Download MIT Talk on Iraqi Economy - index

Constructing a New
Liberal Economy in Iraq


Robert Looney
Professor, National Security Affairs
Naval Postgraduate School
Politics of Reconstructing Iraq Seminar
MIT Center for International Studies
April 4, 2005
Outline – Economic
Transition in Iraq

Approach Taken to Market Transition in Iraq.
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Lessons from the Transition Countries.
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Current Obstacles to a Liberal Market Economy in Iraq.
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Possible Economic/Political Outcomes.
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Factors Affecting Alternative Scenarios.
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Critical Intangibles For the Future.
While Political Developments Will be Critical In Effecting the Likelihood of
a Liberal Market Economy in Iraq, the Focus Here Will be Mainly on the
Economic Reform Processes Likely Under Different Circumstances .
Difficulties in Evaluating Iraqi
Economic Policy and Performance

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Lack of Economic Data. Even before
2003 War, Very Little Basic Data on
Economy.
Lack of Objective Reporting – Many
Accounts Derived from Perception
Rather than Fact.
Lack of Reliable Surveys – Insurgency
Has Limited Field Work.
Transition to Liberal
Market Economy Implies:

Liberalizing Economic Activity, Prices and Market
Operations.
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Allocating Resources to their Most Efficient Use.
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Developing Indirect, Market-Oriented Instruments for
Macroeconomic Stabilization.
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Achieving Effective Enterprise Management and
Economic Efficiency, Usually Through Privatization.

Establishing Institutional and Legal Framework to
Secure Property Rights, Rule of Law, and Transparent
Market-Entry Regulations.
American Economic Objectives - Iraq

Controversial With Numerous Interpretations.

Conventional U.S. View – Create a Modern Democratic State With a
Liberal Market Economy – Assist in War on Terrorism.
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Create An Example for the Region of a Successful, Liberal, Democratic
Country .
Prevent the Economy and Country from Reverting Back to an Unstable,
State-Dominated Nation.
Provide the Environment for a Stable, Secure Source of Oil.
Alternative Views – Various – Just After the Oil, Captive Markets for
U.S. Multinationals – Modern Imperialism.
Actions Taken Suggest A Naïve Version of the Conventional View – An
Attempt to Replicate the Chilean Experience in the mid-1970s and
Several of the Successful Transition Countries.
Goal is Improved Economic Freedom Along with Democracy
Lessons From
The Transition Countries

Sustained Macroeconomic Stabilization is Essential.

Delayed Reforms Risk Negative Growth.

No One Component To Reform Stands Out – Need To
Implement All Components.

Unfavorable Initial Conditions Can Be Offset Through
Correct Reforms.

Most Jobs Created by Small-Medium Scale New Firms.
Transition Lessons (contd.)

Improving Investment Climate Critical for Creation of New
Firms.
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Development of a Legal Framework Critical.
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If Country Puts off Implementing Rule of Law, Enforcing
Discipline, Securing Property Rights, then other Reforms Are
Unlikely to Produce Significant Benefits.
Successful Transition Countries Create Groups That Have a
High Stake in Pressing for Further and Deeper Reforms Over
Time.
U.S. Policymakers Apparently Thought that Transition Success
Stemmed Mainly From an Application of Washington
Consensus Reforms.
Washington Consensus in Iraq

Fiscal Discipline – Limit Budget Deficits.
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Public Expenditure Priorities – Redirect Expenditure Toward
Human Capital and Infrastructure.
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Tax Reform – Broaden Tax Base and Cut Marginal Tax Rates.
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Financial Liberalization – Abolish Interest Rate Controls.

Exchange Rates – Introduce Unified and Competitive
Exchange Rate.
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Trade Liberalization – Replace Quantitative Restrictions by
Tariffs then Reduce Tariffs Over Time.
Washington Consensus (contd.)

Foreign Direct Investment – Encourage Increased
International Capital Flows.
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Privatization – Privatize State Enterprises.
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Deregulation – Regulate only Safety, Environment, and
Financial Sectors.
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Property Rights – Introduce Secure Enforcement at Low
Cost.

