Economic recovery is important for stability and peace in Iraq. The Iraq Study Group proposed financial aid to Iraq of around $5 billion annually, while President Bush has increasingly stressed the importance of job creation in that country. Unfortunately, significant economic progress in Iraq is

unlikely unless part of a comprehensive strategy is designed to overcome several forces currently impeding reconstruction and economic recovery: (a) the growth and dynamics of the shadow or informal economy, (b) the deterioration in social capital, and (c) the evolving relationship between tribes, gangs and the insurgency. The dynamic interrelationship between these factors is causing a downward economic spiral. Progress in one or two areas alone will not be capable of generating significant economic gains. All of these factors need to be addressed.

INTRODUCTION

In a significant policy statement (1) released toward the end of 2005 the United States outlined its strategy for victory in Iraq. Victory is defined in terms of a sequential set of completed goals: (1) Short term, Iraq is making steady progress in fighting terrorists, meeting political milestones, building democratic institutions, and standup security forces; (2) Medium term, Iraq is in the lead defeating terrorists and providing its own security, with a fully constitutional government in place and on its way to achieving its economic potential; and (3) Longer term, Iraq is peaceful, united, stable and secure, well-integrated into the international community and a full partner in the war on terrorism.

The US strategy is essentially three pronged: developing democracy, providing security and reviving the economy. In the economic area U.S. and coalition efforts have focused on helping Iraq restore the country's neglected and damaged infrastructure with the goal of restoring and expanding essential services. Other objectives include: the creation of a market based economy, and greater transparency and accountability in the public sector. (2)

Iraqis themselves have become increasingly skeptical of the ability of this strategy to produce lasting economic gains and a semblance of stability. Certainly the ability to complete infrastructure projects on time and within budget has proven to be a nearly impossible task. As noted by the U.S. Inspector General for Iraq Reconstruction infrastructure programs in that country have been plagued by "violence, corruption and mismanagement." (3) As a result, "the ambitious US reconstruction effort in Iraq is likely to fall far short of its goals because soaring security costs and poor management have slashed the amount of American money available for rebuilding projects." (4) Just as serious is the all too apparent long lead time before any tangible benefits in terms of improved living standards are seen by the average Iraqi.

Implicit in Ambassador Bremer's assessment is that the main flaw in the US strategy has been its inability to deliver short-run economic gains to large segments of the Iraqi population. Also complicating Iraq's recovery is the fact that we still don't have a complete picture of the contemporary dynamics of the Iraqi economy. Clearly, factors such as the "brain drain" and the lack of commercial credit (5) together with uncertainty due to the security situation have largely brought investment in the formal segments of the economy to a halt. (6)

  A third of Iraq's professional class is reported to have fled to
  Jordan, a flight of skills worse than under Saddam. UN monitors now
  report 2,000 people a day are crossing the Syrian border. Over a
  hundred lecturers at Baghdad University alone have been murdered,
  mostly for teaching women. There are few places in Iraq where women
  can go about unattended or unveiled. Gunmen arrived earlier this month
  at a Baghdad television station and massacred a dozen of the staff, an
  incident barely thought worth reporting. The national museum is walled
  up. Electricity supply is down to four hours a day. No police uniform
  can be trusted. The arrival anywhere of an army unit can be prelude to
  a mass killing.... All intelligence out of Iraq suggests this is no
  longer a functioning state. (7)

Yet, from anecdotal accounts (8) there are indications that many areas of the shadow economy are prospering and, as during the period of sanctions, successfully adapting to the harsh environment. On the other hand, the shadow economy has provided a boon to criminal gangs and a major source of funding for the insurgency. (9)

The importance of economic recovery was again stressed in the Iraq Study Group's assessment of conditions in Iraq: (10)

  No political and security progress can be sustained in Iraq unless the
  Iraqi people experience improvement in their daily lives. This will
  demand substantial progress on simple tasks like clearing garbage; as
  well as complex tasks like rebuilding a shattered oil industry and
  establishing law and order. To achieve these goals, Iraq will need
  assistance from the United States and other countries that want to
  prevent a further slide towards chaos.

While the Iraq Study Group proposes financial aid to Iraq of around $5 billion per annum, it is silent on the strategies likely to be most effective in sustaining economic recovery and growth. With these themes in mind, the purpose of the sections that follow is to attempt to gain an understanding of the forces at work in Iraq impeding reconstruction and economic recovery.

ECONOMIC DYNAMICS OF POST-WAR IRAQ

Our working hypothesis is that any efforts to restore the economy will be conditioned by a number of interrelated factors including: (a) the growth and dynamics of the shadow or informal economy, (b) the deterioration in social capital, and (c) the evolving relationship between tribes, gangs and the insurgency as conditioned by the dynamic interactions with (a) and (b).

The Shadow Economy

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. (11) 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. (12) 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 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 political, economic, and social crisis.

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 and military developments in Iraq. This gap in our knowledge has hindered the development of a systematic framework for understanding and planning reconstruction and counterinsurgency strategies in the contemporary Iraqi setting.

Preliminary analysis (13) suggests a clear pattern exists whereby the relative size of a country's informal economy (as a share of Gross National Product) 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. Furthermore, the informal sector becomes significantly smaller as countries increase their control over corruption.

As might have been expected, Iraq under Saddam was in a group of countries with the highest probability of possessing a large informal economy. The profile of these countries is an inward-oriented trade regime with high levels of corruption. On this basis, Iraq's shadow or informal economy probably accounted for around 35 percent of Gross Domestic Product (GDP) in 2000 (14) with nearly 70 percent of the labor force employed in informal activities.

