The Economic Consequences of Iraqs Draft Constitution

1
The Economic Consequences of Iraqs Draft
Constitution

• Robert Looney
• Professor, National Security Affairs
• Naval Postgraduate School
• Colloquium on Iraqs Constitutional Process
• Woodrow Wilson International Center for Scholars
• Washington, DC, October 3, 2005

2
Evaluating the Draft Constitution

• Iraqs Draft constitution should be evaluated on
  two standards Its substance in the areas of
  democracy, human rights and proposed political
  structure and its potential to be a national
  compact that brings Iraqis together and
  undermines the insurgency. It meets the first
  test. With respect to the second, the jury will
  decide in the October 15 referendum. U.S.
  Ambassador Zalmay Khalilzad
• Also Important to Evaluate the Draft Constitution
  from An Economic Prospective
• Will it Assist in Stabilizing and Reviving the
  Economy? Or Will it Undermine the Economy Through
  Creating Internal Conflicts over Resources and
  Tensions Between the Countrys Main Regions? Lay
  the Economic Foundation for a Stable Federation?
• Will its Main Economic Provisions Contribute to
  Long-Run Stability and Expansion of the Oil
  Sector? The Private Sector? Or, Will it Create
  More Uncertainty for Both?

3
Outline

• Current State of The Economy Main Problems.
• Economic Focus of the Draft Constitution.
• Ability to Deal with Current Economic Crisis.
• Potential Conflicts Between Regions Over
  Preferred Economic System.
• Treatment of Oil Methods of Assigning Revenues.
• Draft Constitution Formulas.
• Potential Problems.
• Lessons From Other Countries.
• General Assessment.
• Probable Linkages to Economy-Economic
  Performance.
• Possible Alternative Constructs.
• Summary Main Conclusions- Critical Unknowns.

4
Current Economic Problems

• Very Mixed Picture Since April 2003 -- Some
  Recovery But
• Unemployment Stabilized at 30-40 -- Possibly
  Higher.
• Unstable/Unreliable Supply Electricity, Fuel,
  Water.
• 95 Government Income Comes from Oil.
• Government Employs 50 Formal Labor Not
  Sustainable.
• Many Households With Lower Incomes than 1980.
• Great Deterioration in Social Capital, Loss of
  Trust Corruption Rate Highest in the Middle
  East.
• High Crime Rate Massive Capital Flight, Brain
  Drain .
• Shadow Economy Increased to 65 GDP, 80 Labor
  Force.

5
Economic Orientation of the Draft Constitution

• Article 25 The State Shall Guarantee the
  Reforming of the Iraqi Economy According to
  Modern Economic Bases, in a Way that Ensures
  Complement of Its Resources, Diversifying its
  Sources and Encouraging the Development of the
  Private Sector.
• Appears to Move Away From A Form of Welfare State
  Proposed in Earlier Drafts Where Social Justice
  is the Basis of Building Society.
• All of Iraqs Natural Resources Would be Owned
  Collectively by the Iraqi People.
• The State Would be Legally Bound to Provide
  Employment Opportunities for Everyone.
• The State Would Be the Iraqi Peoples Collective
  Instrument for Achieving Development.
• Legitimizes the Controversial Neo-Liberal
  Washington Consensus Reform Program Initiated by
  the Coalition Provisional Government (CPA) in
  2003.

6
Draft Constitution's Implicit Economic Framework

• Based Largely on Transition Economy (Shock
  Therapy).
• Extreme Version of Neoliberal Reform Package.
• Open Economy, Low Taxes, Economy Open to Foreign
  Private Investment.
• Intent to Wipe Slate Clean and Start New Economy.
• Macroeconomic Stability Independent Central Bank
  But Government Largely Passive in Dealing With
  Economy.
• Strategy Intended to Have High Job Creation
  Through Rapid Private Sector Investment and
  Expanded Output, FDI a Key Ingredient.
• Assumes Numerous Profitable Opportunities Created
  by Imbalances Associated With Massive
  Reconstruction Projects.

