metadata: authors: 0: author: Bou Habib,Chadi
count: Lebanon
docna: 0: docna: Globalization, Dutch Disease, and
            Vulnerability to External Shocks in a Small Open Economy :
            The Case of Lebanon in 1916 and 2019
docty: Policy Research Working Paper
abstracts: cdata!: This paper investigates the similarities
            between the economy of 1912 Mount Lebanon on the eve of the
            famine of 1916 and the economy of 2004 Lebanon that set the
            stage for the major economic and social crisis of 2019. A
            simple general equilibrium simulation shows that, as long as
            the Lebanese economy remains reliant on foreign inflows,
            crises will persist, with different manifestations.
            Regardless of the period considered, foreign inflows
            increase domestic prices and induce real appreciation. Low
            productive capacities and insufficient job creation lead to
            high emigration. Emigration increases the reliance on
            foreign inflows, which in turn increase domestic prices and
            reduce competitiveness, hence triggering further emigration
            and further reliance on foreign inflows. Income and prices
            increase, but exports decline, and growth remains volatile.
            The interruption of the flows of capital and goods and the
            impossibility to migrate due to the First World War drove
            Lebanon into starvation in 1916. The interruption of inflows
            of capital in 2019 led to a major crisis and massive
            outmigration, as predicted through the simulations based on
            the structure of the Lebanese economy in 2004. The
            simulations effectively capture the impact of external
            shocks on the Lebanese economy and closely align with the
            actual changes in economic variables during 2005 to 2020.
display_title: Globalization, Dutch Disease, and
            Vulnerability to External Shocks in a Small Open Economy :
            The Case of Lebanon in 1916 and 2019
listing_relative_url: /research/2024/02/34249073/globalization-dutch-disease-vulnerability-external-shocks-small-open-economy-case-lebanon-1916-2019
topicv3: International Remittances m1326998 355,Exchange Rate Policy m1327143 1124,Jobs and Globalization m1503937 2682,Emigration m1504169 2844,Computable General Equilibrium Modeling
            m1504533 3110
publishtoextweb_dt: 2024-01-31T00:00:00Z
dois: 10.1596/41007
origu: Off of Sr VP Dev Econ/Chief Econ (DECVP)
no_of_pages: 18
author_keys: 0: author_key: 668562
model_extractions: Policy Research Working Paper 10688 Globalization, Dutch Disease, and Vulnerability to External Shocks in a Small Open Economy The Case of Lebanon in 1916 and 2019 _Chadi Bou Habib_ Macroeconomics, Trade and Investment Global Practice January 2024
Policy Research Working Paper 10688

# **Abstract**

This paper investigates the similarities between the economy of 1912 Mount Lebanon on the eve of the famine of 1916 and the economy of 2004 Lebanon that set the stage for the major economic and social crisis of 2019. A simple general equilibrium simulation shows that, as long as the Lebanese economy remains reliant on foreign inflows, crises will persist, with different manifestations. Regardless of the period considered, foreign inflows increase domestic prices and induce real appreciation. Low productive capacities and insufficient job creation lead to high emigration. Emigration increases the reliance on foreign inflows, which in turn increase domestic prices and reduce competitiveness, hence triggering further emigration and further reliance on foreign inflows. Income and prices increase, but exports decline, and growth remains volatile. The interruption of the flows of capital and goods and the impossibility to migrate due to the First World War drove Lebanon into starvation in 1916. The interruption of inflows of capital in 2019 led to a major crisis and massive outmigration, as predicted through the simulations based on the structure of the Lebanese economy in 2004. The simulations effectively capture the impact of external shocks on the Lebanese economy and closely align with the actual changes in economic variables during 2005 to 2020.

This paper is a product of the Macroeconomics, Trade and Investment Global Practice. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://www.worldbank.org/prwp. The author may be contacted at cbouhabib@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **Globalization, Dutch Disease, and Vulnerability to External Shocks in a Small Open Economy: The Case of Lebanon in 1916 and 2019**

Chadi Bou Habib<sup>1</sup> JEL Classification: D58, F6, F22, F24, G01.

Keywords: General Equilibrium, Globalization, Migration, Remittances, Real Exchange Rate.

