NS4053 Robert Looney, The Iranian Economy: the Glass Half Empty Legatum Institute

1. NS4053Robert Looney, The Iranian Economy: the Glass Half EmptyLegatum Institute

2. Overview I • To understand where the Iranian economy is going, important to remember where it has been • Lacking the legal and political institutions of a modern market-based economy, pre-revolutionary Iran suffered from the resource curse • Discontent fed by the resource curse an important factor leading to the overthrow of the Shah in 1979 • After consolidation of power as an Islamic republic under the Ayatollah Khomeini – government proposed to run the economy on a model aimed at avoiding that that trap

3. Overview II • That model shifted priorities from • Economic growth powered by oil wealth to • Social and economic justice • Has worked better in its own terms than many would like to admit • Income per person has increased by half (in terms of purchasing power) since 1980 • Much better distribution of that income • Health measured by infant mortality and life expectancy has improved considerably • Average years of education have increased dramatically for women as well as men

4. Overview III • However the formula has hardly proved a panacea • Country has struggled almost continuously with • High inflation • Unemployment (especially youth unemployment) and • Brain drain that has created a diaspora of well-educated emigrants • In the last 20 or so years most of the growth and job creation has taken place in urban areas • Resulted in massive internal migration from the countryside • Until very recently a raft of subsidies and price controls has badly distorted market prices • Meanwhile economic sanctions have made it difficult to import critical industrial parts as well as depressing the exchange rate – further adding to inflationary pressures

5. Overview IV Raises a series of questions • Can Iran make the changes needed for the rapid growth required to manage unemployment? • More generally, is ongoing authoritarian rule • Complicated by the strictures of fundamentalist Islam and • An aggressive foreign policy • Compatible with further development?

6. Pre-Revolutionary Economy I • Early 1960s Iran’s living standard roughly equivalent to Malaysia, South Korea and Turkey • Monarchy’s drive for regional power was built around • Rising oil revenues and • An alliance with the west in the Cold War • Between 1965 and 1979 the economy grew at an average real rate of 7.4% -- among the fastest in the world.

7. Pre-Revolutionary Economy II • Problem – aggregate figures concealed severe weaknesses • Per capita GDP expanded at 4.4% -- high, but reflected • The population explosion and • Looming necessity of job creation for a very young population • Much of the increase in national income came from • Increases in the production of oil and • After the Arab oil embargo of 1973 from increases in the price of oil • Great wealth of the royal family and cronies increased the perception of injustice Division in living standards between rural and urban areas certainly widened

8. Early Post-Revolution I • Initially conservative leaders of Islamic Republic sought to create new economic structures comatible with • Revolutionary ideology and • Islamic precepts of social justice • Country’s new constitution committed the government to • Eradicating poverty • Banning usury and “extravagance” • Aiming at self-sufficiency in food production and • Preventing foreign economic domination – especially in the oil industry

9. Early Post-Revolution II • Economic policy had an orientation decidedly • Anti-market • Anti-capitalist and • Anti-globalist • Nationalizations took place with the country major • Industries • Private banks and • Insurance companies

10. Early Post-Revolution III • Thousands of businesses belonging to the Shah’s associates and supporters were confiscated and turned over to Islamic charitable foundations – bonyads • The Islamic Revolutionary Guard Corps (IRGC) took on added importance • Initially with the defense of the new regime • During war with Iraq – took on job of providing welfare and small loans to veterans and their families

11. Early Post-Revolution IV • Wholesale nationalization • Exodus of middle class Iranians, • Decline in international oil prices and • Destruction caused by war with Iraq • Had devastating economic consequences. Between 1980 and 1988 • Per capita GDP and capital formation declined by one third • Inflation accelerated to nearly 20%

