Lounsbury: Iraq: Economic Reforms Analysis, a long commentary [corrected formatting]

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October 02, 2003

Iraq: Economic Reforms Analysis, a long commentary [corrected formatting]

This article deserves careful consideration, not only because it agrees with my somewhat ad hoc analysis, but for its range.

ECONOMIC SCENE
An Extreme Plan for Iraq
By JEFF MADRICK
Published: October 2, 2003
http://www.nytimes.com/2003/10/02/business/02SCEN.html?pagewanted=all&position=

The subject here is Bremer's ideologically driven idiocy that is the new tax, investment and finance law.

As the article notes, "by almost any mainstream economist's standard, the plan, already approved by L. Paul Bremer III, the American in charge of the Coalition Provisional Authority, is extreme � in fact, stunning. It would immediately make Iraq's economy one of the most open to trade and capital flows in the world, and put it among the lowest taxed in the world, rich or poor. Is this Middle Eastern nation, racked by war, ready for such severe experimentation? Moreover, the radical laws have been adopted without a democratic Iraqi government to discuss or approve them."

The last item of course is the key factor, for all the assertions that the (unelected)Iraqi Governing Council (a misnomer if there ever was one) was consulted and fully on board. There will be no legitimacy for such a radical transformation of the economy and its structure, without a full debate by Iraqis and some means to help them through what would be certainly a wrenching transition.

I advise not to divorce this from the truly stunningly stupid idea of the forced loan to Iraq, recalling that Iraq under this ninnyhammered scenario not only will be saddled with the lowest aggregate taxation rate anywhere in the region, but also of course a long tradition of non-payment implying even lower real revenues, and in addition, a wrecked oil indusry that must pay for old loans, the new forced loan, and other present activities.

I warned months ago, when writing on the issue on the SDMB message board that every Iraqi oil dollar was looking to be spent five times over. This is precisely the kinds of plans I was seeing back then that led me to this warning.

Now, returning to the article, we see the issue of transition in the context of a relatively similar set of circumstances:
"One would have thought that the failures of swift and sudden free market changes in Russia in the 1990's would have made even extremist economists cautious. In Russia and other nations, spontaneously freeing markets from price controls, reducing taxes and suddenly privatizing business was supposed, almost overnight, to create a thriving economy.

In a recent book, "Income and Influence: Social Policy in Emerging Market Economies" (W. E. Upjohn Institute for Employment Research; $14), two economists, Ethan B. Kapstein and Branko Milanovic, remind us how the assumptions behind such "shock therapy" were not borne out. To the contrary, the gross domestic product continued to fall for years in most of the "reformed" nations, and eventually unemployment rose rapidly. The failure to grow immediately after the transition became, in the words of the M.I.T. economist Olivier Blanchard, "the major theoretical challenge facing economists.""

Let us put this in context of an Iraqi system set up by complete outsiders, an Iraqi economic system that responded not to the image Iraqis may have of their desired economy, or as in the case of Eastern Europe a compromise by local actors between outside advice and local political realities, but rather a system imposed.

I wonder if there is anyone who has given this a modicum of thought, of rational consideration unencumbered by ideology, that thinks this is a good idea. That thinks that this project actually can survive contact with reality?

As I believe I argued a few days back, a significant political threat that exists here to threaten the project of economic reform is the existance of a counter-ideology largely unimpaired by a past: Islamism with its generally odd combination of quasi-Socialist ideas in regards to macro-economic mattres, and small-merchant mercantilist nationalist economic ideas. In East Europe you did not have a real solid counter ideology ready to go, here in Iraq you do, and one that is vehemently hostile to the occupying projects.

Now, the article continues:
"And supply side economics, which argues that low taxes are the main ingredient in motivating people to save, invest and innovate, did not even work in the United States. The economist Arthur Laffer, a member of President Ronald Reagan's Economic Policy Advisory Board, claimed that reduced taxes in the 1980's would actually raise tax revenue. President Bush's current chief economist, N. Gregory Mankiw, wrote in his widely read textbook that "subsequent history failed to confirm Laffer's conjecture.""

Indeed, indeed. Taxation is not the motivator that this new breed of economically irresponsible American "conservatives" want it to be. I would add that the above and my own statement do not indicate taxation levels are in fact not motivators or are without effect on an economy and its innovativeness. However, their marginal effect is in no way what the 'supply siders' thought it was. That is an emperical issue, and it is clearly demonstrated. It also, of course, will vary from culture to culture. It seems clear that some places are more sensitive, that is the elasticity is greater, to tax changes than others. I don't recall the data off the top of my head, however I would hazard the recollection that the US has higher tax response elasticities than other places - and yet even there the response is not as significant as the ideologues claimed.

Now, in a society like Iraq, fraught with all kinds of rigidities and highly, as the rest of the region, risk averse, the naive concept that there will be significant entreprenurial responses is without foundation. There will be responses, but they will be significantly deformed by rent-seeking traditions, by risk aversion, by lack of understanding or experience with such a system.

So what do we have? The article notes:
"The new plan reduces the top personal income and corporate tax rate to only 15 percent. It reduces tariffs on imports to 5 percent. And it abolishes almost all restrictions on foreign investment. It would allow a handful of foreign banks to take over the domestic banking system.