7
Assessment of the Draft Constitutions Implied
Economic Agenda

• While Sound in Many Regards, The Draft
  Constriction's Implied Economic Agenda is Not
  Best Suited for Iraqi Conditions
• Precludes Large Number of Iraqis from Economic
  Process Lack of Skills, Capital.
• Uncertainty Too Great for Private Investors.
• Approach Not Flexible Enough to Adapt to Shocks
  or Adverse Developments Government Not
  Responsive To Obvious Needs.
• Less Extreme Programs in More Favorable Settings
  Have Resulted in Disappointing Results
  Central/Eastern Europe/Latin America.
• Inability to Produce Short-Run Economic Gains
  Likely to Make Economic Approach Easy Target for
  Extremist Groups Imperialism. Little Popular
  Support Among Iraqis.

8
Iraqi Opposition To Draft Constitutions
Economic Framework

• Influential Intellectuals Who View Neoliberal
  Reforms as Extreme and Detrimental to Economy at
  this Time Point to Failures of Similar Reforms
  in Other Countries Cite Credible Alternatives.
• Entrepreneurs Who Fear Foreign Competition.
  Speculators, Corrupt Officials Profiting From
  Black Market Arbitrage on Administered Priced
  Goods.
• Religious Leaders Who See Reforms as Part of War
  on Islam.
• Problem Outside of a Few Technocrats and
  Merchants, Little Popular or Influential Support
  for Reforms Neoliberal Reforms Seen as Imposed
  With No Input From Iraqis.
• The Same Reforms that were Implemented With Some
  Success by the Transition Countries as a Sign of
  Their New Independence are Seen by Iraqis as
  Products of the Countrys Occupation Has Helped
  Extremist Groups Credibility.

9
Economic Reforms and Federalism

• Economics of Draft Constitution Assumes a Limited
  Involvement of the Central Government Markets
  Left To Play Key Role in Reviving Economy.
• Theoretically Federalism Should Encourage Market
  Development, Efficiency and Allow Individual
  Preferences Political and Economic to Prevail
  at the Local Level.
• Little Popular Support and Make-up of Iraq May
  Thwart These Forces. Weak Central Government May
  Not Be Able to Combat Development of Competing
  Economic Systems
• Elements of Islamic System in the Shiite Areas.
• State Intervention in the Sunni Areas
• Relatively Free Markets, Foreign Investment
  Friendly Kurdish Areas.
• Can These Three Competing Systems Coexist or Will
  the Situation be Unstable With One or Two of the
  Systems at a Distinct Disadvantage?

10
Issues Surrounding Iraqs Oiland the Maintenance
of Rentier State

• Oil is an Additional Complicating Factor. How
  Will The Draft Constitution Affect These Common
  Rentier State Problems?
• Oil Rents Usually Result in the Development of an
  Distributive State as Opposed to a Production
  StateConflicts over the Access to and Control of
  Oil Rents.
• Concentration of Oil Rents Reduces State Need to
  Extract Money From Society Gain Citizen Support
  In Return for Redistributing Oil Rents
  Substitution of Political Rights by State
  Provided Welfare.
• Lack of Rigorous Tax System Impedes Emergence of
  a Strong State that Legitimately Represents its
  Citizens.
• Oil Revenues Encourage Patrimonial Loyalties as
  Opposed to Participatory Democracy.
• Associated Corruption Undermines Economic
  Efficiency and State Formation.

11
Draft Constitution and Oil

• While Article 109 States that Oil and Gas
  Reserves Belong to the Entire Iraqi People,
  Article 110 Greatly Limits the Role of the
  Federal Government in Managing these Resources.
• Article 110 Clarifies that Revenue Sharing Will
  Be Based on Needs as well as Demography
  Reflecting the Region's Duties and Obligations,
  and Taking Into Consideration the (Regions)
  Resources and Needs
• Also a Compensation Factor For Regions that Lost
  Under Saddam. Suggests Sunni Areas Could be
  Disadvantaged for Some Time. Exact Formula for
  Revenue Sharing Will be Shaped by Iraqs National
  Parliament.
• Kurds Had Originally Proposed Formula With
  Revenues Shared Between Center and Region 30
  To Federal Government, 5 to Producing
  Governorate and 65 to Region Where Oil Is
  located.

