Iraq's Odious Debts

Rebuilding Iraq: The hard path to new nationhood

The Economist
April 19, 2003

Iraq’s military occupiers will be starting almost from scratch

SHOUTS of rage greeted General Douglas MacArthur in 1945, when he entered Japan as head of the American army of occupation. But many Japanese shed tears when he departed six years later, having set up a working country again. A retired general, Jay Garner, is shortly to fill the MacArthur mould in Iraq, at least in the beginning. Whether the occupying powers are mourned when they leave this time, perhaps some years from now, will also depend on how good a job they do of rebuilding.

The overriding lesson from past efforts is that economic and political reconstruction are tightly linked. One cannot happen without the other. Beyond that, two further lessons emerge. First, how aid is used matters at least as much as how much aid there is. The Marshall-plan aid after the second world war, for example, was actually quite a small proportion of European GDP at the time. Second, although handing over to local government must be an explicit goal of nation-building, power should be transferred only as quickly as local institutions can exercise it properly—no matter how keenly the occupiers feel that they must not appear to be imperialist.

So, in Iraq, the first priority should be to establish sovereign power across the whole territory, backed with sufficient money and force to ensure that the country does not break up. Second, the ruling powers must quickly establish institutions involving all the main factions, while considering—within the overriding imperative to hold the state together—the devolution of power to distinct regions on a federal pattern. It should help that none of Iraq’s neighbours wants to see the break-up of the country, and that some, especially Turkey and Iran, are deeply worried at the prospect.

But where is the legitimacy of the nation state to come from? There are two possible sources. One is historical: appealing to a pre-Saddam notion of Iraq. The other is practical: getting the Iraqi state to deliver efficiently to its people the things they want and need.

In post-communist Europe, the countries that did best had an existing, pre-communist base of democratic, market and civil-society institutions. Poland and Hungary, therefore, have been much more successful than Russia and the central Asian states. In Iraq, a 20th-century imperial creation, it is still unclear whether the pre-Baath Party era provides a founding myth for a post-Saddam state, and whether de-Baathification of the bureaucracy can succeed as well as did similar purging and redirection of the organs of state in Germany and Japan.

De-Saddamisation could be done in three ways. The first is to draw “a thick black line under history”, as Poland and some other ex-communist countries did, refusing to investigate and punish the leaders of the communist regime. The second is to set up local bodies to address the sins of the old order: South Africa’s Truth and Reconciliation Commission, for example. The third method is victor’s justice, carried out by the occupying powers—of which the Nuremberg war-crimes trials remain the most famous instance.

Failure to prosecute past crimes can leave open political wounds; but, in general, it will be better to get on with building the new Iraq than with settling every score from the old. And so long as justice is seen to be done to the nastiest elements of the Saddam regime, it may be better to stop at a point which, for some, will not be rigorous enough.

The top priority is to avoid a power vacuum during the transition to a new regime. This happened in post-communist Russia, where rolling back the frontiers of the state meant, in effect, handing power to the mob. Most successful nation-building efforts have involved occupying powers staying long enough to bed-in effective government, and this takes time. America did not fully hand over power in Japan until 1952.

In most countries where a tyranny falls, the most obvious evidence of lack of effective government is an economic mess. Arguably, for nation-builders, fixing this mess should precede full political reform, both to meet the material needs of the population and to lay the foundations of social and political stability. In Bosnia, the peace process paid too little attention to economic reform; as a result, the country became largely dependent on aid, with a sizeable shadow economy dominated by organised crime.

Iraq’s great advantage over countries such as Bosnia, Afghanistan, East Timor and Rwanda is that it has oil. This creates the potential to do reconstruction well and at little fresh expense to the rest of the world; but it also creates a risk that this hugely valuable asset will be mismanaged or expropriated—by local elites or, indeed, by the occupying power.

The occupiers’ right to make use of Iraq’s oil has been studied by Dobie Langenkamp, of the University of Tulsa’s law school. He concludes that, under international law, oilfields are “immovable government property”: occupying powers have the right to revenues from the sale of oil from existing fields, but no right to ownership of the underlying assets themselves. An occupying force would probably have no right to build new wells to exploit Iraq’s reserves faster—and certainly no right to sell off Iraq’s oil assets to foreign firms through privatisation.

What is more, oil revenue must be used for Iraqi purposes, such as feeding the population or rebuilding bridges; it cannot simply be whisked away to pay for tax cuts for Americans or, perversely, be used to pay for the war itself. Both America and Britain, in any case, have stated repeatedly that they have no wish to seize the oil for themselves.

Under the Geneva Convention, the occupying powers are also entitled and obliged to carry out basic humanitarian reconstruction, such as repairing roads, rebuilding bridges and restoring electricity and water supplies. The political storm over the awarding of contracts by the American government suggests that in Iraq they are getting on with this task quite quickly, and that the American taxpayer will probably finance it—as he financed the war that did the damage.