To Date Only Limited Progress Has Been Made – Mainly
in the Neoliberal Core of Reforms.
Neoliberal Reforms in Iraq
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Neoliberal Reforms in Iraq Oriented Towards Stimulating
Investment and Creating a New Economy.
Investors (except oil production and refining) allowed 100%
ownership of Iraqi Assets, Full Repatriation of Profits and Equal
Legal Standing With Local Firms. Foreign Banks May Establish
New Operations or Purchase Equity Shares in Existing Iraqi
Banks.
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Income and Corporate Taxes Capped at 15%.
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Tariffs Reduced to Universal 5% With None on Food, Drugs, and
Other Humanitarian Imports.
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Independent Central Bank Created.
Neoliberal Reforms (contd.)
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State Owned Enterprises to be Privatized, No Timeframe
or Method Specified.
Text-Book Application of Reforms – Belief in Advantages
of Shock Therapy -- Little or No Consultation With or
Input From Iraqis on Design or implementation of
Reforms.
Main Problem – Status of Reforms in Future
Governments Not Clear – Imposed by Occupying Power,
but May Be Overturned or Significantly Modified by an
Elected Iraqi Government – Effect Has been to Create
More Investor Uncertainty on top of the Insurgency.
Neoliberal Reforms (contd.)
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Adequate Foundation Not Laid To Take
Advantage of Reforms Strengths.
Reforms Stalled, Incomplete – Limited
Benefits and Numerous Dislocations.
Because of Initial Failure, Now Have to
Face Many More Severe Obstacles than
in Initial Pre-War Period.
Impediments to
Liberal Market Development
1.
2.
3.
4.
5.
6.
7.
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Corruption.
Insurgency.
Deterioration of Social Capital.
Rentier State—Resource Curse Effects.
Large and Growing Informal Economy.
Macroeconomic Instability.
Opposition to Further Reforms.
All are Interrelated to Some Extent With
Corruption the Common Element.
(1) Corruption in Iraq
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Long History in Iraq – Diversionary State Under Saddam When
Corruption Became Institutionalized.
In Transparency International’s Corruption Index For 2004
Iraq Was the Most Corrupt Country in the Middle East, Ranking
129th down from 113th in 2003.
Economic Impacts of Corruption in Iraq:
Undermines Market System – Limits Government
Effectiveness.
Distorts Incentives – Encourages Rent Seeking.
Creates Inefficient Industries – Protection From Competition.
Creates Arbitrary and Uncertain Tax – Wasted Time.
Weakens Financial System – Cash Economy.
Creates Perverse Public Sector Priorities – Big Project Bias.
(2) Insurgency Economy
Black M arket
Arbitrage
Reduced
Gov ernment
Financial
Resources
Low Formal
Sector Job
Creation
Relat iv e
Expansion
of the
Shadow,
Informal
Economy
Retarded
M odern
Agricult ural
Dev elopment
Kidnapping,
Crime,
Violence
Lost
Entrepreneurial,
Professional
Class
Limit ed New
Indust ry
Hawala
Financial
Transactions
Retarded
Dev elopment
of a M odern
Financial
System
(3) Social Capital in Iraq
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Social Capital Represents Networks of
Relationships that Bind People Together—
Deteriorated Significantly Under Saddam.
Trust a Key Element of Social Capital. In Iraq
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Ascribed Trust – Kinship Groups and Family
Members.
Process Based Trust – Individuals That Have Known
Each Other for Some Time – Key Element in Business
Networks
Extended Trust – Transactions Between Individuals
With Only Limited Information About Counterparts
Attributes.
(3) Social Capital in Iraq (contd.)
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In Iraq Today, Most Networks Ascribed Trust,
With Some Process Based and Fewer Extended
– Extended Critical for Liberal Market
Development.
May Explain Some of the Problems
Encountered by the Neoliberal Reforms
– Lack of Response to Price Movements
– Limited Growth of Markets and Exchange
– Regional, Local Market Development Rather
than National.
(4) Rentier State Effects
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Expectation that Favorable Natural Endowments Would
Lead to Growth has been Disappointed.
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Many Economies Have Become Progressively More
Reliant on Natural Resources.
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Several Countries Have been Able to Avoid the
“Resource Curse” Indonesia 1970s
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Resource Curse Stems from Combination of 4 Factors
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“Dutch Disease.”
High Volatility of Commodity Prices.
Inefficient Specialization.
Rent-Seeking.
(5) Informal Economy
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At End of Saddam Hussein’s Regime Accounted for About 35% of GDP