12. Early Post-Revolution V • Compounding these problems Islamic government encouraged rapid population growth – even higher than under the Shah • Population expanded at unprecedented rate of 3.8% between 1980 and 1988 • Demographic momentum built up in early 1980s was difficult to overcome • Population nearly doubled between 1979 and 2001 • Put enormous demands on Iran’s education system • Sent millions of young, relatively unskilled Iranians into the workforce

13. Rafsanjani Era I • Following death of Khomeini (1989) Akbar Hashemi Rafsanjani became president and began an economic liberalization. • Priority – rebuild economy after the war • Understood economy’s problem stemmed from much more than the war: • Overbearing regulation • Narrow tax base • Non-targeted subsidies • Overvalued currency and • A dysfunctional banking system

14. Rafsanjani Era II • Rafsanjani’s program similar to a structural adjustment program • Wanted to privatize many inefficient state enterprises but faced strong opposition from state employees and other beneficiaries • Did manage to stimulate competition between state enterprises – especially in • Construction and • Restoration of facilities damaged in the war.

15. Rafsanjani Era III • IRGC was a key participant • Transformed itself into a conglomerated that • Opened enterprises and • Bid on government contracts • Expanded its financial activities through extending its wartime micro-lending operations into • Money laundering and • Smuggling networks • IRGC opposed to inclusive reforms

16. Rafsanjani Era IV • Once Khomeini died social justice no longer the primary goal of the revolution. • In its place a crony capitalist system reminiscent of the Shah’s time developed. Corruption rose as the • Bonyads, • Guards • Traditional military • Rafsanjani family and • Their clients • Free to do business without either the discipline of • Even handed regulation or • A competitive marketplace

17. Rafsanjani Era V • At one point Rafsanjani reputed to be Iran’s wealthiest individual • Insider mullahs also benefited through • Interest free loans from state banks and • Access to foreign exchange at official rates that could be resold at a market rate that was five times higher • Though designated as religious charities serving the poor, bonyads became some of Iran’s wealthiest entities • Owned much of Iran's industry as well as vast tracts of real estate. • May control up to 20% of Iran’s GDP • Free from taxation

18. Rafsanjani Era VI • Protection from competition granted to the bonyads and the IRGC took a toll on productivity – reflected in lagging economic growth • Economy recovered somewhat during the post-war period with per capita GDP growing by 26% between 1989 and 1996 • However gain only brought income back to the level at the time of the revolution • High inflation become chronic averaging 25% across the period

19. Khatami Era I • 1997 Mohammed Khatami, an Islamic scholar became president • Ushered in social reform phase vigorously opposed by the conservatives • Economic policies • Sought a normalization of trade and investment with the outside world • Talked about re-privatizing industry • Did not really have the will to challenge the economic interests of the new military-theocratic complex • Did not have a way either as world oil prices low

20. Khatami Era II • Declining oil revenues after Asian financial crisis (and subsequent fiscal retrenchment) in 1997 did put pressure on Khatami to attack the country's vast array of household subsidies. • Most introduced during Iran Iraq war • Left in place to mask the regime's economic failures and insure the support of the poor • Subsidy reform postponed for a decade during which their cost grew to nearly one-fifth of GDP

21. Khatami Era III • Declining oil revenues after Asian financial crisis (and subsequent fiscal retrenchment) in 1997 did put pressure on Khatami to attack the country's vast array of household subsidies. • Most introduced during Iran Iraq war • Left in place to mask the regime's economic failures and insure the support of the poor • Subsidy reform postponed for a decade during which their cost grew to nearly one-fifth of GDP

22. Khatami Era IV • During Khatami's second term (beginning in 2001), rising oil revenues made it possible to pursue some adjustment policies -- in particular • Move to ease controls on capital movements and • Adopt a floating exchange rate to stimulate non-oil exports • Achieved good results • Inflation eased to around 15% and • Investment grew by about 8% -- faster than any time since the revolution • Main problem was job creation

23. Khatami Era V • Even before the full effect of the 1980s baby boom began to be felt in labor markets, unemployment rose to double digits • Between 1996 and 2000, 700,000 workers entered the labor market while only 300,000 jobs were created • By 2000 unemployment was estimated at between 15 and 25% with much higher rates among urban youth • Country needed to create 700,000 to 800,000 new jobs each year to reduce unemployment to acceptable levels • To keep it there would have required 6% growth • Post-revolution Iran has not come close to this rate.

