On March 4 last year, with the military campaign just 15 days away, the United States agency for international development asked three American firms to bid for a unique job; after Iraq had been invaded and occupied, one company would be charged with setting up 180 local and provincial town councils in the rubble.

This was newly imperial territory for firms that were more accustomed to the friendly NGO-speak of "public-private partnerships", and two of the three companies decided not to apply. The "local governance" contract, worth $167.9m in the first year and up to $466m in total, went to the Research Triangle Institute (RTI), a private non-profit-making body best known for its drug research. None of its employees had been to Iraq in years.

At first, RTI's Iraq mission attracted little public attention. Next to Bechtel's inability to turn the lights on, and Halliburton's wild overcharging, RTI's "civil society" workshops seemed rather benign. No more. It now turns out that the town councils RTI has been quietly setting up are the centrepiece of Washington's plan to hand over power to appointed regional caucuses - a plan that has been so widely rejected in Iraq, it could end up bringing the occupation to its knees.

Last week, I visited the RTI vice-president Ronald W Johnson, the director of the Iraq project, at the firm's offices near the North Carolina town of Durham (down the block from IBM, around the corner from GlaxoSmithKline). Johnson insists that his team is focused on the "nuts and bolts" and has nothing to do with the epic battles over who will rule Iraq. "There really is not a Sunni way to pick up the garbage versus a Shiite way," he tells me. Perhaps, but there is a public and private way - and, according to a July report last July from the Coalition Provisional Authority (CPA), RTI is pushing the latter, establishing "new neighbourhood waste collection systems" that "will be arranged through privatised kerbside collection".

Nor are the councils that RTI has been setting up uncontroversial. On the same day that Johnson and I were calmly discussing the finer points of local democracy, the US-appointed regional council in Nasiriya, about 200 miles south of Baghdad, was surrounded by gunmen and angry protesters. On January 28, as many as 10,000 residents marched on the council offices demanding direct elections and the immediate resignation of all the councillors, whom they accused of being pawns of the occupying forces. The provincial governor called in bodyguards with rocket- propelled grenade launchers and proceeded to flee the building.

Poor old RTI; the appetite for democracy among Iraqis keeps racing ahead of the plodding plans for "capacity building" that it drew up before the invasion. In November, the Washington Post reported that when RTI's people arrived in the province of Taji, armed with flowcharts and ready to set up local councils, they discovered that "the Iraqi people formed their own representative councils in this region months ago, and many of those were elected, not selected, as the occupation is proposing". The Post quoted what one local man told a RTI contractor: "We feel we are going backwards."

Johnson denies that the previous council was elected and says, moreover, that RTI is only "assisting the Iraqis", not making decisions for them. Perhaps, but it doesn't help that Johnson compares Iraq's councils to "a New England town meeting" and quotes another RTI consultant, who observed that the challenges in Iraq are "the same thing I dealt with in Houston". So is this Iraqi sovereignty - conceived in Washington, outsourced to North Carolina, modelled on Massachusetts and Houston and then imposed on Basra and Baghdad?

The United Nations, now that it has gone back to Iraq, must somehow carve out a role for itself in all this mess. A good start, if it decides that direct elections are impossible before the White House's deadline of June 30, would be to demand that the deadline be scrapped. However, the UN will have to do more than just monitor elections; it will have to stop a robbery in progress - the American attempt to rob Iraq's future democracy of the power to make meaningful decisions. And it all hinges on the powers of the transitional government.

Washington wants a transitional body in Iraq with the full powers of sovereign government, able to lock in decisions that an elected government will inherit. To that end, Paul Bremer's CPA is pushing ahead with its illegal free-market reforms, counting on these changes being ratified by an Iraqi government that it can control. For instance, on January 31 Bremer announced the awarding of the first three licences for foreign banks to operate in Iraq. A week earlier, he had sent members of the Iraqi Governing Council to the World Trade Organisation (WTO) to request observer status - the first step to becoming a WTO member. And Iraq's occupiers have just negotiated an $850m loan from the International Monetary Fund, giving the lender its usual leverage to extract future economic "adjustments".

In other countries that have recently made the transition to democracy - from South Africa to the Philippines and Argentina - this transition between regimes is precisely when the most devastating betrayals took place: backroom deals to transfer illegitimate debts, commitments made to maintain "macro-economic continuity". Again and again, newly liberated people arrive at the polls only to discover that there is precious little left to vote for.

But in Iraq, it's not too late to block this process. The key is to confine the mandate of any transitional government to matters directly related to elections: the census, security, protection for women and minorities.

And here's the really surprising thing: it could actually happen. Why? Because all Washington's reasons for going to war have evaporated; the only excuse left is President Bush's deep desire to bring democracy to the Iraqi people. Of course, this desire is as much a lie as the rest - but it is a lie that we can use. We can harness Bush's weakness on Iraq to demand that the democracy lie become a reality, that Iraq be truly sovereign: unshackled by debt, unencumbered by inherited contracts, unscarred by American military bases, and with full control over its resources, from oil to reparations.

Washington's hold on Iraq is growing weaker by the day, while the pro-democracy forces inside the country grow stronger. Genuine democracy could come to Iraq, not because Bush's war was right, but because it has been proven so desperately wrong.

· A version of this article first appeared in the Nation