TO SUCCEED in its Middle East policy of promoting democracy, peace and regional stability, the U.S. government (with the support of America's private sector) must bring economic prosperity to this troubled region. After years of dismal economic performance and high population growth, unemployment in many of these countries is around 20 percent. As things stand, there is little hope for a better economic future for the youth of the region. Unemployment and economic despair have become the order of the day, and this, along with rampant corruption, breeds resentment and extremism. To turn the unemployment picture around, most countries will need sustained annual growth in excess of 7 percent.

Foreign financial assistance and oil revenues will not translate into economic growth. The Middle East has been the world's worst economic performing region over the last 25 years. This is all the more surprising because a number of countries in this region have received an enormous transfer of wealth in the form of oil revenues. While the natural resource endowment should have enhanced economic development prospects, vast oil and gas deposits have in practice done the opposite in the Middle East.

Between 1975 and 2000, Middle Eastern oil exporters received well over $2.3 trillion in aggregate oil export revenues. One would expect the Middle East to have enjoyed an economic boom. Yet most countries in the region have had poor economic performance with low and even negative real GDP per capita growth rates over the last thirty years--Bahrain at 3 percent, Iran at -16 percent; Kuwait at -30 percent; Saudi Arabia at -31 percent and the United Arab Emirates (UAE) at a whopping -105 percent. Oil has been a crutch for the region, enabling governments to put off painful but necessary economic decisions.

While political instability, an unfavorable business climate, rampant corruption, shortsighted or inconsistent policies, and ineffective institutions have contributed significantly to the dismal economic performance of the countries in the Middle East, military expenditures and regional instability have also played a decisive role in hampering economic growth. Even with capital availability, economic liberalization and consistent economic policies, economic growth could hardly be guaranteed in the area because of its total insecurity and relentless conflicts. To succeed economically, the region needs peace and stability. To support stability, the region needs economic prosperity. In short, sustained economic growth and security go hand in hand.

There is an urgent need for economic diversification, trade expansion and a dramatic improvement in the business and investment climate. Egypt's relatively impressive GDP per capita growth rate can be explained by its move toward private sector development (similar economic reforms have also started in Lebanon) and the respite from conflict.

The underlying reason for the region's significant underperformance is undoubtedly the adoption of shortsighted, inconsistent and politically motivated economic policies. Sound economic policies, including the promotion of a vigorous private sector and fiscal prudence (including an effective system of taxation) have not been adopted. Middle Eastern countries have instead saddled themselves with an overbearing public sector, indiscriminate subsidies, an uncompetitive private sector and rampant corruption. The result is that today's oil-exporting countries export very few manufactured goods and services in the competitive global marketplace and have instead squandered their oil wealth in consumption and corruption.

Governments have not used these revenues to lay the foundations of economic growth but instead have resorted to giving handouts to buy support, investing in grandiose projects and increasing military expenditures. With the decline in oil revenues during the 1980s, most of the oil-exporting countries had very little to show--their economies were not diversified, their governments continued to rely on oil (not taxes) as their main source of revenue, and their private sectors were no more competitive than before. Since then, economic growth has been at best anemic, and a number of countries (in particular Saudi Arabia) have accumulated significant national debt. The economic basis for sustained growth is still missing in most, if not all, of the oil-exporting countries. The regimes lack the legitimacy and courage to adopt the needed policies. And it has been difficult to adopt the needed economic reforms in an atmosphere of insecurity.

One cannot ignore the real costs incurred by the continuing lack of security in the region, which drives up military expenditures and leads to destructive conflicts. In the Middle East, the standard reasons for military expenditures are security, the maintenance of power by a ruling elite, "pay-backs" to foreign supporters of unpopular regimes, a convenient conduit for commissions, and the waging of war. The payment for military equipment and military might have been facilitated by oil revenues (that is, the availability of easy-come, easy-go, unearned foreign exchange from oil) in most cases or by military aid in the case of Egypt and Israel. Support for the military has been further facilitated by the fact that the Middle East is one of the most undeveloped and undemocratic regions in the world.

Guns, Not Butter

ALL OF THIS means that resources that could otherwise be used for economic development and modernization are siphoned away. It is not surprising that of the world's top 15 arms importers, five are Middle Eastern countries, with Saudi Arabia comfortably at the very top. Between 1997 and 1999, Saudi Arabia imported $27.5 billion worth of arms. The United Arab Emirates purchased $3.7 billion, and Egypt and Kuwait each bought $3.2 billion in weaponry--more than Germany or the Netherlands--at a time when Egypt was receiving large amounts of Western economic aid.

In addition, maintaining a large military diverts both capital and labor from productive employment in the civilian sector. The Middle East's aggregate ratio of military expenditures to GNP of 6.8 percent in 1999 was far higher than that of any other country grouping. This peculiarity of the regional figures may be explained by the fact that rich oil-producing Middle Eastern countries have to spend incredible amounts to protect their unpopular regimes from their own subjects, from aggressive neighbors and from the pressure of foreign manipulation.

