The Other Way to Win Iraq

by Michael S. Bernstam
December 12, 2005
http://www.hoover.org/research/russianecon/essays/5083881.html

It’s economic policy. The new Iraqi government will be well positioned to implement it. Replace
food rations with prepaid debit cards. Under the sanctions imposed in 1990, some 97 percent of the
Iraqi population subsisted on free food rations. Since the onset of the Oil-for-Food program in 1996,
food rations relied on imports. Invasion past and the sanctions lifted in May 2003, 96 percent of the
Iraqi people still subsist on food rations. According to the U.N., World Bank, and World Food
Program estimates, some 50 to 60 percent of the population critically depend on food rations lest
they starve. Free, universal food rations make Iraq a veritable commune in life essentials, courtesy
of the U.S. taxpayers and protected by the U.S. and coalition military. This species of Communism
is more ubiquitous than the Soviet Union, Mao’s China, and even North Korea.

This Communism feeds insurgency in more ways than one. First, food rations, made up of
imports and distributed for free, depress crop prices, and suppress agricultural output. On top of
that, the government continues to act as an agricultural procurement monopsony and further
suppresses food prices, which stamps out the emerging free market segment. Agricultural output
has been declining by over 2.5 percent per year since 1990. Under the sanctions and two-and-a-half
years hence, some 50 percent of arable land remains uncultivated and 70 percent of cattle stockyards
shut down. This displaces rural population to urban slums. In December 2004, Iraq’s Minister of
Agriculture Sawsan Ali Magid al-Sharifi did not mince words on the subject, saying: “Agriculture
is the main sector to provide jobs to young people instead of leaving them in the hands of terrorists.”

Second, the central government runs the Public Distribution System, which is just a
euphemism for food rations. But who is the final distributor at the local level? Who allocates food
rations and enforces their actual distribution to every family in all localities? Under the Saddam
regime, it was his local administrators backed by his feared law enforcement. Under the U.S.
occupation and the democratically elected Iraqi government, it is local militias. That is, sectarian
and jihadist militias. There is no one else there to enforce delivery, secure storage, repel corruption
and theft, and ensure that food rations reach every family. Some of these militias report to political
groups which are allied with the U.S. and coalition forces, and we call them the police, the
paramilitary, and the army. Other militias report to political groups hostile to the U.S. and we call
them insurgents, rebels, terrorists, thugs, etc. Some militias shift between the two or drift between
war and peace, like the Mahdi Army in the Baghdad slum suburb, the Sadr-city, which the U.S.
military also fought in Najaf. These various militias constitute real local governments. They have
taken over villages, towns, and cities across the country and various districts of Baghdad. They
enjoy local popular support because they serve as the life-line. These militias distribute food rations
as their raison d’etre and moonlight in fighting the opposing sectarian groups and, in the case of
insurgents, also the U.S. and coalition forces. Their stakes are bigger than food rations. It is power,
ideology, and, in the case of jihadists, revolution and world domination. But food rations enable
and empower them to pursue those bigger stakes. Disband food rations, and this will disempower
the militias, including the insurgents. A subsequent agricultural development will dilute their ranks
and reduce them to cells instead of urban armies.
From food rations to prepaid debit cards and beyond

Universal food rations represent a double accident of history, first, of the sanctions, and then
of the failure of the occupying powers and the Iraqi government to dispose of them. The Coalition
Provisional Authority (CPA) debated disbanding food rations at the outset but stopped before the
turning point. The general idea was to replace food rations with cash subsidies which would buy
food on the market at market prices. These could be direct cash subsidies to households or more
innovative instruments. Each month, the government could credit household accounts at local bank
branches or issue prepaid debit cards (stored value cards). The idea seems to have been sidelined
on humanitarian grounds. First, initial disruptions of food supplies could occur and lead to unrest.
Second, in the traditional society, tribal chiefs, heads of patriarchal families, and men in general
might seize cash, which is fungible, and spend it on cars and guns while women, children, the
elderly, and the frail would starve. Given these potential humanitarian undesirables, retention of
food rations was deemed a lesser evil.