Macroeconomic imperatives
Longer-term economic rebuilding should start with the establishment of a reliable medium of exchange. When Anwar-ul-Haq Ahady left the University of Providence to become governor of the new central bank of Afghanistan last year, he found a fine building—a legacy of British rule—but two competing currencies and a money supply captive to a firm in Russia that was reluctant to stop printing notes. In Bosnia, the “convertible mark”—which replaced Yugoslav dinars and Croatian kunas—has been one of the few successes of economic policy. It is widely accepted across the country because of its explicit fixed link first to the Deutschmark, and now to the euro, through a currency board.

A similar arrangement might work well in Iraq. What the dinar is pegged to does not matter much, providing it is a hard currency. Why not peg it to a basket of 50% dollars and 50% euros, a neat political compromise? True, simply introducing dollars—or, indeed, euros—would mean instant currency credibility. But it carries other risks, besides unhelpful political symbolism. Dollarisation would fully expose Iraq to volatile oil prices; creating a new currency, on the other hand, would allow it eventually to move from a currency board to something more flexible, thus permitting monetary policy to soften the impact of swings in the price of oil.

An equally urgent priority will be to settle Iraq’s external financing position. It faces massive financial claims from other countries, first over its Saddam-era debt and second over its Saddam-era reparations bill. If Iraqi oil is to generate a sufficient flow of finance to pay for reconstruction, this burden must be reduced.

Outstanding debts are probably best handled by rescheduling via the London and Paris Clubs. If those measures do not go far enough, Iraq would obviously not qualify for debt forgiveness under HIPC, a World Bank initiative to help highly indebted poor countries. But precedents exist for debt forgiveness on political grounds, as some of Poland’s was forgiven in the early 1990s.

The repayment of some Iraqi debt, despite regime change, is crucial to rebuilding Iraq’s credibility in international credit markets. The payment of war reparations is not. Its $200 billion liability arises exclusively from Saddam’s expansionist activities. The case for continuing to punish the Iraqi people for the sins of their unlamented dictator is a poor one, as Keynes so eloquently demonstrated in Germany’s case at the end of the first world war.

This mixture of rescheduling and forgiveness will allow Iraq to return to international capital markets to raise the cash for reconstruction. Unlike many countries where regimes have changed, its copious reserves of oil should guarantee plenty of willing lenders. Managing this resource and using the revenues wisely are the next big challenges.

Good budget behaviour
If the fabulous returns available on Iraq’s oil reserves—second only to Saudi Arabia’s—are captured by an elite and salted away overseas, the reconstruction will fail and the Iraqi people will remain in poverty. The scale of this challenge cannot be overstated; Iraq is surrounded by countries that have had their oil wealth expropriated in exactly this way. Indeed, the only countries, or parts of countries, that both depend on natural resources and have made a decent fist of sharing the wealth broadly among their people are those with well-established democracies, such as Canada, Australia, Norway and Alaska.

At a bare minimum, what happens to Iraqi oil and the revenues from it should be decided in an open and accountable fashion. This means that oil should be extracted and sold by a company, or companies, at arm’s length from government, and that the government should extract its cut through taxation, not by sucking the revenues directly into the Treasury. However, given the risk that political cronies of the government will run any “arm’s-length” company, there may be a strong case for putting the oil and the revenues from it under international administration, perhaps for several years. Such a scheme might be built on the existing, and admittedly far from perfect, UN Iraqi oil-for-food (OFFP) programme.

Having secured for the Iraqi people what will probably be the country’s main source of budget revenue, a proper budgetary process must be set up for spending it. This should be put under local leadership, if not necessarily full control, as soon as possible. Spending commitments should be developed by ministries to deliver vital services such as policing, health care and education. Co-ordination of spending programmes should be done by a ministry of finance, which would also oversee the development of a taxation system. These ministries would then become the core institutions of the new Iraqi state, benefiting from expert international advice. (The World Bank would probably prove a better adviser than America’s State Department.)

A steady flow of finance from Iraq’s oil wealth, however, may inspire this new local leadership simply to squander the revenue. So there is a case, too, for internationally imposed budget constraints. In other nation-building efforts, the bulk of financing has come not from local assets but from international aid, paid directly into the Treasury. Access to these resources is typically subject to agreed terms and conditions, with a view to promoting good government. A similar mechanism could be put in place to ensure that the new national administration in Iraq can gain access to the oil revenues, at least at first, only if it can demonstrate that it is using the money efficiently.

Managing the oil
After macroeconomic and budgetary reform must come structural reform: and this, too, begins with oil. The easiest way to maximise efficiency is to sell off the Iraqi oil industry and reserves to the highest bidder. In a competitive auction, the international oil companies would bid up the price to a level where they are making only a normal rate of profit, thus giving any economic rents to the Iraqis. (Oil generates huge economic rents because the world oil price tends to be far above the cost of producing an additional barrel of oil; it may cost as little as $2.50 to produce a barrel of oil in Iraq, compared with a current global oil price of around $24 a barrel.)

