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Poor Policy, Not Sanctions, Weakens Iran's Economy

Interviewee: Djavad Salehi-Isfahani, Professor of Economics at Virginia Tech, Nonresident Guest Scholar, Brookings Institution
Interviewer: Greg Bruno, Staff Writer, CFR.org
March 26, 2009

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With the low price of oil and a global economic crisis eroding Iran's economic growth, some analysts believe the economy will emerge as a political liability for President Mahmoud Ahmadinejad as he seeks reelection in June. This leads some to argue that now is the time for the West to turn up the heat with new sanctions in an attempt to win concessions on Iran's nuclear program. But Djavad Salehi-Isfahani, a professor of economics at Virginia Tech and a former economist at the Central Bank of Iran, says these broad-brush observations miss the subtle realities of Iran's mature, if troubled, economy. Iran has proven adroit at navigating U.S., UN, and EU sanctions in the past, he says, by seeking alternative buyers for oil and exports. And while Western restrictions on Iranian banks "have apparently had bite," Salehi-Isfahani says "Iran's economy is suffering from bad policies to begin with, and sometimes it is hard to tell what is causing what."

Iran is in the middle of a presidential election campaign. The incumbent, President Mahmoud Ahmadinejad, was elected in 2005 on a populist agenda, and promised to share the country's oil wealth with the masses. But today the president is often criticized for mismanaging the economy. How has he failed?

When oil prices are high, Iran uses its wealth to buy imports, which often compete with goods that are produced inside Iran. While this practice might keep the populace happy with inexpensive products, it also has the potential to put Iranians out of business because they can't undercut the low-cost goods being imported. So the net effect could be negative. In an attempt to bring the oil money to the people's dinner table, as President Ahmadinejad had promised, the guy at the head of the dinner table may lose his job.

This has happened in a couple of instances that people have written about, like textiles. Iran's textile industry has pretty much been wiped out because of cheap [imports], and the sugar industry has suffered hugely because of increased imports of sugar. A lot of farmers [were hurt] because they were producers of the sugar beet, which is the input into the sugar industry. So bringing oil money to people's dinner table is not the best way to spend the oil money. If Ahmadinejad had done more of it, things might have gotten actually worse.

As soon as oil prices go up, imports go up. That shouldn't happen. The government should put some of the money away and invest it in infrastructure on a larger long term basis.

Why the criticism, then?

The way to bring oil money to people at the dinner table, so that they actually benefit from it, is to use the oil money to equip people with better means to earn a living. And those are things like investing in equipment and machinery and investing in infrastructure. And on those accounts there is some evidence that the economy has not done so well, and Ahmadinejad should take some of the blame because he has not been supportive of the private sector, which creates the bulk of new employment these days, and whose outlook and willingness to invest is critical for economic growth and employment.

Despite these criticisms, none of the major candidates challenging him have offered up their own economic models or alternatives to the electorate. Why is that? Why is this not a bigger issue in the campaigns?

I wonder to what extent this is a problem with a lack of sophistication of the campaigns, and to what extent a lack of sophistication of the voting public about economic matters. Iran has become a very complex economy in terms of its operation, but the level of understanding of the people of how the economy functions lags behind. There was one Iranian website--a conservative website--that complained that these presidential candidates are insulting people by not giving them good information and clear plans about the future. I agree with that. I think that both Mr. [Mehdi] Karroubi and Mr. [Mohammad] Khatami, when he was running, and the new entrant, Mr. [Mir-Hossein] Mussavi, have not been very specific about what is wrong with the economy and how they would fix it. When asked by an interviewer, Mr. Mussavi singled out the dismantling of the Management and Planning Organization as the major problem. But it is way down on the list of problems that I would consider serious.

To start with, 2.3 million of the 3 million people who are unemployed in Iran are under the age of thirty. That is a huge problem. You have the future of a country, which are these 15 to 29 year old people-most of them educated; a lot of them with a high school or university education, but are unable to find work. This is supposed to be the demographic gift of this nation, something that happens once in history, and it's being squandered.

Or maybe [politicians] know this is a very difficult issue, and they just wish it would go away. So I haven't seen anyone address this particular issue that I think is the number-one issue of the country.

I wonder if there is any part of this puzzle that is simply voter disenfranchisement-voters don't believe that their vote matters.

Iran has gone back and forth on that. I think some people thought that in the last election, it didn't really matter who was elected and then realized that it did, because Mr. Ahmadinejad is not the candidate they were looking for. [Former Iranian President Akbar Hashemi] Rafsanjani partly regained his political stature after he lost to Ahmadinejad in the presidential election in 2005. He later won the election for the Assembly of Experts, which was a way for voters to have said, "We made a mistake." This time, I think, Iranians are more likely to take the elections seriously than the last time.