Yet, minor adjustments can significantly, even if not completely, neutralize these problems.
Recall prepaid debit cards. They do not require a sophisticated banking system with universal
household accounts. Only merchants and vendors need to hold business accounts at local bank
branches. When an individual swipes his prepaid debit card through a merchant’s machine, cash is
credited from the government account to this merchant’s account at the bank. All merchants, even
small-time vendors, will be interested to honor prepaid debit cards. Incentives will render it
unnecessary to make honoring prepaid debit cards obligatory. These incentives invite widespread
participation of big and small producers and purveyors and minimize supply disruptions.

Disbursement of prepaid debit cards can be made directly to families at places of

employment for workers, tax offices for small businessmen, and the social assistance agencies for
the unemployed and other dependents. The amount will be assessed as the free market value of the
food ration per month per person or per family of four weighted by the number of family members
and their age. Food rations, public distribution, state procurement, and state import can be phased-
out as the new system is phased-in across the country. Food supplies and transactions can be
relegated to competitive wholesale traders and importers, initially as concessions on a tender basis,
and additional supplies will flow through farm markets and retail. Food will be traded at free market
prices for both producers and consumers.

Still, some disruptions of food supplies may occur initially and then sporadically during the
process, no matter how meticulous is the preparation. Then a simple adjustment can mitigate market
frictions. All it takes is to retain the residual system of food rations as a backup to offer emergency
deliveries. Thus, consumers will cash-in their prepaid debit cards to acquire basic food supplies
from the erstwhile public distribution system. The cost of its maintenance as an emergency backup
will be small in comparison with the overall reduction of administrative costs, let alone all other
efficiency gains.

The next adjustment can mitigate, albeit not preempt, individual abuses and deprivation.
Prepaid debit cards can be made less fungible than money. If necessary, they can act as a
technologically advanced version of food stamps. Their earmarking for food purchases (plus a few
other household items, e.g., soap, detergent, etc., which are currently included in food rations) will
make it more difficult for patriarchal men to deprive women, children, and other weaker citizens of
food. Still, men might buy guns, radios, and tires and hoard debit card balances to buy cars and
other big ticket items. There will be abuse and fraud aplenty. Any welfare system, in the phrase of
Arthur Okun, is a leaking bucket. But the objective here is not to design a food subsidy scheme that
is perfect and permanent.

It is not the objective to keep the entire nation on alms for eternity. At the same time, it is
not the objective to lure and coax the war-worn Iraqi nation into a scheme that will be arbitrarily
abandoned at some point for the sake of fiscal austerity. The latter would cause food riots, akin to
those in Jordan in 1996 and in Egypt in 2004, and won’t stimulate production. That outcome could
resuscitate the insurgency which the disbandment of food rations should suffocate. No, the objective
is rather to think of a working device that is transitional and contains the built-in incentives for its
own phase-out. It should stimulate production and economic growth.

To this end, prepaid debit cards can take the form of a flat negative income tax rate.
Suppose, food expenditures constitute 50 percent of the average family budget. In reality, in poor
countries it is 60 percent or more, but leave it at 50 percent for simplicity of exposition. Then the
double value of the food ration constitutes the reference income for the average family of four.
Adjustments for family size and structure can be made. Then prepaid debit cards that act as a flat
negative income tax rate can replace 50 percent of the income gap between the family’s current
income and the reference income. Let the market value of the food ration be $100 (147,500 Iraqi
Dinars) and the reference income $200. If the family earns no income, it receives a prepaid debit
card in the amount of $100 (50 percent of $200) which makes up its total income. If the family
earns income equal to $50, it receives $75 (50 percent of the difference between $200 and $50) and
makes total income of $125. If the family earns $100, it receives $50 (50 percent of the difference
between $200 and $100) and enjoys total income of $150. If the family earns $150, it receives a
prepaid debit card in the amount of $25 and commands total income of $175. If the family earns
$200 or more, it receives no prepaid debit card. The formula of course applies continuously to all
income values from zero to $200. Within this interval, each $1 of income not earned is replaced by
only 50 cents in the food subsidy embedded into a prepaid debit card.