24. Khatami Era VI • Explanations for Iran's mediocre economic performance • Playing a part included • 1980s war with Iraq • International sanctions, and • Volatile oil prices • More fundamental cause was a structural trap in which the power of incumbent interests stymie reallocation of capital from inefficient firms to more productive ones. • In case of Japan (where the term was first applied) the government couldn't bring itself to withdraw support • From failing businesses and • The banks that propped them up during the economy's "lost decade."

25. Khatami Era VII • In the case of Iran • The mullahs, • Elements of the armed forces and • Those who enjoyed their patronage • Exercised veto power over reforms that would have • Privatized state-owned enterprises • Rationalized the businesses controlled by the bonyads, and • Replaced consumer subsidies with less-distorting transfers to the poor • The result has been chronic underperformance, even during peroiods in which oil revenues are abundant

26. Khatami Era VIII • Research at the IMF supports this interpretation • In the 1960-76 period, changes in total factor productivity rose sharply • Most of the gains were lost during the Iraq war and productivity continued to slide through 2000 • Nearly half of the difference in growth rates before and after the revolution can be attributed to lagging productivity -- particularly in • The government and • Bonyad-dominated manufacturing sector • Khatami-era reforms did open a few opportunities for private enterprise but limited access to credit plus predatory competition from the bonyads, the IRGC, and other protected entities made success very difficult.

27. Ahmadinejad -- New Populism I • Hopes that reformers would dig Iran out of its structural trap faded with the election of Mahmoud Ahmadinejad in 2005. • Former member of the Basij, the civilian auxiliary of the Revolutionary Guard • Enjoyed active support from the Guards and Ayatollah Khamenei • Ahmadinejad's economic strategy one of petro-populism • Similar to that of Hugo Chavez of Venezuela • Idea was to serve as the champion of the common man in the struggle against ill-defined exploiters • To “put the oil money on everyone’s dinner table” by redistribution to the masses.

28. Ahmadinejad -- New Populism II • To many Ahmadinejad’s economic policies seem erratic and capricious however they follow from simple principles: • First he believed in an active role for the government, and has little confidence in ability of privatization to improve the lot of the common citizen. • To make sense privatization would have to strengthen his political coalition • Second he was a genuine populist in that he believes government out to redistribute wealth and income to the poor. • Third he was skeptical of the need for fiscal conservatism • Believed the state should spend oil revenues aggressively to enhance its power

29. Ahmadinejad -- New Populism III • Fourth, he viewed financial institutions, particularly state-owned banks, purely as instruments of government policy • Had little understanding of the role of financial intermediaries in the efficient allocation of capital • He strength lay in his inclination to pragmatism in designing policies that push his agenda and keep him in office. • Seen in two big initiatives • Privatization, and • The removal of subsidies

30. Ahmadinejad -- New Populism IV Privatization • In the 2009 election both Ahmadinejad and his opponent, Mir-Hossein Mousavi • Promised wholesale privatization of the public sector • Both had in mind transfers that would serve their own influential constituents • Major difference in the groups they would benefit • Mousavi, backed by Rafsanjani intended to enrich Rafsanjani’s network of businessmen, mullahs and their Bazarri partners – essentially continuation of Khatami’s policy. • Ahmadinejad wanted state enterprises to go to senior officers in the Revolutionary Guard and their business partners. • Under either candidate the fortunate recipients could count on financing their acquisitions with cheap loans from state-owned banks.

