Iran Sanctions: Who Really Wins?

Djavad Salehi Isfahani
Djavad Salehi Isfahani
Djavad Salehi Isfahani Professor of Economics - Virginia Tech

September 30, 2009

U.S. and Iranian representatives meet this week at a time when trust between the two countries is at a low ebb following the revelation last week of a previously undisclosed Iranian nuclear facility under construction and the test firing of Iran’s long-range missiles on September 28. Meanwhile, the Obama administration’s policy of engagement with Iran has emerged as little more than the old policy of “carrots and sticks.”

The focus of the debate in the U.S. has shifted from Iran’s internal political crisis to its economy. The group of 5+1 (the five UN Security Council members plus Germany) is weighing the costs and benefits of additional sanctions on Iran as a way of pressuring the Ahmadinejad government to change its position on the nuclear issue.

The discussion on sanctions takes place under considerable uncertainty about their effectiveness and the state of Iran’s economy. The emerging consensus in Washington that new, “crippling” sanctions could persuade Iran to change its nuclear policy seems in part based on the lack of a better alternative. But it is also based on two assumptions that I find questionable: first, that the existing sanctions are largely responsible for the weak state of Iran’s economy and second, that the weak economy has helped fuel the popular discontent that boiled over in Tehran’s streets this summer.

The premise of the first assumption – Iran’s weak economy – was revealed last week to be truer than most people (including myself) had anticipated. Survey data released by the Statistical Center of Iran indicate that the performance of the economy last year was the worst in recent memory. Last year incomes fell by a whopping 20 percent in rural areas and 10 percent in urban areas. Such annual declines in consumer incomes have not been seen before, even during the worst years of the Iran-Iraq war. Confirmation that the economy did actually shrink must await the publication of the national accounts for last year by the Central Bank, which has delayed their release. These figures are unlikely to change the bleak picture painted by the survey data, because private consumption accounts for about 55 percent of Gross Domestic Expenditures (GDE) and investment, which accounts for another third of the GDE, likely took a similar hit. Investment was probably the first to drop, as the private sector lost confidence in government policy and the public sector diverted its own investment funds to pay for its populist programs.

Proponents of sanctions need to prove that sanctions were responsible for the weak economy in 2008. This is difficult to do, because the same sanctions were in effect in 2007 when the economy enjoyed a robust growth rate of about 7 percent. True, the sanctions may have taken time to bite, but the government’s own policies are a major source of Iran’s economic woes. A case in point is the banking crisis in Iran which contributed to the economic downturn in 2008. In principle, this crisis could be attributed to sanctions that prohibited U.S. and participating banks in other countries from doing business with Iranian banks which, in effect, severely disrupted financial flows that connected Iran to the outside world and scared off private investment. However, the most crippling blows actually came from inside Iran. The Ahmadinejad government lowered interest rates by fiat and, as a cornerstone of its redistributive policies, at the same time pushed for a massive expansion of credit to small and medium sized enterprises, forcing banks to lend at interest rates 5 to 10 percent below the rate of inflation. In an attempt to restrain the expansion of bank credit and the resulting inflation, the Central Bank stepped in and effectively stopped the program. Ahmadinejad dismissed two central bank governors, but tight money prevailed and inflation dropped sharply, from 25 percent in 2008 to the current annual rate of about 15 percent. The cost has been the present deep recession.

The problem with the argument that sanctions have inflicted damage to the Iranian economy goes beyond a problem in attribution of cause and effect and to simple misreading of data on Iran’s economy. Descriptions of the economy as “dilapidated” or “teetering” are misleading, because Iran’s economy has been on a growth trajectory for the past decade. Over this time, it has doubled per capita incomes, expanded basic services like water and electricity to over 95 percent of the population, and helped expand the country’s systems of health care and education, which are the envy of its neighbors. Even as the economy was in serious decline last year, the proportion of urban Iranian households with a cell phone jumped from 64 to 79 percent (from 31 to 50 percent for rural households).

It is a further misreading of Iran to believe, as many proponents of sanctions do, that the tensions that boiled over into Tehran’s streets this summer were proof of mass dissatisfaction with rising poverty and economic stagnation. The sharp economic decline in 2008 no doubt contributed to dissatisfaction, but for the most part what was on display in Tehran after the disputed election was more the fruits of improvements in living standards than economic decline. The economic growth of the last decade, boosted by effective health and education policies since the Islamic Revolution, has doubled the size of the middle class and reduced the ranks of the poor by two-thirds. Sanctions that reverse these trends may hurt rather than help the cause of moderation in Iran. These considerations lead to a different view of sanctions.

The case for sanctions as an effective foreign policy tool is strongest when the country in question is brimming with internal political tensions caused by years of stagnation or decline in living standards, which sanctions can intensify to bring about the desired policy shift by the country’s rulers. This is not the situation in Iran.

The sizeable majority of Iran’s economically disadvantaged population that supports the Ahmadinejad government is not poor in the sense of lacking food and shelter. Its support for the current government signifies a clear choice between a populist leader with oil money to distribute and his liberal opponents, who criticize his redistributive policies for being inflationary and dismiss them as mere charity. In this political atmosphere sanctions are likely to cement the authoritarian pact between the conservatives and the economic underclass and at the same time weaken the voices calling for greater social, political and economic freedom. Heavy sanctions are likely to strengthen the hands of the Iranian leaders who have opposed the liberal economic reforms of the Rafsanjani and Khatami era and favor a return to the controlled economy of the 1980s, when the government rather than markets decided on the allocation of foreign exchange, credit, and even basic necessities. The sanctions on gasoline imports under review may be a godsend for President Ahmadinejad, who would use the sanctions as an excuse to raise gasoline prices to the middle class and use the proceeds to expand his popular base.

Crippling sanctions could still change the balance of power against the Ahmadinejad government if the stresses caused by badly run government services and waiting in long lines for basic necessities were to bring the middle class into greater conflict with the government. But the principal victim of sanctions would not be the middle class, but the lower classes who may rally around the government in greater numbers. Economic pain caused from the outside is unlikely to weaken a populist government.

If general sanctions are blunt tools for foreign policy, can smart sanctions help change the balance of power inside Iran by targeting specific industries and sections of the population? As with smart bombs, we should expect the case being made before their deployment to be rosier than the actual outcome.

Against this backdrop, engagement, as originally espoused by President Obama, may have a better chance of diffusing the crisis. First, if Iran is as close to nuclear capability as it is claimed, it should have a strong interest in non-proliferation. Making it difficult for a newcomer to join the nuclear club would enhance the value of its own potential membership and dissuade rivals from taking a similar path. If a major goal of sanctions against Iran is to dissuade other countries from taking the path to nuclear capability that Iran has taken, the possibility to make that case with “Iran as a partner” should be kept in mind if the strategy of “Iran as a victim” falls apart. Second, the U.S. and its allies should emphasize positive inducements, and expect to learn during the negotiations what those are rather than decide in advance. U.S. help for Iran to join the World Trade Organization (WTO), which has been offered before and which would benefit some sections of Iranian society while not others, is not a priority for the Ahmadinejad government. Third, it would help the engagement process if the U.S. acknowledged that Iran has something to offer the region in terms of lessons for economic development and building infrastructure – roads, electricity, education and health. This would have the added benefit of shifting the focus from Iran’s military role in the region to economic development, which is the long term road to regional stability that both countries seek.

Djavad Salehi-Isfahani is a Dubai Initiative research fellow at the Belfer Center for Science and International Affairs at Harvard University.