Rethinking Iraq’s Neoliberal Reforms -- Implications for State

Formation

Robert Looney Professor, National Security Affairs Naval Postgraduate School

Persian Gulf Initiative Workshop on Iraq

MIT Center for International Studies April 26-27, 2005

Outline:Rethinking Iraq’s Neoliberal

Reforms

Linkages Between State Formation and The Iraqi Economy.

Neoliberal Reforms in Iraq.

The Likely Effectiveness of Continued Neoliberalism in Iraq.

Most Important Obstacles to a Viable Market Economy in Iraq.Large Informal Economy.Deterioration in Social Capital.Rentier State Effects.Insurgency and Corruption the Common Elements.

The FutureLessons From Other Countries.Alternative Approaches – Main Considerations.Conditions for Economic Recovery in Iraq – IntangiblesAn Integrated Strategy For Growth and State Formation.

General Propositions: Economic Component of Iraqi State Formation

The Government Must Reduce Its Role in the Economy and Expand The Play of Market Forces.

For this, The State Itself Must Be Strengthened so That It Can Assume an Interventionist Role In:

Assuming Much of the Insurgency-Related Risk.

Liberalizing Economic Activity, Prices and Market Operations.

Establishing Political Accountability for Economic Performance, as Well as Public Responsiveness to Private Sector Economic Needs.

General Propositions (contd.) Developing Indirect, Market-Oriented Instruments

for Macroeconomic Stabilization.

Using these Macroeconomic Instruments to Increase Market-Based Employment Opportunities for Iraqis.

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.

Key Questions in Designing Iraqi Policy

Can An Economic Strategy be Developed that is Viable Given the Likelihood of an On-going Insurgency over the Next Several Years?

Can the Necessary Movement to Free Markets Be Accomplished Without Creating Another Layer of Angry and Marginalized Iraqis?

Will a New Market Economy Benefit Some Groups at the Expense of Others?—Some Regions Over Others? If so are there Satisfactory Solutions? Or a Equity/Growth Trade-off?

Will There Be Broad-Based Popular Support for Market Liberalization? Or Will the Movement to Markets Be Perceived as Dictated by Outside Interests to the Detriment of Iraqis?

The Extent to Which the US/IMF Will Affect the Nature and Speed of Economic Reforms. Will it be in the Form of Consensus Building? Or Conditionality for Financial Support?

Economic ImpedimentsTo State Formation in Iraq

Oil Rents Create a Allocation State as Opposed to a Production State—Conflicts over the Access to and Control of Rents.

Concentration of Oil Rents Reduces State Need to Extract Money From Society –Gain Citizen Support In Return For Valued Services and Effective Economic Management.

Lack of Rigorous Tax System Impedes Emergence of a Strong State that Legitimately Represents its Citizens.

Oil Creates an Implicit Social Contract – Substitution of Political Rights for State Provided Welfare.

Oil Revenues Encourage Patrimonial Loyalties as Opposed to Participatory Democracy.

Associated Corruption Undermines State Formation.

Economic Keys for Successful State Formation in Iraq

Separate the Government from the Natural Resources.

Ensure the petroleum benefits the people—Avoid the Curse of Resources or the Paradox of Plenty Problems.

Diversify—Follow the Example of Countries Like Mexico, Successful in Reducing Dependence on oil, by Encouraging Other Industries as Well as Non-oil Exports.

Design Policies and Institutional Support that are Resilient to the On-Going Insurgency – Avoid Programs and Policies Whose Success Depends on Long Time Horizons or Market Stability.

Attempt to Develop an Environment of Economic Accountability on the Part of Both the State and the Private Sector – Each Place Pressure on the Other for Improvements.

Ideal Interaction of Economic Development and State

Formation

Two Way Pressure to

I mprove Productivity

and Government

Services

Market, I nstitutional

Reforms

Sophistication of Company

Operations and Strategy

Quality of the Business

Environment

Responsive, Reformist,

I nterventionist State

Increased Competition

Market Liberalization

Economic Growth

Taxes, Government

Revenues

Critique of theNeoliberal Reforms in Iraq

Problem: Few of the Economic Policies or Reforms Needed for Successful State Formation in Iraq Appear to be Occurring:

Neoliberal Reforms in Iraq Extreme by Most Measures -- Oriented Towards Stimulating Private 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.

Critique: IraqiNeoliberal Reforms (contd.)

Independent Central Bank Created.

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 Problems – 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.

Critique: IraqiNeoliberal Reforms (contd.)

Adequate Foundation Not Laid To Take Advantage of Reforms Strengths. Extremely Vulnerable to the Insurgency.

By Reducing Interventionist Role of the State, No Way to Stabilize Economy Once Downward Spiral Began. Now Have to Face Many More Severe Obstacles than in Initial Pre-War Period.

Reforms Focused on Long-Term Issues, Structural Changes – Neglected Short-Term Problems Such as Unemployment – Reforms Lost Credibility by Not Resolving Pressing Problems.