31. Ahmadinejad -- New Populism V • Having won both reelection and the privatization battle Ahmadinejad • Issued a number of “Justice Shares” -- blocks of stocks reserved for employees of the privatized companies • Clear that high-ranking IRGC officers comprise the major stockholders of many of the privatized companies • Possible that a military-security elite of around 100,000 is emerging as the principle economic power block in the Islamic Republic

32. Ahmadinejad -- New Populism VI • Subsidy Reform • Under Khatami government spent equivalent of $100 billion a year on energy and basic commodities to the population at large • However • The global financial crisis make oil revenues more volatile and • The international sanctions on Iran began to bite • Ahmadinejad had to implement a parliament approved plan under which subsidies world be phased out over five years

33. Ahmadinejad -- New Populism VII • Plan well thought out • Provision made for cash payments on a graduated scale to buffer the anticipated price increases • Just 20% of the savings was earmarked for the government treasury • Rest returned to households in form of cash or used to subsidize new, energy saving equipment for business • On one hand program redistributed income from the rich (who enjoyed more than their share of energy subsidies) to the poor. • On other hand it reduced distortions in markets – cheap energy meant overuse and a growing diversion of oil from export to domestic use • Initially reforms were backed by key political interests and supported by the IMF

34. Ahmadinejad -- New Populism VIII • Plan ran into difficulties because survey data used to identify poor households for cash compensation deeply flawed • Instead government opted for uniform payments of around $40 for almost every man, woman and child in Iran • Problem – budgetary cost of the revised compensation even higher than that of the old subsidies • Overly optimistic revenue projections left the government unprepared for the added fiscal burden • Rising inflation also eroded the value of monthly compensation payments

35. Ahmadinejad -- New Populism IX • Half full or half empty • By most criteria Ahmadinejad administration rates a failing grade for economic management • Approach to privatization • Benefits went to select few • Nor did privatization increase efficiency since newly privatized firms no more subject to competitive pressures than they were as state enterprises • Subsidy reforms mixed • Good idea on paper, but government not prepared for complexity of the task • Basically would up throwing money on the problem causing fiscal stress

36. Ahmadinejad -- New Populism X • Growth record also mixed • Between 2005 and 2010 period when oil revenues grew at 7% economic growth averaged only 3.3% • Inflation around 20% • Long run investment trend continued under Ahmadinejad • Gross capital formation by pubic sector reached a peak of nearly one-quarter of GDP in last years of the Shah • Has fallen almost continuously thereafter to 5% of GDP in 1989 • Recovered a bit but remains low for a middle income country with a high rate of savings and a big government sector

37. Per Capita Iran Lags Behind

38. Ahmadinejad -- New Populism XI • Reasons for low investment • Much of government budget goes to consumer subsidies • Narrow tax base – half of the productive economy is tax-exempt because owned by government agencies or Islamic charities • Consequences are reflected in backward state of agriculture, manufacturing and transportation • Private investment has never picked up slack – reasons • Hostile business environment • Price controls • Crony capitalists unwilling to bear risk • Uncertainty over government polity • With Iran at loggerheads with rest of world FDI only a trickle

39. Assessment I • While the macroeconomic/growth trends make Ahmadinejad look bad, other policy areas tell a different story • Country has succeeded on mullah’s own terms • Poverty down since days of the Shah • Benefits of basic medical care, public health, and education have been spread to most of the population • At time of the revolution Iran scored well below the average of all countries on the United Nation’s Human Development Index • But by 1995 country had closed gap with Turkey and by 2000 it exceeded that country’s average score

40. Human Development Better than You’d Expect

41. Assessment II • On the other hand, progress did stall quickly in another area of revolutionary priority income distribution • After revolution Gini index fell from 0.56 to 0.46 but has remained constant since 1990 • Inequality still higher than other middle income countries in region including Tunisia and Egypt • Problem as Islamic charities and Revolutionary Guard gained power they became increasingly effective in blocking reforms that would threaten their situations • Since political opposition to these groups was liquidated after the contested elections of 2009, the situation unlikely to improve anytime soon