1 Lead Economist at the World Bank. The paper carries the name of the author and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the author. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent. This paper reproduces elements from an initial work for a thesis submitted in partial fulfillment of the requirements for the degree of Master of Arts to the Department of Economics of the Faculty of Arts and Sciences at the American University of Beirut on September 24, 2007. See: _The effects of capital inflows on a small open economy growth or Dutch disease? a study of the Lebanese case_ , Bou Habib, Chadi Adib. American University of Beirut, 2007. <u>https://scholarworks.aub.edu.lb/handle/10938/7549 I am grateful for Dr Samir Makdisi (Advisor), Dr Simon Neaime</u> (Member of Committee), and Dr Markus Marktanner (Member of Committee) for their guidance during the preparation of the thesis in 2007. The current paper written in 2023 reinserts, revises, expands, and updates the work from 2007. This version benefited from the valuable advice from Emilia Skrok, and Eric Le Borgne, Practice Managers at the World Bank, and from insights by John François, Economist at the World Bank.
# **Introduction**

From the end of the 19th century to the beginning of the 21st century, Lebanon has managed to attract large amounts of resources that are disconnected from the country’s productive system and its internal accumulation of capital. This was possible thanks to three major characteristics: a large Lebanese diaspora, a comparative educational advantage of human resources, and an efficient banking sector. Transfers of wealth from the diaspora were constantly high, but what changed is their nature. These transfers in the early years were mainly remittances sent to relatives or invested in housing or in different sectors of the economy. They were first amplified by capital inflows from the region and gradually took the form of deposits in the banking sector.

Seeking to attract capital that fled Palestine in 1948 and other Arab countries that experienced waves of nationalization, Lebanon implemented a law on bank secrecy in the 1950s and established the legal foundations for a modern banking system. These inflows helped to create the basic infrastructure on which Lebanon built its productive capacities in agriculture, industry, tourism, and services in the 1950s and 1960s. At the end of that period, the oil boom reached its height with multiple increases in oil prices starting 1973. In parallel, and thanks to skills acquired through an efficient education system set by missionaries in the 19th century, Lebanese labor massively moved to the Gulf countries where they were employed as engineers, specialists, and skilled workers. These emigrants have naturally transferred an important share of their wealth accumulated in the Gulf into Lebanon and its banking sector.

# **A. Lebanon: A History of Foreign Inflows**

“The wealth and luxury you see in this Mountain do not come from its land, but from the money saved by the sons of Lebanon in the emigration.” This sentence from the study ordered by the Turkish governor of Mount Lebanon in 1918, ( _Lubnan, mabaheth ilmiah wa ijtimaya – Lebanon, scientific and social studies – 1918_ ) remains true more than a century later.

This part of the Middle East was prematurely exposed to the international flows of people, goods, and capital during the first globalization. Statistics from 1912 show that 25 to 30 percent of the population of Mount Lebanon was living and working abroad. The reasons for this emigration, according to contemporaneous sources, are the repeated crisis in an economy that was heavily relying on the production and export of raw natural silk. Another reason was the high concentration of the population in Mount Lebanon with a density of 110 individuals per square kilometer, which was high compared to the international standards of that period.

# **_1. The Silk Curse: Monoculture, Deindustrialization and Emigration_**

Since the first quarter of the 19th century and the implementation of the first factories for the treatment of raw silk, Lebanese agriculture has gradually been monopolized by mulberry culture to provide mulberry leaves to silkworm breeding plants. The low cost of a large labor force concentrated in regions close to the coast and ports was the main reason that motivated foreign investors to develop silk industry in Mount Lebanon.<sup>2</sup> This exporting activity raised the revenues of Mount Lebanon and triggered an enhancement of the standard of living together with substantial

> 2 Mount-Lebanon, or the Mount Lebanon Mutessarifat (1861-1915) covered one-third of the area of modern Lebanon and was a semi-autonomous district of the Ottoman Empire created in 1861 as a consequence of the civil war of 1860 between Christian Maronites and Muslim Druses.

2
|Year|Price|Year|Price|Year|Price|
|---|---|---|---|---|---|
|1861|73.5|1882|55.5|1901|40.5|
|1862|71|1880|45|1903|46.6|
|1864|73.5|1890|52|1904|40.5|
|1870|93|1892|44|1908|40|
|1872|105|1894|37|1909|40|
|1875|57|1896|34|1910|40.5|
|1881|58|1900|38|||

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<!-- Start of picture text --> N<br>q “hy<br>7eZ |<br>ec<br>185 1861 187( TM 1890 “ “ | 1905 1910 1914<br><!-- End of picture text -->
<!-- Start of picture text --> Other<br>Remittances<br>Silk |<br><!-- End of picture text -->
of GDP. Despite the lack of accuracy of these statistics, they hint to the size transfers had reached in the small economy of Mount Lebanon. Such a level of transfers had deep structural and permanent impact on the economy.

# **_3. The Impact of Transfers on the Economy of Mount Lebanon_**

Scholars from the beginning of the 20th century acknowledged the positive impact of transfers on household income and welfare. But they complained about the misuse of this money, pointing to an uncontrolled real estate development with an “excessive inflation of the prices of land.” This statement is simply indicating the occurrence of a price increase in the non-tradable real-estate sector due to a strong spending effect caused by large transfers into the domestic economy. With land being an input to the productive activity, the large increase in its prices had a harmful impact on agriculture and on many industrial activities. Also, the booming real-estate sector has initiated further adjustments with resources moving into construction activities. Scholars talk about some technology transfers to agriculture and industry by returning migrants, but they present their effect as being marginal and limited. In sum, transfers have reinforced the deindustrialization already experienced by Mount Lebanon due to the mono-industry of raw silk.

