Peter Passell
Editor, The Milken Institute Review; Senior Fellow
California and Capital Markets and Europe and Finance and Global Economy and Labor and Public Policy and U.S. Economy
Peter Passell is editor of The Milken Institute Review, the Institute's economic quarterly. A senior fellow, Passell joined the Institute after eight years as economics columnist for the news department of The New York Times. He previously served on the Times' editorial board and was an assistant professor at Columbia...
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Egypt's costly free lunch
By: Peter Passell
September 14, 2012
For months, Egyptian demonstrators risked their lives (and some lost theirs) standing up to Hosni MubarakaEUR(TM)s thugs. Then, the newly elected president stared down the military, which was planning to fix the election after the fact. And this week, the government walked the tightrope between sympathy with anti-American protests and a commitment to maintain close ties with the West. Now comes the hard part.

The Egyptian economy is only shakily recovering from the global recession. In part, thataEUR(TM)s the inevitable consequence of the political uncertainty that drove investors (foreign and domestic) to safer climes. In part, itaEUR(TM)s the bitter aftertaste of two decades of MubarakaEUR(TM)s crony capitalism, which generated a lot of growth from some market reforms, but alienated the urban middle-class and rural poor (see below). The immediate problem, though, is dysfunctional government that, ever since the reign of Abdul Gamal Nasser, has managed popular discontent with Treasury-draining handouts rather than economic opportunity.

Egypt is currently running a budget deficit equal to a numbing 11.5 percent of GDP; foreign exchange reserves are at dangerously low levels and -- no surprise -- private lenders are unwilling to buy Egyptian bonds unless the IMF confers its symbolic imprimatur on EgyptaEUR(TM)s creditworthiness. Thus, the new government faces a stark choice between bowing to terms imposed by the IMF that are bound to anger Egyptians, and ducking the problem with default and/or inflation. Much, then, depends on making a deal with the IMF that can be sold to the public, yet still tackles the scattershot food and fuel subsidies that are bankrupting the fisc.

Back up for a moment. You may not have noticed, but the Egyptian economy responded very well to market-opening reforms begun in the early 1990s that attracted massive amounts of foreign capital. Real income per capita has nearly tripled, to a respectable $6,300. The catch: the growth dislocated the lives of millions of Egyptians, eliminating the security of many government workers, sucking the rural poor into crowded urban slums, and creating a wealthy elite of insiders who made no effort to hide their (sometimes ill-gotten) gains.

No democratic government will succeed in the long run unless it reduces official corruption, controls military patronage spending, lays out the welcome mat for new businesses, and reforms the antiquated education system. But the immediate problem is managing the runaway food and energy subsidies that are now equivalent to about 10 percent of GDP.

Simply targeting the funds to those truly in need would go a long way toward fixing the problem. About one-third of the money pays for food, mostly in the form of lower prices for bread sold to everybody, rich and poor. The other two-thirds is in subsidies for gasoline, natural gas and butane for cooking, little of which raises the living standards of the poor; the rest goes to industry and the middle-class.

But efficient targeting is more easily proposed than done. Subsidized bread is widely viewed as a birth right. And itaEUR(TM)s hard to imagine the Muslim Brotherhood-led government risking an outbreak of urban discontent that gave the military an excuse to reassert power. Gasoline and cooking gas are almost as problematic -- Jordan just rescinded an increase in gasoline prices after mobs hit the streets (led, ironically, by the Muslim Brotherhood).

If the subsidy system is to crack, the first fissures will probably be in the delivery of cheap natural gas, most of which is used by business. Indeed, the interim government floated a plan back in Julyfor raising the price of natural gas sold to heavy industry. ThataEUR(TM)s a credible beginning (if the government follows through), and one that could pacify the IMF (and foreign investors) for a while. To save really big bucks, though, gasoline would have to take a hit, and perhaps food down the road.

The model for managing such reforms may lie in -- believe it or not -- IranaEUR(TM)s approach to the subsidy problem. While the mullahs are hardly known for their superior economic management, they did have the sense to convert price-distorting gasoline subsidies into flat cash rebates for consumers that more than compensated the poor for increases at the pump. Of course, Iran could quell resistance by labeling protests as treason, which isnaEUR(TM)t in the cards in Egypt.

The bad news here is that implicit threats to force Egypt into default arenaEUR(TM)t entirely credible. The government may calculate that the West has no choice but to support moderates in Egypt over the alternatives. The good news: Egypt is a market just itching to emerge. And a serious effort to discipline the government budget could lead to a virtuous circle in which business confidence (and foreign investment) returns, and rapid economic growth generates the jobs and income that Egyptians really need.

Mr. Passell is a senior fellow at the Milken Institute and editor of the Milken Institute Review. Mr. Hahn is director of economics at the Smith School, University of Oxford and chief economist at the Legatum Institute.