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Defense & Security Analysis Vol. 26, No. 2, pp. 181188, June 2010

Did Monetary Forces Help Turn the Tide in Iraq?

Peter Berck
Department of Agricultural and Resource Economics, University of California at Berkeley, USA

Jonathan Lipow1
Defense Resource Management Institute, Naval Postgraduate School, Monterey, CA, USA

INTRODUCTION
Back in 2006 and 2007, the conventional wisdom was that the United States and its allies faced imminent defeat in Iraq. Remarkably, however, that is not the way things have turned out. By every available metric, the security situation in Iraq has improved over the past three years. For example, the total annual number of fatalities sustained by American troops in Iraq ran between 822 and 904 for the period between 2004 and 2007 but declined to 150 in 2009. As for the Iraqis, average civilian fatalities have declined from 72 per day in 2006 and 61 per day in 2007 to 7.2 per day in December 2009.2 What accounts for the marked improvement in Iraqi security conditions? There are two probable explanations widely discussed in the media. The first is that the new American strategy popularly known as The Surge turned the tide of battle. The second is that the poor personal conduct of foreign insurgent fighters alienated many Iraqis who had previously supported their common cause, leading to what became known as The Awakening a series of organized mass insurgent defections. In this article, a new but certainly not exclusive explanation is offered for the evolution of the conflict in Iraq and the improvement in security conditions. It is argued that the extraordinary appreciation in the real value of the Iraqi dinar over the past six years may have contributed greatly to the Coalitions success in reducing insurgent violence. The argument is simple: the real appreciation of the dinar eroded the value of foreign funds that insurgents were using to finance their operations. As a result, insurgents found it necessary to transition to forms of domestic fund raising such as crime and extortion. These forms of fund raising inflicted a lot of hardship on Iraqs civilian population, and this in turn undermined support for the insurgency. There are five sections: an Introduction is provided in Section 1. In Section 2, the financial needs and economic vulnerabilities of insurgent groups are discussed, with a

ISSN 1475-1798 print; 1475-1801 online/10/020181-08 2010 Taylor & Francis DOI: 10.1080/14751798.2010.503100

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focus on the role that real currency appreciation could play in weakening them. In Section 3, the evolution of the real value of the Iraqi dinar is reviewed and the reasons for its revaluation discussed. In Section 4, the revaluation outlined in Section 3, that impacted the Iraqi insurgent movements in the manner predicted in Section 2, are evaluated. Section 5 concludes the paper.

REAL EXCHANGE RATES AND INSURGENCY

All wars cost money, and unconventional wars are no exception to the rule. Insurgents need funds for a variety of reasons. Weapons need to be procured, and combatants need to be fed and housed. One potentially large additional expense, particularly in Iraq, is the purchase of outsourced combat services from mercenaries: some of the insurgents appear motivated at least as much by pay as by ideology. With most Iraqis unemployed, the prospect of a significant payment for an assassination is appealing even to those not deeply sympathetic to the Baathists.3 How much cash is enough to hire an Iraqi mercenary? Early in the conflict, reports suggested that Iraqi and foreign mercenaries were accepting something between $150 and $1,000 per attack.4 By early 2004, sums as high as $5,000 were being mentioned.5 Of course, that was six years ago when the Iraqi economy was much weaker and the purchasing power of the US dollar (USD) much higher than it is today. The authors have not been able to find current estimates of the going rate for insurgent attacks, but given the general improvement in Iraqs economy, the cost of purchasing the services of mercenaries in Iraq must have gone up substantially. With as many as 80 per cent of insurgents captured in Iraq proving to be mercenaries, serious sums are required to finance insurgent operations in that country.6 Successful insurgencies, however, need much more money than the sums required for the financing of actual operations. Insurgencies also require popular cooperation. Evidence offered in Berman, Shapiro, and Felter suggests that to a great extent, this cooperation has to be bought.7 Basing itself on Akerlof and Yellins analysis of street gangs efforts to secure popular support in the neighborhoods in which they operate and Masons paper on insurgencies and rational peasant behavior,8 the analysis in Berman, Shapiro, and Felter begins with the proposition that insurgents cannot function without operational security: The population, or at least portions of it, knows what the insurgents are doing. The silence of the population, or at least a substantial portion thereof, is necessary (but not sufficient) for insurgent success. Conversely, the willingness of the population to share information with counterinsurgents is sufficient (though not necessary) for insurgents to fail.9 The authors go on to say that, if we acknowledge that counterinsurgency is fundamentally about information, then we are still left with a critical unanswered question: what makes information more or less forthcoming at the margins?10 So how does an insurgency go about earning the cooperation or at least acquiescence of the people that inhabit the regions in which they operate? There are a number of ways for insurgents to instil loyalty amongst those with sensitive information regarding their operations. It helps if the insurgents cause is popular, but this is rarely sufficient on its own to earn the loyalty of the local population.11 Alternatively,