and 68% of the Labor Force.
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Currently Accounts for About 65% of GDP and 80% of the Labor
Force.
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Statistically Corruption and Protection From Trade Main Determinants
of Informal Economies in the MENA Region.
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Demographic Bulge Also a Prime Determinant.
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Black Markets/Illegal Activities Impede Liberal Market Economy – No
Tax Base, Weakens Fiscal Policy, Macroeconomic Stabilization.
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Will Require Specific Policies/Reforms if Sector to be Incorporated
into Formal Market Economy – Free Markets and Growth Alone
Unlikely to Integrate the Economy .
(6) Macroeconomic Stabilization
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Main Difficulties:
Cash Economy – Difficult to Control Money Supply.
Beginning to Develop a Government Bond Market.
Interest Rates Have Been Allowed to Fluctuate.
Exchange Rate Floats, But Has Been Relatively Stable –
Perhaps Overvalued.
Concerns: Inflation Rising, Possible Bubble in Real Estate,
Existing Monetary Tools May Be Ineffective at Stopping
Inflation.
Flexible Exchange Rate Makes Sense With Large External
Sector—However Means Monetary Policy Assigned to Domestic
Stabilization – May not be up to the Task.
(7) Opposition to Further Reforms
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A Number of Groups are Likely to Oppose Further Reforms at
this Time:
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Workers in State Enterprises—Fear Job Loss.
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Many Farmers Insecure Over New Market Arrangements.
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Former Ba’thists Who See Reforms as New Imperialism –
Forcing Abandonment of Nationalist Goals.
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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.
Opposition to Further Reforms (contd.).
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Entrepreneurs Who Fear Foreign Competition.
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Speculators, Corrupt Officials Profiting From Black Market
Arbitrage on Administered Priced Goods.
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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 Great Success
by the Transition Countries as a Sign of Their New
Independence are Seen by Iraqis as Products of the Country’s
Occupation.
Religious Elements Who See Reforms as Part of War on Islam.
The Future: Alternative Courses
Obstacles to Liberal Market Can Be
Overcome Under Certain Mixes of:
 Economic/Institutional Reforms.
 Political Environment.
 Level of Insurgency.
 Oil Production.
 Macroeconomic Stability.
Key Empirical Linkages
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MENA Informal Economies f (Trade Policy, Corruption,
Rule of Law)
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Neoliberal Reforms Reduce Political Corruption –
Gerring and Thacker
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Growth f (macroeconomic Stability) – Barro
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Growth f (financial development) – Levine
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Growth f (trade openness) – Barro
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Growth f (political stability) -- Barro
Rentier State Political Systems
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Likely Systems:
Factional Democracy – Venezuelan
Model
Reformist Autocracy – Indonesia 1970s
Pragmatic Theocracy – Iran/Baathist
Basic Model Likely to Be Modified to
Iraqi Conditions and Political Realities.
Rentier State Political Systems (contd.)
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Unlikely Systems:
Traditional Theocracy – Iran
Predatory Autocracy – Ba’thist
Model
Mature Democracy – Norway
Paternalistic Autocracy – Saudi
Arabian Model
Market/Political
Variants Possible in Iraq
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Virtuous Circle – Liberal Market Economy
Leading to Stronger Democratic Institutions –
Chile With Oil.
Muddle Through – Mixed Economy – Nigeria of
the Middle East
Pragmatic Theocracy – State Dominated –
Iranian/Ba’athist Mix Secular Nationalist With
Strong Islamic Influence.
Vicious Circle – Diversionary State – Eventual
Collapse -- Yugoslavia With Oil.
Virtuous Circle of Reform, Growth
and Liberal Market Development
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Infrastructure Led Public Investment – Begin Rapid Growth to
Overcome Development Impediments.
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Complete Neoliberal Price Reforms – Block Incentives for
Shadow Economy – Make Official Corruption More Difficult.
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Insurgency Lessens With Economic Progress.
