Driving a Dangerous Course:Obstacles to Iraq's Macroeconomic Health

Driving a Dangerous Course:

Obstacles to Iraq's Macroeconomic Health

by Steven Saus, Wright State University

Despite the opinions of my wife and children, I do not always like being right. This paper is an excellent case in point.

The Second Gulf War, combined with the effects of a decade of general sanctions, left Iraq's infrastructure in shambles. Some degree of reconstruction was -- and is still -- necessary to allow Iraq to fully rejoin the world economy. It is not just a matter of justice, or humanitarian need. As other's research has shown, economic stability is strongly correlated with political stability. A politically stable Iraq -- and Middle East -- is in the interests of the United States.
Therefore, creating a robust Iraqi economy is vital to the national security of the United States.

The Bush administration has compared the reconstruction of Iraq to the Marshall Plan. Despite that allusion, the methodology chosen for reconstruction has ignored several relevant historical examples. This paper identifies two major obstacles to Iraq's continued economic growth: (1) the shift in funding of reconstruction from donations from the United States and its allies to IMF loans, with the policy restrictions such loans incur; and (2) the trend of placing highly paid contractors in supervisory positions instead of Iraqi nationals. It outlines the specific detrimental effects each of these can have on the economy of Iraq.

This paper argues that the historical precedents of the Treaty of Versailles, the effects of IMF policies in Nicaragua, and the British Raj in India all have great relevance to the economics of Iraq in 2006, and the problems it faces. The examination of these examples' failures leads directly to suggested methods to avoid the pitfalls of the past.

Since the first words of this paper were written, there has been a large increase of violence and political strife in Iraq. The intensity and frequency of the conflict has grown to the point where many are calling it a civil war. I have to wonder how much of this violence was preventable, how much is tied to the problems in Iraq's economy. I wonder if it is already too late, if the problems presented here are now playing out in bloody partisan battles. I hope that my bleak analysis of Iraq's economy is completely wrong.

I am very much afraid that I am right.

Read the full paper here as a PDF.

This paper was presented at the 2006 AURCO conference.

The slideshow with the text of the presentation is below.

All text of this work is original, and is copyrighted under a Attribution-NonCommercial-NoDerivs Creative sCommons license.

The Bush Administration invoked the spirit of the Marshall Plan to describe Iraq's reconstruction, but it's a different road, with large obstacles down the way our country has chosen. In the next few minutes, we will quickly look at two major obstacles in Iraq's path and find ways around them. We will do this in three sections: The First Obstacle - sources of funding; The second obstacle - Human Investment; and finishing with conclusions and concrete steps that can be taken to avoid these obstacles.

In January 2006, things already looked pretty grim for Iraq. Reconstruction wasn't done, with billions of dollars of work left. Electricity was only on for half the day - or less. Unemployment rates are similar to ours during the Great Depression. There simply isn't the money in the Iraqi economy to finish the job. Profits from the oil industry, which was supposed to pay for everything, were at the lowest point since the war began. The US is planning to stop aid at the end of this year - and the "Coalition" has only given a quarter of what it promised. So where's the money going to come from?

Iraq is going to have to borrow money from lenders like the World Bank and the International Monetary Fund (or IMF). In fact, the first IMF loans have already been approved. This method of funding reconstruction is the single biggest difference from the Marshall Plan. Let me explain.

The origins of the Marshall plan can be traced to the treaty of Versailles after WWI. Despite warnings from prominent economists such as John Maynard Keynes, the Allies made huge demands on Germany for reparations. The economic consequences were disastrous, and set the stage for WWII. Since then, this pattern has been noted in other, smaller conflicts: Economic hardship correlates with political strife. In contrast, the Marshall Plan was developed after WWII, which reinvested "repayments" for loans into aided countries. As a direct result, the GDP (or gross domestic product) of Europe was soon growing at a good 5% a year.

The IMF is the major modern lender to developing countries. It has different policies than the Marshall Plan; requiring standard repayment of loans. It also has a history of overstating projected growth, which determines how much a country can afford to borrow. The IMF typically also requires economic reforms of its choosing. This combination is a one-two punch that has hurt many weak economies.

Nicaragua is a typical example from Central America. Overstated projected growth (and thus larger-than-payable loans) meant that paying their debt required cutting human investment programs…like healthcare and education. The reforms of the IMF focused on short-run growth, encouraging unsustainable exploitation of the rainforest, with disastrous long-run results. Now the IMF wants Nicaragua to focus on "good governance and controlling corruption" to improve their economy - even though a lack of corruption has no correlation to economic growth. These all imply a disconnect from economic realities.