Clearly, despite American feelings of betrayal by France and Russia, it would be against the interests of the Iraqi people to restrict bidders only to firms from countries that supported the war. It would also make sense, legal issues permitting, to cancel any contracts signed by the Saddamites, as these did not benefit from bidding pressure from firms obeying UN sanctions, and were therefore not a good deal for the Iraqi people.

One option would be to put the money raised in a trust fund and invest it for the long term. The question of distribution could be addressed by allocating shares in the trust fund, or by promising to make annual payments, to each Iraqi, or by creating personal savings accounts along the lines of the Singapore state retirement fund. The trust fund could be managed to maximise returns to its shareholders, the Iraqi people, presumably by investing most of the money outside Iraq. This would reduce inflows of foreign currency, keeping the exchange rate down and protecting the competitiveness of the rest of the economy.

Such a scheme would certainly irritate economic nationalists. But the problem with many alternative schemes, such as retaining an Iraqi oil monopoly or using production-sharing agreements between international firms and Iraqi companies, is the potential for corruption arising from the economic rents. Iraqi elites would have a powerful incentive to expropriate at least a portion of them.

To exclude foreign competition entirely, some policymakers propose a programme of mass-privatisation with competition among Iraqi firms to ensure efficiency. The Iraqi oil industry would be divided up between several competing companies. Shares in these companies would be given free to every Iraqi, as tangible proof of their ownership of the oil.

Alas, there are no notable examples of this sort of scheme working. In Russia, mass-privatisation spread ownership among many shareholders; the result was management that was largely unaccountable or, in some cases, allowed investors with relatively small shareholdings to exert disproportionate influence. Moreover, before a market in shares became established and a fair price was set, many small shareholders—mostly the poorer ones—sold their shares quickly at well below their true value. These problems might be reduced by prohibiting the quick sale of shareholdings, say for a few years. But the other weakness in an entirely domestic Iraqi privatisation is that Iraq may find it harder to gain access to valuable foreign know-how and capital.

A need for sound laws
For the rest of Iraq’s economy, the basic principles of sound economic management apply. Keep bureaucracy down, maximise competition, set reasonable and efficient tax rates. Experience from nation-building elsewhere suggests that the main challenge here concerns the legal system.

A first question will be the adequacy of the Saddamite legal system, and the willingness of the Iraqi people to continue to use it. At the very least, there will be widespread scepticism about the independence of judges. Arguments will also rage about the validity of formal property rights established under the old regime, and about how to recognise property rights that are informal and implicit. In post-war Japan, one of the biggest challenges was to draw up laws to recognise oral ownership contracts for land in what was essentially a feudal farming system.

To what extent can legal systems be imported “off the shelf” from abroad? In post-war Japan, General MacArthur oversaw the introduction of American corporate law, including the old Glass-Steagall Act that separated investment banking from commercial banking. This worked to some degree, though Japan’s industrial structure evolved in a very different direction. Several American departments of state are now preparing proposals to graft the best of their legal and regulatory structures on to Iraq. But according to Hernando de Soto, the most fashionable economist among market-oriented development policymakers, importing a legal system wholesale carries big risks. It is often more effective to go with the grain of local legal practice—formal or, more often, informal—than to adopt an alien “first-best” model.

In Iraq, the thorniest questions may well concern restitution—particularly of property abandoned by political prisoners and Iraqis fleeing into exile. In post-communist eastern Europe, settling claims for restitution has been an intrinsic part of establishing the legitimacy of the new regime. Against the argument of justice can be pitted an economic concern: that prolonged uncertainty over ownership of assets can undermine their economic use. The best solution is to transfer the liability on to the state budget, to provide financial compensation when the claim is settled, with the actual property remaining in the hands of the current owner—whether the state, as in eastern Europe, or private individuals, as is more often the case in Iraq.

As well as restitution, regime change in many countries—especially in Latin America—has brought pressure to redistribute land and other sources of wealth. In Iraq, there is certainly a chance now to make such transfers—though perhaps not by introducing an equivalent of America’s old Homestead Act, as some American policymakers have proposed. Would Iraqis really be better off if they had the right to stake a claim to a few acres of desert? Furthermore, in Iraq the big issue is not the land, but what lies underneath it. The real redistributive challenge is to give everybody an equal share of the oil wealth.

One particularly tricky question will be whether to pay every adult a chunk of the oil revenues each year as basic income. This would, of course, provide tangible evidence that the oil really belongs to the Iraqi people. However, it could have a big downside. Many young Saudi Arabians have become so accustomed to living off oil wealth that they are now disinclined to work, and the government has been driven to hectoring them to take jobs.

If that is the worst problem Iraq has to face in a few years’ time, its reconstruction will be counted an astounding success. At present, however, Jay Garner’s task makes Sisyphus’s—and even, possibly, MacArthur’s—look easy.

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