When looking to apply pressure on Iran, sanctions have been the most consistent policy choice for outsiders. The UN has imposed three rounds; the EU is talking about another round of sanctions; and President Obama--despite talk of a diplomatic opening--recently extended sanctions that have been around since the Clinton administration. There seems to be a belief that with oil prices so low, this is the time to make sanctions work. What are your thoughts on that? Are sanctions an effective pressure point inside Iran?

If people thought that last year was bad, or the last two years were bad, when we were importing an average of $60 billion a year, then they are in for a big surprise: things are going to get worse, much worse.

I am often asked that question. I don't really know what is the effect of sanctions, or the effect of tightening the sanctions. I have a hunch that a lot of other people don't either. There are lots of ways to get around the sanctions, though at some cost. They can substitute domestic inputs, and that may even benefit the economy. Or they can substitute from one foreign source to another. The one thing that is clear is when oil revenues go down, shifting around the sanctions becomes a little harder. Because when your pocket is full of money, people come and find you and try to help you to get around the sanctions. But if you are shopping with no money and hoping to get suppliers' credit, then that does not happen. So at some level, yes, the sanctions are going to bite a little harder now that there is less oil money but I am not sure if that alone will make Iran change its policy. There is very little evidence globally that sanctions change the behavior of governments. It is just a very ineffective tool as far as I am aware. I see it more as a domestic U.S. policy issue (showing that our policies are not just carrots) than actually affecting international relations or relations with Iran.

Or maybe it's a matter of the sanctions not targeting the right things? So far they have focused on nuclear and dual-use technologies, travel, and foreign investment. Would an oil embargo or some other strategy aimed at the oil industry be more effective?

At some point it becomes very close to an act of war, which is presumably what the Obama administration is trying to avoid. An oil embargo, in the sense of not allowing ships to come and go out of Iranian ports, I am sure it's going to be met by quite a bit of resistance from Iran's navy. So I don't see that as an economic move. If a number of countries boycott buying Iranian oil, that will be a financial and economic sanction, and that will probably have very little effect because other countries would be still buying Iranian oil. All Iran would have to do is to give a little discount--a dollar or two at low cost to itself--and still sell its oil. The oil sector is under sanctions in terms of investment but even there a lot of companies, smaller companies, some from developing countries, seem to be getting around the sanctions because the U.S. punitive reach does not go that far.

The restrictions against Iran's banks have apparently had bite, but we are not sure how large the negative effects of those sanctions are. You have to remember that Iran's economy is suffering from bad policies to begin with and sometimes it is hard to tell what is causing what. For example, interest rates have been lowered to an extent that real interest rates are negative 10 percent. So, naturally there is very little lending by banks. But we do not know [how] the negative effects of Iran's own policies measure up against those of the sanctions.

Oil accounts for about 80 percent of government exports and 60 percent of its revenue. Tehran must be focused on diversifying its economy, correct?

Absolutely, the desire to diversify has been there for the last fifty years, since [Mohammed] Mossadeq times. Everybody has recognized that oil is not the future of Iran, that oil wealth needs to be transformed into other forms of wealth, physical and human capital for producing other goods. And they tried to do that but it is very difficult to do, it is a historic development challenge that the country faces. Iran's non-oil GDP now comes primarily from services, which is about two-thirds of the GDP, and then manufacturing and agriculture at about 15 percent each, and the rest is utilities and construction. In 2007, when oil prices were quite high, oil only accounted for 27 percent of the total GDP. So there is already a fairly diversified economy. It is nothing like Saudi Arabia, or UAE. The problem is that when you have a productive sector like oil--productive in the sense that you have few workers there, and few meaning about sixty thousand--and you get a huge amount of income out of that, everybody else looks very unproductive relative to that. So when you trade, people buy your oil and they don't want to buy anything else from you because everything else is expensive because labor is expensive.

It takes a lot of sophistication on part of the government to protect the domestic economy from the adverse impact of oil, which goes back to what we were talking about in the beginning, about taking the oil money to the people's dinner table without hurting employment. It must take the oil money to roads, dams, to improving technology, education, health and so on - not directly to people's dinner table. And let people's dinner tables be filled with the fruits of the labor using that technology and infrastructure that oil has provided. Now populism is the opposite of this kind of scenario because "the populace" want the goods immediately, and the government tries to give that to them directly. That's why Iran imported so much last year, I think more than $70 billion. As soon as oil prices go up, imports go up. That shouldn't happen. The government should put some of the money away and invest it in infrastructure on a larger long-term basis. That hasn't happened. So diversification is something people talk about all the time, but when they actually come to doing it, they don't have the political will. Populism triumphs.

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