Hossein Askari

WASHINGTON—Iran analysts recently have focused on Tehran’s economic vulnerability as the system’s Achilles’ heel. They are right on this point. But they, and a clear majority of Iranians, are wrong in believing that sanctions are the reason for Iran’s dismal economic conditions.

Iran’s economic failures are largely self-inflicted. The country’s less than stellar economic performance is well documented: real per capita income in 2007 was about what it was at the time of the revolution in 1979; income distribution is worse today; unemployment and inflation rates probably exceed 20 and 30 percent respectively; there have been natural gas shortages for winter home heating and electricity shortages for summer cooling; the social infrastructure to provide universal access to health care and higher education is inadequate; dire government budgetary pressures are necessitating a drastic cut-back in consumer subsidies that have sustained the poor; and rapidly declining foreign exchange reserves, which are threatening the stability of the Iranian currency, the rial, may require currency controls in the not too distant future, further fueling inflation.

Iran’s oil output is about 60 percent of its pre-revolutionary level, and its natural gas development is pitiful when compared to its tiny neighbor Qatar. It is estimated that 150,000 educated Iranians are leaving the country every year to seek better opportunities elsewhere. All of this in a country that is a major exporter of oil, with the second largest reserves of natural gas and third largest oil reserves in the world.

How did Iran fail its people so badly? What could the removal of sanctions do? The key strangleholds in Iran today are government policies—subsidies, regulatory and price controls—and corruption and institutional limitations.

Consumption subsidies in Iran are all pervasive—fuel, electricity and food—with direct and indirect subsidies adding up to well over 25 percent of Iran’s GDP, a truly staggering figure for any country. These are resources that could have been invested to enhance economic growth and development and create much-needed jobs, but have, instead, been squandered. The policy prescription is simple: eliminate subsidies, especially those on energy products. This is easier said than done. Although government officials have wrestled with various approaches, they have always backed away at the last minute. They are afraid of a public backlash. Their fear has been evident to me during many hours of one-on-one discussions with the most senior members of the Iranian state since 1991.

In Iran, factor and product markets are heavily administered and regulated. The labor markets are highly inflexible, as exemplified by the cost of firing workers. The government sets numerous product prices. Financial markets are dominated by state-owned banks, with rates of return “dictated” by the government. The exchange regime is inflexible, and is supported by government regulation and intervention.

The government’s control over rates of return on deposits and exchange rates requires further elaboration. Rates of return at commercial banks have been in the range of 15–25 percent per annum for roughly a decade. At the same time, although Iran’s exchange rate system is officially a managed float, it is more accurately a managed fixed system, with a total nominal fluctuation of only about 15 percent of the rial in five years. The government is reluctant to let the rial become more flexible because of inflationary pressures and backlash from powerful domestic constituencies that benefit from an overvalued currency. Exchange rate policy as the prime policy to control inflation is misplaced (it is akin to scratching one’s face with one’s feet). Tighter monetary and fiscal policies are needed to reduce inflation.

The government’s exchange-rate policy coupled with high inflation has encouraged speculation in real estate, even by Iranians living abroad. The overvalued rial has hampered the development of an export-oriented manufacturing sector and is making Iran’s agricultural exports increasingly uncompetitive on world markets. The policy prescription is simple: deregulate and free all markets. But the regime is afraid of further fueling inflation.

Corruption is rampant in Iran. Every official expects something to process and advance any routine request. Under President Mahmoud Ahmadinejad, the Islamic Revolutionary Guard Corps (IRGC) have been a major beneficiary. Sweetheart contracts have been awarded to the IRGC in areas where they have no expertise or track record. Smuggling (of gasoline to neighboring countries and imported goods) is pervasive. Permits for illegal construction are routinely bought. And of course the oil and natural gas industries provide officials with a multitude of opportunities. All of these corrupt deals, and much more, have deprived the economy of much needed productive investments to stimulate growth.

All Iranian institutions are weak and ineffective and are further corrupted by oil revenues, as the discovery of oil within a country may actually frustrate institutional development. In countries that had strong institutions when oil was discovered, such as Norway and the United Kingdom, oil has been a blessing. But in countries that had weak institutions, such as Iran and Nigeria, the discovery of oil gave those in power the incentive to block institutional development to protect their personal interests, and oil may be more of a curse.

