investors are bullish about Iraq's economic prospects. The stock market has been on the upswing for the past year. Fitch gave the economy another vote of confidence in March when it upgraded Iraq's economic outlook to stable, mostly based on the country's improving public finances. And Iraq's GDP growth has also been booming. Is it time to celebrate?

By Dr. Leif Rosenberger, Former Professor of Economics, US Army War College

Not so fast. For those of us who follow Iraqi ups and downs, this is what Yogi Berra, a former catcher for the New York Yankee baseball team, used to call "déjà vu all over again." Back in 2014, it also seemed like the best of times. The war was over in Iraq and investors were pouring money into this country’s economy. International investors were confident that economic rewards in Iraq outweighed any possible risks.

Iraq’s economy looked promising in so many ways. In February 2014 Iraq’s oil production surged to its highest level in over 30 years and Iraq’s oil exports hit a post-2003 high. Iraq was one of the hottest commercial markets in the world. Asia Cell Communications had the biggest initial public offering (IPO) in the Middle East since 2008.

The future also looked bright. With the 2nd largest proven oil reserves in OPEC, the International Energy Agency predicted Iraq’s oil output would double by the end of the decade. Its oil output was expected to grow by 600-700%. EIU predicted that Iraq’s GDP growth would reach 8% in 2014 and almost 9% by 2020. No other country in the world had this kind of growth trajectory.

But this was all a false dawn. What did the optimists miss? U.S. military doctrine says civilian-led stabilization and reconstruction operations need to take place, as the U.S. did successfully in Germany after World War II. Hans Binnendijk and Stuart Johnson correctly argued that there was a widening gap between the scale down of combat operations and the start of stabilization and reconstruction operations. Bad things happen in this gap. The most dangerous scenario could include Shia repression and discrimination against Sunnis in Iraq.

Optimists thought the fall of the divisive Prime Minister Maliki and the rise of a seemingly more inclusive Prime Minister Abadi was a hopeful sign. But it was too little, too late. Maliki’s repression of the Sunnis was deep-rooted and contributed to the rapid expansionism of ISIS. The initial ISIS military success and the subsequent and belated military response of the US and its allies are now well known.

However, what was not so well known back then was the economic impact of ISIS. While the major oil fields in southern Iraq were located away from the battle zones and were not seriously affected, ISIS actions in northern Iraq occurred close to the Kurdish oil fields. In addition, ISIS controlled areas in Iraq seriously hindered the routing of the oil and gas output beyond Iraq’s borders. ISIS control of this area prevented Iraq’s oil being shipped via Kirkuk-Ceyhan pipeline to Turkey and over highways to Jordan.

As a result, Iraq’s international trade took a big hit. Iraq lost $1.5 billion a month due to an oil export pipeline under ISIS control that ran from Kirkuk to the Turkish port of Ceylon. And of course, low oil prices also hit Iraq’s exports. In addition, Iraq’s imports fell 60-70%. Foreign reserve levels also fell. On the domestic front, two million internally displaced people (IDP) lost their jobs. Investors were then understandably scared off. Farms and factories shut down, which in turn caused several domestic markets to collapse.

Fiscal Crisis.

The Iraqi economy went from boom to bust. IMF announced that the Iraqi GDP was contracting. When an economy like Iraq gets smaller, its revenues also shrink. That in turn caused the budget to run a large budget deficit. Not surprisingly, therefore, Iraq ran a budget deficit of 4% of GDP. EU’s Maastricht criterion says any budget deficit over 3% of GDP is financially unstable. In short, Iraq all of a sudden found itself in a fiscal crisis.

What were the drivers of this fiscal crisis? Even before the war against ISIS, Iraq was struggling to finance reconstruction of its armed forces. But the war against ISIS meant Iraqi military spending started to skyrocket. Iraq all of a sudden had to train, feed and house tens of thousands of men who volunteered to fight ISIS. The associated costs of fighting ISIS was also rising. In addition, Iraq had no productive industry or agriculture. So it obviously couldn’t tax farms and factories that no longer existed.

