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The Economy of Iran

Jewish Policy Center Conference Call with Professor Steve Hanke

Steve H. Hanke Friday, June 1, 2018

Event Date: Friday, June 1, 2018

Shoshana Bryen, JPC Senior Director and Editor of inFOCUS Quarterly, hosted noted economist Professor Steve Hanke in a call with JPC members

Shoshana Bryen: Welcome to the Jewish Policy Center conference call on the economy of Iran. We, at the JPC, generally think of Iran in its external manifestations – nuclear policy, support for terrorism, involvement in Syria. Today, we’re going to look inside at Iran’s economy and consider the impact on its ability to wreak havoc abroad. We are thrilled to have Professor Steve Hanke with us today.

Professor Hanke is Professor of Applied Economics and Co-director of the Institute for Applied Economics, Global Health, and the Study of Business Enterprise at Johns Hopkins University. He is a senior fellow and director of the Troubled Currencies Project at the Cato Institute; senior advisor at the Renmin University of China’s International Monetary Research Institute in Beijing; and a contributor at Forbes.

Prof. Hanke: Thank you. I just looked a moment ago at some data to give us a longer range perspective.  If you look at GDP per capita in 1990 dollars, in 1950, the Israeli GDP per capita was about 1.6 times greater than Iran’s GDP per capita.

By 2003, again using constant 1990 dollars, Israel had leaped further out in front. In 2003, its per capita GDP led Iran’s by a margin of 3 to 1. Since then, that margin has increased further. This gives you some perspective.

Today, the size of the economy in Iran is about $420 billion. The population is around 80 million people. So, the GDP total is higher than that in Israel. Israel’s is around $375 billion, but the population is about 8.8 million. Israel has far fewer people, but an economy only a tad smaller than Iran’s.

To look at the structural setting of the Iranian economy and where it ranks in the world, we can look at all kinds of studies and metrics. I like to use the ease of doing business annual report published by the World Bank. It’s a detailed study of 190 countries. In the overall global ranking for the ease of doing business in these 190 countries, Iran ranks 124 out of 190. That puts it more or less in the same bag as the bulk of other countries in the Middle East and North Africa.

So, by that metric, Iran is very low. But they don’t stand out in the region because all the countries in the Middle East/North Africa region, with the exception of Israel, occupy the lowest ranks. If we look at the Cato Institute’s Economic Freedom of the World report, there are 159 countries covered, and Iran ranks 150th. Cato measures a lot of free market indicators: size of the government, nature of the legal system, protection of property rights, sound money, freedom to trade internationally, regulatory burden, and so forth. Only a few countries come in behind Iran in the Cato Economic Freedom of the World report. These include Libya, Argentina, and Venezuela.

If we look at a broader study, which includes 79 different indicators of personal and economic freedoms, including the size of government, regulations, and freedom to trade, the Human Freedom Index that the Cato Institute also puts out has Iran ranked 154 out of 159 countries studied.

So, from a structural point of view, Iran has an economy that is very regulated. It is fundamentally a socialist setup in which the private sector is very tiny, maybe 15% of the total economy. Therein lies the rub. The reason Iran doesn’t perform well is that there is essentially no private sector.

There are a couple of things I find interesting when looking at the contemporary performance of Iran. One of those is obviously the exchange rate. There’s an official exchange rate in Iran, and it is 42,000 rial to the dollar.

But there’s also a black market, which is really a free-market exchange rate. Today, the exchange rate in the black-market is 65,000 rial to the dollar. There’s a deterioration in the black-market exchange rate that’s been going on this year. To give you some idea, the black-market exchange rate on April 27th was 56,500. On June 1st, it was 65,000. That’s a 13% decline in the value of the rial against the dollar in just the last month.

The best way to measure how bad the situation is with regard to the currency is to look at something called a “black-market premium,” the extra you have to pay to obtain greenbacks in the black-market vs. the official exchange rate. Only the privileged few are allowed to exchange rial for dollars at the official 42,000 rate. The gap between the official exchange rate and the 65,000 black-market rate is called a black-market premium. That premium is 54%, meaning you that to purchase dollars on the black-market vs. the official rate, you have pay a 54% premium.