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Second Stage Washington Consensus Reforms – Institutional
Development – Foundation for Private Sector.
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Dual Track Development Strategy – Comparative Advantage
and Informal Economy – Focus on Creation of New SmallMedium Scale Enterprises.
Virtuous Circle (contd.)
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Improved Macroeconomic Stability – Market Based
Financial Instruments Developed – CBI Gains Better
Control of Monetary Policy.
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Informal Economy Focused Credit – New Small-Scale
Firm Creation.
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Oil Fund for Public Distribution – Helps Develop
Expanding Domestic Markets.
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New Firms, Workers and Large Segments of the
Population Have Stake in Moving the Reform Process
Ahead.
Virtuous Circle of Growth
and Liberal Market Development
Development
Strategies/
Policies
Expanded
Number of
SMEs
Increased
Entrepreneurship
Infrastructure
Led
Development
Dual Track
Development
Expanded
Supply -Growth of
the
Economy
Reduced
Corruption
Neoliberal
FDI
ReformsFree Trade
Informal
Economy
Focused
Credit
Oil Fund for
Public
Distribution
Expanded
Public
Expenditures
Education/
Health
Pressures for
Further
NeoliberalInstitutional
Reforms
Development
Extended
Trust
Networks
Expanded
Demand -Domestic
Market
SecondStage
Washington
Consensus
Reforms
Reduced
MarketBased
Corruption
Phase out
Subsidies,
food, oil,
electricity
Muddle Through
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Insurgency Does Not Lessen Significantly.
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Oil Revenues Pick Up, But Not Significantly.
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Factional Democracy Largely Stalemated on Key Reforms,
Development Strategy.
Moderate Macroeconomic Instability – Inflation.
Unemployment Gradually Reduced Through Public Works Programs,
Expanded Bureaucracy Rather Than Dynamic Private Sector.
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Significant Regional Economic Differences Persist.
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Corruption Pervasive.
Economy Can Never Build up Enough Momentum to Offset Forces
Impeding Liberal Market Development. Window For Reforms Missed.
Pragmatic Theocracy Model
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Nationalistic – Insurgency Co-opted.
Goal of Rapid Reduction of Unemployment At Possible
Expense of Growth.
Partial Integration into Global Economy – Import
Substitution Development Strategy.
Selective and Limited Foreign Investment.
Islamic Financial System.
Protection of Islamic/Iraqi Cultural Identity.
Reduction in Poverty At Possible Expense of Growth.
Large State Role in Production and Distribution – Food
Voucher, Gas, Electricity Subsidies Maintained.
Vicious Circle of Stagnation
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Unemployment Remains High.
Informal Economy Continues Growing.
Crime, Shadow Economy Expand.
Insurgency Increases.
Neoliberal Reforms Repealed/Watered Down.
Macroeconomic Instability – High Inflation.
Vested Interests Compete for Oil Rents.
Reforms Blocked by Vested Interests.
Surge of New Entrants to Labor Force Expand
Unemployed.
Insurgency Continues – Investment Low – Growth
Stagnates.
Possible Civil/Resource War.
Vicious Circle
Insurgency
Neutralizing
Positive
Aspects of
Neoliberal
Economic
Reforms
Large
Shadow
Economy,
Created to
Fund
Insurgency
Vested
Interest in
status-quo
Inefficient
Administered
Price System
High
Unemployment
Low
Productivity,
Dualistic
Economic
System
Difficult to
Integrate
Large and
Growing
Informal
Economy
Massive Oil Based
Expenditures
Easily
Diverted,
Patronage
Relationships
Facilitated
Current
Ethnic-Tribal
Frictions
Limit
Extended
Market
Networks
Lack of
Trust SelfContained
Market
Networks
Outside
Formal
Economy
Lack of
Legal
Protection,
Property
Rights Make
Activities
Hard to
Grow to
Formal
Economy
Status
Abundant Oil
Revenues
Take
Pressure off
of
Government
to Proceed
with Reforms
with shortrun costs
Key Assumptions:
Iraq Market Outcomes
Insurgency
Insurgency
Lessens
20%
Insurgency
Stabilizes
60%
Insurgency
Worsens
20%
Oil
Production
2.8-30
million
b/day 30%
2.2 -2.8
million
b/day 50%
< 2.2 million
b/d 20%
Macroeconomic
Stability
Fairly Stable
Inflation
>15%
Moderately
Stable
Inflation
15-30%
Unstable
Inflation >
30%
Corruption
Declines
10%
Stabilizes
60%
Increases
30%
Liberal
Market
Outcomes
(most
probable
path)
Liberal
Market
Outcomes
(most
favorable
path)
Liberal
Market
Outcomes
(most
unfavorable
path)
Virtuous
Circle
10%
Virtuous
Circle
45%
Virtuous
Circle
0%
Muddle
Through
50%
Muddle
Through
30%
Muddle
Through
40%
Pragmatic
Theocracy
30%
Vicious
Circle
10%
Pragmatic
Theocracy
20%
Vicious
Circle
5%
Pragmatic
Theocracy
45%
Vicious
Circle
15%
Critical Intangibles
What are the Critical Intangibles Likely To Influence Iraq’s Future
Economy?