Reforms Stalled, Incomplete – Limited Benefits and Numerous Dislocations.

At Issue: Should Iraq -- Abandon Reforms, Continue Along the Broader Washington Consensus Path or Develop An Alternative Approach Specific to Iraqi Conditions?

General Criticisms of Neoliberal Reforms/Washington Consensus

Many Reasons to Question the Wisdom of Continuing to Pursue a Strict Neoliberal/Washington Consensus Approach to Reforms in Iraq.

Narrow View of Macroeconomic Stability—Focus on Price Stability Rather than Demand Management.

Disregard for Role Public Sector Policy Interventions Can Play in Increasing Investment and Growth.

Hierarchical View With Sound Economic Policies Primacy Over Social Policies.

One Size Fits All Approach Negates Local Responses to Unusual Circumstances.

Tendency to Forget that it is the Citizens Who Should Choose The Economic and Social Institutions they Prefer.

Alternative Approaches: Relevant Experiences With

Reforms

Neoliberal Reforms in Vogue Around 1990 – Since Then Much Disillusionment With their Effectiveness – No Longer the Dominant Paradigm.

The Empirical Record Suggests:

Transitions to High Economic Growth Usually Characterized by Narrow Range of Policy Changes and Institutional Reforms.

Proper Sequencing of Reforms Extremely Important, but Hard to Arrive at Generalizations Applicable to a Wide Range of Environments.

Policy Changes that Initiate Successful Growth Transitions Typically Combine Elements of Washington Consensus With Unconventional Institutional Innovations – Need for Creativity and Local Participation in Inputs.

Alternative Approaches: Relevant Experiences With Reforms (contd.) Institutional Innovations Do Not Migrate Well – Many

Are Specific to Country of Origin.

Sustaining Economic Growth Requires Continual Deepening of Reforms and Renewing Institutions –Inability to Improve Regulatory Environment Often Undermines Earlier Successes.

To Initiate Growth, Iraq’s Approach to Reforms and The Economy Will Have to Successfully Resolve a Number of Specific Impediments Unique to the Iraqi Context.

A Successful Policy Must Address Each of These Impediments – Something the Neoliberal Reforms/Washington Consensus Were Not Designed to Contend With.

Impediments to Economic Recovery and Growth in Iraq

Major Impediments to Economic Recovery and State Formation in Iraq Include:

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

Iraq: Criminal Activity, the Insurgency and the Shadow

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

Iraqi OppositionTo Neoliberal Reforms

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.

Entrepreneurs Who Fear Foreign Competition. Speculators, Corrupt Officials Profiting From Black Market Arbitrage on Administered Priced Goods.

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

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.

Lessons From The Transition Countries

Looking at the Transition Country Experience There is Hope for Iraq in Overcoming These Impediments. The Main Lessons From This Experience Are:

Sustained Macroeconomic Stabilization is Essential.

Delayed Reforms Risk Negative Growth.

No One Component of Washington Consensus Reforms 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 Country 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.

From the Start, 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. Creativity in Adapting Reforms to Local Circumstances Appear As or More Important.

Key Empirical Linkages

In Addition to Drawing on the Lessons For Success, A Strategy for Economic Growth and Recovery Will Have To Take Advantage of A Number of Key Empirical Linkages. The Most Relevant to Iraq Appear To Be:

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

The Future: Key Variables

Obstacles to Viable Market Economy And State Formation Can Be Overcome Under Certain Conditions.

Many Economic/Social/Political Elements in Iraq are Interrelated: Need to Initiate A Set of Forces So that Each Can Build on the Other – Growth Through Positive Externalities:

Economic Reforms – Progress, Stage I to II. Political Environment – Encompassing. Level of Insurgency – Stabilizes/Declines. Oil Production – 2.2-2.8 million b/d. Creation of Oil Fund for Public Distribution. Macroeconomic Stability – Inflation 15-30%. Falling Corruption.

Virtuous Circle of Reform, Growth and Liberal Market

Development Infrastructure Led Public Investment – Increased Use of

Iraqi Firms and Workers -- 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 Expansion.

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 – State Sponsored SME Development Banks.

Expanding New SME Firm Creation.

Oil Fund for Public Distribution – Helps Develop Expanding Domestic Markets –Promote State Formation.

New Firms, Workers and Large Segments of the Population Have Stake in Moving the Reform Process Ahead.

Expanded Reforms Reduce Corruption, Improve Regulatory Climate.

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

Critical Intangibles

What are the Critical Intangibles Likely To Influence Iraq’s Future Economy?

The Extent to Which Economic Progress Made Without Significant Reduction in Corruption.

Speed and Degree to Which Trust Can be Restored.

The Extent To Which Improved Economic Performance Can Undermine the Insurgency.

The Level to Which Religious Influences Are Likely Mold The Country’s Economic Institutions – Will The Result Make Movement to a 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 – Can Progress Be Sustained Without an Oil Fund?.

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, The Extent to Which the Iraqi Government Can Evolve into a Developmental State.