Constructing a New Liberal Economy in Iraq Robert Looney Professor, National Security Affairs Naval Postgraduate School Politics of Reconstructing Iraq.

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

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 .

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.

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.

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

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.

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.

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.

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.

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.

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.

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.

Impediments to Liberal Market Development

1. Corruption.2. Insurgency.3. Deterioration of Social Capital.4. Rentier State—Resource Curse Effects.5. Large and Growing Informal Economy.6. Macroeconomic Instability.7. Opposition to Further Reforms.

All are Interrelated to Some Extent With Corruption the Common Element.

(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.

(2) Insurgency Economy

Black Market Arbitrage

Kidnapping,Crime,

Violence

Hawala Financial

Transactions

Reduced Government

Financial Resources

Retarded Modern

Agricultural Development

Lost Entrepreneurial,

Professional Class

Retarded Development of a Modern

Financial System

Low Formal Sector Job

Creation

Relative Expansion

of the Shadow, Informal Economy

Limited New Industry

(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.

(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.

(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.

(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 .

(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.

(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.

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.

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.

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

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.

Rentier State Political Systems (contd.)

Unlikely Systems:

Traditional Theocracy – Iran Predatory Autocracy – Ba’thist

Model Mature Democracy – Norway Paternalistic Autocracy – Saudi

Arabian Model

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.

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.

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.

Virtuous Circle of Growth and Liberal Market Development

Infrastructure Led

Development

Increased Entrepreneurship

Dual Track Development

InformalEconomy Focused Credit

Expanded Number of

SMEs

DevelopmentStrategies/

Policies

Neoliberal FDI

Reforms-Free Trade

Second-Stage

Washington Consensus Reforms

Oil Fund for Public

Distribution

Development Extended

Trust Networks

Pressures for Further

Neoliberal-Institutional

Reforms

Reduced Corruption

Phase out Subsidies, food, oil, electricity

Reduced Market-Based

Corruption

Expanded Demand --Domestic Market

Expanded Supply -- Growth of

the Economy

Expanded Public

Expenditures -

Education/Health

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.

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.

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.

Vicious Circle

Large and Growing Informal Economy

Insurgency

Lack of Trust Self-Contained

Market Networks Outside Formal

Economy

Neutralizing Positive

Aspects of Neoliberal Economic Reforms

Large Shadow Economy, Created to

Fund Insurgency

Vested Interest in status-quo Inefficient

Administered Price System

Massive Oil -Based

Expenditures Easily

Diverted,Patronage

Relationships Facilitated

Current Ethnic-Tribal

Frictions Limit

Extended Market

Networks

Abundant Oil Revenues

Take Pressure off

of Government to Proceed

with Reforms with short-run costs

Low Productivity,

Dualistic Economic System

Difficult to Integrate

Lack of Legal

Protection, Property

Rights Make Activities Hard to Grow to Formal

Economy Status

High Unemployment

Key Assumptions: Iraq Market Outcomes

Virtuous Circle10%

Muddle Through

50%

Pragmatic Theocracy

30%

Vicious Circle10%

Insurgency Worsens

20%

Liberal Market

Outcomes(most

probable path)

Insurgency Stabilizes

60%

Insurgency Lessens 20%

Insurgency Oil Production

2.8-30 million

b/day 30%

2.2 -2.8 million

b/day 50%

< 2.2 millionb/d 20%

Corruption

Increases 30%

Stabilizes 60%

Declines 10%

Macroeconomic Stability

Fairly StableInflation >15%

Moderately Stable

Inflation 15-30%

Unstable Inflation >

30%

Liberal Market

Outcomes(most

favorable path)

Virtuous Circle45%

Muddle Through

30%

Pragmatic Theocracy

20%

Vicious Circle5%

Liberal Market

Outcomes (most

unfavorable path)

Virtuous Circle0%

Muddle Through

40%

Pragmatic Theocracy

45%

Vicious Circle15%

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.

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?

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

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.

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.