In retrospect, financial crises usually appear predetermined; but rarely do they offer much clarity about history’s direction. That is certainly the case in Lebanon today, where a predictable crisis has thrown the country into a state of deep uncertainty.

Since Lebanon’s long civil war (1975-1990) ended, its economy and political system have been propped up by external borrowing, leading inevitably to unsustainable levels of public debt. At some point, capital inflows had to stop, and that moment came in late 2019, following a series of negative shocks.

This ‘sudden stop’ has left the country with a triple crisis of dramatic magnitude. The first problem is the balance of payments. Lebanon’s current account deficit stands at a whopping 25% of GDP and its export base is too small even to pay for essential imports.

The second problem is fiscal. Lebanon’s public debt now totals more than 150% of GDP. Government revenues are collapsing under the weight of the recession, and the budget deficit – already large, at 10% of GDP in 2019 – is widening rapidly.

On top of it all, Lebanon is also experiencing a banking sector crisis. The major banks, the main recipients of capital inflows from abroad, have invested heavily in Lebanese sovereign debt (which accounts for 50% of their portfolios, on average), and are now essentially insolvent.

Together, these crises have plunged the economy into an abyss. Firms, starving for loans and imports, have started to lay off workers or shut down entirely. The recession has the makings of a Lebanese Great Depression.

The primary source of capital for Lebanon’s rentier political economy was not oil, as elsewhere in the region, but rather investment from the diaspora, which was attracted by high interest rates and a fixed exchange rate pegged to the dollar.

Not surprisingly, there are signs of ‘Dutch disease‘ everywhere: deposits have grown to above 400% of GDP, creating a wealth effect that has lowered the national saving rate to an improbable -3% of GDP. Inequality is high and rising. And a real (inflation-adjusted) exchange rate appreciation of about 50% between 2000 and 2015 has weakened the tradable sectors. In the absence of goods and services to export, Lebanon has been haemorrhaging educated young people.

But more centrally, massive capital inflows allowed a sectarian elite to entrench itself through patronage rather than performance. These elites have milked both the public and private sectors to create a bloated ruling coterie of cronies. While this arrangement has ensured some political stability in an otherwise chaotic region, it has failed to meet basic needs. Even electricity provision is inconsistent and unreliable, while the broader challenges facing the macroeconomy have gone completely unaddressed.

The financial crisis has triggered a political uprising. A popular revolutionary movement has taken to the streets to reject sectarianism and demand an end to corruption. Nonetheless, the regime’s responses to Lebanon’s economic problems have so far overwhelmingly favoured the elites, suggesting that the crisis could end up being ‘resolved’ on the backs of the poor and the middle class, and in a way that further consolidates sectarian politics.

For example, the state has refused to introduce capital controls, leaving it to each bank – whose major shareholders include ruling politicians – to decide how to ration cash withdrawals. In practice, this has allowed elites to shift their capital abroad while average citizens struggle to access their deposits.

Moreover, the central bank has reduced interest rates on deposits, but not yet on public debt, thereby boosting banks’ profits. It has also continued to service its foreign debt, which is mostly owed to domestic banks, despite its falling international reserves. And there are signs that it could start to sell state-owned assets to elite-connected entities at fire-sale prices.

The formal exchange rate, meanwhile, has been left untouched, allowing elites to access cheap dollars while average citizens confront the realities of a rapidly falling free market rate, which is now at a 40% discount.

This devaluation will accelerate when the state starts printing liras to cover civil service wages. In fact, the central bank is already using lira to pay interest on dollar deposits (which account for over 80% of all deposits), thus setting the stage to inflate away the public debt. With the costs of debt reduction being pushed onto depositors through ‘liralisation‘ of their holdings, the banks’ equity could be largely spared.

If this scenario materialises, Lebanon’s middle class will be decimated by lower real wages and pensions and a liquidation of its savings. The emigration of skilled youth would accelerate, and even the financial interests of the diaspora – on which the system relies – would be harmed. If the sectarian system were to survive under these conditions, it would govern an impoverished population that could be controlled by ever cheaper patronage. Lebanon would find itself in a situation similar to that of Venezuela.

The new republic being promoted by the revolutionaries, by contrast, would take a radically different approach. The revolutionaries want to improve Lebanon, not abandon it. They believe that it is performing far below potential, and that performance, meritocracy, and social justice should replace corruption, cronyism, and inequality. They want to build vibrant high-tech industries, make agriculture more environmentally sustainable, position the country as a cultural powerhouse and create more synergies with the diaspora.

To achieve these goals, the reform movement wants to pursue an orderly reduction of public debt, which would be underwritten with bank equity, and to force haircuts on the 1% of depositors who account for more than 50% of all deposits. They support a moderate currency devaluation and radical improvement in the business climate to boost export competitiveness. And they would pursue deep fiscal restructuring, emphasising the elimination of corrupt practices, and higher spending on social programmes and infrastructure. The inevitable recession would be softened with support from the international community, including the International Monetary Fund.

Today’s infighting over the composition of the country’s next cabinet is part of a larger battle for a new political settlement. The financial crisis poses a mortal danger to the country; but it also represents an opportunity for political change. Lebanon’s future hangs in the balance.

This article was originally published by Project Syndicate. Read the original article.