Economic consequences of conflict: the rise of Iraq's informal economy.

Author:Looney, Robert

Iraq's economy has undergone a number of profound changes over the last several decades, many of which have had significant implications for the manner in which the country's informal economy has evolved. The statist, heavy-handed economic policies of the Ba'athist government concentrated much of Iraq's productive capacity in nationalized factors, which degraded under the sanctions regime of the 1990s, when both industrial and agricultural production faltered for lack of inputs.

When coalition officials arrived in Iraq after the war, they planned on turning Iraq into a free market economy--a model for capitalism in the Middle East (Looney 2003). As part of this plan, they expected private companies, both foreign and domestic, to play a leading role in jump-starting the economy. Free market incentives driven by pent-up demand and a massive aid-financed reconstruction program were thought to be sufficient to induce a massive wave of investment and hiring of Iraqi workers (Cha 2004). But violence, crime and uncertainty over the future have undermined investor confidence, preventing market-driven mechanisms from playing their anticipated role. As a result, nominal Gross Domestic Product (GDP) contracted by about 35 percent in 2003. It has recovered little since then, despite the U.S.-led reconstruction efforts.

The only part of the economy to have survived both Saddam Hussein and the post-2003 period of instability and insurgency is the country's informal economy. In fact, there is ample evidence that the country's informal economy has expanded considerably since Saddam's overthrow. In this regard, Iraq's informal economy is following a pattern seen in other parts of the world--the informal economy tends to grow during periods of economic crisis. This phenomenon has occurred on each of the main continents:

* In the 1980s, the Latin American economic crisis produced a significant increase in the size of the informal sector and the scope of its activity (Tokman 1992);

* In the Asian economic crisis of the late 1990s, millions of people who lost formal jobs in the former East Asian Tiger countries tried to find jobs or create work in the informal economy (Lee 1998);

* Structural adjustment in Africa caused the disruption of many long-standing employment patterns and the resulting expansion of informal activities. Once developed, the continent's informal sector has continued to grow unabated and increasingly encompasses massive money laundering and counterfeiting operations, illegal trade in minerals, and the trafficking of humans and narcotics (Fashoyin 1993); and

* Economic transition in the former Soviet Union and in Central and Eastern Europe was associated with an expansion of employment in the informal economy, much of which persists today (Oxford Analytica 2004).

Perhaps because of the inherent difficulties in measuring informal economic activities, compounded by the reluctance of many government agencies to acknowledge its importance, the informal economy has been neglected in policy discussions. (1) A similar development is occurring in Iraq, where despite the obvious importance of the informal economy, it is barely mentioned in the many official economic reports. In fact, few systematic attempts have been made to integrate the analysis and quantification of the informal economy into an overall review of economic developments in Iraq. This lack impairs understanding of the fundamental workings of the economy. At the macro level, limited knowledge of the size of the informal economy impedes monetary policy's ability to control inflation. At the sectoral level, neglecting the informal economy blurs the ability to understand what is happening with commerce, services, and the regional flow of goods and services. While at the micro level, lack of information on the informal economy hinders an effective assessment of which households can or cannot cope on their own during the transition.

The omission of a systematic treatment of the informal economy impairs the provision of effective advice on the proper course for reconstruction and the policies most effective in inducing maximum gains in productive employment and output. As an initial attempt to fill this gap in our knowledge of the Iraqi economy, the sections that follow develop a framework for understanding the possible extent, causes and policy implications of Iraq's informal economy.

Iraq's Informal Economy Prior to the Overthrow of Saddam Hussein

Historically Iraq was one of the major agricultural countries in the world. However, since the 1950s, the country's economy has been increasingly dominated by the oil sector. While not employing many workers the oil sector in a normal year provides the country with about 95 percent of its foreign exchange earnings.

Data from Iraq's 1997 census can be used to generate labor-force participation rates and employment shares by industry (Table 1). The results, which are limited to civilian employees outside the Kurdish region, suggest that about two-thirds of Iraqi males aged 10 and older were in the labor force, though only 7.5 percent of females in the same age group were. This rate of female participation is low even among economies of the Middle East.

As is the case with many of the Middle East oil producing states, employment patterns in Iraq have been affected by what is often termed the Rentier State Syndrome (Looney 2004). Because the oil sector itself is not capable of absorbing many workers, a disproportionate number of workers must be absorbed through oil financed public sector employment. The largest employers for men were public administration, wholesale and retail trade and agriculture. For women, major employers were education, agriculture and public administration. At the time of the census, about eighteen percent of men and two percent of women were unemployed (Foote et al. 2004).

Because the sanctions regime of the 1990s placed severe constrains on government revenues, the private sector had been expanding relative to the public sector throughout this period to the extent that before the April 2003 war, a minority of the country's workers were employed by the government. Most people worked in the private sector, though a majority of these jobs were in the informal sector. Many were engaged in trading or subsistence agriculture or some other form of self-employment.

While Iraq's oil has always held out the prospect for future prosperity, the unfortunate fact is that most oil-rich developing countries are underperformers across a whole spectrum of economic, social, political and governance standards (Gelb 1988). Large windfall gains associated with a rapid increase in oil prices have been a particular problem in that they "appear to create severe distortions in the working of the economy and the political system with strongly negative socio-political consequences" (Stevens 2002). In countries as diverse as Iran, Nigeria, Venezuela, and Indonesia, the combination of state infancy and revenue windfalls has proved overwhelming, undermining even the best efforts to develop each country's non-oil economy, eradicate poverty and improve living standards for broad-based segments of the population (Isham et al. 2002).

Almost universally, agriculture has been adversely affected by the growth and expansion of the oil sector. In the case of an initial agricultural-based economy such as Iraq's, a commonly observed pattern is one whereby the exchange rate appreciation resulting from a ramp up of oil exports is likely to reduce the profitability and competitiveness of traditional agricultural exports. It would also encourage imports of food and raw materials, which may compete with domestic production; it is also likely to discourage the emergence of new manufacturing exports, essential for the successful diversification of the economy and job creation in the formal economy (Looney 2004a, 17).

Within this environment, economic policy and government actions have also contributed to the expansion of the informal economy. Economists have traditionally considered the size of the informal economy to be not only a function of the level of development but, perhaps critically, a function of government policy, particularly with respect to regulation, taxation and the size of the pubic sector. As has been extensively documented in the literature, (2) high taxes and a large but restricted (often by unionization or party membership) bureaucracy have tended to be associated with substantial informal sectors, with the latter acting, in part, as an employment ladder to the public sector (Aarris and Todaro 1970).

In addition, explanations of the relative size of the informal economy in the developing countries have increasingly stressed the importance of relative competences of governments and associated institutions. Where governments have provided an uncertain policy environment, where rules and restraints have been ineffectual, and where public agencies have possessed an overall low level of credibility, the informal sector tends to account for a larger share of GDP as entrepreneurs attempt to evade capricious actions by public agencies. Openness to world market forces tends to minimize the economic distortions that governments can create, thus often reducing the incentives for entrepreneurs to engage in informal activity (World Bank 1997).

Several of these general considerations concerning the extent of the informal economy are borne out empirically. Preliminary analysis (Looney 2006) suggests a clear pattern exists whereby the relative size of a country's informal economy (as a share of Gross National Product (GNP)) is related to its progress in opening up to the world economy. Those countries that are relatively closed and inward oriented (like Iraq around the year 2000) tend to have large informal economies, while those countries open to the pressures of globalization have much smaller informal economies...

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