The Economic Consequences of Iraq’s Draft Constitution

Robert LooneyProfessor, National Security AffairsNaval Postgraduate School

Colloquium on Iraq’s Constitutional Process Woodrow Wilson International Center for Scholars

Washington, DC, October 3, 2005

Evaluating the Draft Constitution

Iraq’s 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 Country’s Main Regions? Lay the Economic Foundation for a Stable Federation?

Will it’s 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?

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.

Current Economic ProblemsVery 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.

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 Iraq’s 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 People’s Collective Instrument for Achieving Development.

Legitimizes the Controversial Neo-Liberal Washington Consensus Reform Program Initiated by the Coalition Provisional Government (CPA) in 2003.

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.

Assessment of the Draft Constitution’s 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.

Iraqi Opposition To Draft Constitution’s 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 Country’s Occupation – Has Helped Extremist Group’s Credibility.

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?

Issues Surrounding Iraq’s Oiland the Maintenance of Rentier

StateOil 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 State—Conflicts 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.

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 (Region’s) 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 Iraq’s 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.

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 Country’s 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 Country’s Fiscal Expenditures?

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.

Lessons From NigeriaCentral 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.

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 Constitution’s 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 Region’s Economic System at the Expense of the Other Region’s Economies Thus Creating Additional Frictions.

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.

Possible SolutionsPossible 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.

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 Fund—Immediate 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 Programs—Many 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.

Summary -- Iraq: Key Constitutional – Economic Linkages

Efficiency vs. Diversionary

Islamic Content

Oil Revenue Assignment

Neo-LiberalEconomic System

Security vs. Efficiency

National vs Regional

Emphasis on Economic

Stabilization,Development

Strategy

Short vs Long TermPolicy

Orientation

Economic Outcomes

Markets

Constitutional Rules

Political Outcomes

Policy Preferences

Policy Decisions

Corruption

Rentier StateEffects

Shiite ReligiousConcerns

Kurdish/Shiite

Political Strength--

Oil Geography

United States- IMF

Financial Assistance/Debt Relief

Insurgency

Dynamics-Vicious Circles

and Collapse of Federal System

vs. Virtuous Circles and the Strengthening

of the Federation

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?

Likely OutcomesIn 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:

1. Assist in Stabilizing and Reviving the Economy? – Unlikely.2. Create Tensions Between Main Regions? – Probably.3. Contribute to Growth and Stability of Oil Sector? –

Unlikely.4. Encourage Regional Competition over Resources? – Likely.5. Reduce Uncertainty for Private Investors? – No. 6. Lay a Foundation for a Stable Federation – Unlikely.