the first phase of these reforms was complemented by regular repression of unions and systematic attacks on organized labor. This led to declining collective bargaining coverage and union density rates as many workers found it increasingly difficult to organize under autonomous unions.

However, none of these measures resulted in a drastic increase of cheap credit offered by the banks. Instead, the troubles of the banking system deepened as managers sought quicker returns on public debt while nonperforming loans bloated banks’ balance sheets, leading to major takeovers and restructuring by a state agency. The situation worsened following the 2001 economic downturn. Eventually, the growing disappointment of the voters wiped the majority of the parties from the political scene in the 2002 elections. The surprising winner was AKP—an unconventional player that combined political Islam with a commitment to liberal market economy.