Constructing a New Liberal Economy in Iraq

1. Constructing a NewLiberal Economy in Iraq • Robert Looney Professor, National Security Affairs Naval Postgraduate School • Politics of Reconstructing Iraq Seminar MIT Center for International Studies April 4, 2005

2. Outline – Economic Transition in Iraq • Approach Taken to Market Transition in Iraq. • Lessons from the Transition Countries. • Current Obstacles to a Liberal Market Economy in Iraq. • Possible Economic/Political Outcomes. • Factors Affecting Alternative Scenarios. • Critical Intangibles For the Future. While Political Developments Will be Critical In Effecting the Likelihood of a Liberal Market Economy in Iraq, the Focus Here Will be Mainly on the Economic Reform Processes Likely Under Different Circumstances .

3. Difficulties in Evaluating Iraqi Economic Policy and Performance • Lack of Economic Data. Even before 2003 War, Very Little Basic Data on Economy. • Lack of Objective Reporting – Many Accounts Derived from Perception Rather than Fact. • Lack of Reliable Surveys – Insurgency Has Limited Field Work.

4. Transition to Liberal Market Economy Implies: • Liberalizing Economic Activity, Prices and Market Operations. • Allocating Resources to their Most Efficient Use. • Developing Indirect, Market-Oriented Instruments for Macroeconomic Stabilization. • Achieving Effective Enterprise Management and Economic Efficiency, Usually Through Privatization. • Establishing Institutional and Legal Framework to Secure Property Rights, Rule of Law, and Transparent Market-Entry Regulations.

5. American Economic Objectives - Iraq • Controversial With Numerous Interpretations. • Conventional U.S. View – Create a Modern Democratic State With a Liberal Market Economy – Assist in War on Terrorism. • Create An Example for the Region of a Successful, Liberal, Democratic Country . • Prevent the Economy and Country from Reverting Back to an Unstable, State-Dominated Nation. • Provide the Environment for a Stable, Secure Source of Oil. • Alternative Views – Various – Just After the Oil, Captive Markets for U.S. Multinationals – Modern Imperialism. • Actions Taken Suggest A Naïve Version of the Conventional View – An Attempt to Replicate the Chilean Experience in the mid-1970s and Several of the Successful Transition Countries. • Goal is Improved Economic Freedom Along with Democracy

6. Lessons From The Transition Countries • Sustained Macroeconomic Stabilization is Essential. • Delayed Reforms Risk Negative Growth. • No One Component To Reform Stands Out – Need To Implement All Components. • Unfavorable Initial Conditions Can Be Offset Through Correct Reforms. • Most Jobs Created by Small-Medium Scale New Firms.

7. Transition Lessons (contd.) • Improving Investment Climate Critical for Creation of New Firms. • Development of a Legal Framework Critical. • If Country Puts off Implementing Rule of Law, Enforcing Discipline, Securing Property Rights, then other Reforms Are Unlikely to Produce Significant Benefits. • Successful Transition Countries Create Groups That Have a High Stake in Pressing for Further and Deeper Reforms Over Time. • U.S. Policymakers Apparently Thought that Transition Success Stemmed Mainly From an Application of Washington Consensus Reforms.

8. Washington Consensus in Iraq • Fiscal Discipline – Limit Budget Deficits. • Public Expenditure Priorities – Redirect Expenditure Toward Human Capital and Infrastructure. • Tax Reform – Broaden Tax Base and Cut Marginal Tax Rates. • Financial Liberalization – Abolish Interest Rate Controls. • Exchange Rates – Introduce Unified and Competitive Exchange Rate. • Trade Liberalization – Replace Quantitative Restrictions by Tariffs then Reduce Tariffs Over Time.

9. Washington Consensus (contd.) • Foreign Direct Investment – Encourage Increased International Capital Flows. • Privatization – Privatize State Enterprises. • Deregulation – Regulate only Safety, Environment, and Financial Sectors. • Property Rights – Introduce Secure Enforcement at Low Cost. • To Date Only Limited Progress Has Been Made – Mainly in the Neoliberal Core of Reforms.

10. Neoliberal Reforms in Iraq • Neoliberal Reforms in Iraq Oriented Towards Stimulating Investment and Creating a New Economy. • Investors (except oil production and refining) allowed 100% ownership of Iraqi Assets, Full Repatriation of Profits and Equal Legal Standing With Local Firms. Foreign Banks May Establish New Operations or Purchase Equity Shares in Existing Iraqi Banks. • Income and Corporate Taxes Capped at 15%. • Tariffs Reduced to Universal 5% With None on Food, Drugs, and Other Humanitarian Imports. • Independent Central Bank Created.