12
Draft Constitution and Oil (contd).

• Oil and Gas Wealth are to Be Developed in a Way
  That Ensures the Best Benefit to the People
  Using the Latest Market Principles and Promotes
  Investments.
• However by Dropping Phrase Collectively Owned
  Opens Way for Privatization of Iraqi National Oil
  Company and to Open Countrys Reserves to Foreign
  Investors.
• Federal Government along With Regional
  Governments and Producing Governorates to Jointly
  Manage Oil and Gas in Current Producing Fields.
• Creates Great Uncertainty Areas of Authority
  Not Defined Open to Interpretation. Role of
  Federal Government in Oil Matters May Be
  Marginalized.
• Other Issue Is Stabilization Policy How Will
  The Central Government be Able to Pursue
  Macroeconomic Stabilization if The Regions
  Control Most of the Countrys Fiscal
  Expenditures?

13
Major Issues

• Draft Constitution Article 111-- Regions Have
  Right to Exercise Legislative, Executive and
  Legal Power.
• If a Dispute Arises with Federal Government, The
  Laws of the Region Take Precedence
• By Limiting Joint Management of Federal
  Government and Regions to Currently Producing
  Fields, Draft Constitution Excludes Fields not in
  Production and Fields to Be Discovered. However,
  Does Not Say who will Manage Them.
• Same Problems for Revenue Assignment From
  Non-Producing Fields and New Fields Producing at
  a Later Date. Draft Can be Interpreted as License
  for Producing Regions to Benefit Exclusively.
  Most of the Discovered But Not Developed Fields
  Lie in the Shiite Regions of Southern Iraq.
• In Sum, Although There Were Other Options
  Available, The Draft Constitution Creates
  Potentially Serious Problems for Economic
  Stabilization and Regional Income Distribution.

14
Lessons From Nigeria

• Central Government Weakness in Federal Nigeria,
  Remnant of Colonial Era Has Led to Economic
  Instability
• Attempt by Groups to Encourage Further
  Centralization or Decentralization to Gain
  Personal of Group Based Benefits Further
  Decentralization Has Predominated. But Attempts
  to Reverse Decentralization Have Led to Increased
  Force.
• Main Difficulty Central Government is The
  Enforcement of Appropriate Distribution of Oil
  Revenues From Oil Regions to Central Govt.
  Regional Governors Often Ignore Court Orders for
  Splitting Oil Revenues.
• By Diffusing Power Across Several Layers of
  Government, Set Up Conflicting Claims of
  Jurisdiction and Legitimacy Often Making it
  Difficult to Achieve Policy Goals-Attract
  Investment.
• Without Strong Central State, Incentives and
  Opportunities for Kurds and Shiites to Act Like
  The Oil States of Nigeria Will Be High Problem
  When Federation Forced Rather Than Developed.

15
Assessment Potential Problems

• The Economic Sections Are Consistent With U.S.
  Goals and Objectives as Well As IMF Standard
  Guidelines, but Will Find Limited Support in the
  Sunni and Shiite Regions.
• As Written Draft Constitutions Sections On Oil
  Appear to Satisfy Kurdish and Shiite Concerns and
  Needs, but Not Those of The Sunnis. Furthermore
  The Constitution Leaves Open the Possibility of
  Abuse of Economic Power By the Kurds and Shiites.
  Lack of Clarity Also Conducive to Corruption.
• The Likely Regional Assignment of Oil Revenues
  Will Make Make Macroeconomic Stabilization
  Extremely Difficult The Resulting Instability
  Inflation, Erratic Movement in Exchange Rates May
  Undermine the Ability of the Neoliberal Economic
  System to Bring Prosperity to the Country.
• How this Will Be Resolved is Unclear With
  Completion Possibly Favoring One Regions
  Economic System at the Expense of the Other
  Regions Economies Thus Creating Additional
  Frictions.