Since the fall of Saddam, Iraq's informal economy has been affected by that country's on-going crisis. Clearly, conflict and the insurgency have taken a heavy tool on the formal economy. As private firms or public enterprises are downsized or closed due to conflict, retrenched workers often find the informal sector the only source of livelihood. Also, in response to conflict-driven inflation or cutbacks in public services, households have often needed to supplement formal sector incomes with informal earnings. In some parts of the country such as al Anbar, the breakdown of law and order has led to an expansion of criminal activity, some of which is carried out in the shadow economy--street vendors selling stolen merchandise, etc.

A partial list of factors contributing to the current expansion of Iraq's shadow economy includes:

* Compared with the previous regime, there is considerable political liberalization in Iraq. In transition economies, this normally results in a larger informal economy.

* The demand for services and trade is particularly high due the introduction of free trade soon after the fall of the Hussein regime. Again, this factor would encourage the development of an informal economy--petty retailing, street vending of imported goods, etc.

* Increased bureaucratic discretion and associated corruption are greatly contributing to the informal economy.

* Because of Iraq's insurgency, institutional enforcements have weakened, thus allowing the incentives for informal activity to become very high.

* The underdevelopment in the rule of law and related institutional enforcement mechanisms have not improved to date. Given the insurgency, the enforcement mechanisms may have even declined.

* In Iraq's case, the present extremely low tax structures should not have been a contributing factor to the informal economy, but many marginal firms do not like to pay any taxes.

* The macroeconomy has been relatively stable, but rising inflation in some areas may be contributing to an expansion of the informal economy.

Of the items noted above, the most critical factor affecting the size of the informal economy is no doubt the inability of the Iraqi government to control corruption. In addition, given the insurgency and uncertainty surrounding political developments, it is safe to say that large segments of the population have reverted to the survival relationships characteristic of the period of sanctions in the 1990s. This is confirmed daily with the news coming out of Iraq describing economic mismanagement, (15) vast black markets in gasoline, (16) increased crime, and shortages of critical inputs. (17) These developments do not bode well and suggests that the current size of the informal economy is considerably larger than in the late 1990s. As noted above, another ominous sign (18) is a recently released index of corruption for 2004. The prestigious Transparency International Corporation ranks Iraq as the most corrupt country in the Middle East. In 2004 the country's ranking was 129th out of 145 nations worldwide. By 2005 it had fallen to 135 out of 158 countries. (19)

Based on these factors, it is likely that the size of the underground economy has expanded significantly beyond the 35 percent of GNP figure, noted above, for the end of the Hussein regime. A safe estimate, in light of the insurgency and its detrimental impact on investment, electricity, and transport, would put the informal economy at around 65 percent of Gross National Product. This figure is reinforced by the unemployment stemming from the disbanding of the army and the anti-Baathist campaign following Saddam's overthrow.

In addition to the factors noted above, the informal economy may be growing simply because of the constraints limiting expansion of formal economic activity. Just as private capital formation is often critical to the development of a thriving modern economy, social capital creation may be just as essential in creating the shift to more formal activities. Again, corruption plays a significant role in structuring the informal--this time through its effect on the country's social capital. Figure 1 provides a brief sketch of the factors contributing to the growth of the country's informal/shadow economy.

The Deterioration in Social Capital

Social capital refers to networks of relationships that bind people together. (20) Social capitalists distinguish such relationships from physical capital and the attributes of individuals, or human capital. (21) In the context of Iraqi reconstruction and the establishment of a market economy, a key element of social capital centers on a component of social capital, the notion of trust.

Growing literature (22) on social capital stresses the importance of trust in the institutional infrastructure of a market economy. The focus on trust is inspired by its importance for business formation, which in turn seems to be crucial for explaining the variation in economic performance in a large cross-section of developing and transition economies. Entrepreneurship cannot flourish in an environment of distrust, since many economic opportunities are closed off. As Nobel laureate, Kenneth Arrow, has noted:

  Almost every commercial transaction has within itself an element of
  trust, certainly any transaction conducted over a period of time. It
  can be plausibly argued that much of economic backwardness in the
  world can be explained by the lack of mutual confidence. (23)

The transition to a market economy experience of many of the former Communist countries suggests successful modernization and development take place through a web of diversified social life, mediated by families and communities, and the personal relationships of people within them. (24) In a similar fashion, Fukuyama (25) has identified trust as a central value in prosperous, highly productive societies. Trust is a cornerstone of individuals' ability to subordinate their own interests to those of larger groups and to associate and cooperate with each other to achieve economic purposes and other social satisfactions.

[FIGURE 1 OMITTED]

Trust is such a critical factor in the development of modern economies because it motivates contacts with others and opens access for the exchange of goods and services. It facilitates cooperation. Cooperation, in turn, breeds trust in a two way interaction necessary for the creation of long-term generalized norms for cooperation. Social capital thus represents a set of resources rooted in networks of relationships possessing the power to facilitate economic progress. There are three types of relationships among parties to an economic transaction, giving rise three different types of trust: (26)

1. Ascribed Trust. This first type of relationship is found among kinship groups and family members. These relationships dominate economic transactions in subsistence economies and still characterize reproduction and the household economy (but also many small-scale crafts and trades).

2. Process-Based Trust. This type of relationship is between individuals that have known each other for a long time, without sharing the loyalty to a specific group. Most business networks are characterized by this type of repeated relationship and the prevalence of what develops as a process-based trust.

3. Extended Trust. This relationship is between individuals who enter into a transaction with only limited information about the counterpart's specific attributes. For economic exchange to take place between these types of individuals, generalized or extended trust is needed. The importance of this third type of relationship and the correspondent economic transactions between largely anonymous individuals is a key element of a modern economic system.

