Growth, democracy, law and central bank independence: A demand-side approach
Ilhan Dögüs
Independent Economist
Monetary Policy Institute Blog #113
“In short, the relationship between democracy and growth investment does not only work through the capital and supply side factors, as mainstreamers think; rather the roles of labor and demand are much more decisive.”
The relationship between growth and democracy/law has been widely discussed, not only in the economic literature but also widely and openly in Turkish media, especially after the 2018 currency shock.
Turkish mainstream scholars have been arguing that Türkiye has greatly developed, largely by virtue of foreign investment between 2002 and 2016, but now suffers because foreign investors have fled due to a lack of a rule of law, since 2018. Their argument that Türkiye has a ‘saving deficit’ problem and hence needs foreign capital to finance domestic investments rests on this idea of an exogenous money supply. However, Türkiye does not need foreign financial capital to grow. A significant portion, if not all, of the imported raw materials and machinery equipment can be produced domestically. If Türkiye has sufficiently strong domestic demand (which can be strengthened by way of public investments and public employment), private investments and growth can be financed by loans created by domestic banks ex nihilo as they say — or out of thin air. For public investment and public employment, the Treasury does not need to collect money in advance, either through taxes or bond issues. Public spending itself creates money, and then the excess amount of money is drained through bond issuances and taxes. The need of Türkiye for foreign money is not to finance domestic production and growth, but rather to appreciate the Turkish lira.
Based on the assumption of an exogenous money supply, these same Turkish mainstream economists place great emphasis on the notion of central bank independence regarding democracy, and never on, say, human rights violations against Kurds, non-Muslims, and other minorities and opponents. For example, the dismissal of the Central Bank governor is a much greater outrages to them than the unlawful arrests of dozens of Kurdish deputies or of protesting students.
Given several sharp increases in the rate of interest by the Central Bank of the Republic of Türkiye (CBRT), since June 2023 (from 8.5% to 40% in as little as 5 months) have failed so far to appreciate the Turkish lira against the dollar (rather, the dollar has appreciated against the Turkish lira by 47%, since May 2023), mainstream scholars who have been advocating such sharp rate hikes now started to argue that foreign capital was not coming in because of the lack of ‘structural reforms’. I argued in November 2022 in an entry on this blog that Türkiye will fall into an exchange rate/interest rate spiral if it abandons ‘currency protected deposits’ implementation. Since the new CBRT-governor Gaye Erkan (former co-CEO and president of First Republic Bank) and the orthodox-neoliberal Minister of Finance, Mehmet Şimşek, announced that they abandoned the ‘currency protected deposits’ implementation, these deposits are fleeing back to the dollar, not to the Turkish lira, and the dollar is appreciating despite rate hikes.
Curiously enough, before the failure of interest rate hikes, these mainstream economists never once suggested the culprit was the lack of structural reforms. Cast aside is the fact that structural reforms indeed imply the precariousness of the labor market, and these reforms have already been conducted by the Erdogan-government since the very beginning. Much funnier is that they suggest the structural reforms required to attract foreign capital in order to appreciate the Turkish lira as educational and judicial reforms. That sounds fine, but we can experience their impacts at the earliest in 5 years. No one can wait for 5 years to see if rate hikes work to appreciate their domestic currency.
Objections to this reasoning on the relationship between the rule of law and growth are mostly made by Marxist scholars based on the argument that “capitalists do not care about law; they care only about their profits”.
I largely agree with this objection, yet I have some reservations to emphasize.
The sort of capital that will not care about the judicial order, democracy, and political stability in the host country is the financial capital that will buy and sell Turkish bonds and shares just with a keystroke, and Turkish mainstream scholars are eager to attract this type of capital to appreciate their currency. Financial capital has an inherently short-term horizon and makes profits from speculating on the future prices of financial assets. They move in and out of the bond and equity markets as long as there are minimum regulations to secure their property rights and contracts. It should also be highlighted that the foreign direct investments coming to Türkiye came only by buying existing facilities instead of initiating new factories, which is different from buying shares on the stock exchange only in terms of the bureaucratic procedures and required time.
In this sense, Marxist scholars are right. Yet, I think stability, which is largely determined by political and legal guarantees, is important for real investment, so-called ‘foreign direct investment’, and for domestic real investment because these decisions rely on longer-term projections since production and sales revenues take time and the investment decisions are made under the uncertainty of the future. Therefore, reducing uncertainty as much as possible and ensuring stability is not an insignificant factor for real investment decisions. Moreover, securing the complex flows of production materials and the supply chain through contracts, the level of education of the workforce, and the quality of the country’s law and democracy and political stability are not insignificant factors at all. For example, Volkswagen was about to open a factory in Manisa (west of Türkiye) but gave up in 2020 due to the political instability caused by the involvement of Türkiye in the Syrian war and other political developments. It should be noted that the trade union, which has a voice in Volkswagen’s Works Council, also blocked this decision.
This is the argument of mainstream economics, and it is a supply-side approach. I don’t think it is totally wrong, but I think it is incomplete. Yes, a lot of foreign direct investment has fled to authoritarian regimes like China, but they have had tons of legal problems regarding property rights, and the sectors that have migrated are labor-intensive sectors that care about low levels of labor costs enough to take these risks. German automotive and chemical companies, for example, did not leave Germany because they did not see the low labor costs as worth abandoning both Germany’s ‘comparative institutional advantages’ and the sector-specific skills of the German workforce. Hence, we have a picture in which the bulk of global FDI is going to developed countries, more than to developing countries (See the Figure). Low-value-added, labor-intensive but high-volume investments went to developing countries, while perhaps low-volume but high-value-added, technology-intensive investments went to developed countries (This argument needs an empirical scrutiny).
In this blog entry I try to construct a relationship between growth, real investment — the main engine of growth — and democracy that is based on a post-Keynesian approach in which demand is the driving force.
As the deepening authoritarianism, especially since 2016 in Türkiye, has shown, the centralization of decision-making processes is a factor that increases inequality. A situation in which only those with close ties to the decision-making authority have access to the rents created by the state and in which other firms are kicked off by fabricated tax penalties, etc., and a situation in which privileged firms have easier access to loans and dominate the media that shapes the advertising market, foster monopolization in the goods market, and increase the level of inequality A situation in which the capitalist who is close to the ruling party can win tenders and the worker who is close to the ruling party can find a job while the others are left out prevents the economic circulation from being run in a way that makes stable growth possible.
We know from Kalecki and Steindl that in a case of high market concentration and inequality, investment and production remain low. This is both because the few firms that dominate the market can earn high profits without producing much, since they can charge high markups on their unit costs, and because in such a market, unemployment is high and hence demand is low, so investments are not triggered. Growth would be sluggish and unstable as it is being driven only by consumer loans as households try to maintain their standard of living since their wages have been suppressed.
Wages have been suppressed under the ‘inflation targeting regime’ conducted by ‘independent central banks’ (See Khan, 2020; Rochon and Rossi, 2006). It is obvious that independence of central banks corresponds to a ‘democracy gap’ because citizens can not involve in decisions which have an impact on their lives (Rochon and Vallet, 2022). Interest rates are a distributional factor, and hence, having a ‘targeted’ inflation rate is a political decision. Much has been written on that in the post-Keynesian literature, with leading voices being Marc Lavoie, Mario Seccareccia, Sylvio Kappes and Louis-Philippe Rochon, among others.
In short, the relationship between democracy and growth investment does not only work through the capital and supply side factors, as mainstreamers think; rather the roles of labor and demand are much more decisive.