11. Neoliberal Reforms (contd.) • State Owned Enterprises to be Privatized, No Timeframe or Method Specified. • Text-Book Application of Reforms – Belief in Advantages of Shock Therapy -- Little or No Consultation With or Input From Iraqis on Design or implementation of Reforms. • Main Problem – Status of Reforms in Future Governments Not Clear – Imposed by Occupying Power, but May Be Overturned or Significantly Modified by an Elected Iraqi Government – Effect Has been to Create More Investor Uncertainty on top of the Insurgency.

12. Neoliberal Reforms (contd.) • Adequate Foundation Not Laid To Take Advantage of Reforms Strengths. • Reforms Stalled, Incomplete – Limited Benefits and Numerous Dislocations. • Because of Initial Failure, Now Have to Face Many More Severe Obstacles than in Initial Pre-War Period.

13. Impediments to Liberal Market Development • Corruption. • Insurgency. • Deterioration of Social Capital. • Rentier State—Resource Curse Effects. • Large and Growing Informal Economy. • Macroeconomic Instability. • Opposition to Further Reforms. • All are Interrelated to Some Extent With Corruption the Common Element.

14. (1) Corruption in Iraq • Long History in Iraq – Diversionary State Under Saddam When Corruption Became Institutionalized. • In Transparency International’s Corruption Index For 2004 Iraq Was the Most Corrupt Country in the Middle East, Ranking 129th down from 113th in 2003. • Economic Impacts of Corruption in Iraq: • Undermines Market System – Limits Government Effectiveness. • Distorts Incentives – Encourages Rent Seeking. • Creates Inefficient Industries – Protection From Competition. • Creates Arbitrary and Uncertain Tax – Wasted Time. • Weakens Financial System – Cash Economy. • Creates Perverse Public Sector Priorities – Big Project Bias.

15. (2) Insurgency Economy

16. (3) Social Capital in Iraq • Social Capital Represents Networks of Relationships that Bind People Together—Deteriorated Significantly Under Saddam. • Trust a Key Element of Social Capital. In Iraq • Ascribed Trust – Kinship Groups and Family Members. • Process Based Trust – Individuals That Have Known Each Other for Some Time – Key Element in Business Networks • Extended Trust – Transactions Between Individuals With Only Limited Information About Counterparts Attributes.

17. (3) Social Capital in Iraq (contd.) • In Iraq Today, Most Networks Ascribed Trust, With Some Process Based and Fewer Extended – Extended Critical for Liberal Market Development. • May Explain Some of the Problems Encountered by the Neoliberal Reforms • – Lack of Response to Price Movements • – Limited Growth of Markets and Exchange • – Regional, Local Market Development Rather than National.

18. (4) Rentier State Effects • Expectation that Favorable Natural Endowments Would Lead to Growth has been Disappointed. • Many Economies Have Become Progressively More Reliant on Natural Resources. • Several Countries Have been Able to Avoid the “Resource Curse” Indonesia 1970s • Resource Curse Stems from Combination of 4 Factors • “Dutch Disease.” • High Volatility of Commodity Prices. • Inefficient Specialization. • Rent-Seeking.

19. (5) Informal Economy • At End of Saddam Hussein’s Regime Accounted for About 35% of GDP and 68% of the Labor Force. • Currently Accounts for About 65% of GDP and 80% of the Labor Force. • Statistically Corruption and Protection From Trade Main Determinants of Informal Economies in the MENA Region. • Demographic Bulge Also a Prime Determinant. • Black Markets/Illegal Activities Impede Liberal Market Economy – No Tax Base, Weakens Fiscal Policy, Macroeconomic Stabilization. • Will Require Specific Policies/Reforms if Sector to be Incorporated into Formal Market Economy – Free Markets and Growth Alone Unlikely to Integrate the Economy .

20. (6) Macroeconomic Stabilization • Main Difficulties: • Cash Economy – Difficult to Control Money Supply. • Beginning to Develop a Government Bond Market. • Interest Rates Have Been Allowed to Fluctuate. • Exchange Rate Floats, But Has Been Relatively Stable – Perhaps Overvalued. • Concerns: Inflation Rising, Possible Bubble in Real Estate, Existing Monetary Tools May Be Ineffective at Stopping Inflation. • Flexible Exchange Rate Makes Sense With Large External Sector—However Means Monetary Policy Assigned to Domestic Stabilization – May not be up to the Task.