That left Iraq as pretty much a “one trick pony” economy that relied on high oil prices to make ends meet. That in turn made Iraq extremely vulnerable to falling oil prices. As a result, falling oil prices hit Iraq’s economy and budget hard. Oil prices fell from over $100 a barrel in May 2014 to about $50 a barrel by early-January 2015. Iraq also could not increase southern oil production and exports because of poor infrastructure and a shortfall of water.

In addition to these unexpected costs, the Iraqi economy suffered from years of corruption and mismanagement despite billions of dollars in US financing. As a result, the budget was full of structural problems. For instance, the government funded public payroll and food and energy subsidies equal to 70% of the budget. To make matters worse, Iraq was in arrears. Baghdad still owed the Kurdish Regional Government (KRG) billions of dollars.

What were Baghdad’s options?

Due to doubling its gold holdings in recent years and relatively large foreign reserves, Iraq could use its foreign reserves to finance the current fiscal crisis. But that would reduce its ability to address balance of payment crises and future financial crises.

Until then Iraq’s dinar was solidly pegged to the US dollar. Instead of reducing reserves, Baghdad could devalue its foreign exchange rate. However, that could cause a panic, destabilize Iraq’s financial markets and trigger massive capital flight. It would also worsen Iraq’s debt and increase inflation, the cruelest tax of all to Iraq’s working poor.

Baghdad could also go to the IMF to finance its budget deficit. But the IMF wouldn’t give Iraq loans to finance its budget deficit until a budget was in place. New Iraqi Prime Minister Haider-al-Abadi initially created a 2015 budget that was based on a “break even oil price” of $70 a barrel. But he had to scrap the budget once oil prices hit $60 a barrel.

Austerity Budget.

Once Iraq decided how to finance the budget deficit, it had to come up with a new more realistic budget so that a fiscal crisis did not keep happening in the future. In this regard, Iraqi Prime Minister Abadi decided to create an austerity budget that would safeguard the war against ISIS while sharply cutting back on other spending. Under this plan the Iraqi government proposed to prioritize public sector salaries, security needs, the energy sector, humanitarian relief, and provincial transfers. Iraq would finance the projected 2015 budget deficit of $40 billion by freezing development and reconstruction and issuing domestic bonds and exploring efforts to generate additional revenue. In this regard, the austerity budget was a vital first step which in turn paved the way for future IMF financing.

Military Emphasis.

On the kinetic side, the austerity budget showed that Prime Minister Abadi was serious about the war effort. For instance, $1.5 billion was transferred from the finance ministry to pay the remaining balance in the contract for 36 F-16 fighters. But instead of transferring money from wasteful subsidies or cutting bloated civil service salaries, Prime Minister Abadi postponed most of the spending on development and reconstruction. While breaking things and killing people is obviously a necessary part of the war effort against ISIS, there is also an important non-kinetic side to the war effort.

Striking a Balance.

In this regard, Iraq needed to strike a balance. The Abadi government needed to also win the hearts and minds of all Iraqis. That wasn’t easy. ISIS propaganda and recruitment was quick to criticize Abadi for taking money that should go for Sunni economic development in order to buy more F-16s. In short, Prime Minister Abadi needed to make sure the kinetic approach did not play into the hands of ISIS or another insurgent group like ISIS.

Things have changed.

During the Arab Spring, oil prices were high and Iraq was running a budget surplus. Iraq was able to tap into this budget surplus and boost social spending to placate potentially rebellious Iraqis. But then oil prices fell and Iraq was faced with a large budget deficit it had to finance. That meant Abadi had to find creative ways to unify all Iraqis – Shia, Sunni and Kurds. That wasn’t easy.

It didn’t take long for ISIS expansionism across a third of Iraq to turn an economic boom in Iraq into economic contraction and a fiscal crisis. In the midst of a fiscal crisis, it was tempting for Baghdad to maximize military spending to crush ISIS and short-change socio-economic development for all Iraqis.

But that was a mistake. Although Iraq’s economy was primarily a war economy, unity among all Iraqis in the war effort was essential to recruitment of good soldiers to fight ISIS. In addition, Iraq will not be able to sustain the costs and sacrifice of the war effort against ISIS unless all Iraqis are part of a unified battle against ISIS.