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insurgents could impose draconian punishments on those suspected of being informants. This tactic does not appear to work that well. It is extremely difficult to identify traitors, and execution of innocents can engender greater rather than less public willingness to cooperate with counterinsurgent forces.12 Another tactic could be to offer social services that would assure that the insurgents continued survival is indispensable to the local population. Particularly in regions where the government provision of public goods has broken down, the returns accruing to the local population from insurgent provision of such services could be extremely high. It is unlikely that the private returns to individuals from such public-good provision would exceed the payoff from selling information to government forces, but people who live in areas with strong family and clan ties may very well feel that the benefits of insurgent activities for their community (i.e., those they care about) as a whole far outweigh the individual incentives being offered by the government. The empirical analysis conducted in Berman, Shapiro, and Felter offers some evidence that social-service provision can play a valuable role in insurgency and counterinsurgency.13 Consider the alternatives available to insurgents seeking to mobilize the funds required to finance their operations as well as provide social services sufficient to command the loyalty of the population. There are really only two options. The first is taxation of the local population. Such taxation can be formal but may also include tactics such as extortion, conscription, and robbery.14 The second is funding from generally, but not exclusively, foreign donors and state sponsors. As the authors will discuss below, these two alternative sources of funding differ significantly in terms of their desirability. The analysis begins with the observation that what should motivate a population to remain loyal to insurgent groups in the sense that Berman, Shapiro, and Felter are using the term are not the gross benefits accruing to them from insurgent provision of social services but rather the net benefits of such activities.15 As a result, it is far superior to rely on foreign donations or sponsorship. The use of foreign funds assures that the insurgents can offer local populations large net benefits in the form of social services. As far as locals are concerned, foreign-funded insurgents offer benefits that literally fall out of the sky like manna. In the absence of foreign funding, however, insurgents must resort to taxation of the local population. This is inherently inferior. Reliance on local funding reduces the net benefits that accrue to populations under the insurgents sway since the benefits stemming from the insurgents social-welfare spending are at least partially offset by the cost of insurgent tax collection. Indeed, given that at least some of these funds must be diverted to the insurgents operational needs, and the likelihood that the tax policies available to insurgents are likely to be economically inefficient, it is entirely possible that the presence of an insurgent cell may actually result in net costs for the local population if it is funded through local sources. This would make it extremely attractive for locals to betray the insurgents to the governments security services. While it is advantageous for insurgents to rely upon foreign rather than domestic sources of funding, the efficacy of foreign funding depends critically on the real exchange rate the value of foreign currency in terms of its ability to purchase local goods and services. A real exchange rate appreciation would erode the purchasing

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power of foreign funds smuggled in or held by the insurgents. One way to think about this is to view the violence conducted by foreign-funded insurgent groups as an export product. Foreigners are buying violence being sold by the insurgents. An increase in the real exchange rate renders exports uncompetitive - including the export of violence directed at the government. A country whose real exchange rate has appreciated so much that its exports have become uncompetitive suffers from what is known as Dutch Disease. Normally, Dutch Disease is considered a bad thing because it causes employment dislocations in export industries.16 If the export is terrorism and insurgency, however, then such dislocations may be a good thing. Dutch Disease has two possible causes. Sometimes it is caused by exogenous developments. That is what happened in the Netherlands, where the development of major offshore natural-gas resources led to a sharp appreciation of the guilder. This damaged the exports of other goods and engendered unemployment in export and import-substitution oriented industries. Alternatively, Dutch Disease can be temporarily engendered by the pursuit of monetary policies that are, in the long run, unsustainable. Maintaining a chronically overvalued currency induces a decline in foreign reserves. Eventually, those reserves must run out. Indeed, if the desired level of overvaluation is sufficiently large, most countries foreign-currency reserves can be exhausted in a matter of months or even weeks.