21. (7) Opposition to Further Reforms • A Number of Groups are Likely to Oppose Further Reforms at this Time: • Workers in State Enterprises—Fear Job Loss. • Many Farmers Insecure Over New Market Arrangements. • Former Ba’thists Who See Reforms as New Imperialism – Forcing Abandonment of Nationalist Goals. • Influential Intellectuals Who View Neoliberal Reforms as Extreme and Detrimental to Economy at this Time –Point to Failures of Similar Reforms in Other Countries – Cite Credible Alternatives.

22. Opposition to Further Reforms (contd.). • Entrepreneurs Who Fear Foreign Competition. • Speculators, Corrupt Officials Profiting From Black Market Arbitrage on Administered Priced Goods. • Problem – Outside of a Few Technocrats and Merchants, Little Popular or Influential Support for Reforms – Neoliberal Reforms Seen as Imposed With No Input From Iraqis. • The same reforms that were Implemented With Great Success by the Transition Countries as a Sign of Their New Independence are Seen by Iraqis as Products of the Country’s Occupation. • Religious Elements Who See Reforms as Part of War on Islam.

23. The Future: Alternative Courses Obstacles to Liberal Market Can Be Overcome Under Certain Mixes of: • Economic/Institutional Reforms. • Political Environment. • Level of Insurgency. • Oil Production. • Macroeconomic Stability.

24. Key Empirical Linkages • MENA Informal Economies f (Trade Policy, Corruption, Rule of Law) • Neoliberal Reforms Reduce Political Corruption – Gerring and Thacker • Growth f (macroeconomic Stability) – Barro • Growth f (financial development) – Levine • Growth f (trade openness) – Barro • Growth f (political stability) -- Barro

25. Rentier State Political Systems • Likely Systems: • Factional Democracy – Venezuelan Model • Reformist Autocracy – Indonesia 1970s • Pragmatic Theocracy – Iran/Baathist • Basic Model Likely to Be Modified to Iraqi Conditions and Political Realities.

26. Rentier State Political Systems (contd.) • Unlikely Systems: • Traditional Theocracy – Iran • Predatory Autocracy – Ba’thist Model • Mature Democracy – Norway • Paternalistic Autocracy – Saudi Arabian Model

27. Market/Political Variants Possible in Iraq • Virtuous Circle – Liberal Market Economy Leading to Stronger Democratic Institutions – Chile With Oil. • Muddle Through – Mixed Economy – Nigeria of the Middle East • Pragmatic Theocracy – State Dominated – Iranian/Ba’athist Mix Secular Nationalist With Strong Islamic Influence. • Vicious Circle – Diversionary State – Eventual Collapse -- Yugoslavia With Oil.

28. Virtuous Circle of Reform, Growth and Liberal Market Development • Infrastructure Led Public Investment – Begin Rapid Growth to Overcome Development Impediments. • Complete Neoliberal Price Reforms – Block Incentives for Shadow Economy – Make Official Corruption More Difficult. • Insurgency Lessens With Economic Progress. • Second Stage Washington Consensus Reforms – Institutional Development – Foundation for Private Sector. • Dual Track Development Strategy – Comparative Advantage and Informal Economy – Focus on Creation of New Small-Medium Scale Enterprises.

29. Virtuous Circle (contd.) • Improved Macroeconomic Stability – Market Based Financial Instruments Developed – CBI Gains Better Control of Monetary Policy. • Informal Economy Focused Credit – New Small-Scale Firm Creation. • Oil Fund for Public Distribution – Helps Develop Expanding Domestic Markets. • New Firms, Workers and Large Segments of the Population Have Stake in Moving the Reform Process Ahead.

30. Virtuous Circle of Growth and Liberal Market Development

31. Muddle Through • Insurgency Does Not Lessen Significantly. • Oil Revenues Pick Up, But Not Significantly. • Factional Democracy Largely Stalemated on Key Reforms, Development Strategy. • Moderate Macroeconomic Instability – Inflation. • Unemployment Gradually Reduced Through Public Works Programs, Expanded Bureaucracy Rather Than Dynamic Private Sector. • Significant Regional Economic Differences Persist. • Corruption Pervasive. Economy Can Never Build up Enough Momentum to Offset Forces Impeding Liberal Market Development. Window For Reforms Missed.