This topology suggests that the building of extended trust is a key challenge in Iraq's development to a modern economy. It is also important to bear in mind the relationships between the various forms of trust. In particular, extended trust could not exist without the experience of reciprocity made in repeated interactions among family and other members of a societal or business community. Where process-based trust is absent, extended trust is unlikely to develop.

Moreover, it is unlikely that extended trust in economic exchange could be sustained without the availability of third party enforcement by the state. Clearly, trust in government institutions will be a necessary prerequisite before Iraq can expect any type of significant expansion of the formal economy. Here is where the country's problems lie. One of the main impediments to a formal market in Iraq today is the absence of trust at most levels. The Ba'athist government created a profound imprint on the nature of formal and informal institutions in Iraq. Not only did Ba'athism hamper the emergence of a market economy, it corrupted the judicial and legal institutions needed to create and nurture trust.

In short, Iraqi values today are no longer those that were reported in earlier accounts of the pre-Ba'athist period, which stressed the country's vibrant entrepreneurial spirit. Individual and managers' values have been affected by years of repression under authoritarian top-down decision-making. In an environment of several decades of political and economic insecurity, doubt and distrust are deeply entrenched in the individual mind. They represent a major constraint against drawing entrepreneurs and individuals out of the safe, kinship-based informal economy.

One of the main criticisms of U.S. policy in post-war Iraq has been its rejection, not only of social reform, but of the very state-centered approaches that were critical to the reconstruction and subsequent economic growth in post-war Japan and Germany. At the same time, fundamental social reforms were ruled out. (27) As might be expected, combined with the demise of the state as a safety net, the lack of trust in the buying and selling of goods and services has resulted in the contemporary Iraqi economy being divided into segments of largely non-overlapping networks.

Ascribed Trust Networks

First and by far the largest in number in Iraq are the individual and business networks built on ascribed trust. These are usually confined to the local, informal economy. Most ascribed trust networks involve groups bound together by family, tribal, or ethnicity, which facilitates business organization built on oral contracts. Many of these networks have the potential to expand through selective interaction with outsiders. However, such expansion will take time in Iraq, especially under the current conditions of public corruption and great uncertainty over the enforceability of contracts.

In today's Iraq, many ascribed trust activities fall in what is commonly referred to as the coping economy--numerous economic interactions during armed conflict that provide benefits to the civilian population, particularly the poorest and most vulnerable. These functions are even more important to civilian livelihoods where the formal economy and traditional livelihoods are destroyed or rendered difficult or impossible to sustain. The coping economy includes a wide range of activities including subsistence agriculture, petty trade, and various out of the household businesses--catering, food processing, and the like.

Of the country's three main economic sectors, it is reasonable to assume that the coping economy contains a disproportionate share of the country's poverty. Recent data released by the Ministry of Labor and Social Affairs indicate that about 5 million Iraqis are living under the poverty line, compared with 143,000 in 1993. (28) Significantly, the Ministry noted that more than one million Iraqi women aged 25 to 40 were unmarried, while divorce cases were increasing as was child labor. It is reasonable to assume that this group of women is firmly entrenched in the coping economy.

Process-Based Trust Networks

Second, there are the process-based trust networks reliant on existing ties between the previous members of the Ba'ath government and criminal groups, like smugglers, that thrived during the sanctions period of the 1990s. Today, these activities are largely in the criminal area. The emergence of pervasive criminality was readily apparent soon after the overthrow of Saddam Hussein.

If anything, these problems have become increasingly severe. According to a U.N. report, "The emerging crime problem is subtler and scarier: theft, extortion, and drug- and arms-smuggling operations that have become more sophisticated, more clandestine, and more organized. In Baghdad, one team of thieves recently burned down a warehouse filled with the hot booty of another group. It was one mob sending a message to another." (29)

As in the case of the ascribed trust groups, the activities of these networks have been affected by the insurgency. However, process-based networks' activities often directly contribute to prolonging the insurgency through:

* The destruction or circumvention of the formal economy and the growth of informal and black markets, effectively blurring the lines between the formal, informal, and criminal sectors and activities;

* Pillage, predation, extortion, and deliberate violence against civilians, used to extort ransoms, capture trade networks and diaspora remittances, and exploit labor;

* High decentralization, both in the means of coercion and in the means of production and exchange;

* The use of licit or illicit exploitation of trade in lucrative natural resources;

* The reliance on cross-border trading networks, regional kin and ethnic groups, arms traffickers, and mercenaries, as well as legally operating commercial entities, each of which may have a vested interest in the continuation of conflict and instability.

Scores of the cross-border relationships cultivated by the various smuggler/criminal groups in the 1990s are still in place and operational at the present time. Goodhand observes that the shadow economy is frequently already widespread before the outbreak of conflict and is a permissive factor for conflict when it contributes to violent state collapse. Or it serves as a source of income to would-be rebels. Once conflict erupts, shadow economies are easily captured by combatants and thus often become the basis for the combat economy. (30) This has happened in Iraq, with the current wave of kidnappings and smuggling providing significant financial assistance to the insurgency. (31)

Western intelligence agencies are becoming increasingly worried this systematic strengthening of ties between terrorists and organized crime. Stefan Maier of the German Institute for International and Security Affairs confirmed that cooperation between the two camps was on the rise, despite their different political and economic motives. (32) As he observes: "Common ground between terrorists and organized criminal groups can be found primarily in two areas. First, the two come together in money-laundering activities: Terrorists often need to park their money temporarily with somebody else to cover up their tracks. Secondly, they need weapons, and they usually get them straight from organized crime." (33)

"With the lack of security measures, disorganized crime became organized crime," said Hania Mufti, Baghdad director of Human Rights Watch. "Then, at some point, there was a merging between organized crime and political crime."