IRAQS REAL CURRENCY APPRECIATION

Now, let us review the evolution of the new Iraqi dinars real purchasing power since its introduction in January 2004. As can be seen in Table 1, the USD has been depreciating in real terms when compared to the dinar continuously for the past five years. The magnitude of this devaluation is quite large. Since 2004, the real value of a dinar in terms of the USD has quadrupled. Two factors have contributed to this. In nominal terms, the USD has been depreciating relative to the dinar. At the same time, inflation in Iraq has consistently exceeded that of the United States. Note that the Saudi currency, the riyal, is pegged to the USD so that funds raised in Saudi Arabia today buy only a quarter of the local goods and services in Iraq that they did at the end of 2003.
Table 1. Real Depreciation of the USD US inflation Iraq inflation Dinar/USD Real depreciation of USD

2003 2004 2005 2006 2008

2.5 3.2 2.5 2.7

25.4 33 64.8 4.7

1690 1461 1469 1324 1213

30% 22% 44% 10%

Note: Aggregate real depreciation of USD: 74 per cent. Source: Central Intelligence Agency (CIA), 2009.

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There is no reason to believe that the real appreciation of the Iraqi dinar was economically unsustainable. As evidence, consider that Iraq recorded a current account surplus of roughly $8 billion in 2008, while foreign-currency reserves held at the Central Bank of Iraq (CBI) have grown from $10.7 billion at the end of 2004 to $49.2 billion in September 2009. Clearly, from a balance-of-payments perspective, the numbers suggest that the real appreciation of the Iraqi dinar is based on market forces and not an unsustainable depletion of foreign currency reserves.17 Comparisons based on purchasing-power parity (PPP) yield similar results. Iraqs nominal gross domestic product (GDP) stood at $84 billion in 2008. The CIA estimates that, adjusted for PPP, Iraqs GDP should be $114 billion. This suggests that, as of January 2009, the Iraqi dinar was still 26 per cent undervalued relative to the USD.18 Why did the appreciation of the dinar happen? Two developments probably contributed more to the revaluation than any others. The first was the recent rally in crude oil prices. According to the US Energy Information Administration, Iraqi Kirkuk oil was trading for $26.67 per barrel in January 2004. In December 2009, Kirkuk oil was going for $71 but, as recently as July 2008, the price was $134. Given that the oil industry accounts for 60 per cent of Iraqs GDP, the oil price rally would certainly have engendered a significant appreciation in the dinar. Perhaps as important, the Coalition has poured vast sums into Iraq. It is estimated that the US Armed Forces alone have injected well over $20 billion in cash into the Iraqi economy between 2003 and 2009.19 Note that this represents only the physical cash payments made by the US military to Iraqis in return for local goods and services. Add to that the sums spent by other countries as well as the portion of Allied reconstruction aid devoted to the purchase of local labour and raw materials, and you reach sums that must be large enough to meaningfully alter the real value of the dinar.

DID THE DINARS APPRECIATION WEAKEN THE IRAQI INSURGENCY?