Table 3. Imports, exports, and transfers of Mount Lebanon

|Item – in Ottoman Pound|Imports & outflows|Exports & inflows|Balance|
|---|---|---|---|
|Food and livestock|760,000|78,000|-682,000|
|Tobacco,beverage & olive oil|80,000|198,000|118,000|
|Textile and silk|63,000|687,000|624,000|
|Manufacturedgoods|650,000|85,000|-565,000|
|Total|1,553,000|1,048,000|-505,000|
|Tourism Income/Expenditures|0|15,000|15,000|
|Transfers from/to America|300,000|1,200,000|900,000|
|Current Account Balance|||410,000|

_Sources: Lubnan, mabaheth ilmiah wa ijtimaya - Lebanon, scientific and social studies - 1918._ The eviction of tradable sectors became quasi total by 1910-1914 and while silk reached 61 percent of total exports, Mount Lebanon became a net importer of tradable goods financed by Net Transfers from the Americas. Table 3 summarizes the imports and exports of Mount Lebanon for an unspecified year between 1910 and 1914, most likely 1912. It shows a trade deficit equivalent to 30 percent of Mount Lebanon’s GDP and a ratio of Current Account surplus to GDP of 24.5 percent. Transfers and silk exports are clearly the main sources of revenues fueling the growing demand in Mount Lebanon that is met through increase in the imports of goods. For instance, statistics show that imports of food and beverage were three times larger than the exports of these same items. Also, imports of manufactured goods from Europe are almost eight times higher than exports of manufactured items other than textile and silk. This dependency on mono-exports and on transfers to finance imports of food and manufactured goods would have disastrous consequences for Mount Lebanon in times of economic or political crisis.

5
# **B. Confronting History and Theory: A General Equilibrium Analysis of Dutch Disease in Mount Lebanon of 1912**

With the mono-export of silk and net transfers from the Americas accounting respectively for 41 and 54 percent of GDP, the economy of Mount Lebanon was both particularly globalized and highly vulnerable to external shocks. The data set available for the year 1912 is suitable for a simple general equilibrium analysis.

# **_1. Dependence and Vulnerability to External Shocks: The Case of Mount Lebanon through a Simple General Equilibrium Framework_**

In the following, I use the simple general equilibrium framework of the 1 2 3 Model developed by Devarajan et al ( _Simple general equilibrium modeling – 1997 & The simplest general equilibrium model of an open economy - 1998_ ) to assess the effect of external shocks on the economy of Mount Lebanon.

The 1 2 3 Model builds on the Harrod-Samuelson-Balassa two-sector (tradable and non-tradable sectors) model to examine the effects of remittances, inflows, and external shocks. The model involves one country, two producing sectors and three goods. The country has a small open economy and is a price taker on the international market. The two producing sectors are (i) one sector that produces goods for export only and (ii) another sector producing goods for the domestic market only. The three goods are (a) export goods, (b) goods produced and consumed domestically (mainly non-tradable goods), and (c) imported goods. Remittances, export prices and import prices are set as exogenous variables. The model does not take factor markets into consideration. In this model, the RER is weighted by the shares of imports and exports in the total foreign trade of the economy, _PD M PD E_ according to the following equation: _RER_ = + where PD is the price of domestic _PM FT PE FT_

> goods, PM the price of imported goods, PE the price of exported goods, FT foreign trade, M

> imports and E exports _._ In this equation, real appreciation is equivalent to an increase.

The model fits the case of Mount Lebanon because: (i) Mount Lebanon was a small open economy; (ii) it had a large industry producing a single good dedicated for exports (silk) and (iii) relied on imports for almost all other types of goods, including food. The simulation aims to: (i) assess the impact of external shocks on GDP, income, and prices and, (ii) test the relation between remittances and exports. While the model assesses the spending effect of foreign inflows, it cannot assess the impact in terms of resource movement since it neglects factor markets.

# **_2. A Simple General Equilibrium Analysis for Mount Lebanon: Simulation and Results_**

The analysis below is done through four scenarios: a drop by 90 percent in remittances, an increase by 10 percent in remittances, a decline by 10 percent in the prices of exports, and a compensation for the effect of that decline on consumption through a rise in remittances. The four scenarios are designed in a way both to confront theory with history and to understand the latter through the former. Table 4 summarizes the results of all four scenarios. Prior to the simulations, I have brought the current account surplus to zero by increasing imports in resources and raising consumption and investment in uses. This is equivalent to assuming that Mount Lebanon did not build up reserves and used all the funds available. This modification neutralizes the effects, however limited, of a large 6
current account surplus (large negative foreign savings) on the results of the simulation. Also, this modification is not far from the reality since Mount Lebanon back then did not have a monetary authority.

