The Next Move in the Iraqi War of Reconstruction

By and April 10, 2005

BESA Center Perspectives Paper No. 5

EXECUTIVE SUMMARY: While the insurgency continues, Iraqi families continue to suffer financially. As long as there is violence in Iraq there will be no large-scale foreign direct investment, but this is all the more reason to focus on institutional and structural changes with the help of moderate Arab regimes, such as Jordan.

As so often in disaster economies, the macro-economic statistics cloud the jagged contours of the more complex micro-economic reality. Behind the media persona of the streets of Baghdad, littered with suicide bombings, beheadings, assassinations and poverty, new economic realities are gradually crystallizing, buoyed by the results of the elections of January 30, 2005. The rudimentary components of a market economy are gradually replacing – more cynical critics would say emulating – decades of command economics and petrol money profit-pinching.

For the first time in a generation, ordinary Iraqis are savouring consumer luxuries. Sales of new refrigerators, televisions, DVDs, CD players and mobile phones are on the rise. Such items were previously the preserve of only the Ba’athist lackeys who propped up Saddam’s regime. Restaurants are said to be doing better than people can ever remember. While Iraq still has one of the lowest rates of fixed line phones per person in the world, the cell phone business is booming. Thousands of families have bought used cars from abroad – used car prices are one-third less than in Saddam’s time – giving a greater feeling of mobility, although the effect on the city’s streets is more traffic and pollution.

But the overall pattern remains dismal. According to the Joint Iraq Needs Assessment, conducted by the UN and World Bank in 2003, average income in Iraq fell from $3,600 per person in 1980 to between $770 and $1,020 by 2001 and only $450-610 by the end of 2003. Economists have somewhat despaired of providing final estimates for the tumultuous year of 2004, but it is unlikely that the average income will be much higher than the 2003 levels and certainly no higher than 2001. Alan Larson, undersecretary for economics in the U.S. State Department, claims that Iraq’s economy has expanded by 40% in 2004 from its low in 2003. However, much of that growth rests on output in the Kurdish areas of Iraq, where the insurgency has not disrupted the lucrative oil production.

Despite improvements over the Saddam years, few Iraqis, even those supplying the American army, would choose their current situation. Despite Iraq’s mammoth proven oil reserves, the well-to-do still have to pay extortionate fees for private generators. Meanwhile, ordinary Iraqis freeze because of the lack of available heating fuels and 24-hour queues for petrol. While electricity and other utilities are extremely cheap, this hardly compensates for the fact that in most parts of Baghdad there is electricity service for only one hour in ten. And although unemployment skirts around – but not below – the fifty per cent mark, most Iraqis would quote a more useful category – underemployment, which experts put at the 80% mark.

The invigorated, albeit somewhat disorganized, trade on the streets of Baghdad is not necessarily sustainable over time. Sixty-one highly inefficient state-controlled companies, under the supervision of the Ministry of Industry, account for 90% of the nation’s industrial production. Governmental offices and institutions are providing more employment than ever, and at higher wages, but largely thanks to cash being poured into government work-creation programs, funded by the U.S. Police salaries have doubled several times over. Even private sector wages have risen. Wages for construction have risen about seven times since the war.

But the situation could rapidly get out of hand and inflation could ravish the country if the government does not ensure that demand does not rise above what Iraqi firms can produce at their normal level of operation or that distribution channels do not break down. After a period of rising rapidly, inflation now remains fairly steady and there is a steady inflow of consumer and durable goods. Ironically, constant and reliable smuggling routes keep prices down and availability high. However, an early hint of how easily inflation can spread is when Bedouin border herders started exploiting the cardinal rule of supply and demand. They realized they could double profit by smuggling cattle over the border to Saudi Arabia, where prices are higher. At the same time, they created shortages in Iraq – thereby boosting prices of meat. Indeed, the price of meat has rocketed by over 20% according to some counts. Iraq remains extremely vulnerable to such easy distortions of the market, given its weak monetary infrastructure.

Such a reality is not unfamiliar in transition economies. The comparison between the Eastern Bloc states and Iraq is in order. Both operated under command economies with a strong industrial base and educated population, administered by a pool of well-educated technocrats. Decades of spurious ideological validation denied the average household access to durable consumer goods and mod cons that were freely available in neighboring countries. With the fall of the Iron Curtain, the prescription was simple: privatization and reducing the size of the public sector. Such words were the leitmotif of the harsh and ruthless structural reform programs that equipped Poland, Hungary and the Baltic States to emerge as convincing market economies.

But the opposite is now being said of Iraq by the leading economics gurus in the UN and World Bank. Privatization is not at the top of the agenda and the size of the Iraqi public sector is burgeoning. So why is Iraq escaping the same harsh economic prescriptions which propelled more than a dozen countries, ranging from Chile to Poland, to develop from stagnant command economies to vibrant free-market democratic societies? Simply put, security and oil. On the one hand, the security situation prevents excessive tinkering with economic structures, and oil revenue justifies this approach. Hence the majority suffers and a small minority enjoys the fruits of their monopolies.