A significant real revaluation of Iraqs currency has taken place over the past five years. Indeed, to the best of our knowledge, there is no other recorded episode of real currency appreciation even remotely approaching the combination of scale and speed that has been seen in post-invasion Iraq. Could this real appreciation have forced Iraqs insurgents to introduce domestic financing arrangements that would have damaged their popularity and hence weakened their cause? It is difficult to answer this question. Little is known with certainty regarding the various Iraqi insurgent organizations and their funding arrangements, and much of what is known is classified. What little public evidence does exist, however, is at least consistent with our hypothesis. For example, the New York Times reported in November 2006 that a secret National Security Council (NSC) analysis had argued that insurgent financing efforts had evolved from foreign fighters and couriers smuggling cash in bulk across Iraqs porous borders in 2004, to the present reliance on a complex array of indigenous sources.20 As an example, consider the best known of the insurgent movements, Al Qaeda in Iraq (AQI). Supposedly, an organization well connected with foreign funding sources, AQI eventually turned to local fund-raising of

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the crudest form. By April 2007, other insurgent groups were complaining that AQI, was demanding money in return for protection, killing members of wealthy families when not paid.21 What accounts for this shift in funding? Though one cannot be sure, one plausible explanation is that the value of foreign funds used to finance the Iraqi insurgency declined to such a degree that insurgents were forced to shift to domestic efforts to raise revenue. Given what happened to the insurgency between 2006 and 2008, it also seems plausible that the dependence on domestic funding eroded the popularity of the insurgency. After all, many erstwhile supporters of the insurgency defected often en masse during the Awakening of 2006 and 2007. There are other explanations that could do at least as well in explaining the observed shift to domestic financing. For example, perhaps the insurgents rising operational needs rendered the foreign sums reaching them insufficient and necessitated a supplementary effort to raise funds domestically. This is certainly plausible, but other evidence makes this an unlikely explanation. According to the Times, the NSC report also suggests that, in fact, if recent revenue and expense estimates are correct, terrorist and insurgent groups in Iraq may have surplus funds with which to support other terrorist organizations outside of Iraq.22 This claim was met with considerable derision amongst independent observers and experts but, at least in the case of AQI, this is exactly what appears to have happened. For example, AQI seems to have sponsored Fatah al-Islam (FAI) organization, a group that in 2007 fought a three-month battle with Lebanese Army forces prior to its defeat.23 Meanwhile, a New York Times article from February 2009 describes AQIs involvement with the promotion of terror and insurgency in Mauritania.24 AQIs sponsorship of foreign operations would make little sense if the organization were facing increased financial needs in Iraq. Rather, it makes a lot of sense given AQIs global agenda if the cost of producing violence in Iraq had become relatively high when compared to the cost of generating violence elsewhere. Recall the analogy made in Section 3 between violence and exports: applying it to the case of AQI, it appears that, gradually, over 2005 and 2006, AQI shifted from exporting violence by using foreign funds to finance domestic attacks to importing violence by using Iraqi funds to finance foreign attacks. This shift from exports to imports sounds a lot like what happens in countries as real exchange rates appreciate.

CONCLUSION
A reasonable case can be made that the real appreciation of the Iraqi dinar between January 2004 and January 2009 contributed to the significant improvement in Iraqi security conditions. The appreciation eroded the real value of foreign funds used by the insurgents to finance their operations. This, in turn, forced insurgent organizations to turn to domestic fund-raising, something that undermined their popularity. Going forward, it is unlikely that the Iraqi dinar will continue to appreciate in real terms. Recent declines in the price of oil have eliminated one of the pillars upon which the appreciation was based while the expected drawdown over the next two years of Coalition forces deployed in Iraq eliminates another major purchases of Iraqi goods and services by Allied military organizations. The implications of this for Iraqi national

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security are unclear. While the insurgency may appear to be on the ropes, it is a certainty that various groups will continue their efforts to destabilize Iraq. This suggests that continued appreciation of the Iraqi dinar is desirable for the reasons outlined above. Offsetting this, there are clear signs that Iraq is beginning to manifest the negative economic consequences of Dutch Disease. For example, a Wall Street Journal article from 18 March 2009 reported that, Iranian bricks are invading Iraq while farmers in Iraq long considered the regions breadbasket are leaving land fallow as rice, watermelons and tomatoes stream in from Iran.25 The article goes on to report that, in 2008, for the first time, Iraq became a net food importer. These are the symptoms of a grossly overvalued currency. Protracted and excessive overvaluation of the dinar could damage Iraqs national security is a number of ways. An uncompetitive currency engenders unemployment, and unemployment makes it easier for insurgents and terrorists to recruit mercenaries. The article mentioned above alludes to this, quoting a brick manufacturer edging towards bankruptcy as fearing that, if we close, these young people (his employees) will have to do bad things to support their families.26 Overvaluation of the dinar could also act as a financial obstacle for the many refugees who may be contemplating a return to Iraq. Refugees generally accumulate assets valued in foreign currency. If foreign currency has relatively little purchasing power in Iraq, it is more expensive to return home. Given that refugee communities have historically proven to be a source of political instability in the region, the speedy return and socioeconomic reintegration of those who fled Iraq during the darkest years of the insurgency should be a central objective of any strategy aimed at securing Iraqs security and prosperity. As such, it is entirely conceivable that Iraqi security needs may best be served in the near term by a modest real depreciation of the dinar. As mentioned previously, such a depreciation seems almost inevitable given the correction in oil prices and the projected withdrawal of Allied forces from Iraq.