Table 4. Simulation of external shocks on the economy of Mount Lebanon in 1912 (change, in

|Percentage change compared to base year|percent)<br>Remitt.<br>-90%|Remitt.<br>+10%|Prices of<br>exports -<br>10%|Prices of exports -<br>10% and<br>consumption per<br>capita unchanged|
|---|---|---|---|---|
|Remittances|-90.0|10.0|0.0|16.1|
|Total Income|-39.7|4.5|-6.4|0.9|
|Private Consumption|-33.7|3.6|-4.3|1.6|
|Private Consumption/capita|-34.7|2.0|-5.7|0.0|
|Investment|-31.3|3.3|-4.0|1.5|
|Exports|7.9|-0.9|-0.1|-1.7|
|Imports|-37.0|4.1|-5.5|1.2|
|Demand of domesticgoods|-17.6|1.6|0.3|2.9|
|Price of domesticgood|-36.1|4.2|-9.4|-2.9|
|Real exchange rate|-36.1|4.2|-5.9|0.9|
|Real GDP at marketprice|-2.6|0.0|-0.1|0.0|

N.B: Per capita consumption is calculated taking into consideration an estimated 3 percent yearly natural increase in population. In the last scenario, I add an emigration rate of 1.4 percent. These assumptions are set according to tendencies observed during 1900-12. Note: Remitt. Stands for remittances. Source: author simulations.

The first column summarizes the effect of a decline in remittances by 90 percent. The impact on income is strong and generates a sharp decline in consumption and investment. This is consistent with historical developments: when remittances inflow to Mount Lebanon halted in 1914-18 because of WWI, the country fell into a disastrous famine. Imports, including food imports, collapsed. The RER decreases strongly, due to a collapse in the demand and prices of domestic goods. The decline in the RER boosts exports by 8 percent. The increase in exports keeps the decline in real GDP moderate at a negative 2.6 percent. In reality, history shows that exports stopped in 1914-18 because WWI interrupted all trade flows.

The second column simulates the effect of a 10 percent increase in remittances. Income, consumption, and imports increase while real GDP remains unchanged. The country loses in competitiveness since RER appreciates due to higher demand and prices of domestic goods, and exports decline. This result meets the observations on the increase in the prices of land, a key nontradable good, with the rise in remittances to Mount Lebanon.

The third column assesses the impact of a decline by 10 percent in the prices of exports. Income declines and triggers a decrease in consumption. Imports also decrease since there is less foreign financing available due to the drop in exports. Real GDP regresses slowly while RER declines due to lower prices of domestic goods. The decline in the RER is however less marked than the drop in the prices of domestic goods since the relative price of domestic non-traded goods to traded goods declines moderately. Indeed, in the denominator, part of the prices of traded goods (exports) has also declined. Also in this case, history reports on the negative impact of a decline in the international prices of silk on income and consumption.

7
The last column simulates the increase needed in remittances to compensate for the impact of a 10 percent decline in the price of exports on private per capita consumption. The assumption here is that in the face of a drop in income and consumption, part of the population would emigrate while the diaspora would increase transfers to the motherland. Interestingly, to compensate for the impact of a 10 percent drop in the prices of exports on private per capita consumption, Mount Lebanon needed to receive remittances higher by 16 percent. The combined effect of the decline in exports and rise in remittances is higher income, higher imports, and higher demand for domestic goods while real GDP remains unchanged. The prices of domestic goods remain on the decline due to a combination of a high deflationary effect stemming from the decline in exports prices and of a more moderate inflationary impact related to higher remittances. The RER increases despite the decline in domestic prices since, in the denominator, the decline in the prices of a part of the traded goods (exports) is strong, and the relative price of domestic non-traded goods to traded goods increases. In line with the appreciation of the RER, exports decline; pointing to a loss in competitiveness. In short, an important decline in the price of exports on the international market would reduce the income of the population and increase the reliance on remittances which in turn has a negative impact on competitiveness and depresses exports.

# **C. Back to the Future: A Simple General Equilibrium Analysis of Dutch Disease in Modern Lebanon**

After the First World War, Lebanon was extended beyond Mount Lebanon to its current borders to include larger farming lands. The famine had claimed the lives of one-third of the population and, while emigration continued, it was much lower than the pre-war levels. Between 1920 and 1950, the country developed a more diversified economy and abandoned the mono-industry model of the silk era. Remittances continued to play an important role, but less than in 1880-1914. In the late 1950s, social and economic transformations drove growing numbers of the rural population out of their areas. Some of them emigrated, but the largest part settled in cities. The second generation of this new urban population had access to better education and was attracted by the booming economies of the oil rich countries of the Gulf, starting in the early 1970s. Since that period, remittances and foreign inflows have become once again a major element of GNDI. The war of 1975-1990 triggered a large outmigration and increased the reliance on foreign inflows, since large segments of the economy were severely damaged due to the direct and indirect consequences of the war. In the following paragraphs, I will be considering foreign inflows as a whole, since the development of the banking sector reduced the boundaries between remittances and capital inflows, making it possible to examine the economic impact of the two variables combined.