That premium shot up in April. Indeed, when the U.S. indicated that it was going to scrap the nuclear agreement [the Joint Comprehensive Plan of Action or JCPOA, ed.], the black-market premium shot up. People want to get out of the rial as fast as they can and into the dollar. Now, this has a significant impact on the economy because as the currency goes down relative to the dollar, inflation goes up. The official inflation rate is 7.9%. It’s projected to go up a little bit over the year, maybe a little over 10%.

But, I measure the annual inflation rate with high frequency data using the black-market exchange rate and transforming it into an inflation rate using purchasing power parity theory. By my measure, the annual inflation rate today is 78.5%. There’s a huge gap between what is officially reported and the actual inflation rate. The actual rate of 78.5% is not as high as it has been in years past, but it is getting up into a serious territory – one that causes a lot of angst among the population and makes the regime unpopular.

One thing that’s surprising when you look at the economy is that they do run an international current account surplus, meaning they’re selling more to the outside world than they’re importing from the outside world. So, Tehran doesn’t really require any external financing to finance the international transactions that are taking place. The other thing I would point out is that last year, GDP growth was about 3.5% in real terms and it is projected to be maybe a little bit under 2% for 2018.

Most of the projections going forward see a recession in the cards for 2019 and 2020. I think the performance of the economy is not really related to sanctions in any substantive way. Sanctions are negative. There’s no question about that. But they’re not a serious negative.

Most of the problems with growth are wrapped up with how the economy is organized and has been organized for many, many years. The Achilles’ heel of Iran’s economy revolves around internal structural problems. Even before the current, theocratic regime took over, you had the Shah, and he made a mess out of the Iranian economy. One “five-year plan” after another “five-year plan,” and one mess after another. So, it’s one of those countries in which the internal economy does not work very well, but is kept afloat by a sea of oil revenue.

Shoshana Bryen: The first question will be on your last point. Is Iran’s economy primarily strengthened by energy exports and doesn’t that make Iran vulnerable to price fluctuations, with the presently higher price of oil helping them?

Prof. Hanke: Yes. It is vulnerable to the price of oil fluctuating. At the current prices, obviously Iran is much better off than it was right after the Great Recession started in 2009, when we had the massive price collapse on oil. I’ve traded oil for many years and forecast oil prices. Today, I forecast that the price per barrel for West Texas Intermediate crude by the end of this year will be $75 bbl. Currently, the price is a little bit under that; it’s about $67 per barrel. So, the oil price will stay stable and might increase a little bit.

The model I use is one in which I look at the relationship between oil prices and gold prices. That ratio tends to be quite stable over long periods. When oil collapsed in 2008/9, the ratio got way out of whack, and you can figure out how long it takes that ratio to revert back to the mean. Indeed, it takes about 13 months for the ratio to retrace itself 50% back towards the average.

Since the oil price collapse, the price has gradually reverted towards the mean, the equilibrium between the price of oil and the price of gold. Based on that, I’m getting the $75 WTI crude.

Shoshana Bryen: Aside from oil, is there any natural resource mining in Iran? Is there gold? Is there silver? Is there anything other than oil that they extract?

Prof. Hanke: Nothing overwhelming. Oil is Iran’s main export and that’s the reason its current account balance is positive, meaning they’re exporting more than they’re importing. The implication there is interesting because it simply means that they don’t need any external financing for their international trade.

Shoshana Bryen: That would have an impact on banking sanctions. In other words, as we restore sanctions to Iran, we’re looking for banks not to finance Iran, but they may not have to finance them in any event.

Prof. Hanke: They don’t really need any external financing to finance their international trade transactions. There are two aspects to the banking situation. The internal problem with banking is really that the Iranian banks are rather dysfunctional. Many are probably insolvent since they have huge non-performing loans. These result, in part, because the banks, and this is the way the system works: the banks are told – ordered – how to do business and extent credit.