The level of military expenditures per capita in the Middle East is also astonishing. Countries such as Qatar, Kuwait and Israel have ratios that are more than ten times the world figure of roughly $140 per capita. Military expenditures for the region constitute over 21 percent of government expenditures. In contrast, the average for developed countries is under 10 percent and for developing countries, around 14.5 percent.¹

The Middle East has the highest ratio of people under arms--10.3 per 1,000 people. (The world average is 3.6 per 1,000.) Israel leads with around 30.1, and Iraq and Syria have around 20 under arms per 1,000. Such ratios in turn imply tremendous financial costs. Armed forces in the region constitute 2.8 percent of the labor force, as compared to the world average of 0.8 percent. Arms constituted 14.5 percent of all Middle East imports, versus a 1 percent average worldwide.

Nor has there been any manner of "oil dividend", whereby increasing revenues have been able to fund both "guns and butter." While aggregate Middle East oil-export revenues increased by about 150 percent from 1983 to 1999 (excluding 1989-90), this growth is matched by military expenditures and arms-imports growths for the same period of 160 percent and 130 percent respectively. For the region, aggregate arms imports represent about 17 percent of oil revenues over the period, and military expenditures represent about 55 percent.

The Middle East was the leading region for defense imports until 1989, with Saudi Arabia as the biggest arms importer from the United States, absorbing 12 percent of U.S. global defense equipment sales during 1985-89. Oil revenues are employed to keep unpopular ruling classes in the region in power and to fuel an arms race that threatens regional stability, while the oil-exporting countries of the Middle East provide a lucrative arms market for both the West and countries in Asia.

The Case of Kuwait

IT IS FAIR TO suggest that oil revenues would have been better used to develop productive non-oil industries and not squandered on the economically unproductive military sector. In addition, the region's many conflicts have not only directly fueled military expenditures but have also resulted in the destruction of infrastructure and property, led to the emigration of many of the educated classes, drained labor from economically productive endeavors, and further reduced economic growth and development because of increased risk and uncertainty.²

It is difficult to develop viable democratic institutions, achieve sustained economic growth or attract foreign investors when a region has been plagued by such turmoil. The economic burden of even one of these conflicts is quite staggering. The cost of the Iran-Iraq War has been estimated between $500 billion to $1 trillion for Iran and more than $500 billion for Iraq. It is estimated that more than two million Iranians have left Iran since the Revolution. Most of these were highly educated and highly skilled, and many took their capital with them. The cost of the invasion of Kuwait and of the Gulf War alone has been placed at more than $600 billion for Kuwait and up to a staggering $3 trillion for Iraq. The sum of these figures dwarfs total oil revenues for the entire region over the last 25 years.

This one conflict alone--Iraq's invasion of Kuwait and the subsequent Gulf War--caused enormous damage and exemplifies the self-perpetuating destructiveness of internecine Middle East conflict. The oil industry was the key productive sector to suffer. Some sources speak of $5 billion to reconstruct the damaged oil infrastructure. Reconstruction and rehabilitation of the oil industry was the main objective after 1991. Iraq had destroyed a total refining capacity of 700,000 barrels per day at Kuwait's three major refineries. Nearly 800 oil wells were set on fire by Iraqi forces, amounting to a loss of about 2 percent of Kuwait's 100 billion barrels of reserves. About six million barrels were burned per day in March 1991. Kuwait had to repair its damaged refineries and oil infrastructure and was forced to drill new wells to replace the old ones. It has been reported that damage claims by Kuwait were $130 billion.

Aggregate losses may be much higher if we add to reconstruction costs, lost oil revenues, foregone non-oil GDP and the burden of an increase in government debt of $70 billion from pre-war levels. The direct economic cost to Kuwait has been placed at $300 billion. While Iraq still owes Kuwait significant reparations, these are unlikely to be paid in full. Kuwait will suffer the consequences, and from a regional standpoint these costs constitute a net loss for the region, no matter who in the region pays. Moreover, much of the cost of the Gulf War for the allies was paid by Saudi Arabia, Kuwait and the UAE. The resulting environmental damage of the Gulf War, the effects of which continue today, is also staggering. In September 1995, Kuwait submitted five claims to the United Nations of $385 million against Iraq for damage to health, coastal areas, the maritime environment, the desert environment and ground-water resources.

Kuwait's economic burden did not cease with the end of the Gulf War. The war resulted in a tenfold increase in military expenditures from around $2.3 billion in 1989 to $15.6 billion in 1990, $18.2 billion in 1991, reaching a high of $21.2 billion in 1992. Only after 1993 did military expenditures start to decline. They ranged between $2.7 and $4 billion from 1993 to 1999, figures that remain higher than pre-war levels. The decrease in GNP resulting from the war was also significant, falling from $39.2 billion in 1989 to $29.4 billion in 1990, and down to $17.9 billion in 1991. Another striking fact is that the military-expenditures-to-GNP ratio increased from around 6 to 77 in 1992. This ratio has still not fallen to its 1989 level. All of the above observations are easily explained by the fact that since 1990 the government in Kuwait has not felt safe and has diverted a significant part of its expenditures to greater military security.