In today's Iraq, terrorist groups use many of the same channels for their activities that the Iraqi government and associated criminal groups used in the 1980s and 1990s. In this regard, Iraq is an ideal environment. Decades of socialist and statist experiments of the Ba'ath Party regime, together with subsequent wars and the consequences of UN sanctions, left the Iraqi economy heavily damaged, distorted, and exposed to administrative and political interference. (34) Within this context, terrorists, insurgents, and organized crime elements have been able to thrive through exploiting various economic and institutional weaknesses.

Extended Trust Networks

While extended trust networks may involve some reliance on kinship and family relationships, they are largely characterized by transactions between largely anonymous individuals. As noted, they are a key element in a modern economic system. Since the focus of the present analysis is on the informal economy, these networks will not be treated in detail other than to note that they are largely undeveloped outside the public sector and the national oil industry. Some banking arrangements are moving in this direction, albeit extremely slowly. (35)

Clearly, for Iraq, the key challenge facing the economy is developing the conditions conducive to the creation and growth of extended trust networks to encourage the growth and development of this type of networking. Conversely, the lack of supporting institutions has constrained most economic agents and those entering the labor market to informal activities characterized by family/kinship-based ascribed trust.

Adding network and labor market conditions to the equation provides additional insights to the factors shaping the overall size and, to some extent, the composition of Iraq's contemporary informal economy. These are summarized in Figure 1, with the informal economy seen largely as a function of fundamental supply and demand factors: (a) a youth population bulge, (b) a long-standing state employment program providing incentives for employment in the public, but not private sector, (c) a workforce of diminished skills following a long period of sanctions, (d) little private sector growth stemming from the instability and the insurgency following the overthrow of Saddam Hussein (e) deficient social capital, especially in the form of trust, thus confining most private sector transactions to the informal market, and (f) openness to trade (neo-liberal reforms) makes many potentially profitable firms unprofitable. In turn, the lack of a sizable private sector reduces the links often found between the informal and formal economy.

Because the informal economy is largely the result of a convergence of powerful long-run demographic and economic forces, it will be a fixture for some time to come. At best, informal activities may evolve over the next several years with some progression from ascribed-based networks to process-based networks. If this transition is viewed as successful by Iraqi entrepreneurs and the government makes significant strides in the governance area, then the progression to process-based networks and extended modern networks is a distinct possibility, particularly if the security situation stabilizes enough to support foreign direct investment.

However, a good case can be made that, under current conditions, the development and evolution of organized networks may perpetuate and even expand the informal/shadow economies. Many of the organized networks today have evolved out of Ba'th party efforts to limit traditional centers of tribal authority. In effect, the Ba'th party encouraged the growth and proliferation of informal associational links locally.

EVOLUTION OF LOCAL NETWORKS (36)

More precisely, local-level kinship affiliation was increasingly encouraged as the effects of the 1980s war with Iran and the sanctions of the 1990s drained the power of the central government. Particularly after the 2001 Gulf War, the central government was weakened to the extent that it was unable to perform many of its traditional military, economic and security functions. (37)

The Ba'thist survival strategy during this period was for the party to serve as a broad tribal unit with local associations performing in supporting roles. By 1996, officially sanctioned "tribes" were responsible not only for the maintenance of law and order locally, but also collected taxes on behalf of the government, were appointed judicial powers and extended tribal customary law to the extent of their territorial reach. They received arms and ammunition, vehicles, and logistical support as payment for services rendered to the party.

Local dominance of revived tribal networks was evident in the 1998 crisis involving the United States. At that time, heavily armed and equipped Sunni tribal units were positioned in and around Baghdad to control the restive urban population, a role formerly belonging to the Ba'th party militia. With time the interests of the central government and local networks began to diverge. Clan-based groups controlled the highways around Baghdad.

They increasingly turned to criminal activities--looting, smuggling, and hijacking throughout most of al Anbar province. Conditions deteriorated to the extent that convoys were necessary even for basic travel in daylight to avoid raids by tribal guerillas.

By 2000, policeman, judges, and party officials were subject to violent tribal recriminations. Encounters between Iraqi soldiers and tribal irregulars, especially those based in Al Anbar province escalated in terms of frequency and scale. In this ever more lawless environment, tribal elements began to take over many of the local, informal street-markets. These markets comprised a sub-stratum of the informal Iraqi economy that, as noted above, began to grow in the early 1980s as a result of chronic resource scarcities brought on by war, unrest, and a decade of sanctions.

In addition, Saddam Hussein's selective distribution of increasingly scarce resources created some of the underlying group rivalries that exist today. By directing funds, rations, government positions, electricity, clean water, fuel and industrial investment toward specific villages in the western Sunni regions in exchange for service to the regime, and withholding resources to other villages as a punitive mechanism, a local-level competitive calculus developed that was perpetuated by Hussein as an instrument for rule. Because the state-level formal economy was dramatically curtailed by sanctions, this competition for resources further encouraged the growth of informal activities and employment.

The tendency of corrupt party and state institutions to favor key supporters and engage in fraud in the distribution of goods and services encouraged those operating in the informal (and formal) economy to rely on local level mediation by tribal groups. Because informal activity is based in large part on social capital--the trusted familial and kinship ties noted above--local tribal groups played a central role in the expansion of the informal economy. By assessing fees for the settlement of disputes and collecting taxes on local production, local tribal groups also began to establish financial support free of state control.