You don’t have a credit officer combing over the credit-worthiness of a borrower. Banks are told that they’re supposed to be loaning money to a company, but that company might, in reality, be controlled by the Revolutionary Guard or a religious foundation or what have you, and be a very bad credit risk. That’s one reason why the whole economy doesn’t work. Credit is not allocated on any kind of market basis, it’s allocated by diktat, to a large degree. So, that gives you a sense of the internal economy.

By the way, I am totally opposed to sanctions anywhere in the world because they do not work. They sound good maybe, depending on which side, obviously, of the battle that you’re on. But they don’t work. The history of sanctions is that they are utter failures.

Among other things, sanctions typically motivate support for the regime at which they’re aimed. They tend to solidify, not destroy a regime politically, whether it’s in Iran or Venezuela or Zimbabwe. Zimbabwe had sanctions forever and they also had Mugabe forever.

As Peter Beinart wrote in his recent edifying article in the Atlantic, “The academic literature is clear: Far from promoting liberal democracy, sanctions tend to make the countries subject to them more authoritarian and repressive.” That is my position after studying the scholarly literature on the use of sanctions, blockades, and so forth during wars and non-wars.

There are three kinds of sanctions. We have primary sanctions, secondary sanctions, and what I’d call tertiary sanctions. Tertiary sanctions are those that aren’t really in a law or regulation, but the idea that maybe you could get caught up in some kind of sanctions and you’re a little bit worried about it. Therefore, you stay away from whatever the activity or country that’s being sanctioned.

In the case of Iran, we have primary sanctions. We have secondary sanctions that are especially affecting the Europeans. But we also have a lot of, in effect, this cloud of tertiary sanctions. That is why banks just don’t want to get involved with anything close to a country with primary and secondary sanctions. If there’s even a whiff of maybe crossing a line or getting involved with somebody that’s covered under sanctions, a compliance office tends to stay away.  I would say that when it comes to Iran, international banking activity has pretty much dried up.

Shoshana Bryen: We already have some sanctions related questions. So, I’m going to go ahead with those.

Prof. Hanke: Okay. Shoshana, may I reiterate my remark about sanctions?

Shoshana Bryen: Of course.

Prof. Hanke: My position is [sanctions] don’t work. Even though they might sound good, they don’t work. But one thing that concerns me a great deal about what’s going on with all the sanctions flying around now, is that the U.S. Treasury has essentially become a war machine. The Treasury issues financial sanctions of all sorts. You have a lot of countries under sanctions. We focus on Iran, obviously, and we know Russia and Venezuela, but there are many other places.

The more financial sanctions are loosely thrown around and used, the more the U.S. dollar becomes vulnerable, because the dollar is the international currency. Almost all trade that takes place in the world is invoiced in dollar terms. All commodities, such as oil and all agricultural commodities, and most minerals are invoiced and priced in dollars. In over 90% of foreign exchange, one side of the transaction is the U.S. dollar.

Over 60% of all Central Bank reserves are held in dollars. About 65% to 70% of U.S. dollar notes actually are not circulating in the United States; they’re overseas someplace. The dollar is the international currency. If you go back about 2,500 years, there was always one dominant international currency. The dominant currency comes into being because of economies of scale and networking economies that are associated with being big and being used in all these trade transactions, and so forth.

The dollar’s vulnerability is that if you have sanctions being thrown around and the dollar is being pinched here and there, a situation may arise in which all this pinching invites a competitor to enter the scene, and challenge the U.S. dollar’s dominance. Maybe the Chinese yuan. The Chinese would love to overthrow the dollar’s dominance. They’re trying every way they can to possibly compete with the U.S. dollar right now. That’s a problem because the U.S., contrary to Iran, has run a large trade deficit since the early ’70s. Who finances a deficit? Well, the U.S. have to borrow.

That’s easy now because the U.S. dollar is the international currency – as the French say, we have the “exorbitant privilege” of borrowing cheap. It’s easy to borrow. And when it’s easy to borrow, cheap to borrow, and everyone wants to be in dollar-dominated assets, it’s not a problem.

