Shock Therapy For Iraq

The New York Times has a piece that severely criticizes the economic strategy for Iraq. It’s a typical anti-market piece that ignores the evidence that suggests that the CPA’s economic strategy is the single best way to rebuild the Iraqi economy.

…But 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 point is true, but unfortunately until the Iraqi economy is stable, there cannot be sufficiently stable Iraqi government to build an economy. It’s the classic chicken-and-egg problem. You can’t have democracy without economic stability, but the Times wants democracy first. In the end, such a strategy would quickly degenerate into autocracy and economic chaos – as the Times subsequent argument unintentionally proves:

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.

The argument that market strategies work overnight have never been seriously believed by anyone rational. However, they do work given enough time, as Russia is only now beginning to show. The Russian economy in the early 1990’s was beyond troubled; it was in shambles. There was no economy after more than seven decades of Communism which had reduced Russia and Eastern Europe into a state of near anarchy.

However, it was leaders like Arkady Gaidar and Anatoly Chubais that realized that there was no chance for Russia to have an “orderly” transition to the free market. The realized that the only way to deal with an economic crisis of that magnitude was to immediately create the foundation for a market economy and hold things together as best they could until conditions improved.

The lessons of Russia are clear: despite the massive turmoil of the first few years of a market economy, the situation stabilized. The Russian people rejected the former Communists led by Gennedy Zyuganov in the election of 1996 and re-elected Boris Yeltsin – mainly on the basis of the popularity of free-market reform. While Russia’s economy is still dealing with issues of transparency and corruption, Chubais and Gaidar’s reforms kept the Russian economy alive for long enough for Russia to begin to develop on its own. Realistically such a model would likely behave much the same in Iraq.

The Times also makes the predictable arguments that high taxes, high barriers to foreign investments, and high public spending are the only ways to create a market economy in Iraq.

Yet history has shown that those three factors are the last things that a developing country needs. While the Times criticizes economic shock therapy they ignore the lessons of Latin America where such policies have had great effect.

From 1993 to 1997 President Gonzalo Sanchez de Lozada engaged in a series of difficult economic reform measures in Bolivia. In the mid-1980’s the Bolivian economy was in shambled. Inflation was at a rate of 24,000% and was expected to reach an incredible 1,000,000%. Bolivia had an incredibly high rate of taxation, yet only 3% of government revenue came from taxation because so many people were simply not paying. Bolivia was being crushed under a sea of debt, exacerbated by massive and out-of-control public spending. The Bolivian economy was near collapse.

Then in August 1985 de Lozada implemented Decree 21060 – another economic measure passed in an undemocratic manner that was very similar to the CPA’s plan for Iraq.

Decree 21060 radically restructured the Bolivian economy. Price controls were eliminated. Tariffs were slashed, along with government spending. Bolivia’s 450 taxes were collapsed into only 7 and the marginal tax rates were radically reduced.

The effects of these changes between 1985 and 1987 were dramatic. The rate of inflation fell from 24,000% to only 9%. Tax revenues dramatically increased as more taxes were collected. The Bolivian economy stabilized and became vibrant once again. GDP and per-capita incomes went up. The Bolivian economy went from one of the worst in Latin America to far more stable than many of the other countries in the region. Bolivia worked with the IMF in 1987 to create a debt-reduction program that substantially reduced its foreign debt.

In both the cases of Russia and Bolivia, shock therapy worked. The complete destruction of the Russian economy made it a long and difficult problem, but Russia also endured 70 years of utter economic neglect.

Iraq is in a better situation as the US is footing much of the bill for reconstruction which takes the strain off the Iraqi economy. With a restored infrastructure, the CPA’s plans would ensure that tax revenues were actually collected rather than the lack of tax collection that comes from high tax rates in other developing nations. Iraq cannot be self-sufficient in terms of agriculture and manufacturing for some time, which is why low-priced imports are absolutely essential for quality of life in Iraq. Iraq also needs to have a system in which the central government cannot spend their way into even greater debt. Due to Iraq’s immense foreign debt there simply is not enough revenue to support massive public spending without later forcing painful and devastating austerity measures. Furthermore, public subsidies will only ensure that unemployment remains high, reducing the productivity of the Iraqi economy and endangering the Iraqi economy.

Despite the claims of the Times there is no shortcut to a market economy in a time of complete economic collapse. The model of shock therapy has already been applied and worked in Bolivia, Russia, Poland, the Czech Republic, Chile, Argentina, Japan, and elsewhere. In each case the results of these rapid economic transformations was an economy that was in far better condition afterwords than it was before.

The Times solution would only exacerbate the problems of the Iraqi economy by subsidizing lower productivity at government expense, keeping prices of consumer goods prohibitively high, and ensuring that government revenue from taxation would be low due to chronic problems with collection. Such a strategy simply doesn’t work, and would put Iraq into an economic tailspin. Given the importance of a free, democratic, and vibrant Iraq the costs of such an outcome would be too great to bear.