16
Assessment Viability of Federation

• Federalism Predicated on Meeting Two, Seemingly
  Irreconcilable Goals
• Seeks to Unify Diverse, Often Hostile Localities
  Under a Single National Banner.
• Allow Considerable Authority to Remain at the
  Local Level.
• Unless It is Structured skillfully, Any Federal
  System Will Find it Difficult to Maintain An
  Appropriate Balance Between Local and Central
  Power.
• Tentatively, Must Conclude That as Written The
  Economic Sections of The Draft Constitution Will
  Create An Environment In Which It Will Be Very
  Difficult If Not Impossible to Maintain This
  Balance.
• With Oil Revenue Assignment Shifting More Toward
  The Producing Regions, Their Ability and Perhaps
  Willingness To Pursue Independent Policies Will
  Increase With Time.

17
Possible Solutions

• Possible Solutions to Minimize Risk And Achieve
  Broader Based Political Support If Draft
  Constitution Approved
• Privatize Oil So It Is Owned by Separate Entity
  Not People Who Live Over It.
• New Ownership Better Able to Finance Needed
  Modernization and Infrastructure in Oil Sector.
• To Be Politically Attractive, Might Consider
  Setting Up Alaska Type Fund So Citizens Can Begin
  to Receive Immediate Benefits.
• Centralize Oil Revenues to Better Stabilize
  Economy, While Dealing With Regional
  Inequalities.
• Whatever Done it is Critical That Citizens Have a
  Direct Stake in Success of The Economy and That
  Government Official are Accountable and
  Constrained Through Transparency Requirements
  From Corruption or Wasteful Use of Oil Rents.

18
Critical Variable Avoidance of Rentier State

• Critical Variable in Analysis of Economy is the
  Rentier State Draft Constitution May Create
  Incentives for Bad Aspects to Prevail Regional
  Competition Over Rents, Broadly Perceived
  Inequities in Allocation, Revenue Instability.
• Alternative Direct Distribution FundImmediate
  Distribution of 25 Oil Revenues to All Citizens
  -- Rapidly Creates A Middle Class With State in
  Success of Federation. Transparency Clauses Help
  Control and Reduce Corruption.
• Gives Sunnis An Alternative to Improve their
  Situation Rather Than Trying to Wrest Control
  Over Resources.
• Allows Central Government to Phase out Corruption
  Plagued Subsidy ProgramsMany of Which Have
  Assisted the Funding of the Insurgents Through
  Smuggling and Shadow Economy.
• Since Dividend a Function of Oil Production,
  Pressure on Insurgents to Cease Attacks on Oil
  Production and Distribution System May Greatly
  Reduce Popular Support for Insurgency.

19
Summary -- Iraq Key Constitutional Economic
Linkages
20
Critical Unknowns

• Likely The Kurdish Regions will Likely Thrive
  Under A Wide Range of Possible Environments.
• Will This Success Assist or Undermine Development
  in the other Regions?
• The Federation?
• Critical Unknowns
• How Will the Draft Constitution Affect the Manner
  In Which The Rentier State Evolves? Many Have
  Become Authoritarian.
• Does The Draft Constitution Make Corruption Less
  Likely? Provide Motivation for Continuing the
  Insurgency? Will it Provide Incentive for
  Resource Wars as in Much of Africa?
• Will These Forces Culminate in a Virtuous Circle
  of Democracy and Success? Or Will They Set in
  Motion a Vicious Circle of Conflict and Failure?

21
Likely Outcomes

• In Assessing the Draft Constitution, One is
  Immediately Struck By the Realization that We
  Know Very Little About the Set of Forces that
  Will be Unleashed if it is Passed. Many of These
  are Identified in the Previous Diagram.
• While The Constitution Leaves Much To Be Decided
  By Future National Assemblies, In Terms of the
  Questions Posed Earlier, Some Tentative
  Conclusions. Will the Draft Constitution
• Assist in Stabilizing and Reviving the Economy?
  Unlikely.
• Create Tensions Between Main Regions?
  Probably.
• Contribute to Growth and Stability of Oil Sector?
  Unlikely.
• Encourage Regional Competition over Resources?
  Likely.
• Reduce Uncertainty for Private Investors? No.
• Lay a Foundation for a Stable Federation
  Unlikely.