Will Oil Profits Reshape the Middle East?

Kenneth M Pollack
Kenneth M Pollack Former Brookings Expert, Resident Scholar - AEI

July 13, 2008

You might think that $140 per barrel oil would be good for at least one part of the world, the Middle East. It’s too soon to tell for certain, but the region may well turn out to be the part of the world that suffers the most.

As painful as the current (or coming) oil-driven recession will be for Americans, it does seem to be convincing us to make the sacrifices necessary to diminish our reliance on oil. Over the long term, that could prove a huge boon for our economy, our environment and our national security.

In the Middle East, the situation may be reversed. Right now, the region is experiencing an economic boom, creating the opportunity to address the deep-seated political, economic and social problems that have spawned terrorist groups like Al Qaeda. That’s certainly what the people of the region hope.

The danger is that the way that the rising revenues are being spent will more likely worsen the region’s instability over time.

And that’s a problem, because problems in the Middle East have a bad habit of becoming big problems for the rest of the world. The Middle East isn’t Las Vegas: what happens there doesn’t stay there.

In the 1970s and ’80s, during the first great oil boom, the Middle Eastern producers largely squandered their wealth. Some did set up vast social-welfare networks that improved health care (an important reason for the explosive population growth of the past 30 years). But by and large they sent the money overseas, putting it in foreign real estate and Swiss bank accounts. This did nothing to develop (let alone diversify) their economies, and so when the boom turned to bust in the 1990s, economic problems mushroomed. With them came political discontent, terrorism and rebellion.

This time around, some Middle Eastern oil producers are trying to be smarter. They are investing billions of dollars at home, building industries, repairing roads and factories, and expanding social services. This has led regional elites and many in the international financial community to proclaim a new era in the Middle East — one in which the new oil revenues will diversify the region’s economies, create jobs for everyone, and make the Arab states the world’s economic superpower.

If this sounds unlikely, it’s because it almost certainly is. More oil money is being re-invested in the region, but it is not being spent where it is most needed. As a result, it is having little impact on what really matters, and is even creating problems.

The macroeconomics often do look great: gross domestic product, trade and foreign direct investment are all rising substantially. But unemployment and underemployment have declined very little and inflation is rising quickly. At a microeconomic level, critical problems belie the rosy picture painted by the superficial macro indicators.

In addition, much of the money is being re-invested in projects intended to produce quick profits for investors rather than long-term political and economic gains. A great deal of it is going into non-productive sectors like real estate and oil refining. Many of the factories being built with the new oil revenues will be heavily automated plants that will employ few people.

The industries that create lots of new jobs, like tourism, agriculture and construction, import workers from southern and southeastern Asia rather than hire locals. Similarly, the oil revenues are being used to expand educational systems but, with a few exceptions, not to reform them. Consequently, more students are being educated — and their expectations of a better life whetted — only to find out that they lack the skills to get the jobs they believe their schooling entitles them to. Across the region, youth unemployment averages at least 25 percent, close to double the global average.

Both the rise in energy prices and the flood of oil revenues have stoked inflation. Qatar’s current rate is 14 percent, up from 2.6 percent in the 2002-2004 period. As always, inflation hits the middle and lower classes hardest, and in many Arab states it is destroying the middle class, driving its members to the levels of the poor. That is pushing many into the arms of Islamist extremists seeking to overthrow the regimes.

The rise in global food prices has also hit the Middle East hard. Bread riots have convulsed Egypt and Yemen (not major oil producers, but two of the Arab world’s most populous states and cogs in the regional economy). In Saudi Arabia, fear of riots led the government to threaten to detain or confiscate the businesses of bakers and store owners who sell flour above the government-set subsidized price.

To combat the effects of inflation, Saudi Arabia, Qatar, Oman and the United Arab Emirates have raised government salaries by 15 percent to 70 percent. In the short run this could help civil servants, but it also further increases inflation and does nothing to deal with the structural economic problems.

The foreign workers whom Arab states increasingly rely on because they tend to be cheaper and more productive than their own citizens are also beginning to show signs of unhappiness with their shoddy treatment. Foreign workers, who make up 80 percent to 95 percent of the private sector work forces in the small Persian Gulf states, have gone on strike in recent months in Bahrain and the United Arab Emirates to protest inflation, which is eroding their earnings. With foreigners making up roughly 40 percent of the population of the Arabian Peninsula, such labor unrest is ominous.

Meanwhile, the region’s rich have grown obscenely more wealthy through their ability to tap into the windfall oil profits, both legally and illegally. The wealthiest measure their wealth in the billions, while the poorest are so poor that growing numbers cannot even afford to marry.

Money pouring in but not trickling down tends to create a dangerous social imbalance. People hope their country’s oil windfall will alleviate their own economic problems only to find that vast sums are being siphoned off into graft; redirected out of the country to private accounts; spent on luxury items, military hardware or “white elephant” projects; or simply wasted.

It is worth keeping in mind the worst case from the history of the first Middle Eastern oil boom. Under Shah Mohammed Reza Pahlavi, Iran tried to use the influx of oil revenues after the 1973 oil-price increases to build new industries, eradicate unemployment, transform the economy and modernize society.

On paper, the shah’s efforts seemed superbly enlightened. As in the Arab states today, the macro indicators of Iranian progress — per capita gross domestic product, education expansion, foreign investment — seemed phenomenal. But the projects were mismanaged and riddled with graft. The royal cronies became fabulously wealthy while the plight of the average Iranian worsened because of protracted unemployment coupled with soaring inflation. Rather than solving Iran’s problems, the oil boom sparked the Iranian revolution.

A few in the region seem to be heeding that lesson. King Abdullah of Saudi Arabia continues to demonstrate a keen grasp of what is in his country’s best long-term interests. He has poured money into economic cities that serve as “centers of excellence” to attract the kind of meaningful investment that, over time, could lift the Saudi labor force out of its dangerous doldrums. He is establishing the King Abdullah University, bringing in professors from all over the world to develop a curriculum emphasizing science, technology and innovation. But even here there is a dark lining: Abdullah is 83, and it is doubtful that his successors would continue such projects with the same progressive determination.

How can the region turn things around? For starters, those charged with managing its sovereign wealth funds and private investments need to shift from bankrolling capital-intensive industries that guarantee a high return for the investor to financing labor-intensive industries that could increase employment and develop a more capable work force.

At some level, this means thinking of regional investment as a form of deliberate wealth redistribution, social engineering and charity. It will certainly cut into the bottom lines during the short term, but if those who hold the purse strings are wise enough to do it, it should yield priceless political rewards in the years ahead — political rewards that are probably going to be necessary if they are to avoid being swept out of power by angry mobs.

Avoiding those kind of internal upheavals and eliminating much of the anger and despair upon which the terrorists and extremists prey would be a major boon to a world that is likely to remain addicted to Middle Eastern oil, and therefore vulnerable to its vicissitudes, for decades to come.

This opinion was originally published with the title “Drowning in Riches.”