After the Ba’ath Party revolution in 1968, Iraq’s dependence on oil revenue deepened by nationalization and command management throughout the economy. The effects of the consequent atrophy of almost all the private sector, except agriculture in outlying areas and trade, are reverberating harshly today. Given the political situation, and having gathered experience in several other transition economies, it is too risky to tackle privatization at the moment. While oil revenues flowed at their peak, Saddam’s Iraq was able to support a bloated public sector and keep the population provided with cheap services. Then, with the introduction of sanctions, the public sector got larger and income plummeted. The role of the state inevitably increased with the UN oil-for-food program, which led to nearly 60% of oil revenue being spent on goods distributed by the Iraqi government. As a consequence, the role of the private sector was reduced during the last years of the Saddam regime to an even smaller portion of the economy. The rare import-export franchises were granted as a gift from regime patronage networks.

Now, as can be seen above, the Americans are risking pushing up inflation and creating an even larger and even more inefficient state sector, carrying out jobs designed by bureaucrats and not responding to market forces. Obviously the security situation is a complicating factor in Iraq’s reconstruction effort. The insurgency severely reduces institutional capability to regulate and administer the privatization of 192 major state enterprises employing at least 30% of the Iraqi workforce. But, the extent of the economic mismanagement of the reconstruction effort is not entirely because of the insurgency and perpetuating the same logic of relying on oil to support the public sector will have long-term negative economic repercussions.

The present U.S. administration is familiar with the experience of post-war Germany and Japan that taught that to make sure a victory does not turn into a pyrrhic victory, economists and bankers must come immediately after the generals. Even while the Ba’ath regime was frantically clinging on to power and its befuddled spokesmen were carrying out their duty to deny American victory, the Americans were thinking business. That was a mistake. They should have been thinking economic management. Indeed, while the Americans inaccurately (but with the wrong rationale) predicted a huge commercial battle with European and Russian business over Iraq’s massive economic resources, they failed to prepare for a full-time insurgency. The Americans presumed that the war after the war would be a U.S.-European commercial one, not a military one. The real war now is breaking the control of oligarchs and monopolists of resources. Hard as it sounds, there is a dual war taking place against the insurgents – one against the security threat they pose and another on economic grounds, denying them the ability to harm the development of the Iraqi economy.

Most of the money that was spent on the initial reconstruction euphoria went to U.S. contractors rather than the Iraqi economy per se. U.S. contractors still receive the bulk of U.S. reconstruction funds. Hiring large U.S. contractors to carry out reconstruction projects is not only far more expensive than hiring local Iraqi expertise – it pushes up prices. It also means that a large percentage of reconstruction funds experience capital flight out of Iraq at the expense of the Iraqi work force. Too few funds are used to build local capacity and now that the issue of privatization of state concerns is not an issue, there are hardly any institutional investors willing to inject much-needed foreign direct investment, and most certainly not from the U.S.

The Iraqi economy continues to be fuelled by cash, barter and, most worryingly of all, aid. While a new upper class has emerged, there is no stable middle class, and that which existed before the war has dissipated in the uncertainty of the insurgency. Strong hand tactics still dictate who gets what of the pie in the Iraq of early 2005.

At this stage in Iraq’s battle for reconstruction, it is important not to get carried away with rewarding American business. Focus must be on institutions. The Iraqi government has to focus on restoring confidence in its institutions as a prelude to creating the rule of law. The experience of all transition economies teaches that stable institutions are vital in the early stages of a transition economy. All nine floors of the Iraqi Central Bank were reduced to rubble and insurgents will continue to target such significant symbols of power.

Without a stable court system, taxes go uncollected and contracts are not respected. No profitable business can survive in this environment without resorting to hard hand tactics or suffering intolerably.

Just as Iraq’s more sophisticated commercial and business structures played a leading part in helping to modernize Arab economies such as Jordan, it now makes sense that Jordan, which has succeeded in revitalizing its economy and has enjoyed good economic and infrastructure growth, should take part in the development of a new Iraqi commercial system, especially since Jordan’s current business courts and environment are considered among the most fair and least corrupt in the Arab world.

While the political and economic components of the situation in Iraq are deeply inter-related, it is possible to separate out economic policies that can help circumvent the political realities. Focus should not be on international business. Indeed, awarding large contracts only complicates matters given Iraq’s enormous foreign debt: $130 billion and approximately $57 billion in pending contracts (mostly with Russian and French companies. Other claims hover over the Iraqi exchequer including $27 billion in compensation claims from Iraq’s invasion of Kuwait.

While the insurgency continues, there will be no large-scale foreign direct investment, but this is all the more reason to focus on institutional and structural changes with the help of moderate Arab regimes, such as Jordan.

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Dr. Gil Feiler
Dr. Gil Feiler

Dr. Gil Feiler is managing director of Info-Prod Research, Ltd, and a research associate at the Begin-Sadat Center for Strategic Studies. Email: [email protected]

Simon Lassman

Simon Lassman works as a business consultant with Info-Prod Research Middle East, and served as a feature writer for the Palestinian English-language weekly Jerusalem Times.