Tribal groups were also increasingly involved in criminal-type activities, especially in the western border regions. Illicit criminal networks were initially based on the cross-border smuggling of animals, tea, alcohol, and electronics. Later these activities began encompassing the drug trade. Tribal-based organized criminal activities increased toward the end of Ba'thist rule with many party members becoming involved due to declining opportunities to acquire official resources. By early 2002, the entire route along the Euphrates River in Al Anbar had essentially developed into a sanctuary for illicit traffickers and criminal entrepreneurs.

Resource scarcity and the stature of sub-tribal groups were both greatly enhanced at the local level following the removal of Saddam Hussein:

* The Coalition Provisional Authority's (CPA) early adoption of a neo-liberal economic program impeded the growth of regulatory and legal institutions. This institutional vacuum forced businesses and those entering the labor market to rely on the trusted kinship or extended family networks of the informal economy.

* Shortages of critical inputs such as electricity and fuel, and the dangers of transportation further encouraged informal entrepreneurs to rely on tribal and extended family associations for protection and support.

* As noted above, endemic corruption and uncertainty have contributed to a dramatic increase in the informal sector following the 2003 invasion. As a result, approximately eighty percent of the labor force is now engaged informally, accounting for nearly two-thirds of Iraq's gross domestic product.

* Growth of the informal economy is particularly evident in certain areas west of the capital, where the destruction of the Sunni-oriented military establishment and related industries has contributed to a substantial contraction of formal activities and jobs.

* A principle driver of this growth has been a dramatic rise in criminal activity related to he shadow economy and dominated by local-level tribal elements, including the emerging economies based on the distribution of scarce resources, kidnapping, trafficking in petrol, narcotics, looted weaponry, and the targeting of coalition forces.

* In areas beyond the control of the Iraqi government and lacking a substantial coalition presence, the shadow economy is rapidly displacing any legal or semi-legal structures that may have survived until the present.

The removal of the Hussein regime and the actions of the CPA presented a range of opportunities and constraints that have in part determined the manner in which street-level groups have mobilized and generated new opportunities and constraints for both the original organizations and follow-on groups over time. This evolution has gone through three distinct phases: (1) March 2003-December 2003; (2) December 2003-January 2005; and (3) January 2005 to the present.

March 2003-December 2003

During this initial phase, the persistent lack of security and the policy directives issued by the CPA accounted for the greatest opportunities for armed groups to expand their positions locally. Within this period the most prominent actors at the street-level in term of mobilization potential, organization and stature within the surrounding community were those legacy groups of local/kinship-based "tribal" associations reminiscent of the period under sanctions.

These groups are composed of pre-existing social groups (some former regime elements, and perhaps regime opponents) within the tribe that come armed and equipped, and they are activated by conflict, inspired leadership and the prospect of loot.

A second tier of gangs was comprised of those groups engaged in entrepreneurial and organized criminal activities, also a legacy of the sanctions. These gangs are largely based on local associations. While there is some degree of overlap between these two tiers, the fact that many tribal groups maintained militias precisely to protect their local economic interests from Ba'th encroachment prevented an alignment between these two groups--at least in the immediate aftermath of the invasion.

The chaotic lawlessness of this period presented a significant opportunity for groups in both tiers to solidify and extend their presence locally. Hesitation on the part of coalition forces to manage the deteriorating security situation in most urban centers, particularly Baghdad, acted as a catalyst in the very process of institutional devolution that had been occurring under the Hussein regime. The vacuum that developed in the weeks following the invasion increased the scale and intensity of this process as the role of self-protecting mutual assurance groups responded to the precipitous decline in law and order.

In sum, CPA policies of "de-Bathification," disbanding of the Iraqi national army, and the Coalition's ambivalence toward the rise of militias presented a second opportunity for street-level gangs to expand their influence and control of resources. By the closing months of 2003 the die had been cast.

December 2003-January 2005

Hostilities between coalition troops and local populations, the inability of coalition forces to adequately repress insurgent violence, and the return of sovereignty to the Iraqi government provided the most significant opportunities for the various local networks to expand during this second period.

First, the dominant groups at this stage reflected a three tiered structure. The networks corresponding to the two most prominent groups began exhibiting a high degree of overlap:

* The combination of tribally-based former security personnel and criminal groups comprised the first tier.

* The second and third tiers were occupied by indigenous elements motivated by vendetta, and extremist Islamic ideologies, respectively.

* Factors such as the collateral costs of the Fallujah operations and the abuse of detainees at Abu Ghraib represented a substantial political opportunity by further legitimizing the existence of armed street-level groups.

This environment facilitated the emergence of the second and third tier of violent street-level actors. These actors, predominantly foreign in the latter case, were easily absorbed by the expanding networks of street-level groups. These groups provided both the means and an added incentive to engage in anti-coalition targeting by offering generous monetary incentives.

This pattern of network evolution was further stimulated by shifting budgetary patterns after June 2004--the time the CPA transferred control of government portfolios and the national budget to Iraqi ministries. This shift in budgetary authority represented a political opportunity for the street-level groups. Specifically, the allocation of state assets reflected a new budgetary dynamic that tended to favor those interests centered in Baghdad over the remote provincial areas. As a result, the capacity of the coalition to respond to conflict conditions and proceed with reconstruction was seriously weakened.

Second, newly appointed ministers fostered a climate of parochialism by attempting to establish an independent, self-supporting infrastructure within the new institutions under their control. The relationship between the Ministries of Interior and Defense is instructive. Both ministries assumed control of an array of smaller "special" units comprised of thousands of supporters and local affiliates, sustained by diverted funds intended for aid and reconstruction.