Economic Progress Made Without Significant Reduction in Corruption.

Extent of U.S./IMF Leverage over Iraqi Policy.
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Speed and Extent to Which Trust Can be Restored.
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Ability of the Financial System to Play a Significant Role in Private
Sector Investment.
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The Extent to Which Religious Influences Are Likely Mold The
Country’s Economic Institutions – Will The Result Make Movement to
a Liberal Market Economy More Difficult?
Effectiveness of USAID/NGO Small-Scale Social Capital Projects at
Local Level.
Critical Intangibles (contd.)

The Extent to Which an Elected Iraqi Government is Committed to the
CPA Approach to Reforms – Is Able to Assure Investors of the
Government’s Commitment to Free Markets, Rule of Law and Property
Rights Before Significant Progress is Actually Made in these Areas.

Willingness of Iraqis to Adopt a Pragmatic Approach Towards
Privatization.
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Ability of the Iraqis to Achieve Political Stability.
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The Manner in Which Oil Revenues are Managed.
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The Degree and Extent to Which Average Iraqis View Free Markets as
a Opportunity to Create a Better Standard of Living rather than a
Threat Imposed by Outside Interests.
Most Importantly, Has Iraq Missed the Window for Initiating
Significant Market Liberalizing Reforms?
Contrasting Views
of The Liberal Market
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“If I Am Permitted to Dream, Iraq Will Develop into the
Japan of the Middle East.” Talib al-Tabatie, Chairman,
Iraq Stock Exchange
“The Best Thing is to Overhaul the Whole Financial
System. It’s Like When You Have A House Infested with
Termites. It’s Much Easier to Knock it Down and Rebuild
Than to Keep Spraying for Termites and Fixing the
Holes.” Rubar Sandi, Head U.S.-Iraq Business Council.
“We Want to Go Back to the Old Healthy Management of
the 1970s.: Thamir Ghadhban – Oil Minister, Iraqi
Interim Government
Contrasting Views (contd.)
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“..the Lack of Law and Order is Bound to Delay the
Country’s Economic Rebirth. Yet Without that Rebirth,
the Country Will Remain Sullen, Resentful and a
Breeding Ground for all Sorts of Undesirable
Developments. It is a Vicious Circle.” –Al-Jazeerah
“It Seems that Many Iraqis do not Understand…why a
Market Economy Can Make the Poor People Much Better
off Than They Ever Were When Saddam Controlled the
Oil Wealth and Doled out Perks to the Iraqis Like a Stern
Parent Rewards Small Children for Being Seen and Not
Heard.” Ronald Rotunda – George Mason University
Foundation Professor of Law.
For Further Reading
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Presentation Draws on the Following:
Robert Looney, “Iraq’s Economic Transition: The Neoliberal
Model and its Role,” The Middle East Journal, Autumn, 2003.
Robert Looney, “The Viability of Iraq’s Shock Therapy,”
Challenge, September-October 2004.
Robert Looney, “A Return to Ba’thist Economics?” Orient,
September 2004.
Robert Looney, “Iraq as a Transition Economy,” The Milkin
Institute Review, Fourth Quarter 2004
Robert Looney, “Postwar Iraq’s Financial System,” Middle East
Policy, Spring 2005.
Robert Looney, “Corruption’s Reflection: Iraq’s Shadow
Economy,” Strategic Insights, March 2005.