How Kuwait and other countries in the region will feel about their future in the aftermath of the Iraq War depends on how events unfold in the region. On the one hand, Saddam Hussein may be gone, but a peaceful Iraq is not a certainty, and even a peaceful Iraq would be insufficient to give Kuwait total comfort. On the other hand, the Iraq War has given birth to a new generation of revolutionaries whose explicit aim is to overthrow traditional regimes. This is already clearly evident in Saudi Arabia and may spread to other countries in the region. Traditional regimes feel further threatened because of the demonstrated mobility of these revolutionaries and terrorists across porous borders. This new external threat can be expected to increase military expenditures--expenditures that will be further fueled by the re-arming of Iraq and by the ready source of financing from record high oil prices.

Overcoming the Present

THE U.S. government and other international donors cannot bring prosperity to the region simply by pouring in money. For one thing, the region is totally devoid of democracy, of viable institutions and of security. At the same time, its economic policies and practices are designed to keep autocratic regimes in power. The absence of democracy in the area has enabled corrupt Middle Eastern rulers to maintain their power over populations--whether crawling under the weight of poverty, unemployment, malnutrition and illiteracy (the masses) or benefiting from incredible wealth (the few)--by distributing resources and social services to buy off potential insurrection.

Economic growth, on the other hand, requires sustained and productive investment, an educated and skilled labor force and a good dose of technology. Most developing countries acquire technology through foreign direct investment and through imported machinery and equipment. They spend a great deal on education and create a business environment with policies to encourage private sector investment and foreign direct investment. Although education has been promoted in the Middle East, it has not received the highest priority. People in oil-exporting countries have become more accustomed to handouts than hard work. The region needs domestic and foreign private sector investors if it is to grow economically, but private investors need security and stability. The absence of a favorable business climate has discouraged long-term investment, both from domestic sources and from abroad. What investor can be expected to risk all in a totally insecure environment that many citizens want to leave and where foreigners are reluctant even to visit?

If the United States is serious about bringing peace and economic prosperity to the region, it will need more than eloquent rhetoric about democracy and development and a few high-profile projects. And while a final settlement may be decades in the making, there are several short-term confidence-building steps (similar to those undertaken in Europe during the Cold War) that can help to create a greater sense of stability to encourage reform and investment.³  These include an international agreement to embargo the sales of all sophisticated, offensive weaponry to the region and a Security Council resolution guaranteeing the borders of every country in the region from external incursion, as ongoing border disputes remain a major source of tension. In time, such steps could lead to the development of a Middle East version of the "Helsinki process" to promote regional security and cooperation.

Moreover, there are economic steps that can be more readily adopted even if final peace settlements remain illusory. Middle Eastern states should be encouraged by the International Monetary Fund and the World Bank to adopt the economic reforms outlined above. All the countries of the region should be encouraged to join the WTO (and not be selectively barred from membership by the United States). OECD countries should open up their markets to the non-oil exports of the Middle East and provide special low-cost insurance to companies that invest in the region, especially for investments outside of the oil and gas industries.

Most importantly, this requires ongoing U.S. engagement with all countries in the region, even with those that do not embrace U.S. policies. Threats and isolation can only alienate the general population and diminish support for U.S. policies--including adopting reforms. We should be prepared to offer carrots as well as brandish the stick to make it clear to the states of the region that, to the extent that they play a responsible role in the world and engage in political and economic reform, they will be supported in such efforts. America's multigenerational commitment to promote positive change in the Middle East also needs the support of Europe, Japan, China and Russia; and this support must be steady and forthcoming for years to come. There is no quick fix--and oil is certainly not the solution.

1 In Saudi Arabia, military expenditures constitute 43.2 percent of all government expenditures, while in the UAE, the level is around 39 percent.

2 Since World War II, major conflicts in the region include the establishment of the state of Israel in 1948 and subsequent related conflicts (the Six-Day War of 1967, the 1973 Yom Kippur War, and the eruption of the second intifada in 2000); the Egyptian Revolution in 1952; the 1956 Suez Canal War; numerous revolutions in Iraq and Syria; the war between the two Yemens in 1972; the civil war in Lebanon from 1975 to 1990, the Israeli incursion into Lebanon, and Lebanon's occupation by Syria; the Iranian Revolution in 1979; the Iran-Iraq War from 1980 to 1988; the invasion of Kuwait by Iraq in August 1990; the Gulf War in 1991; and the Iraq War in 2003.

3 A durable settlement would require all countries in the region to be at peace with each other. This would include a Palestinian-Israeli settlement where the two sides are convinced that they got the best possible deal. Another component would be transforming the region into one that is free of all weapons of mass destruction, including nuclear arms.

Hossein Askari is Iran Professor of International Business and professor of international affairs at the George Washington University. Rana Atie is a recent MBA graduate of the George Washington University, whose research was supported by the Iran Endowment at GWU.