At each level of earnings, total income is higher with lower subsidy and higher market
earnings. Every family has the built-in incentive to earn income rather than receive a food subsidy.
This is the built-in incentive to phase-out prepaid debit cards on the part of every family. This is the
built-in incentive for work and production. To strengthen these incentives, the 50 percent income
gap replacement ratio can be applied for the first year and reduced to, say, 40 percent in the second
and 25 percent in the third, and then eligibility capped at 30 percent of the reference income.

Since prepaid debit cards will be disbursed to workers at the place of employment, to
business owners at the tax offices, and to the unemployed and dependent at the social assistance
agencies, the reference income could be readily determined. Still, there will be plenty of fraud and
abuse. But the partial income replacement formula implies that the entire program will cost a
fraction of the current food rations. Government expenditures and U.S. aid will fall dramatically
over time. This transition will achieve the very objectives of austerity programs but it will also be
sustainable because it is based on incentives, not imposition.
 This way, Iraq will transform from a commune to a market economy with strong incentives
for work and economic growth. Disbandment of food rations, state procurement, and agricultural
price suppression will revive agriculture and employment. Given the 50-70 percent idle capacity,
agricultural output can more than double in a short time span with minimal initial investment. The
growth effects will spill over to processing industries and construction, and then to manufacturing
and services. The rise of agricultural prices will allow the government to disband compensatory
agricultural subsidies for fertilizers, energy, and other inputs and eliminate cross-subsidies and
market distortions. Productive incentives and investment opportunities will improve across
industries. The budget will streamline. Economic betterment of both rural and urban populations
will foster savings, domestic investment, and entrepreneurship.

Gains in employment and income will facilitate civic order and security after the
displacement of militias and insurgency. Add oil. Make it benefit all Iraqis.

Oil, sectarian quotas, and family accounts

When Senator Patty Murray from Washington intoned that Usama Bin Laden enjoys support
in Muslim countries because he raises funds for their communities and builds schools, hospitals, and
housing, her critics chastised her for praising Bin Laden and missed her deeper point. Al Qaeda,
Hamas, Hizbullah, and similar organizations created a new economic species of private, non-tax
based welfare states financed by foreign charities and international racket. These are parasitic
welfare states on both ends. On the demand side, it is foreign aid, voluntary or otherwise. On the
supply side, it is idle or displaced populations dependent on this welfare state and available for
jihadist activities.

Redistribution of oil revenues between sectarian enclaves and provinces in the Iraqi
Constitution may undergird several new such parasitic welfare states exactly in those Sunni Arab
areas which already have clusters of idle towns taken over by the jihadist militias. Even apart from
the Sunni Arab triangle, regional and sectarian quotas and claims on oil revenues cannot be stable.
They invite sectarian extortion, continuous redistribution of wealth by uprising or threat of thereof.
Want more, kill more, get more. They perpetuate civil war.

Ahmad Chalabi, the Deputy Prime-Minister of Iraq, advocates an alternative proposal. It is

individual endowments in oil fields and revenues, individual accounts in the national trust fund to
which oil revenues accrue. This proposal can solve not only economic but also security and political
problems. Few forces hold disparate people together like a joint economic interest. This is
especially important for artificially created, multi-ethnic, multi-religious countries such as Iraq.
Some of such countries sustain (e.g., Belgium and Jordan), others split up (e.g., Yugoslavia and
Pakistan, from which Bengali East Pakistan seceded in 1971 and became Bangladesh). Iraq can still
go either way, regardless of whether or not it has a constitution, democracy, and occupation.