That system is what I think ultimately is vulnerable, and one of the potential risk and costs associated with slapping sanctions of everybody right and left. The sanctions won’t work anyway, but they might ultimately make the U.S. pay a dear price, because we’d might be forced to give up our “exorbitant privilege” we have of being able to borrow cheap in dollar terms.

Shoshana Bryen: There are people who think it would be better if we couldn’t borrow cheap and had to deal with our own deficit problem. There is a rolling rebellion in Iran now. There has been since December. We don’t see much of it in the American media, but it is there. Are you suggesting that sanctions may actually help to turn the Iranian population back toward its government? Some of this rebellion is economic, some of it is political. Is it possible that the sanctions will tamp down the rebellion and turn the people back toward the government?

Prof. Hanke: Yes.

That’s the history of sanctions. People on the receiving end don’t look at the one imposing sanctions as a friend; they look at them as the enemy. Why do you think Maduro is in power in Venezuela? The place is completely collapsing. The inflation rate now is 27,000% per annum. I just calculated the thing this morning. He’s in power because he has this hardcore group around him that thinks, and with some justification, that the U.S. is at war with them, and the U.S. wants a regime change.

Shoshana Bryen: I actually think Maduro was in power because he cheats, but I see your point.

Prof. Hanke: He does cheat. But if you actually look at the polling and okay, you can question the polling, all the independent polling shows that if you look at Maduro, he doesn’t have much support. But he has more support than any individual opposition or potential opposition candidate because he’s got a hardcore base.

Shoshana Bryen: European governments have not been terribly pleased with the president’s decisions about those sanctions. How much cooperation, though, has there been from European companies? It seems that a number of European companies are pulling out of Iran or winding down their activities in Iran. How much of that is going on?

Prof. Hanke: A lot. This is the secondary sanctions. That’s part of it. But it’s also this thing that I define as tertiary sanctions. That is, companies saying, “Maybe we’re going to get into some sanctions flap with the U.S. government, but we don’t even know.” It’s kind of a fear of the unknown.

Shoshana Bryen: So, they’re pulling out?

Prof. Hanke: If sanctions, both primary and secondary, are not clearly defined so that you know exactly – you go to the rule book and you look up rule 121, I’m complying or I’m not complying – there’s a lot of fuzziness in all of this. The fuzziness gets compliance officers very nervous and they say, “No. There’s too much risk involved in this.” The European companies are pulling out. The big one was French energy giant Total. It recently pulled the plug on the South Pars gas field in Iran. Now what’s going to happen, who’s going in? The Chinese and the Russians will go in and pick up the pieces.

This is the second-best position for Iran; obviously, they wanted Total. That was the first best, and that’s why they had the deal with them. This is second best. It’s hurt, it’s imposed the costs, and so forth. But who really gets whacked? The owners of Total; they’re out. And who wins? The Chinese and the Russians.

Shoshana Bryen: When the JCPOA took effect, there was a lifting of sanctions. Do we know how Iran utilized the proceeds? There was a hope that those would go into the civilian economy and help people. Do we know what they did with the money?

Prof. Hanke: No.

We’re talking about a country that’s pretty opaque, as are many countries in that part of the world. When I’m looking at economics, it’s more like being a private detective to solve a murder case or something. You turn over a lot of stones, you try to connect the dots, and figure out and make estimates and so forth.

The one thing I know is what the black market exchange rate is, and I understand that how it works exactly – it is totally transparent. I can do my calculations and I know what the inflation rate is, and that it’s up almost 80%. It’s not the official rate. But, many other things are very opaque and very fuzzy. So, you asked a question and I’m just saying, I can guarantee you no one actually knows how they spent the money.

Shoshana Bryen: We probably don’t know, either then, what part of Iran’s GDP is spent on defense and security, what part of it might have been used to sponsor terrorism in other countries.

Prof. Hanke: That’s correct.

Shoshana Bryen: Are there food shortages in Iran? There’s a reported drought and drying up of water in certain agricultural areas that would be very important. Have you seen food shortages?

