Iraqi Economy: Setser Replies
Reader and economist Brad Setser responded to my comment on the Financial Times article on the Iraqi economy last weekend.
I . . . have tried to follow Iraq closely (both the debt restructuring forgiveness debate, the use of oil revenues, the loans v. grants debate and more generally the pace of economic reconstruction). I share your amazement and frustration that the CPA seemed to prioritize doctrinaire conservative economics (low marginal taxes, openness to foreign investment) rather than practical steps to manage the enormously difficult transition from a state dominated economy to a more mixed economy without generating massive hardship, and the as difficult challenge of managing the oil curse.
I also agree with the main thrust of your commentary on the FT posting — Iraq’s economy now is one based on taking the funds resulting from the distribution of oil revenues through the state (mostly) and any CPA reconstruction that trickles down (plus any savings) and buying imported consumer goods. In many ways, imported consumer goods seem to be the preferred form of savings. Iraq also is at risk of Dutch disease — indeed, I worry that the combination of higher than expected oil revenues with oil at 40 (assuming the pipelines function) and the eventual disbursement of the $18 billion aid package will create an economy temporarily swimming in dollars (with a strong real appreciation of the currency). all fine if it lasts — Iraq should have an economy a lot bigger than $20 billion even if it does little more than sell its existing oil production capacity and spend the proceeds. But also risky if oil falls just when the aid package is finished off — Iraq needs steady external revenues from oil/ aid of $25-30 billion a year, not $40 billion one year and $15 billion the text.
One small point of disagreement though. I don’t see why Iraq is at risk of hyperinflation. Hyperinflation (weimer style, or argentine style) usually occurs when a government spends more than it takes in, and runs the printing presses (borrows from the central bank) to make up the difference. As inflation accelerates, the government has to run the presses faster and faster to continue to fill its coffers. Iraq should not have that problem — higher oil revenues = higher external reserves, so any domestic money creation ought to be backed by a solid external asset (it won’t be printing more dinars and thus spreading the same set of dollar reserves ever thinner). The budget should be fully funded out of revenue/ aid. that should limit the risk of hyper-inflation, as it is normally defined. I do think there is a risk that higher than expected oil revenues will lead to a real appreciation of the currency, whether through a change in the nominal dinar/ dollar rate or a one off increase in dinar prices (a burst of inflation), as more dollars (or dinars, if iraq converts dollars to dinars) are chasing the same set of local goods (I have not thought this through enough to have a sense of which is more likely). But some inflation as the economy grows is not the same as hyperinflation (an ever increasing rate of inflation), and indeed, the substitutability of foreign goods for local goods ultimately will act as a break on the increase in local prices. That’s a long winded way of saying I think the concern about dutch disease (real appreciation due to oil windfall making local production of many goods uncompetitive) is there, but that there is little short-term risk of hyperinflation.
(My hyperinflation scenario would involve the government making up a gap in revenues created by an unexpected fall in oil revenues by running the printing presses — not today’s problem) . . .
Cole replies: I’m very grateful to Dr. Setser for taking the time to respond. O.K., I shouldn’t have said hyper-inflation. But sudden big influxes of oil wealth, as occurred in Iran in the mid-1970s, have historically caused high rates of inflation that in turn created social problems. In Iran’s case, we social historians think the high inflation rate contributed to the outbreak of revolution in 1978-79. It may be, as Dr. Setser says, that this kind of inflation would moderate in the long run, unlike the spiral of hyperinflation caused by the government being trapped into needing to print more and more money. But in the long run, as Keynes said, we are all dead. The question is whether the inflation rate would rise fast enough and far enough to cause major social disruptions in Iraq of the late Pahlevi sort. (It is true that the smaller Gulf monarchies weathered the 1970s better than Iran, but they typically lack absorptive capacity in the first place, having small populations, so I would argue that the oil receipts mainly got recycled into foreign investments.)