Robert Hahn is director of economics at the Smith School, University of Oxford and chief economist at the Legatum Institute. Peter Passell is a senior fellow at the Milken Institute and the economics editor of the Legatum Institute's Democracy Lab. They are cofounders of Regulation2point0.org, a web portal on regulatory policy.
After an indecisive moment last week, Egypt's new government has chosen to defend its relationship with the West, denouncing anti-American violence rather than basking in the support of the Arab street. But this is not the last time President Mohamed Morsi will be forced to make a tough political call this fall—in particular, he will have to decide where he stands on harsh fixes for the budget mess that has been building since the Arab spring began.
The Egyptian economy has not truly recovered from the chaos of regime change, which drove away foreign investment and released the pent-up anger of millions of Egyptians left behind in spite of two decades of growth triggered by market reforms in the early 1990s. But before this government can lure back investors or address the grievances of the disaffected, it must deal with an immediate crisis—a collapsing currency and runaway budget deficit.
That deficit currently exceeds 11 percent of GDP. To make matters much worse, Egypt is rapidly running out of foreign currency reserves that have been hemorrhaging since foreign investors scampered. The best—probably only—hope of a temporary fix is a loan from the International Monetary Fund that gives Egypt sufficient credibility to sell bonds on private capital markets. But the International Monetary Fund isn't inclined to deliver unless Egypt agrees to straighten up and fly right on matters fiscal.
Thus, the new government must choose between belt-tightening that is certain to infuriate Egyptians (who just discovered they could overthrow the last regime they didn't like), and kicking the can down the road. Actually, the can-kicking is not much of a choice: Without hard currency, President Mohamed Morsi simply will not be able to import the food and fuel that Egyptians regard as a right of citizenship.
First things first: All things considered, the fundamentals underlying the Egyptian economy are surprisingly solid. Thanks to rapid industrialization and the growth of exports, the average Egyptian's real income has tripled since the market reforms. But speedy growth is always dislocating in social terms. And the dislocation in corrupt, authoritarian Egypt was especially galling as ordinary citizens scrambled for crumbs from the table at which insiders—Murabak's friends and family, crony capitalists, military bigwigs, and senior bureaucrats—gorged their fill.
Looking down the road, sustained growth will only be possible if Egypt can beat back the cronyism, open markets to small and medium-sized businesses and increase economic mobility. But before it can begin to tackle the economy's structural problems, it must wean those not truly in need from government subsidies—subsidies equal to about one tenth (yes, one tenth) of the GDP that have made a shambles of the budget.
In theory, this should not generate true hardship because one third of the money goes to food that is sold below cost to everybody, while the rest consists of discounts on gasoline, natural gas, and butane in a country in which the poor don't drive and only occasionally heat their dwellings. Simply targeting the subsidies would go a long way to closing the budget deficit.
But bread priced below the value of the flour it contains is a tradition in Egypt that dates back to Nasser. When Anwar Sadat tried to reform the system, he was almost toppled by street mobs. Raising the prices of gasoline and cooking gas in a country that views cheap energy as a perquisite of being Egyptian is almost as problematic.
The weakest political link in the subsidy chain consists of cheap natural gas from the state-owned producer that is used by heavy industry. Big business is on the defensive in post-revolutionary Egypt, and probably lacks the clout to prevent price increases that would translate, dollar for dollar, to the governments bottom line. In fact, early in the summer the unelected interim government said it was about to raise prices. That would be a start, but would probably only cover the down-payment in meeting International Monetary Fund loan terms. Sooner or later—make that sooner—gasoline and food prices need to go up.
To date, the only country in the Middle East to tackle fuel subsidies successfully is Iran. On reflection, that should not surprise. With the Iranian economy in free fall, the mullahs can ill-afford to divert oil that might otherwise yield export revenues. Besides, when Iran's secret police talk, the middle class has learned the hard way to listen.
But the part worth imitating is the design of the reform plan. Engineered with help from the International Monetary Fund, it converted price-distorting gasoline subsidies into flat monthly cash rebates for all households that more than compensated the poor for higher prices at the pump.
There is always the possibility that the Morsi government will procrastinate—and that Western governments will bail out Egypt anyway because the alternative is to risk a turn to Islamic fundamentalism. But that would be a pity. Egypt really does have a shot at the sort of prosperity enjoyed by the Asian tigers. It's not going to happen, though, until the country has a government that is strong enough and smart enough to face up to the inertia and interest-group opposition that blocks reform.