January 2005 to the Present

In addition to a continuation of many of the dynamics noted above, this period has been marked by a set of new opportunities created by elite cleavages within the National Assembly, the increased politicization of militias and the continued expansion of the shadow economy.

Changes in the street-level dynamic have been consistent with the opportunities for expansion. Again a first-tier of networks exists, possessing a high degree of overlap between entrepreneurial and organized criminal networks. They are comprised largely of Iraqis harboring some form of vendetta or personal grievance against the coalition. A second tier of actors is comprised of foreign and domestic Islamic extremists.

As in the earlier two periods, demand for weapons, stolen goods, and hostages determine the roles and relationships between street-level actors more so than ideological or political convictions. Yet in this phase, engagement in the black market has not merely enabled sustained street-level activity, it has in many cases become the activity itself, dominating collective resources and driving group expansion in terms of capabilities and reach. The shift is evident in certain portions of Al Anbar province where despite frequency of anti-coalition targeting, criminal endeavors are now thought to account for the bulk of street-level activity. Clearly the draw of the shadow economy is a major factor tending to decrease the likelihood that Sunni groups will participate more in the political process in the near term.

Summing up the evolution of local network development in Iraq, a pattern emerges whereby during each phase of the post-war period the position of locally-oriented armed groups has been solidified and expanded in a manner consistent with the type and timing of the political opportunities available. The most significant opportunities have included:

* The slow recognition of security conditions facilitated the establishment of armed groups in the first phase. This first phase also represents the playing out of the structural conditions stemming from the sanctions regime.

* An appreciable shift in the street-level dynamic in terms of the relative predominance of certain actors in the second and third phases. This transition has favored the position of indigenous groups radicalized through interaction with the coalition, with a higher degree of overlap between all groups and the shadow economy in the current phase.

State-level political openings may lure some elements of resistance into the political process, but in the present phase, the draw of the shadow economy may be sufficiently strong to keep groups engaged in street-level violence.

ASSESSMENT

Several years have passed since the removal of Saddam Hussein, yet there are few indications that the degree of Sunni-led violence will decline. On the contrary, violent activity has increased in frequency and scale.

The evolution of local insurgent/criminal networks in Iraq suggests several mechanisms that that are consistent with this acceleration of violence. One theory associated with the theory of third generation gangs, or the 3G2 model, (38) provides valuable insights as to the manner in which these groups are likely to evolve and the best methods to arrest their development.

Specifically, the 3G2 model suggests that armed groups function within a rationally bounded and organized space that is responsive to forces affecting the calculus and outcomes of group behavior. When modified by state authorities, these forces represent potential opportunities to minimize, deflect, or redirect the activities of the group.

Many of the structural conditions found in Iraq are key constructs of the 3G2 model. In particular, the existence of violent networks in the context of a state that is constrained by minimal capacity, poor economic performance, and significant social and political disparities are key elements of the model. The 3G2 model also assumes that self-protecting solidarity groups are heavily engaged in the informal and criminal economies at the local level. Insurgent/criminal networks in Iraq are analogous to the form and functions performed by street-level gangs--the basic element of the 3G2 concept.

As the 3G2 model would predict, insurgent and criminal groups in Iraq have expanded their economic and political positions vis a vis the state through corruption and intimidation. Further, the model posits that 3G2 actors themselves initiate this process for the purpose of establishing lawless areas and criminal enclaves or quasi-states.

On the other hand, certain causal relationships in Iraq differ from those posited by the 3G2 approach. In particular, roles of local networks and the state are reversed. Starting with Saddam in the 1980s, the incremental decline of the capacity and presence of the Iraqi state, combined with the sate-initiated scheme to retain power facilitated the expanded role the role of local-level groups. In fact, Saddam's approach during austere times was to compel local groups to fill the political and security vacuum produced by institutional retrenchment.

The process continued after Saddam's fall--nearly all of the available political space with the exception of state-level ministerial portfolios had been effectively abandoned to local forces. In Iraq, the extent of corruption and intimidation exercised by insurgent and criminal groups has resulted from state retreat. As normally constructed, the 3G2 model assumes criminal networks encroaching on the state.

The Iraq case suggests several modifications of the 3G2 model are necessary to better understand the dynamics unfolding in that country. In particular, the end-state of the dynamic group processes currently underway are groups of lawless criminal enclaves or quasi-states stemming from the state's inability to provide essential social, economic and security functions.

On the other hand the present system may exhibit some stability. As the quasi-states take on the local functions of providing security and access to resources, they tend to favor a certain degree of stability and ever-increasing levels of market access. The competitive dynamic between these quasi-states may produce a status quo that preserves the structure of the declining state. The state structure persists not in spite of the proliferation of quasi-states but precisely as a result of this process. This dynamic may explain some of the stability and security in Iraq in the absence of effective national government.

* First, insurgent group activity can be viewed as a cumulative effect of the structural forces prevalent in Iraq. The choice to engage in violence is one element of a strategic rational formed by conditions of scarcity and the functions armed groups perform locally. This rationale also shapes the competitive dynamic that drives political and economic expansion.

* Second, the behavior of locally-based armed groups can be affected by manipulating societal and local-level factors, the most significant of which are: (a) economic conditions especially the growth of the informal economy, (b) competition between entrepreneurial and criminal/insurgent networks linked to the informal/shadow economies, and (c) the openness of the legitimate political sphere.

* Finally, these and other inputs into the 3G2 framework can be expected to generate certain outcomes stemming from group/network evolution from the street level.

The acceleration in violence in Iraq throughout most of 2006 suggests that the informal and shadow sectors will continue to dominate the economic landscape in the near term and will likely grow as the markets associated with insurgent violence expand. The criminal economies based on theft, weapons trading, mercenary kidnappings, black-market smuggling and arbitrage that have become the cornerstone of insurgent mobilization will continue to operate with very few constraints and will likely increase in proportion to increasing levels of violence.