Any version of individual oil revenue accounts is vastly, indeed vitally superior to sectarian
quotas. The obstacles are fiscal and social, or rather their overlap. The budget needs oil revenues
to finance a ubiquitous welfare state, beyond food rations, or else levy an exorbitant and explosive
tax burden. Abolishing or cutting social programs in a fragile country at a time of civil strife is even
more explosive. There is a solution. Call it capital swap. It swaps oil assets for welfare state
liabilities. In practice, it exchanges dividends from oil revenues for the voluntary forfeiture of
welfare state payments and benefits.

Oil revenues (after investment is fully expensed) split into two flexible accounts. One is the
national trust fund and the other is the fund of individual accounts to which oil revenues are credited.
The national trust fund finances budget expenditures on private goods such as government pensions,
unemployment insurance, disability, socialized health care, health care for the elderly, poverty and
emergency assistance, public housing, and higher education. The general budget, financed by tax
revenues, covers expenditures on public goods such as national defense, law enforcement, public
infrastructure, scientific research, general administration, and basic education. Individual accounts
could be used by their owners only for spending on health, education, unemployment, disability,
emergency assistance, and retirement.

Individuals and families have a choice between individual accounts and the national trust
fund. If they choose individual accounts, they forfeit government payments for pensions,
unemployment, health care, poverty assistance, public housing, and higher education. If they choose
government payments for these private goods, they forfeit individual accounts. Individuals can
move between the two systems freely during annual enrollments to and from the fund of individual
accounts. The total amount of oil revenues every year is divided by the total population to establish
annual per capita credit. Then annual oil revenues are allocated between the national trust fund and
the fund of individual accounts depending on individual enrollment into the latter fund. The
advantage of individual accounts is that they are vested with their individual owners and the balance
of income not spent during a given year rolls over to the next year and beyond, can be invested in
low-risk securities, and then withdrawn for retirement and/or bequeathed. It is likely that,
eventually, most people would choose individual accounts and only individuals with high health and
disability expenses would elect to remain on or reenter government rolls. Government expenditures
on private goods will decline significantly. Relatively low taxes will be sufficient to finance public
expenditures of the general budget.

Owners of individual accounts will become unalienable shareholders of the national oil
company or the conglomerate of oil companies, including all oil fields and oil reserves of Iraq, along
with the national trust fund which will be the largest shareholder. This ownership type is based on
the same principle as the Alaska Permanent Fund Corporation which disburses dividends to all
citizens of the state. In Iraq, unalienable shareholding is superior to privatization of assets via
distribution of shares to citizens or via other methods. In the spirit of the Coase theorem,
irrespective of initial ownership, assets sooner or later end up in the hands of most capable owners.
In the presence of sectarian networks, transferrable shares will concentrate, by force, extortion,
cajoling, and purchase, in the hands of sectarian militias and jihadist groups, including, by proxy,
Al Qaeda and Iran. This will be both dangerous and inefficient because these networks have
agendas other than investment, development, and economic growth. In contrast, owners of
individual accounts will have long-term interest in investment in physical and human capital,
technological renovation, and further exploration and development of the oil industry. Growth of
production and productivity in the oil industry will boost production in manufacturing and services
and overall employment. Iraq will set on the path to long-term economic growth, the proverbial
peace and prosperity.
 Oh, we forgot to tell how to win the hearts and minds in the Middle East. Win stomachs and
pocketbooks in Iraq. People in the region will see. Win their eyesight, win their vision. That’s
bigger than hearts and minds.

Michael S. Bernstam is a research fellow at the Hoover Institution, Stanford University. He

participated in the design of the National Iraqi Survey. His ongoing co-authored book, From
Predation to Prosperity: How to Move from Socialism to Markets, is available at
www.russianeconomy.org . This article benefited enormously from corrections and ideas of
distinguished thinkers who were or are involved in Iraq’s economic policy in 2003-2005: Dr. Kamal
Field Al-Basri, Deputy Minister of Finance of Iraq; Col. William Hix of the U.S. Army; Col. Neal
J. Rappaport of the U.S. Air Force; Thomas D. Simpson of the Federal Reserve Board; and John B.
Taylor, Under Secretary of the Treasury for international affairs in 2001-2005. All views expressed
here and all remaining shortcomings are mine.