# **_1. Reliance on Inflows and Transfers in Modern Lebanon: A View through National Accounts_**

The National Accounts of Lebanon reflect the strong impact of the war on the Lebanese economy in terms of reduction in productive capacities and structural reliance on foreign inflows. Through extensive destruction of capital, the war reduced the productive capacities of the economy and increased the reliance on imports financed by substantial flows of income, transfers, and capital. Table 5 compares the structures of GDP and external accounts between the pre-war period (1972), the aftermath of the war (1994) and 2004. I chose 2004 because it is the year when the post-war reconstruction era ended. The champion of that era, former PM Rafik Hariri was assassinated in February 2005. Since then, no other economic and political project was proposed to the Lebanese society, and the rulers focused on extending the life of the post-reconstruction system they inherited from Mr. Hariri, until the system collapsed by end 2019.

8
Table 5. GDP, GNDI and external accounts in Lebanon (in percent of GDP)

||**Share to GDP (%)**|**1972**|**1994**|**2004**|
|---|---|---|---|---|
||Agriculture|9.9|12.1|5.2|
||Transport and communication|7.5|2.8|7.4|
|**ces**|Industry|15.9|17.7|11.9|
|**our**|Trade|31.5|28.8|24.0|
|**Res**|Construction|4.6|9.5|7.4|
||Public sector|7.5|8.3|11.2|
||Services and housing|23.1|20.9|32.9|
||**GDP (uses = resources)**|**100.0**|**100.0**|**100.0**|
||Consumption-public|9.0|10.6|15.0|
||Consumption- private|78.7|110.9|85.5|
|**s**|Investment-public|3.1|4.1|3.1|
|**Use**|Investment-private|17.3|32.3|18.8|
||Exports of goods and services|38.0|8.4|19.9|
||Imports of goods and services|46.0|66.3|42.1|
||**Net exports (trade balance)**|**-8.0**|**-57.8**|**-22.3**|
||Net transfers and factor income|6.3|32.6|11.9|
||Current account deficit|-1.7|-25.2|-10.4|
||Net foreign savings|13.8|37.7|11.2|
||Net<br>change<br>in<br>foreign<br>assets<br>(negative is an increase)|-12.0|-12.4|-0.7|
||**GNDI = GDP + net transfers and**<br>**factor income**|**106.3**|**132.6**|**111.9**|

Sources: National Accounts for 1973, 1994 and 2004. Economic dislocation and recovery in Lebanon - IMF, 1995. Back to the future, postwar reconstruction and stabilization in Lebanon – IMF, 1999.

In 1972, Lebanon remained open to international flows of goods, services, and capital. The foreign inflows of income, transfers, and capital amounted altogether to 20 percent of GDP, which is high but much lower than the 54 percent observed 60 years earlier. Interestingly, only part of these inflows poured into the local economy to finance imports for local consumption and investment. The largest part of inflows helped to build foreign currency reserves and purchase gold. The biggest source of foreign currencies was a dynamic exporting sector with 38 percent of GDP that helped to cover the largest part of imports. Consumption remained at 79 percent of GDP.

After the destruction of the war and the large resource movements in the form of strong outmigration between 1975 and 1990, a radically different picture emerged in 1994 compared to 1972. The second globalization was in full motion and, in 1994, the economy was receiving up to 70 percent of GDP in income, transfers, and capital flows. These inflows financed imports reaching 66 percent of GDP and boosted private consumption up to 111 percent of GDP. Exports shrunk to less than 9 percent of GDP. Investments reached a high of 32 percent of GDP, but large parts of these investments were in housing and real estate, with little impact on the productive capacity. If we look at the distribution of GDP by sector, we notice an increase in the shares of industry and agriculture, two sectors that benefited from the devaluations of 1985-88. Transport and communication declined due to severe damages inflicted to infrastructures and to the redirection of regional transport away from Lebanon during the war. Trade and services also suffered, especially with the decline in tourism.

9
In sum, the real GDP in 1994 was at 60 percent of its 1972 value and at 42 percent in per capita terms, while the country relied on foreign inflows to import goods and services for investment and consumption.

