Why can’t Lebanon’s leaders fix its economic crisis?

Last week in Beirut, gunmen opened fire on protesters objecting to the pace of the investigation into the city’s port explosion more than a year ago. Six people were killed and dozens wounded in deadly street fighting that echoed the country’s past civil war. Just a week earlier, Lebanon’s electricity grid collapsed for four hours a day — the latest visible sign of Lebanon’s economic crisis, which the World Bank called one of the “most severe crises episodes globally since the mid-nineteenth century.”

How bad is it? In March 2020, the government defaulted on its foreign debt. Over the past two years Lebanon’s lira lost more than 90 percent of its value. Between 2018 and 2020, the size of Lebanese economy decreased by 40 percent. As the middle class dramatically shrinks, three-fourths of the population now lives under the poverty line. Persistent shortages of fuel and medicine result in long lines and even armed clashes at gas stations.

And yet Lebanese political groups have barely managed to organize a government, 13 months after parliamentary elections. Little suggests the leadership intends to attempt reform or explore accountability for these catastrophic failures.

This is nothing new for Lebanon. Everyone — the Lebanese political class, ordinary people, and foreign patrons — realizes that the status quo is unsustainable.

But why so little change? What explains the institutional gridlock?

Who wins and who loses from the Lebanese status quo

To answer this, we must return to a basic lesson of political economy: Suboptimal institutions often persist despite good intentions. Even if political leaders support economic reform, they have poor incentives to carry it out. The reason is simple: Inefficient institutions serve the interests of ruling political elites. Politicians find it difficult to commit to reforming a system that benefits them.

In Lebanon, the problem lies partly in its sectarian system. The main political parties in Lebanon are defined along religious lines, such as Sunni, Shiite, Christian and Druze. Lebanese politicians’ power comes from their ability to strategically distribute income opportunities within their own constituency.

To do this, they offer supporters uncompetitive opportunities to bid on projects, hire supporters for public-sector jobs and distribute reconstruction funding within their own sectarian group. Recent research finds that 60 percent of total spending between 2008 and 2018 by Lebanon’s Council for Development and Reconstruction, which leads public investment efforts, flowed to only 10 companies, widely known to be politically connected.

Lebanon’s central bank ran a scheme to enrich politicians

With the escalating economic crisis reducing opportunities for political players to distribute wealth, oligarchs have had to seek new funding sources. Support from foreign countries comes in handy. So do leaders’ abilities to extract regulatory fees from the country’s private sector. A handful of politically connected firms have historically captured most market share in gas, pharmaceutical and other import sectors in Lebanon, thereby limiting competition, private-sector development, job creation and economic growth.

Banking is one of these politically connected sectors. Fifty-four commercial banks operate in Lebanon. Only 20 have total deposits above $1 billion and are not affiliates of or entirely owned by foreign banks. These 20 banks hold 99 percent of consolidated commercial banks’ assets, a sign of high market concentration. Research finds that 18 of these 20 have major shareholders linked to political elites, and 43 percent of the sector’s assets could be attributed to individuals and families closely linked to politicians. Only eight political families control 32 percent of the commercial banking sector’s total assets.

Globally, many central banks have been offering negative interest rates to increase consumption, investment and employment growth. But in Lebanon, bankers and their political patrons offered double-digit interest rates in order to enrich themselves and their clients, relying on a scheme regulated by the central bank. An April 2020 rescue plan, agreed on by the government, estimated that the country had a total sovereign debt at about $90 billion, or 176 percent of GDP, with total bank losses at $83 billion. The banking sector incurred large losses as its exposure to sovereign debt amounted to 70 percent of total banking assets. Neither the government nor the central bank are now able to repay.

In early 2020, depositors and foreign lenders expected the central bank to put a recovery plan in place, possibly with capital controls to reduce capital flight from Lebanon to other countries. Instead, it allowed politicians to transfer billions of dollars to foreign banks, according to Reuters and other sources, even as ordinary people have been unable to withdraw their foreign currency deposits since October 2019. Few ordinary Lebanese citizens were shocked when the Pandora Papers revealed that Lebanon’s billionaire Prime Minister Najib Mikati and central bank governor Riad Salameh had offshore companies that were used to buy overseas properties.

The foreign funding credibility problem

With corruption so endemic, citizens flatly do not believe politicians’ promises to reform the system. Cabinet members in the new Lebanese government come from the same political class that has been enriching itself illegally — and would lose if there were serious economic reforms.

But few understand that Lebanon’s status quo relies on foreign support. Rarely is any Lebanese government formed or sustained without some foreign intervention. For instance, France, the United States and other Arab countries facilitate back-channel negotiations among key Lebanese political factions.

Lebanon also needs foreign cash injections to survive, such as International Monetary Fund bailouts and other assistance. Between 2003 and 2006, for instance, Lebanon received more than $12 billion from oil-rich Persian Gulf nations.

But despite international funding, Lebanon’s governing elites fail to deliver the promised reform. They will do so only if they are sanctioned and suffer some direct losses, such as being unable to make deposits in foreign banks, to access their property outside Lebanon or to travel internationally.

But foreign countries favor particular Lebanese politicians and factions, and don’t want to cut off their allies and reduce their own influence. As a result, when Lebanon's foreign stakeholders promise to support reform, they have no more credibility than Lebanese politicians do.

That leaves Lebanon stuck in institutional gridlock despite its devastating economic collapse.