Designing Institutions for a New Libya

The death of former Libyan leader Moammar Gadhafi has created a sense of elation in Libya. Leaders of NATO countries are also congratulating themselves on a limited and successful mission, achieved without a single coalition casualty. However, the strategic objective of the intervention in Libya was not to kill Gadhafi and destroy his army, but to protect civilians and, in doing so, facilitate Libya’s transition to democracy. In this regard, Libya’s future remains fraught with risk. Left to its own, Libya may soon find itself again run by an autocracy, ruined by a civil war, or both. It is critical now, more than ever, that Libya and the international community consider how to design institutions to ensure a stable and prosperous future for the country. Specifically, Libya should establish a national resource fund (overseen by an independent body) to manage government profits from the oil sector, with a set percentage of the interest reinvested in infrastructure and education.

Libya is plagued by a toxic mix of underdeveloped political institutions, tribal and ethnic fractionalization, and oil-dominated economics. Unlike other states liberated by the Arab Spring, Libya’s economy is heavily dependent on oil. Libya is the world’s 17^th-largest oil producer. Revenues from the oil sector account for 95 per cent of its export earnings, 25 per cent of its GDP, and – most significantly – 80 per cent of its government revenue.

Oil and accountable government rarely mix. Lucrative and accessible natural resources free leaders from relying on taxation, and therefore from public opinion. In short: no representation without taxation. These resources, and the military equipment they afford, also permit leaders to buy off or repress demands for representation. Finally, natural resource dependence leads to the “Dutch disease,” where natural resource exports inflate the value of currency, making other products less competitive in international markets, and this, in turn, reinforces dependence on natural resources. Current Libyan leaders are publicly committed to freedom and democracy, but there are no guarantees that future leaders will be so restrained, especially if they can exploit resources for themselves and break their dependence on their constituents.

When a state relies heavily on natural resources for revenue, these resources become a coveted prize for political contenders. This increases the likelihood of coups or separatist civil wars led by groups wanting to control resource-rich areas for themselves. This is precisely what occurred in Libya, where oil was discovered in 1959 and the government was overthrown in a coup in 1969. The risks of coups in civil war are magnified in Libya, which is riven by tribes and ethnic groups, many of which have lost power with the demise of Gadhafi. The current nationalist euphoria masks underlying social fissures. For instance, there is evidence that rebel general Abdul Fatah Younis was killed by members of an allied militia. With a common enemy defeated, goodwill will start to dissipate – especially as groups begin to negotiate the distribution of power and resources. The spotty human-rights record of the Transitional National Council, reprisals against alleged regime loyalists, infighting among rebel forces, and the apparent execution of Gadhafi provide no reason to be optimistic that such negotiations will proceed smoothly.

What can be done to avert the risks of autocracy and civil war? Robust political institutions to maintain democracy and the rule of law are clearly essential. However, as the cases of Venezuela and Russia demonstrate, they are also insufficient. What are needed are institutions to manage the interaction of political power and natural resource rents.

In this regard, Libya should follow the example of Norway. When Norway came across a natural resource windfall in the 1960s, it deliberately avoided the bonanza that had ruined other countries. Instead, it restricted the exploration and access of oil fields to lessen the debilitating effects of currency appreciation. It mandated that a certain percentage of profits be put aside to fund future exploration and the renovation of oil facilities. Most importantly, profits from extraction were held in a national resource fund (NRF), known as the Government Pension Fund, with the government only being able to access the interest on this NRF. By limiting political access to natural resources, it forced leaders to actively seek the support of their constituents. The NRF provided Norway with some protection from fluctuations in oil prices, limiting dependence on natural resources and creating space for a more diversified economy. For less-developed countries, restricted access to resources would make the state a less attractive prize for those seeking to seize it.

In the context of Libya, two core principles should guide the design of natural-resource institutions: 1) natural resources should serve the long-term interests of the Libyan people, and 2) firewalls must be set up between natural resources and political power. For instance, a fixed share of oil profits should be mandated towards an NRF. A percentage of the interest on the NRF could be reinvested in infrastructure and education, in anticipation of the need to diversify the economy when the resources are depleted. The rest of the interest could be used at the disposal of the government, permitting stable or countercyclical government spending in a volatile economic environment.

To be effective, an NRF must be somewhat independent of government. After all, an NRF that the executive could raid at will would provide neither the desired economic stabilization nor the necessary political constraint. Therefore, an NRF in Libya would need to be managed by an independent and transparent body. Any change to the allocation of funds to the national trust (or interest on said trust) would require a supermajority in the legislature. Ultimately, such an NRF would entail automatic investments in physical and human capital and self-enforcing constraints on discretionary spending by would-be autocrats.

Creating institutions, particularly those that limit the political and economic power of incumbents, is notoriously hard to achieve. These sorts of institutions would force Libya to sacrifice near-term economic flexibility for longer-term stability. There will be a temptation to lean heavily on natural resources in order to rebuild Libya, the economy of which has shrunk by some 50 per cent during the civil war. However, times of crisis and change – and especially the development of a new constitution – provide unique opportunities to chart a new course. Pressure from the international community will be essential.

What leverage does the international community have to encourage the development of such institutions? The U.S. Treasury still controls $700 million of the $1.5 billion in frozen assets from the Gadhafi regime, and Libya remains dependent on foreign aid to redevelop its oil infrastructure, and its economy more broadly. The international community could make the gradual unfreezing of the funds (aside from those dedicated to humanitarian aid) and the provision of economic aid conditional on a set of institutional reforms. For example, it could guarantee the return of certain funds upon the ratification of a constitution, and over the course of two election cycles that are deemed free and fair by outside observers. Interest on frozen funds could even be used to fund the elections. Ultimately, it is much easier (and less provocative) to reward positive political developments than to try to rally the international community to sanction swings towards autocracy.

Some might argue that leveraging frozen assets and investment requirements to shape Libyan institutions is an unfair intrusion into the domestic affairs of another state. Yet such statecraft is no different than the U.S. demanding that China improve its intellectual property laws, the United Nations imposing economic sanctions against nuclear proliferators, the International Monetary Fund requiring structural adjustments for a loan, or the European Union demanding fiscal or political reform as a precondition for membership. After seven months of air strikes and no-fly zones, the point may also be moot. Moreover, incentives have often proven to be more effective than sanctions at motivating political reforms. The former lionizes leaders who make changes, whereas the latter punishes them, only to push them to dig in their heels. The prospect of NATO and EU membership was used with great success to motivate Eastern European states to stay on course toward democratization and liberalization. A similar approach should be used in Libya.

In sum, the international community should maintain pressure on Libya to undertake necessary institutional reform for the responsible stewardship of its natural resources. This will ensure that resource extraction strengthens, and does not undermine, diversified growth, peace, and democratization. Only then will near-term military victory stand a chance of leading to long-term political success.

Photo Courtesy Reuters.