Prof. Hanke: Spotty and very anecdotal. In life, there’s always a frequency distribution, and the distribution will go from one extreme to the other. Draw a bell curve. On the left-hand side you get an extreme, with a low frequency of occurrence. It doesn’t happen very often, but something happens out there. Then you go up the bell curve to the top of the mountain, and that’s where the average is. Things occurring there are happening with the highest frequency. Then you go way off on the right-hand side to the other extreme. Things don’t happen very frequently there, but they happen once in a while.

These anecdotal things you have to be very careful of because they are often reported from the extremes of the distribution, either on the right or left of the distribution. Things at these extremes don’t happen very frequently. So, in the case of Iran, we do have anecdotal reports of shortages. But, from my examination of those reports, and by putting them into the bigger picture, I conclude that they are spotty, extreme events. Events that don’t happen very frequently, and happen in isolated locations. They do not represent the general state of affairs in Iran.

The one general thing that you mentioned is the drought.  The drought is a weather phenomenon, a short-term problem. The real Achilles’ heel in Iran is water. This will ultimately be a huge problem because there’re large swaths of the country in which irrigation systems are failing and the crops or the orchards and so forth have just gone to dust. This is a longer-term problem than the periodic droughts in Iran. Indeed, water is a long-term systemic problem facing Iran.

The infrastructure is in terrible shape. The capital stock is in terrible shape. You can see this. Just read the paper and you’re going to find out a lot of things just by thinking about it.  For example, in one of the last earthquakes, a one wing of a hospital was destroyed. But, that wing was the new wing – built by a company owned by the Revolutionary Guard.

The old wing, the pre-Revolution wing, withstood the earthquake. The local population was very agitated about it. All this shows me is that all of the new infrastructure is of very low quality.

Shoshana Bryen: If sanctions are not likely to work, and the evidence, as you say, is that they don’t, and we certainly do not wish to invade Tehran, is there a way that the United States and Europe can encourage government change in Iran?

Prof. Hanke: This is a very difficult thing. The U.S. has been involved in regime change, certainly since World War II, in many places, including Iran. That’s part of the problem and the regime changes have generally been disastrous. The results have been similar to those of sanctions; they have not worked.

Shoshana Bryen: Except for the Soviet Union. We encouraged the people of Russia and Central Europe in their quest for greater freedoms. We never attacked the Soviet government militarily and I certainly would not be advocating attacking the Iranian government. But is there a way to encourage people who want better?

Prof. Hanke: I was very involved in rebuilding at least parts of the Balkans and Baltics, and was also very involved in all of the former Soviet Union in general. You’re onto something here that’s interesting because the best policy would be to let Iran’s socialist system collapse of its own weight. That’s what happened in the Soviet Union. Yes, there were voices encouraging liberty, economic freedoms, and so forth. All these things were being talked about, but the fact of the matter is, the economic system in the end collapsed.

For those who are thinking in terms of changing the scene in Iran – which is a hopeful thing – I would advocate no sanctions, more trade, more interaction and contact with the West, and a much larger private sector. You really want to squeeze the theocracy out of the scene.

This is hard to do. After all, the Supreme Leader and his regime own and run the country. Even Iran’s tiny private sector is very much controlled, arm twisted and so forth, by the government.

Shoshana Bryen: Do you foresee a government like this and economy like this collapsing under its own impossible structure?

Prof. Hanke: Eventually. That’s the good news. But we also know that we can’t predict the course or duration of the existence of the regime that restricts the freedom and general liberties of the people, as well as freedom in the economy. Look at the Soviet Union. It hung around for a long time. Look at Mugabe. Mugabe was in power in Zimbabwe for over 30 years. It took two hyperinflations in less than 10 years to get rid of him.

Shoshana Bryen: So, on that note, I would emphasize that none of us wish ill on the people of Iran. We feel differently about its government, but it may be that the people have to go through that in order to get rid of this government. Steve, on behalf of the Jewish Policy Center, our members and listeners, I want to thank you for a very interesting presentation and answers to our questions. I know I learned a lot.

Prof. Hanke: Thank you. It was my pleasure.