New government and nuclear negotiations open door for economic reform in Iran

Renowned Iranian economist Hashem Pesaran discussed the origins of Iran’s current economic crisis and explored possibilities for reform.

New government and nuclear negotiations open door for economic reform in Iran

by Catherine Schuknecht

At an event cosponsored by the Center for Near Eastern Studies and the Program of Iranian Studies on February 24, 2014, Hashem Pesaran explained the root causes of Iran’s recent economic decline and offered insights into how these problems could be addressed.

Pesaran is the John Elliot Distinguished Chair in Economics at the University of Southern California, where he directs the Center in Applied Financial Economics. Prior to the 1979 revolution, he headed the economic research department of the Central Bank of Iran and served as under-secretary of the country’s ministry of education.

Economic mismanagement is at the heart of Iran’s constant high inflation and episodic foreign exchange crises, explained Pesaran, warning that another currency crisis was right around the corner if fundamental policy failings were not addressed. This article summarizes the highly detailed economic analysis presented by the speaker.

Root causes of Iran’s economic decline

“The current state of the Iranian economy is the worst it’s been since 1948,” said the speaker, attributing the crisis primarily to government mismanagement.

He concurred with an IMF press release issued in January 2014 that traced the recent weakening of the Iranian economy to a combination of shocks and ambitious social programs that were inadequately funded by the government.

The crux of economic mismanagement lies in the Iranian leadership’s reluctance to address the vicious cycle of high, persistent inflation followed by foreign exchange crises and subsequent currency devaluations, which in turn further exacerbate the inflationary process, said Pesaran.

During former Iranian President Ahmadinejad’s government, the country’s considerable oil revenues created the false impression that the exchange rate was under control. Yet the failure to adequately fund the ambitious social programs put in place by Ahmadinejad created an economic situation in which aggregate demand exceeded available resources. The resulting imbalance produced higher inflation and exchange rate devaluation, accentuating the economic crisis.

Shocks to the Iranian economy identified by the IMF report, such as subsidy reform and harsher trade and financial sanctions, also contributed to the economic downturn, as did rent seeking by semi-governmental agencies. However, neither of these factors were the root cause of the economic crisis, argued Pesaran, refuting the popular belief in both Iran and the American media that the sanctions are singularly responsible for the country’s economic woes.

Latin America as a model

The speaker pointed to the steps undertaken by Latin American countries to reduce inflation and prevent currency crises as a possible model for Iran.

Policy makers in Brazil, he explained, recognized that mismanaged economic policies and unfulfilled promises were the primary contributors to rising inflation. According to Pesaran, Brazilian economist Gustavo Franco argued that inflation became endemic when “people and their political representatives voted to give themselves things they could not afford.”

As a consequence, fiscal responsibility and confidence building become the cornerstones of Brazil’s fight against inflation. A similar policy could be applied in Iran.

The failed policies of Latin American countries also hold lessons for Iranian policymakers, noted Pesaran. Indexing of prices, wages and contracts was, for example, attempted to help people retain their purchasing power as inflation rose. However, this policy was unsuccessful in the long term because it failed to address the fundamental causes of inflation.

Some countries in Latin America attempted price freezes followed by the integration of a new currency, both of which were only marginally effective. Others adopted orthodox monetary policy and strict credit controls in an effort to control liquidity, an approach that eventually led to a decline in output and continued inflation.

Looking forward

Pesaran fervently rejected the argument that economic laws do not apply to Iran because it faces the complications of volatile oil revenues and economic sanctions.

The law of purchasing power parity tells us that the exchange rate is tied to the ratio of relative prices, he noted, pointing to a tendency toward equilibrium in the price of Iranian goods relative to foreign goods. This tendency takes about six to seven years to be realized, he explained, during which time Iran’s exchange rate rises.

As a result, Iran cannot successfully adopt a policy that attempts to control its exchange rate, nor can it assume that the exchange rate will remain constant, said Pesaran. Instead, President Rouhani’s government must strive to reduce inflation by making fundamental policy changes in order to prevent a currency crisis in the near future.

The speaker emphasized that policy changes must address the effects of sanctions on productivity and aggregate output by expanding and diversifying Iran’s productive capacity and increasing “confidence in the functioning efficiency of the government machinery.”

Finally, in order to combat inflation, Iran must come out of isolation and integrate itself into the world economy by promoting non-oil exports, such as tourism, that encourage regional economic cooperation and are also less affected by sanctions.

The speaker intentionally avoided making specific policy recommendations, as he believed the details of a new economic policy must be developed inside Iran without the help of other countries.

“[It] is a receptive period at the moment and I think it’s important to contribute,” observed Pesaran, noting that significant expertise exists within the Iranian government as well as in private research agencies in Iran, such as the International Iranian Economic Association, of which he is currently president.

In light of the recent nuclear negotiations between Iran and the “P5 plus 1” (the five members of the UN Security Council — the United States, Britain, China, France and Russia — plus Germany) he was optimistic that the talks would create confidence in the Iranian economy, whether or not they resulted in the lifting of sanctions.

Should sanctions be lifted, Pesaran predicted that the Iranian economy could grow by up to 10 percent within two to three years.