Constructing a New Liberal Economy in Iraq

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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

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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 .

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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.

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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.

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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

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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Impediments to Liberal Market Development

• Corruption.
• Insurgency.
• Deterioration of Social Capital.
• Rentier StateResource Curse Effects.
• Large and Growing Informal Economy.
• Macroeconomic Instability.
• Opposition to Further Reforms.
• All are Interrelated to Some Extent With
  Corruption the Common Element.

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(1) Corruption in Iraq

• Long History in Iraq Diversionary State Under
  Saddam When Corruption Became Institutionalized.
• In Transparency Internationals 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.

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(2) Insurgency Economy
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(3) Social Capital in Iraq

• Social Capital Represents Networks of
  Relationships that Bind People TogetherDeteriorat
  ed 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.

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(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.

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(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.

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(5) Informal Economy

• At End of Saddam Husseins 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 .

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(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 SectorHowever Means Monetary Policy
  Assigned to Domestic Stabilization May not be
  up to the Task.

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(7) Opposition to Further Reforms

• A Number of Groups are Likely to Oppose Further
  Reforms at this Time
• Workers in State EnterprisesFear Job Loss.
• Many Farmers Insecure Over New Market
  Arrangements.
• Former Bathists 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.

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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 Countrys Occupation.
• Religious Elements Who See Reforms as Part of War
  on Islam.

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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.

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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

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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.

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Rentier State Political Systems (contd.)

• Unlikely Systems
• Traditional Theocracy Iran
• Predatory Autocracy Bathist Model
• Mature Democracy Norway
• Paternalistic Autocracy Saudi Arabian Model

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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/Baathist Mix Secular Nationalist With
  Strong Islamic Influence.
• Vicious Circle Diversionary State Eventual
  Collapse -- Yugoslavia With Oil.

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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.

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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.

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Virtuous Circle of Growth and Liberal Market
Development
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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.

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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.

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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.

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Vicious Circle
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Key Assumptions Iraq Market Outcomes
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Critical Intangibles

• What are the Critical Intangibles Likely To
  Influence Iraqs 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 Countrys 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.

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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 Governments
  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?

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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. Its Like When You Have A House
  Infested with Termites. Its 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

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Contrasting Views (contd.)

• ..the Lack of Law and Order is Bound to Delay
  the Countrys 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 Understandwhy
  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.

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For Further Reading

• Presentation Draws on the Following
• Robert Looney, Iraqs Economic Transition The
  Neoliberal Model and its Role, The Middle East
  Journal, Autumn, 2003.
• Robert Looney, The Viability of Iraqs Shock
  Therapy, Challenge, September-October 2004.
• Robert Looney, A Return to Bathist Economics?
  Orient, September 2004.
• Robert Looney, Iraq as a Transition Economy,
  The Milkin Institute Review, Fourth Quarter 2004
• Robert Looney, Postwar Iraqs Financial System,
  Middle East Policy, Spring 2005.
• Robert Looney, Corruptions Reflection Iraqs
  Shadow Economy, Strategic Insights, March 2005.