In the current phase, competition is actually fueling the expansion of the underground economy in addition to the increased appropriation of market segments by combatants. When viewed in the context of the 3G2 model, the structural setting presently observed in Iraq suggests the continuous and unconstrained expansion of insurgent group capabilities well into the future:

1. The tendency of insurgent groups to capture sectors of the growing informal and criminal economies will increase. This in combination with the growing political stature of armed groups and a liberalizing Iraqi state favors some type of criminal enclaves or quasi-state development in parallel to legitimate state structures.

2. Armed groups will function as the shadow or de-facto governments within these enclaves providing the services and performing the tasks reflective of their local orientation.

3. The structure of the legitimate Iraqi state will survive and may even thrive in those areas outside insurgent influence.

4. Locally-oriented armed groups can be expected to expand from the street to the sub-national level, evolving from mutually protective solidarity groups into prominent political and economic actors.

The degree of intensity of insurgent violence is increasing and this trend is likely to continue. Coalition forces confronting this challenge have been thrust into an environment of great uncertainty. Coalition forces on the ground are facing a variety of threats from across the spectrum of violent actors. The different motivations and relationships between these groups are gradually emerging:

* Indigenous and transnational actors are establishing links and magnifying their capabilities in ways that are consistent with the rapidly changing information-age environment.

* The traditional distinctions between violent groups seeking political goals and those pursuing profit are becoming blurred.

Summing up, an adapted version of the 3G2 model provides useful insights into the Sunni-led insurgency that the general guidelines currently in use tend to overlook. Those guidelines depict the insurgent threat as a discrete collection of actors motivated by a combination of nihilistic range, primordial tribal grievances or a desire to restore the former grandeur of the Ba'th party.

In contrast, the 3G2 model identifies the societal-level conditions affecting the origins, development and orientation of armed groups, the political role that these groups embrace over time and the relationships between groups that span the local, regional and global levels of interactions.

These factors culminate most forcefully at the street level, where the relationships between groups are characterized by violence and competition. The integrated model highlights certain critical junctures where these relationships can be altered and exploited to better combat the insurgency.

CONCLUSION--HOPE FOR THE FUTURE

The integrated model shows that insurgent-group activity can be viewed as part of the continued effects of the structural forces prevalent in Iraq. The choice to engage in violence is one element of a strategic rationale informed by conditions of scarcity and the functions armed groups perform locally. This rationale also shapes the competitive dynamic that drives the expansion of insurgent groups into the political and economic realms. Therefore, the behavior of locally-based groups can be affected by manipulating societal and local-level factors, the most significant of which are the size and composition of the underground/shadow economy and the openness of the legitimate political sphere. These areas comprise the key vulnerabilities of the insurgent/criminal groups in Iraq:

Resolving critical shortages and introducing balanced reforms in the formal sector will slow or reverse the growth of the informal and shadow-economies. These measures would significantly undercut street-level mobilization structures by co-opting the functions of tribal and sub-tribal groups while diminishing the pull of the shadow economy which fuels insurgent activity. Openness at the political level would similarly undercut or co-opt the rising political stature of armed leaders by channeling them into a legitimate political process.

Clearly, greater emphasis should be placed on limiting the growth of the informal and criminal economies, which are easily captured by criminal/insurgent networks. Iraq's present set of economic policies are legacies of the Coalition Provisional Authority (CPA) period. As in many other developing countries, they were intended to produce a thriving, free market economy. These policies reflect much of the reform agenda commonly known as the Washington Consensus, emphasizing fiscal discipline, re-prioritization of public expenditures, privatization, trade liberalization, deregulation, foreign direct investment, property rights and good governance in general. (39) Three years later many of these reforms are only partially or haphazardly in place, contributing the expansion of the vibrant informal and shadow economies at the expense of formal sector development.

One course of action is to try and press ahead with the completion of market reforms. However, given the current political atmosphere in Baghdad with so many government officials having a vested interest in preserving their lucrative links to black markets and the underground economy, this is unlikely to occur until major strides are made toward controlling corruption. Even price reforms will take time to begin slowing the growth of the underground markets. For example, while gas prices are gradually rising as part of an International Monetary Fund (IMF) program, (40) the impact on the shadow economy has been affected by the oil price differential between Iraq and its neighbors.

Another approach is to re-introduce many of the pre-2003 state-based social services with emphasis placed on slowing or reversing the impetus to join the informal and shadow economies. These measures would significantly undercut street-level mobilization structures by co-opting the functions of tribal and sub-tribal groups while diminishing the pull of the shadow economy that fuels insurgent activity.

A variant on this course of action would be the reorientation of economic programs from the post-war centralized top-down orientation toward one that is decentralized and inclusive. This reorientation is likely to erode somewhat the popular or at least passive support for the insurgency--the more people with a stake in the decision-making process and economic outcomes, the more they will participate in building a new Iraq.

Notes

1. National Strategy for Victory in Iraq (Washington: National Security Council, November 2005).

2. Ibid., p. 22.

3. Quoted in Tom Regan, "US Inspector General for Iraq Paints 'Grim' Picture of Reconstruction Effort," Christian Science Monitor, November 1, 2005.

4. Ibid.

5. Cf. Robert Looney, "Building from Scratch: The Transformation of Post-War Iraq's Financial System," Middle East Policy 12:1 (Spring 2005), pp. 134-149.

6. "Unemployment Caused by Insecurity and Vice-Versa," IRINnews.org (November 29, 2004).