Iran needs to reduce its reliance on oil by promoting the non-oil private sector and using oil to benefit all generations. This policy has not been implemented, in part because Ahmadinejad has subverted it with impunity and no one has had to courage to challenge him. Iran has an Oil Stabilization Fund (OSF) designed to protect government revenues from fluctuating with oil prices and to carry the benefits of oil to all future generations. The OSF has been plundered whenever the government needed funds. Its current holdings are estimated to be around $10-15 billion, but should have been around $60 billion if the government had followed the prescribed rules over the past four years.

About five years ago, Iran adopted a policy to reduce government reliance on oil revenues by 10 percent per year so that, at the end of ten years, it would not need oil revenue. The government has made no progress on this most fundamental policy. Taking oil revenues away from the government would force the authorities to adopt the needed policies, as has been done in non-oil exporting countries. If 100 percent of the oil revenues were placed into the OSF and proceeds were distributed to all eligible citizens in the form of an annual payout that maintains the same real purchasing power, then oil would benefit all generations, subsidies could be eliminated, and the government would have to rely on taxation for revenues.

In sum, to enhance Iran’s economic performance and treat all generations equitably, the government needs to implement a number of policies simultaneously: establish an effective oil fund to eventually receive all oil and gas revenues, establish an efficient tax system, deregulate factor and product markets, privatize nationalized industries, eliminate most subsidies, adopt better macroeconomic policies including a more flexible exchange rate system, and crack down on corruption.

Can removal of sanctions improve Iran’s economic performance significantly? In my mind, the removal of sanctions under prevailing conditions and realities in Iran will not improve economic performance significantly. Instead, such a move may hurt the Iranian people and help the leadership.

Sanctions have had a limited impact on Iran. There has been no real impact on oil exports. Iran’s non-oil exports may have been reduced in value by about 5 percent because of lower prices. With the embargo of U.S. exports to Iran, Iran has turned more to Europe and Asia for its import needs and has secured U.S. goods through third countries, principally Dubai (the UAE). By my estimates, the cost of U.S. goods (not those normally imported from other countries) has increased for Iran by a maximum of 10 percent. Financial sanctions have taken a additional toll on Iran, including increasing Iran’s cost of all (not just from the U.S.) imports by about another 10 percent. All in all, existing sanctions may have increased Iran’s import bill by about 15 percent.

While sanctions may have adversely affected foreign investment in Iran’s energy sector, the major reason for the slow development of Iran’s oil and gas reserves has been the perception of Iran as unstable country. Iran’s own policies have also deterred foreign investors.

To my mind, a beneficial effect of sanctions has been to limit Iran’s access to external borrowing. Governments such as Iran’s, caught in a financial bind, are apt to resort to external financing and use the proceeds to buy local support today and to line the pockets of high officials, leaving future generations in the hole. The regime in Tehran has already gone through such a cycle. In Iran’s revolutionary constitution, external borrowing was prohibited. But in the aftermath of the Iran-Iraq War, the government engaged in massive borrowing of about $35 billion. Much of this money was wasted. Iran has since paid this back. The lifting of sanctions could ignite another borrowing binge to the detriment of average Iranians, as the government is unlikely to use such funds productively.

What should the Obama administration do, given Iran’s economic, as well as political, realities? There are two schools of thought—one idea is to lift all sanctions, and the other to put further pressure on Iran.

The first option is based on the following considerations: Iran’s economy and internal conditions are so fragile that further economic pressures would impose unbearable pain on average Iranians and could ignite further social unrest. The second option would leave sanctions in place and see the United States enforcing existing laws for U.S. citizens and permanent residents to initiate a run on the Iranian rial, which would ultimately result in the collapse of the Iranian economy.

I subscribe to the second option for a number of reasons. If the United States adopts the first option at a time when the state treats Iranians with unimaginable brutality, the message we are sending to Iranians is that their treatment matters very little to us as we see rapprochement with this regime in our national interest. We would alienate the majority of Iranians for years to come and they could even see a resemblance to 1953 when the CIA overthrew Iran’s government and embraced what many saw as a dictatorial regime. Many Iranians said as much to President Obama: “Obama, with them or with us?” in demonstrations on November 4, 2009.

While the U.S. administration must adopt the policy that is in America’s national interest, this is one time when the long-term interests of the Iranian and American people coincide, as the government in Tehran does not serve the interests of Iran or afford the U.S. government with a reliable partner in the region.

Hossein Askari is the Iran Professor of International Business and International Affairs at the George Washington University.