Economic Policy Vacuum in Iraq

America needs to help Baghdad build a vibrant private sector.

As the United States plotted interventions in Iraq and Afghanistan, it was often accused of going in without an exit strategy. This has been seldom been more true than in America’s attempts to help the Iraqi economy.

Baghdad’s economic position is dire. Unemployment and underemployment remain widespread, private-sector and agricultural credit are difficult to obtain, and the pace of non-oil-related foreign investment is anemic. Oil exports still make up lion’s share of Iraq’s economy. Iraqis have told me, with variations, that we are “re-patching together Saddam’s old government-dominated economy.”

Delve a bit deeper, and the picture gets worse. Relative to the size of the economy, bank deposits and lending in Iraq are very low, much less than those in financial backwaters like Iran and Pakistan. Even Yemen rates better by this metric. And short- and long-term capital available through other market-based financial channels—factoring, leasing, mortgages, stock issues, etc.—has been even more limited.

The near-absence of finance helps to explain why few business initiatives succeed in Iraq without a government contract or government subsidies. (We have implicitly recognized the latter in the efforts of USAID to offer supporting finance for large and small start-ups, as well as plans for the United States to seed an “enterprise” fund. Iraqi efforts to encourage a home-mortgage market are likely to involve interest-rate subsidies.) The essential question for any investment decision lies in whether expected return on capital exceeds the cost of capital. The inability of most enterprises in Iraq to obtain credit against receivables, equipment or other collateral, except at very high interest rates, raises the cost of working capital—and the resulting reduced financial activity suppresses expected returns. Generating market-driven finance channels is one way out of this economic deathtrap.

A strategy to facilitate non-oil-sector growth would use a multi-dimensional effort to create a market-driven financial sector and foster the adoption of modern property rights. Were Iraq to move in this direction, it would become possible to generate sustainable (read: non government-funded) employment. More market-based finance would reduce the relative role of government ministries in the economy, which would in turn lessen the scope for official corruption.

The steps moving forward are clear. Iraq must adopt a monetary framework emphasizing a stable dinar and interest rates anchored on regional and international levels—one more conducive to financial-sector integration. It must develop alternatives to bank finance, including factoring of receivables, trade IOU’s, equipment leasing, use of civil servants as guarantors, etc. And Baghdad must strengthen property rights, which would facilitate issue of mortgages against land, as well as encourage longer-term engagement on the part of investors and owners.

None of these have been emphasized in our discussions with senior Iraqis, nor are they mentioned in publicly available Coalition planning documents.

A look backward suggests ways forward. Bush-appointed advisors advanced a “shock therapy” privatization agenda in 2003, which neglected development-sequencing issues, and disdained consequences for Iraqi employment in the short term. As such, it’s not surprising that Iraqi officials rejected the approach. U.S. military leaders, cognizant of the disastrous consequences of creating unemployment among former soldiers, never embraced the shock-therapy agenda. A separate Department of Defense unit was later funded to support the revitalization of state-owned enterprises. When petroleum prices rose in 2007, we urged the Iraqi Finance Ministry to boost economic activity by spending growing revenue more quickly. This was not necessarily a bad idea, but earlier visions of market-driven investment faded.

After the Paris Club agreements in December 2005—which greatly reduced Iraq’s external debt burden—the IMF assumed a directional role in economic advice, and with dismaying consequences. It called for revaluation of the dinar and higher interest rates, the latter with the deliberate intent of squeezing private-sector activity to offset inflationary effects of higher government spending. The IMF is, of course, a crisis-management body, and was never intended to offer across-the-board development advice. But the Fund’s focus on price liberalization, control of inflation, fiscal policy, and restructuring of state-owned banks—while neglecting the financial agenda outlined above—was adopted by the U.S. Treasury and State Departments in Iraq as an almost inclusive framework for economic policy.

Lack of strategic focus has in part mirrored bureaucratic incoherence. USAID has conceived its role as project-implementation. Where its officials or contractors have moved beyond that to identify areas for structural reform—including strengthening land-ownership rights and criticizing deflationary monetary policy during 2006–2008—their conclusions have seldom percolated upward. The World Bank, which might have provided a counterpart to the IMF’s emphasis on budget and monetary issues, has not had a prominent role in Iraq. The U.S. Treasury and State Departments have assumed responsibility for economic policy in Iraq, often rejecting “outsider” input; and they ought to be accountable for the lack, even at this late date, of a cogent development agenda.

Pages