In Iraq, the IMF demanded a large increase of gasoline prices. That's reminiscent of another historical situation - Bolivia in 1985. Bolivia had massive hyperinflation, and sharply increasing gas prices stopped the inflation. Stopping that hyperinflation helped more than the increase in gas prices hurt businesses. Iraq, however, doesn't have hyperinflation. The new dinar - and inflation - has been relatively steady from 2004 until Jan 2006. Increasing gasoline prices raises the cost of doing business, so this is simply hurting the free market in Iraq. Does this indicate another disconnect from reality?

Projections of Iraq's GDP growth also remind us of the IMF's historical overestimations. In January, the IMF and US treasury were predicting Iraq's GDP to grow over 10% in 2006, even though Iraq's 2005 GDP growth was only about four percent. Why would there be a difference of this degree? Is it simply optimism or something else?

John Perkins, in his memoir _Confessions of an Economic Hit Man_, pointed out that a high predicted GDP meant large loans were given to countries. Thos large loans meant large profits to foreign contractors called in to work on these projects. Though he personally worked on projects in the late seventies and eighties, it's hard to ignore the similarities between his memoir and current events in Iraq. Besides, as we've seen in our own economy over the last six years - or in Iraq over the last three months - things can change, rapidly. You wouldn't take out a larger mortgage if the bank guessed you'd get a raise that year - but that's exactly what Iraq's being asked to do.

So, to summarize the funding obstacle: Iraq needs more money to finish reconstruction. Their economy isn't up to paying for it yet, and aid money from the US and the coalition is drying up after 2006. They'll need loans, and the main lender has a history of over-lending and requiring burdensome policies that make it hard to repay the loan. And this is only the first obstacle.

The second obstacle deals with people, and investing in human capital. It's more subtle than the funding problem, but it magnifies the problems caused by the first obstacle - a switchback in the road after a long dangerous grade. Most of the contractors working on Iraq's reconstruction are from the US and its allies. They're bringing in third world labor for menial jobs, and reserving the absurdly high-paying jobs - the skilled labor and manager positions - for their citizens and expatriates, not Iraqis. All those wages are quickly leaving the country they're supposed to be helping.

But that's not all. Because the contractors are relying on imported skilled workers and managers, there's no training for locals - and those locals who already had job skills are leaving if they can. When the contractors prepare to leave, there isn't going to be any local talent ready to "stand up when we stand down" - because we didn't train them. That leaves Iraq with only one choice - to keep paying the same foreign companies to keep importing skilled labor. When that money's coming from loans, that only makes the debt burden worse.

This has happened before - during the British Raj (or rule) in India. While Britain brought technological advances, they were for the benefit of Brits, not for the Indians. British companies didn't train local Indians or put them in management positions. Those policies kept India's GDP growth under a third of a percent until independence in 1947 - and the effects took decades to shake off. It wasn't until the Green Revolution in the late 60's that India's GDP got above 2% growth per year, and it was the human investment of the government-funded Indian Institutes of Technology that has given India the ability to have sustained high growth in the technological sector over the last 25 years.

To summarize the human investment obstacle:

Wages for reconstruction are largely going to non-Iraqis

Iraqis are not being trained to replace the contractors

Which will leave Iraq without a skilled workforce and dependent on foreign companies.

So in conclusion, our planned method of funding Iraq's reconstruction through loans is going to put a large burden on Iraq's economy, making it hard for it to be self-sufficient. Our contractors' policies enrich themselves, their stockholders, and the countries in the Coalition - but reduce the long run economic stability of Iraq.

In order to survive these obstacles, the expansion of Iraq's economy from reconstruction must be larger than the contraction due to the debt. Further, Iraq must keep enough money to invest in its own people, or make it attractive (and safe) for skilled workers to permanently emigrate there.

There are some concrete steps America can take to give Iraq a better chance of having a stable economy: We can eliminate no-bid contracts, complete plans for debt cancellation and provide a true Marshall plan. These steps would still allow American companies to make a profit - but without sacrificing Iraq's long-run economic stability.

Since the first words of this paper were written in January, there's been a huge increase in violence in Iraq. The intensity and frequency of the conflict has grown to the point where many are calling it a civil war, with new atrocities nearly every day.

I wonder how much of this violence was preventable, how much is tied to the problems in Iraq's economy. I wonder if it is already too late, if the problems presented here are now playing out in bloody partisan battles. I hope that my bleak analysis of Iraq's economy is completely wrong.