Lessons Learned

What did we learn from the false dawn of 2014? And what should we keep in mind now that the Iraqi military has almost won the operational war against ISIS? The short answer is winning the operational war is not enough. Stabilization and reconstruction must happen immediately. If a gap widens between combat arms and stabilization/reconstruction, another insurgent group (like ISIS) will once again fill the socio-economic gap.

To avoid another false dawn and negative scenario in Iraq, the International Community (IC) should first encourage Baghdad to consider using a third party (such as the Arab League) to serve as a broker for an inclusive economic strategy that would result in shared prosperity for all Iraqis. Second, Baghdad needs to turn this economic strategy into a detailed economic plan. Key Sunni, Shia and Kurdish stakeholders need to be included in the planning process. In phase one, the plan would show how Baghdad would address Iraqi humanitarian needs in this war environment. In phase two, Baghdad should address the socio-economic needs of all Iraqis. This economic development involves upgrading basic services (power, water and housing). In phase three, Baghdad should turn to economic reconstruction.

Since the oil industry produces very few jobs, Baghdad needs to form public-private sector partnerships (PPPs). The PPPs would help create more job opportunities for all Iraqis by rebuilding factories and the agricultural sector. Third and most importantly, there needs to be an economic roadmap. The roadmap needs to have a public awareness campaign with realistic economic assumptions. Since the fiscal crisis means Baghdad cannot do everything in one fell swoop, there needs to be a) concrete actions, b) specific locations and c) achievable time-lines for the economic roll-out to show progress. Public awareness of concrete progress is important because it will build mutual trust, confidence, unity and support from all Iraqis. That in turn will mitigate grievances, reduce the potential demand for violence and foster reconciliation and stability.

Implications for Africa

If ISIS could rise and fill the socio-economic gap in Iraq and Syria, could ISIS do the same thing in Africa? ISIS has long had an interest in establishing a presence in Africa. In fact, it has been part of its vision for a global caliphate. ISIS success or failure in Africa depends on its ties and influence with five major categories of militant Islamists in Africa. These include Boko Haram, Al Shabaab, ISIS linked groups in North Africa, Al Qaeda in the Islamic Maghreb (AQIM) and Sinai-focuses groups. ISIS ties and influence with each of these groups varies widely. In this regard, ISIS has been a cause for concern in North Africa.

Joseph Siegel notes that the main attraction of ISIS in Africa has been less about resources and more about its reputational and ideological potency. That said, Siegel argues that the closest ISIS influence and ties appear to be in Tunisia and the Sinai, plus links to the fighters displaced from Sirte in southern Libya and the Sahel. Tunisia has served as a key recruitment pipeline for ISIS activities in Syria. Some 6,500 Tunisian fighters reportedly travelled to Iraq and Syria to join ISIS there. The concern is the reverse pipeline of well-trained Tunisian fighters returning to Tunisia and fostering terrorism and instability there. Similarly, the return of more Egyptian jihadists from Iraq and Syria to the Sinai could strengthen ABM’s insurgent activities. This in turn could pose a greater challenge for the Egyptian military which has been trying to counter these groups since 2014. In Libya, the seizure and defense of Sirte has been the most publicized ISIS activity in Africa. But ISIS does not enjoy significant home grown support in Libya.

Moreover, ISIS-related ties and influence in Africa must be kept in context. Siegel notes that the most lethal Islamist groups in Africa (Boko Haram and Al Shabaab) pre-date ISIS, are well grounded in their own local communities and grievances and do not rely on ISIS for resources or local support. Siegel also reminds us that the dominant ideological influence for militant Islam in Africa is the ultra-conservative Arab-infused Wahhabi model of Islam that has been propagated from Saudi Arabia and the Gulf states for decades.

Photo Courtesy of The U.S. Army

Dr. Leif Rosenberger retired from the US government in March of 2016. He was a Full Professor of Economics at the US Army War College and held the General Douglas MacArthur Academic Chair of Research in the Strategic Studies Institute. He was also the Chief Economist at both the US Pacific Command and the US Central Command for almost two decades. He can be reached