In 2004, Lebanon recovered much of the characteristics of 1972, but with an inflated public sector since public investment and consumption reached 18 percent of GDP against 12 percent in 1972. Much of the increase was in public consumption that reached 15 percent of GDP against 9.0 percent in 1972. The export sector recovered from 1994 but was still half its 1972 level (19.9 percent of GDP in 2004 against 38 percent in 1972). More importantly, the sector composition of GDP shows the impact of a decade of foreign inflow on the structure of the economy between 1994 and 2004. Sectors producing tradable goods in agriculture and industry saw their share drop significantly, while sectors producing non-tradable goods in services and public sector developed strongly. These are all symptoms of deindustrialization with resource diversion to non-tradable sectors that developed due to a strong spending effect. Noticeably, in real terms, the GDP in 2004 was at 93 percent of its 1972 value, and per capita GDP at 56 percent.

# **_2. A Simple General Equilibrium Analysis for Modern Lebanon: Simulation and Results_**

The analysis below simulates the impact of a 10 percent change in foreign inflows on the Lebanese economy for the years 1972, 1994, and 2004. For the base case, foreign reserves are excluded, and only the amount of net foreign savings that closes the current account deficit is maintained. This modification assumes that any increase in foreign savings is directly and fully channeled to the economy with incidence on demand and prices. The simulation includes both an increase and a decrease of foreign inflows by 10 percent. There is no simulation of any shock on the prices of exports, due to the diversification of industry, exports, and agriculture in modern Lebanon. With this diversification in the tradable sectors, a shock in any single sector would not have an effect comparable to the significant effect of a change in the prices of silk in 1912. The exercise aims to assess the vulnerability of Lebanon to external shocks and their impact on the economy. Table 6 summarizes the results of the analysis.

Table 6. Simulation of external shocks on the economy of modern Lebanon (change, in percent)

|Change in remittances & foreign savings|197|2|199|4|200|4|
|---|---|---|---|---|---|---|
|Scenarios|10.0|-10.0|10.0|-10.0|10.0|-10.0|
|Total Income|1.5|-1.5|10.4|-9.9|4.9|-4.8|
|Private Consumption|0.7|-0.7|3.5|-3.6|1.4|-1.4|
|Private Consumptionper capita|-1.7|-3.1|1.5|-5.5|0.1|-2.7|
|Investment|1.4|-1.4|4.4|-5.0|4.5|-4.8|
|Exports|-0.5|0.5|-6.2|6.9|-2.6|2.7|
|Imports|1.3|-1.3|7.9|-7.8|4.1|-4.0|
|Demand of domesticgoods|0.4|-0.4|0.6|-0.7|0.7|-0.7|
|Price of domesticgood|1.6|-1.5|12.4|-11.6|5.7|-5.5|
|Real exchange rate|1.6|-1.5|12.4|-11.6|5.7|-5.5|
|Real GDP at marketprice|0.1|-0.1|0.0|-0.4|0.1|-0.2|

Source: author simulations.

The simulation for 1972 shows an economy that is relatively sheltered against the changes in foreign inflows. In terms of uses, domestic consumption and investment were largely covered by the supply of domestic goods and services, while exports provided a substantial coverage of imports. Foreign 10
inflows helped to close a small gap and did not have a strong impact on income, and subsequently on demand. The 10 percent rise in remittances and foreign savings in 1972 boosts income, consumption, and investment while GDP rises slightly. The losses of the country in competitiveness are moderate; and RER appreciates due to both higher demand and higher prices of domestic goods. Exports decline slightly while the increase in imports is relatively high. The decline by 10 percent in foreign inflows would have almost exactly the symmetric effect of the rise in foreign inflows.

Lebanon’s economy in 1994 is vulnerable and exposed, with low productive capacities in all sectors. Four years after the end of the war, Lebanon is pouring foreign flows in the economy to boost disposable income and finance large imports supplying a growing aggregate domestic demand. In 1994, a 10 percent increase in foreign inflows has an impact of the same magnitude on income and imports; consumption and investment rise. Competitiveness drops sharply with a strong rise in RER and prices of domestic goods, while exports drop dramatically. However, a rise in inflows remains neutral in terms of impact on GDP growth. Interestingly, GDP declines by 0.4 percent if foreign inflows decrease by 10 percent. Here, the impact shows increased sensitivity of the economy towards the spending effect of foreign inflows when their share to GDP reaches high levels, while the share of exports remains low. Another consequence of the high share of inflows to GDP is increased sensitivity of the prices of domestic goods towards a rise in foreign inflows.

In 2004, the Lebanese economy concluded a decade of high magnitude foreign inflows that diverted the economy towards higher shares of non-tradable sectors at the expense of tradable activities. Exports recovered some of the pre-war dynamic, especially in services and tourism. However, the reliance on foreign inflows to finance imports for local consumption and investment remained high. The effects of these inflows on RER and prices of domestic goods are comparable to the effects observed in 1912. Simulation predicted that a 10 percent decline in foreign inflows would reduce private consumption per capita by 2.7 percent. The reversals in foreign inflows starting 2011 and the aggravation of the tendency in the months leading to the crisis that unfolded in October 2019 have indeed exerted a downward pressure on consumption and welfare and led to large outmigration.