32. Pragmatic Theocracy Model • Nationalistic – Insurgency Co-opted. • Goal of Rapid Reduction of Unemployment At Possible Expense of Growth. • Partial Integration into Global Economy – Import Substitution Development Strategy. • Selective and Limited Foreign Investment. • Islamic Financial System. • Protection of Islamic/Iraqi Cultural Identity. • Reduction in Poverty At Possible Expense of Growth. • Large State Role in Production and Distribution – Food Voucher, Gas, Electricity Subsidies Maintained.

33. Vicious Circle of Stagnation • Unemployment Remains High. • Informal Economy Continues Growing. • Crime, Shadow Economy Expand. • Insurgency Increases. • Neoliberal Reforms Repealed/Watered Down. • Macroeconomic Instability – High Inflation. • Vested Interests Compete for Oil Rents. • Reforms Blocked by Vested Interests. • Surge of New Entrants to Labor Force Expand Unemployed. • Insurgency Continues – Investment Low – Growth Stagnates. • Possible Civil/Resource War.

34. Vicious Circle

35. Key Assumptions: Iraq Market Outcomes

36. Critical Intangibles What are the Critical Intangibles Likely To Influence Iraq’s Future Economy? • Economic Progress Made Without Significant Reduction in Corruption. • Extent of U.S./IMF Leverage over Iraqi Policy. • Speed and Extent to Which Trust Can be Restored. • Ability of the Financial System to Play a Significant Role in Private Sector Investment. • The Extent to Which Religious Influences Are Likely Mold The Country’s Economic Institutions – Will The Result Make Movement to a Liberal Market Economy More Difficult? • Effectiveness of USAID/NGO Small-Scale Social Capital Projects at Local Level.

37. Critical Intangibles (contd.) • The Extent to Which an Elected Iraqi Government is Committed to the CPA Approach to Reforms – Is Able to Assure Investors of the Government’s Commitment to Free Markets, Rule of Law and Property Rights Before Significant Progress is Actually Made in these Areas. • Willingness of Iraqis to Adopt a Pragmatic Approach Towards Privatization. • Ability of the Iraqis to Achieve Political Stability. • The Manner in Which Oil Revenues are Managed. • The Degree and Extent to Which Average Iraqis View Free Markets as a Opportunity to Create a Better Standard of Living rather than a Threat Imposed by Outside Interests. • Most Importantly, Has Iraq Missed the Window for Initiating Significant Market Liberalizing Reforms?

38. Contrasting Views of The Liberal Market • “If I Am Permitted to Dream, Iraq Will Develop into the Japan of the Middle East.” Talib al-Tabatie, Chairman, Iraq Stock Exchange • “The Best Thing is to Overhaul the Whole Financial System. It’s Like When You Have A House Infested with Termites. It’s Much Easier to Knock it Down and Rebuild Than to Keep Spraying for Termites and Fixing the Holes.” Rubar Sandi, Head U.S.-Iraq Business Council. • “We Want to Go Back to the Old Healthy Management of the 1970s.: Thamir Ghadhban – Oil Minister, Iraqi Interim Government

39. Contrasting Views (contd.) • “..the Lack of Law and Order is Bound to Delay the Country’s Economic Rebirth. Yet Without that Rebirth, the Country Will Remain Sullen, Resentful and a Breeding Ground for all Sorts of Undesirable Developments. It is a Vicious Circle.” –Al-Jazeerah • “It Seems that Many Iraqis do not Understand…why a Market Economy Can Make the Poor People Much Better off Than They Ever Were When Saddam Controlled the Oil Wealth and Doled out Perks to the Iraqis Like a Stern Parent Rewards Small Children for Being Seen and Not Heard.” Ronald Rotunda – George Mason University Foundation Professor of Law.

40. For Further Reading • Presentation Draws on the Following: • Robert Looney, “Iraq’s Economic Transition: The Neoliberal Model and its Role,” The Middle East Journal, Autumn, 2003. • Robert Looney, “The Viability of Iraq’s Shock Therapy,” Challenge, September-October 2004. • Robert Looney, “A Return to Ba’thist Economics?” Orient, September 2004. • Robert Looney, “Iraq as a Transition Economy,” The Milkin Institute Review, Fourth Quarter 2004 • Robert Looney, “Postwar Iraq’s Financial System,” Middle East Policy, Spring 2005. • Robert Looney, “Corruption’s Reflection: Iraq’s Shadow Economy,” Strategic Insights, March 2005.