7. Simon Jenkins, "America Has Finally Taken on the Grim Reality of Iraq," The Guardian, October 18, 2006.

8. For example: David Hecht, "Why War Zones Love Monopolies," Fortune 149:11 (May 31, 2004), p. 66; Jeffrey Fleishman, "In the New Baghdad, Viagra a Hot Sell," Los Angeles Times, June 17, 2004; Stanley Reed, "The Kurds Embrace a New Cause: Rivals are Uniting Behind Economic Development in the Northern Iraqi Region," Business Week, January 12, 2004, p. 48.

9. Robert Looney, "The Business of Insurgency: The Expansion of Iraq's Shadow Economy," The National Interest, Fall 2005.

10. James Baker and Lee H. Hamilton, "Beyond Today's Headlines--Answers for Iraq," Houston Chronicle, December 9, 2006.

11. Cf. Robert Looney, "Iraq's Economic Transition: The Neoliberal Model and Its Role," The Middle East Journal 57:4 (Autumn 2003), pp.568-587.

12. Ariana Eunjung Cha, "New U.S. Weapon: Jobs for Iraqi Men," Washington Post, February 22, 2004 p. A. 18.

13. Cf. Robert Looney, "Iraq's Shadow Economy," Rivista Internazionale di Scienze Economiche e Commerciali (2005).

14. Ibid.

15. Sabri Zire Al-Saadi, "Iraq's Post-War Economy: A Critical Review," Middle East Economic Survey XLVII:14 (April 5, 2004).

16. "Iraq: Report of Continuing Fuel and Electricity Shortages," Noozz.com (January 23, 2005).

17. Dan Murphy, "In Iraq, a Winter of Discontent," Christian Science Monitor, January 10, 2005.

18. Also see Adam Davidson, "Still on the Take: The U.S. Has Not Ended Iraq's Culture of Corruption," Los Angeles Times, May 2, 2004, p. M.1.

19. http://www.transparency.org/policy_research/surveys_indices/cpi/2005.

20. An overview of the literature on social capital can be found in Martin Paldam, "Social Capital: One or Many? Definition and Measurement," Journal of Economic Surveys 14:5 (December 2000), pp. 629-654.

21. Christopher Scanlon, "The Problems With Social Capital," The Age (July 19, 2003).

22. The following draws on Robert Looney, "Economic Consequences of Conflict: The Rise of Iraq's Informal Economy," Journal of Economic Issues, XL:4 (December 2006).

23. Kenneth Arrow, Altruism, Morality and Economic Theory (New York: Russel Sage Foundation, 1975).

24. B. Berger, The Culture of Entrepreneurship (San Francisco: ICS Press, 1991).

25. Francis Fukuyama, Trust: Social Virtues and the Creation of Prosperity (New York: Free Press, 1995).

26. Martin Raiser, "Trust in transition" http://www.colmud/hu/honesty-trist.

27. Mark Selden, "We Aren't Close to Doing What We Did in Japan," http://hnn.us./articles/5873.html

28. "Five Million Iraqis Live Under Poverty Line: Report," Xinhua (February 12, 2004).

29. Mark Fritz, "Arms and Drug Smuggling Rise as Crime Gets Organized in the New Iraq," Associated Press, July 5, 2003.

30. Goodhand, op. cit.

31. Roshan Muhammed Salih, "Crime and Disorder Thriving in Baghdad," Aljazeera. net (April 3, 2004).

32. http://www.dw-world.de/dw/article/0,1564,1352140,00.html.

33. Ibid.

34. Robert Looney, "A Return to Ba'thist Economics," Orient 45:3 (2004), pp. 385-400.

35. Cf. Robert Looney, "Postwar Iraq's Financial System," Middle East Policy, XII:1, Spring 2005.

36. This section draws heavily on Nicholas I. Haussler, Third Generation Gangs Revisited: the Iraq Insurgency, Masters Thesis, Naval Postgraduate School, September 2005, pp. 33-41.

37. Excellent accounts of this period is given in: Joseph Braude, The New Iraq (New York: Basic Books, 2003), and Stephen Glain, Mullahs, Merchants, and Militants: The Economic Collapse of the Arab World (New York: St. Martin's Press, 2004), ch. 5.

38. Best articulated in Max G. Mainwaring, "Street Gangs: the New Urban Insurgency." Carlisle, PA: U.S. Army War College, Strategic Studies Institute publications, March 2005. See also John P. Sullivan "Gangs, Hooligans, and Anarchists--the Vanguard of Netwar in the Streets." In John Arqilla and David Ronfeldt, eds. Networks and Netwars: The Future of Terror, Crime and Militancy, Santa Monica: Rand Corporation, 2001.

39. Cf. Robert Looney, "The Viability of Iraq's Shock Therapy, Challenge, 47:5, September-October 2004, pp.86-103.

40. Robert Looney, "The IMF's Return to Iraq," Challenge 49:3, May/June 2006.

Robert E. Looney

Professor of National Security Affairs

The Naval Postgraduate School

Monterey, California 93943

USA

Robert E. Looney is professor of National Security Affairs, and Associate Chairman of Instruction, Department of National Security Affairs at the Naval Postgraduate School, Monterey California. He received his PhD in Economics from the University of California, Davis. He has been a consultant to the governments of Iran, Saudi Arabia, Japan, Mexico, Panama and Jamaica as well as the World Bank, International Labor Office, Inter-American Development Bank, Stanford Research Institute, Rand Organization, and the International Monetary Fund. He specializes in issues relating to economic development in the Middle East and has published twenty books including: Industrialization in the Arabian Gulf and The Pakistani Economy: Economic Growth and Structural Reform.