# **_3. Confronting Predictions with Reality: Simulations and Actual Observations for the Period 20052020_**

The analysis below compares the simulations of the impact of foreign inflow shocks on economic variables to the actual changes observed through the National Accounts and the Balance of Payments. Table 7 shows that those simulations match the actual observations from 2005 to 2020.

Indeed, while a simulated positive shock with a 10 percent increase in foreign inflows raises income by 4.9 percent, the actual yearly average change in those inflows by 14.1 percent between 2005 and 2010 increased income by 6.8 percent on average and the actual change by 7.0 percent in 2011-2016 increased income by 2.1 percent on average. Actual private consumption and investment also increased as predicted by the simulation, as well as imports and domestic demand of domestic goods. However, while consumption per capita increased in 2005-2010, it declined in 2011-2016, due to the rapid increase in the resident population (Figure 4) with the inflow of refugees from the Syrian Arab Republic, a development that the simulations could not predict.

The simulated negative shock with a 10 percent decline in foreign inflows reduces income by 4.8 percent, and the actual decline in inflows by 10.8 percent on average in 2017-2019 reduced income by 2.8 percent. Actual private consumption, investments, imports, and domestic demand for 11
domestic goods declined as predicted. Interestingly, the predicted and observed declines in consumption are extremely close (1.4 and 1.3 percent, respectively). Yet, the actual consumption per capita merely changed, hence pointing to the accelerated outmigration and to the reversal in refugees’ trends (Figure 4).

Table 7. Comparing simulations and observations for the period 2005-2020 (change, in percent)

|Change in|2004|2005-2010|2011-2016|2004|2017-2019|1912|2020|
|---|---|---|---|---|---|---|---|
|remittances &|Simulated|Observed|Observed|Simulated|Observed|Simulated|Observed|
|foreign savings|10.0|14.1|7.0|-10.0|-10.8|-90.0|-50.3|
|Total Income|4.9|6.8|2.1|-4.8|-2.8|-39.7|-16.5|
|Private Consumption|1.4|6.3|2.7|-1.4|-1.3|-33.7|-27.4|
|Private Consumption<br>per capita|0.1|5.2|-1.8|-2.7|-0.1|-34.7|-24.4|
|Investment|4.5|10.8|3.4|-4.8|-16.9|-31.3|-65.9|
|Exports|-2.6|6.7|-1.5|2.7|-1.0|7.9|-34.2|
|Imports|4.1|6.9|3.6|-4.0|-2.2|-37.0|-33.4|
|Demand of domestic<br>goods|0.7|6.9|3.4|-0.7|-4.2|-17.6|-23.0|
|Price of domestic<br>good|5.7|3.6|4.7|-5.5|6.2|-36.1|40.5|
|Real exchange rate|5.7|0.1|8.1|-5.5|5.5|-36.1|-43.7|
|Real GDP at market<br>price|0.1|6.7|2.0|-0.2|-2.7|-2.6|-25.9|

Source: author simulations and observations from Lebanon National Accounts 2004-2020 (CAS, 2022) and WDI, 2023.

Figure 4. Population in Lebanon 2004-2022 (thousands, right hand axis) and share of ages 15-64 (percent, left hand axis) <!-- Start of picture text --> 70% 6,500<br>69% 6,250<br>68% 6,000<br>67% 5,750<br>66% 5,500<br>65% 5,250<br>64% 5,000<br>63% 4,750<br>62% 4,500<br>Total Population Share Ages 15-64<br>2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022<br><!-- End of picture text --> Source: World Bank, WDI 2023.

The most striking outcome is the similarity between the observed changes in 2020, the year of fullblown crisis, and the simulation with the structure of the economy in 1912. Here, with the exceptions of the decline in growth that substantially overshoots predictions, and exports and prices of domestic goods that present reversed signs,<sup>3</sup> all other changes are within the range of the 1912 simulation. Indeed, the simulated 90 percent collapse in foreign inflows for the economy of 1912 depresses income by 39.7 percent. The actual decline in

> 3 The simulation using the structure of 1912 predicts a decline in domestic prices and an increase in exports which attenuates GDP decline. Indeed, in 1912, exports represented over 60 percent of GDP (see Tables 2 and 3). In 2019, exports were only 21 percent of GDP, domestic prices increased because of massive increase in money supply, and, more importantly, the massive disruptions in service provisions – including energy shortages – prevented the economy from turning the decline in real exchange rate into an opportunity for a better competitive position.

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foreign inflows in 2020 is 50.3 percent and leads to a contraction of income by 16.5 percent. Private consumption, private consumption per capita, imports, and domestic demand for domestic goods all decline within the range and direction of the simulation.