NOTES
1. The authors would like to thank Eli Berman, Martin Feldstein, Kenneth Kuttner, Francois Melese, Ellis Tolman, and the participants in the February 2009 NBER Workshop in the Economics of National Security for their invaluable comments and insights. Data: Iraq Coalition Casualty Count, iCasualties.org. http://www.icasualties.org, 2009. Metz, Steven. Insurgency and Counterinsurgency in Ira. The Washington Quarterly Vol. 27 2003: p. 29. Dillon, Dana, and Melissa Parham. The Iraqi Mafia. National Review Online. http://www.nationalreview.com/comment/dillonparham200401150820.asp, 15 January 2004. Statement by Maj. General Raymond Odierno, cited in Hoffman, Bruce. Insurgency and Counterinsurgency in Iraq. Rand Corporation National Security Research Division Occasional Paper Series, Santa Monica, RAND Corp., 2004. p. 12. Ibid. Berman, Eli, Jacob Shapiro, and Joseph Felter. Can Hearts and Minds Be Bought? The Economics of Counterinsurgency in Iraq. NBER Working Paper 14606, 2008. Mason, T. David. Insurgency, Counterinsurgency, and the Rational Peasant. Public Choice Vol 86 1996: pp. 63 83.

2. 3. 4.

5.

6. 7. 8.

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9. Ibid., p.10. 10. Ibid., p. 11. 11. See, for example, Thomson, Robert. Defeating Communist Insurgency: The Lessons of Malaya and Vietnam (Studies in International Security, No. 10). New York: F.A. Praeger, 1966. 12. Chechab, Zaki. Inside Hamas: The Untold Story of Militants, Martyrs, and Spies. Taurus: London and New York, IB Taurus, 2007: pp. 69 - 84. 13. Berman, Shapiro, and Felter op. cit. 14. The Vietcong and the Tamil Tigers, for example, levied formal taxes on the population under their control. 15. Berman, Shapiro, and Felter op. cit. 16. Williamson, John. Exchange Rate Economics. Open Economy Review Vol 20 2009: .for a recent discussion of Dutch Disease and the advantages of maintaining an undervalued currency: pp. 12346. 17. Source: CBI. Republic of Iraq. http://www.cbi.iq/index2.htm, 2009. 18. Source: CIA. The World Factbook. https://www.cia.gov/library/publications/the-worldfactbook/index.html, 2009. 19. Kunkel, Peter. Jesse James, the Telegraph, and the Federal Reserve Act of 1913 Can Help the Army Win the War on Terrorism. Military Review Vol. 88, 2008: pp. 88 96. 20. Burns, John, and Kirk Semple. U.S. Finds Iraq Insurgency Has Funds to Sustain Itself. New York Times, 26 November 2006. 21. Andoni, Lamis. On Whose Side is Al Qaeda? Al-Ahram Weekly, 26 April 2007. 22. Ibid. 23. Bloom, Rebecca. Fatah al-Islam. Council on Foreign Relations Backgrounder (www.cfr.org), 21 May 2007. 24. Schmidle, Nicholas. A Saharan Conundrum. The New York Times, 13 February 2009. 25. Chon, Gina. Iraqs Cheap Goods Stifle Iraqs Economy. Wall Street Journal, 18 March 2009. 26. Ibid.

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