Mismanaging Iraq

Mismanaging Iraq

Mini Teaser: When politics and policy collided in Iraq, too often politics won.

by Author(s): John Doe

Viewed slightly differently, demands to privatize and otherwisedelegitimize SOEs were economic parallels to what is widelyacknowledged to have been the political mistake of disbanding theIraqi army. Among Iraqi firms, SOEs are more likely to be involvedin job-creating manufacturing than the more trade-oriented privatesector firms. Both policies treated structures in place as detritusto be removed rather than as institutions that employed largenumbers of Iraqis. In both cases, coalition actions led to Iraqibitterness, something that would surely have been greater hadprivatization in fact occurred.

The coalition has been correct in seeking to reduce food andenergy subsidies, and in attempting to introduce market-determinedprice signals. All sectors of the Iraqi economy, not just SOEs,have received subsidies and have been subject to price controls.Even where privatization is delayed, introduction of price signalswill give impetus to sustainable economic activity. On the otherhand, a government facing an insurgency and a legitimacy gap is notlikely to embrace higher prices for food and energy.

In the meantime, we should understand the economic scale of thesubsidies. Estimated Iraqi GDP ran at $25-30 billion during 2003,with the government budget accounting for about half of that.Refined fuel products and electricity are sold in Iraq for pennieson the dollar of their international value; large amounts ofrefined fuel are even purchased abroad--at least $2 billionannually, though considerably more than that at currentprices--then sold domestically for a tiny fraction of the cost.Assuming such amounts are valued at a crude-oil export price of $30per barrel, the implicit subsidy for domestic fuel consumption isin the vicinity of $9 billion annually. This is the amount thatwould accrue to the Ministry of Finance either throughinternational or domestic sale of crude. At $50 per barrel, thesubsidy rises to perhaps $15 billion annually. This subsidybenefits mostly middle income Iraqis, those able to affordautomobiles and appliances.

The Public Distribution System (PDS) food basket, inherited fromthe UN Oil for Food program, now costs around $3.5-4 billionannually. Most of the amounts are used for bulk foreign purchasesof wheat, rice and other commodities. Proposed PDS reforms wouldreplace the food allotments with cash or perhaps food stamps, sothe direct savings to the budget would be minimal. The economicbenefits would come through a shift from foreign bulk purchases toconsumption of domestic production; indeed, bulk foreign purchasescontributed to destroying the market for locally produced grains.Notwithstanding the low quality of many items, however, the PDSfood basket is highly popular with Iraqis, who fear thatmonetization of benefits would mean reduced access to food. Manyrecall the previous government's demonstrated ability to inflateaway promised entitlements. Unlike fuel subsidies, the PDS is ofmost benefit to low-income Iraqis. At present the food basket isthe most important element of the Iraqi welfare net. Public opinionsurveys have shown that monetization of food benefits might triggersocial unrest and abet the insurgency. Despite this, Iraqiofficials are encouraging upgrades in services and products byvoluntary abandonment of the subsidies. For example, Iraqis can nowavoid queues and other inconveniences by paying more for gasoline.More varieties of foods are available through cash purchasesoutside of the PDS.

PDS monetization gets more policy emphasis than it warrants interms of the economic boost that it could be expected to generate.Saddam's government initiated bulk foreign purchases in 1990because the domestic agricultural system was already dysfunctional.Agriculture faces supply-side constraints induced by war,sanctions, unenforceable contract and property rights, inadequatefertilizer, salinity, lack of soil testing, low seed quality and soon. Yields per hectare run at about 30 percent of what they are inneighboring countries. These matters are now getting attention, ascoalition advisors have developed reform agendas, and as $100million of U.S. reconstruction funds have been shifted toagriculture restructuring. Regrettably, these programs should havegeared up months or even a full year earlier. As yields recover,PDS purchases from the domestic market are likely to increase.

Reform of subsidies should also be combined with development ofsocial safety nets and more broadly with consideration of how bestto use oil revenues. At present, the safety net is badly frayed.Former soldiers are collecting severances, and by a recent countsome 1.3 million people collect pensions, while about 100,000families collect subsistence welfare, out of a population of 26 or27 million. There is no unemployment insurance. It is, however,more efficient to provide social insurance through means-testedbenefits than through universal entitlements. Data gathering forimplementation of means-tested benefits should begin immediately.The PDS rolls can be used as a starting point.

If fuel and electricity subsidies are scaled back or eliminated,large amounts of money would flow into the national treasury. Froma development point of view, that would be a very mixed benefit.Oil revenue has seldom been used effectively to generatebroad-based development--it tends to foster centralist control,lack of transparency in investment allocation and distribution ofsurpluses, and weak or perverse incentives. While the insurgencycontinues, and as reconstruction demands absorb any availableresources, Iraq may have little choice but to funnel revenuesthrough the Ministry of Finance. But at some point, probably assubsidies are reduced, a portion of oil revenues should be placedin a separately managed oil fund, and portions of interest on thefund, or even portions of annual revenue, should be distributed tothe citizens of Iraq. This could be a mechanism for helping peopleoffset costs of decontrolling fuel prices. It would also giveIraqis a stake in the economic success of their country. If oilprices remain at the high levels of late summer 2004, introductionof an oil fund should be accelerated.

Economic policy always has political consequences, but nevermore so than in a society facing widespread insurgency andpotential civil war. The precepts of diplomatic "realism" should beconsciously extended to economic decisions. To announce freemarkets as a goal of economic policy is not an effective programfor waging war against an insurgency. Our failure to put people towork, abetted by our campaigns against state-owned enterprises, mayprove to have contributed to irrevocable damage.

As we look ahead, it seems likely that Iraqi officialsunderstand the importance of decontrolling prices and removingsubsidies and will address them in the event that public safety isrestored. We may also expect that Iraqi officials will seek waysto meet subsistence requirements of those Iraqis otherwise withoutresources--although they would surely benefit were they tointroduce means tested, "rationalized" safety nets.

It is less clear that Iraqis understand the importance ofdecentralizing control over their oil resources. It will beimportant over the next several years that coalition advisors, aswell as those from elsewhere, including the World Bank, theInternational Monetary Fund and the European Union, continue toemphasize mechanisms for distributing revenues. But by far the mostsignificant short-term issue remains inadequate employment. It maybe that higher oil prices will now work their way through theMinistry of Finance so as to generate domestic projects anddomestic demand. Given the awful public safety situation, we cannotpresume that disbursements will have the desired amplifier effectson private sector investment. It remains urgent that public fundsbe directed into types of investment, including public sectorinvestment, that will have maximum impact upon the use of Iraqilabor and resources. Iraq's future demands it.

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