Building a durable market democracy in Iraq

Raghuram Rajan, and Luigi Zingales, Project Syndicate

One goal of the recent war in Iraq was to build a lasting market democracy that could serve as an example for the Middle East. While progress towards this goal has been stymied by the mundane practicalities of restoring law and order, the coalition must eventually take it up. When it does, it will also have to face the fact that the current distribution of economic power in Iraq is not conducive to democracy or markets, and that outside interim administrations tend to make matters worse.

Start first with the distribution of economic power. Years of dictatorship and sanctions decimated Iraq's business and professional classes. Estimates suggest that over 60 percent of Iraqis depend for their income on government, which will obtain the bulk of its revenues from oil for the foreseeable future. But when an easily extractable, government-controlled resource accounts for a large share of national output, democracy can suffer.

Consider Venezuela. Hugo Chavez's government faced a widespread opposition strike, whose intent was not only to demonstrate popular opposition, but also to starve the government of revenue. Without revenue, such a government cannot pay the army or thugs who keep it in power.

Although it seemed that Chavez would fall, oil saved him. Few people are needed to extract oil. With the help of some loyal (and foreign) engineers and enough new workers to replace strikers, the government kept the oil flowing, securing the resources needed to maintain the loyalty of mercenary forces who would otherwise have gone over to the opposition. The strike is all but over, and the Chavez government is now taking action against its leaders.

It was the same with Saddam Hussein. Even with Saddam deposed, what is to prevent a successor regime from using oil power to oppress Iraq's people? Democracy is stable only when it is accompanied by a wide diffusion of economic power, which gives the citizenry the ability to keep a government from becoming arbitrary and tyrannical.

The conditions under which democracies flourish are also the conditions under which free markets prosper. When people do not fear that a rapacious government will expropriate their wealth, and when an elite that owes its success to the government does not determine market rules, opportunities percolate to everyone.

So how to build the economic basis for a stable democracy in post-war Iraq? Douglas MacArthur's partially successful policies in Japan after the Second World War offer some guidance. Japan was perhaps easier to transform because it did not have an abundance of easily extractable natural resources. But land holdings were concentrated and a few large combines called "Zaibatsus" held industrial power.

MacArthur attacked concentrated economic power under the assumption that large landholders and large firms become pawns of government. Subsequent reforms expanded and widened the land- owning class, fostering an agricultural revival and making Japanese democracy more stable.

But MacArthur did not have enough time to finish the job. The need for reliable suppliers during the Korean War forced a compromise with the Zaibatsus. This partly explains why Japan's domestic market remains uncompetitive despite its vibrant democracy.

Some suggest that Iraq's oil "problem" be dealt with by distributing shares in the state oil company to the people. This is no solution, because the government will still control oil revenues and determine the dividend. Without adequate governance, oil revenues will be wasted on grandiose projects, corruption, or rearmament. Even if the government-owned oil industry is broken up and privatized, whether to foreigners or not, there is no guarantee that a future government cannot regain control.

The best hope for an enduring market democracy in countries like Iraq lies in building the countervailing economic power of professionals and entrepreneurs. Such people abound in Iraq, however decimated by years of sanctions. A priority for any interim administration must be to restore and improve educational and healthcare institutions so that they can recover lost ground.

Another priority is to wean people from dependence on government. Reconstruction could revive the entrepreneurial classes if small contractors and businesses are given opportunities. The danger is that the interim administration may hand out contracts to those well connected in Washington or the rich westernized Baghdad elite that gets cozy with whatever government is in power. As Russia's recent experience shows, creating a politically sycophantic business oligarchy makes the prospect of a market democracy more remote.

It is far wiser to distribute contracts widely and ensure that more Iraqi businesses gain access to credit. Clearly, many old financing institutions are compromised. The easiest fix is to let foreigners in so that they can channel foreign capital into domestic private ventures. New domestic financial institutions should also be encouraged. Such policies would mirror those followed by Napoleon III in France in the 1850's. Destroying the financial power of the Ancien Regime laid the foundations for the vibrant market democracy France became.

All this will not happen overnight. Economic institutions must be built, repaired and strengthened. The interim administration must undertake a delicate balancing act: Iraqis will have to be prevented from choosing how they will be ruled until the economic preconditions are in place for that choice to be genuinely free.

At the same time, Iraqis need to be convinced that the interim administration has their best interests at heart, rather than the interests of American or British businesses. Success in this balancing act requires leadership, transparent policies, and good communication. America provided this in postwar Europe and Japan. It must rise to the challenge again.

Raghuram Rajan and Luigi Zingales are professors at the Graduate School of Business, University of Chicago and authors of "Saving Capitalism from the Capitalists."