The openness to private investment unleashed immediate protests among Iraqi businesses and is now being reconsidered. But an even bigger worry for regional economists like Fadhil Mahdi is the low tariff on imports. Mr. Mahdi is the regional program manager for the United Nations Development Program in Beirut; in an e-mail discussion, he stressed that his views were his own, not necessarily those of his organization.

"After the long years of war since 1980 and the sanctions since the 1990's," he said, "Iraq's technological prowess in the civilian sector is worse than Russia's in the 90's. Opening up to imports at a mere 5 percent tariff will most probably ruin many producers and exacerbate unemployment.""

Indeed, given my contacts with Iraqi "businessmen" I rather suspect that may be the case, although I am not sure that 'worse' is fully supportable, certaily the conditions are terribly degraded and the institutional capacity to respond to change probably significantly worse than in Russia.

Now, imagine mass unemployment and how that will go over politically. Does anyone believe an Iraqi government installed by the US can survive such a thing? If you do, you are a fool.

As I warned in an earlier note on this subject, because of instability, few producers will initially wish to relocate to Iraq, however large the advantages to near to market advantage are. With a mere 5 percent tariff with no transition, there will be every incentive to simply export to Iraq without any domestic presence beyond distribution.

That of course is likely to more or less destroy a weak Iraqi economy utterly unprepared institutionally or in terms of human capital, for real competition in a free market context.

The article then asks the wise question: "As for a 15 percent top income tax rate, can this ever be enough to support adequate social programs? High rates of inflation long ago undermined the Iraqi safety net. Pensions of $3 and $4 a month are almost meaningless. Flows of funds from the three million to four million Iraqi family members overseas are now crucial support. The most important social program is the food-rationing system developed internally when the United Nations created an exception to sanctions on trade, allowing Iraq to export oil in return for food."

I note in addition to this comment that whatever the theoretical amounts collectible off of such a rate, one has to heavily discount because of poor tax collection capacity and a long tradition of tax aviodance. If they collected an equivalent of a 5 percent rate, I would be surprised.

The article continues: "But, as has been characteristic of such shock therapy in the past, the new economic planners have not included provisions for social programs. Mr. Kapstein and Mr. Milanovic point out that the shock therapy of the 1990's also neglected social needs. But out of necessity, this soon changed.

Even in Poland, where advocates of shock therapy claim success, the authors point out that there was substantial social spending. It is easy to forget that Poland's economic output fell sharply in the early 1990's after the first round of shock therapy. But unemployment benefits were ample � reimbursing 60 to 70 percent of a worker's pay compared with an average of 35 percent in the United States. Public pension benefits were indexed to inflation.

Iraq is in far worse shape than Eastern and Central Europe were back then. After two decades of wars and United Nations sanctions, Iraq's economic output had fallen by the late 1990's to the same level it attained in the 1940's, discounted for inflation. The latest war destroyed transportation, water and communications systems. Mr. Mahdi estimates that the current unemployment rate in Iraq is 50 to 60 percent."

Now I believe the last paragraph conveys the depths to which the country has sunk, and in addition, the serious state of the economy.

It is hard to imagine an Iraqi economy or society successfully responding (above all if saddled with further debt in the form of a forced loan) to the sudden shock of transition to a utterly free market near libertarian economic system.

One need only imagine the political backlash in Iraq as the few Iraqi firms still operating, fitfully, collapse under a wave of imports, as unemployment persists at the stunning level of say 60 percent or more, and as their government dedicates its resources not to enabling them to live, but industrial reconstruction in the oil sector or debt payments that will be widely viewed as illegitimate and serving foreign interests. Is this a means of estabilishing a pro-American Iraq? I think not, it is a means of setting up failure, of handing a propaganda victory to the extremists Jihadis who claim a new colonialism is in the offing.

As the article says, "But even under better circumstances, ideology outweighs common sense in the current proposals. Free markets just will not be enough.

Infrastructure needs rebuilding. Law and constitutional authority must be established. Security is required to attract investment.

Mr. Mahdi argues that new capital is needed but so is a full-fledged equivalent of the Marshall Plan that rebuilt Europe after World War II. He would like to see a public works program established to produce jobs. As part of this, Iraq's international debt should be reduced as much as feasible.

Mr. Mahdi also says he believes that the food-rationing system must be maintained for now and phased out only slowly."

Quite right, and not a plan that involves forced loans.

Finally the closing is a compelling critique that merits restatement in full "The Iraqi Governing Council and its American supporters will be taken seriously when they present a balanced plan for growth that involves gradual evolution to a market economy that can attract foreign capital and create adequate, well-thought-out social programs. The current plan is supported neither by theory nor experience, only by the wishful ideological thinking of its advocates. Its consequences, as in Russia, could be widespread cruelty."

Now on this last I disagree, its consequences are likely to be collapse of the American project and the emergence of a radical state after a long guerilla war, or in the alternative, a client state even worse than Egypt.

October 02, 2003

Iraq: Economic Reforms Analysis, a long commentary [corrected formatting]

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