The RER dynamics is of particular importance. Indeed, while a decline in foreign inflows in 2017-19 should have led to a decline in RER, this did not happen, and the RER continued to increase. This is owed to the continuation of the policy of de-facto peg and is a symptom of the overvaluation of the Lebanese currency. This persistent increase in RER led to a drop in exports by 1-1.5 percent on average between 2011 and 2019. The shutdown of the main channel for foreign inflows through the banking sector in 2020 and the sharp decline in these inflows led to a decline in the RER, in parallel to a collapse of the de facto peg of the LBP. This decline in the RER happened despite the increase in domestic prices, the latter being influenced by a massive expansionary monetary policy followed by the Central Bank. Yet, the increase in the prices of imports owed to the collapse of the peg outweighed the increase in domestic prices and produced a decline in the RER.

In sum, it is interesting to see that the observed dynamic in 2020 is better proxied through a crisis scenario applied to the structure of the economy of 1912 rather than to the economy of 2004. This implies that the economic policy followed between 2004 and 2019 gradually distorted the economy of Lebanon towards an extraversion, dependence on foreign financial inflows, and vulnerability that prevailed a century earlier. Back then, the shock of WWI starved the population. Nowadays, the path towards the crisis and the crisis itself reduced the resident population by 900,000 individuals between 2015 and 2022, of which 300,000 between 2020 and 2022 (Figure 4), despite the COVID-19 restrictions on travel. Hence, a century later, the adjustment to the crisis in Lebanon is again happening through the society and the population, in 1916 through starvation, and in the 2020s through outmigration.

# **D. Conclusion**

In the early 20th century, Mount Lebanon experienced deindustrialization due to the development of exports of raw silk. The strong development of the silk sector generated both a resource movement effect and a spending effect like those described by Corden & Neary. This deindustrialization and the monopolization of industry, agriculture, and exports by the silk sector created strong dependency and vulnerability of Mount Lebanon to shocks in the silk market. Outmigration and remittances were the spontaneous responses of the system to the fluctuation of income and consumption related to the fluctuation in exports and prices of silk. Remittances from migrants improved income and consumption and had a strong spending effect. The latter led to an increase in the demand for imported goods and in the demand for and prices of domestic goods. This in turn led to a real appreciation and to deindustrialization and eviction of exporting sectors, which further increased the reliance on remittances. The dependency on silk exports and remittances reached such levels that the interruption of international flows of goods, capital, and people drove the population into starvation in 1916.

Between 1972 and 2004, Lebanon moved back to characteristics close to those of Mount Lebanon of 1912 in terms of dependency on (and vulnerability to) foreign inflows. In 1972, prior to the oil boom in the Middle East, Lebanon already was receiving substantial foreign inflows, but with few effects on income, prices, and GDP. Most of these inflows were accumulated into foreign currency reserves and gold and neutralized. Between 1975 and 1990, war devastation was a major shock to the country and the spontaneous responses of the system were outmigration and high foreign inflows. These foreign 13
inflows sustained income and consumption during the war and allowed a rapid recovery of income, consumption, and investment after the war. In 1994, large amounts of foreign inflows had a strong spending effect on the economy with an increase in the demand for imported goods and in the demand for and prices of domestic goods. This in turn led to a real appreciation and repressed exporting sectors over the whole decade between 1994 and 2004.

In 2004, Lebanon became an indebted country, with large non-tradable sectors and structural dependency on foreign inflows that depressed competitiveness and promoted outmigration in patterns like those observed 92 years earlier. However, similarities with 1912 stop here. Indeed, Mount Lebanon could not make any policy choice since it was a subordinated entity within the Ottoman Empire. In the Lebanon of 2004, policy choices were clear: the country adopted a de-facto peg between the US$ and the LBP in nominal terms. Lebanon has also adopted a double currency system where US$ and LBP are equally used in all types of transactions. These two measures have reduced the role of the nominal exchange rate as a variable of adjustment that would affect RER and competitiveness. These two measures also allowed banks to attract an increasing amount of capital that has been channeled to the public sector, to importers, and to non-tradable sectors. Real appreciation and loss of competitiveness have been aggravated.

Political economy weighed heavily on the direction of policy choices. Bankers used high interest rates to attract more capital, which they were sure would be highly remunerated. Politicians were comfortable with the availability of funds they could channel to their constituencies. Importers were encouraging policies that expanded markets for their products. Bankers, landlords, and real estate developers would push for the overvaluation of real estate assets and for their extensive use as collateral in lending operations. These deliberated policy choices paved the way to the collapse in 2019 when a reversal in foreign inflows over many years culminated in a major crisis with unprecedented impact on the society unseen since the famine of 1916. Instead of starvation, the Lebanese society is now bleeding its vital forces through a massive outmigration, an adjustment that weakens the society and enhances the grip of the existing power structures over its destiny.

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