The real trouble in Tehran

 

Should we blame sanctions for Iran’s woeful economy?

The surprisingly strong showing last week of a moderate in Iran’s presidential election, Hassan Rowhani, suggests that the economy perturbs voters more than the regime had realized.  The Iranian on the street may worry most about rising prices.  At the current rate of inflation, prices throughout the economy would double in less than three years.  (And that’s just at the official annual rate, 32%.  Last October, a well-known U.S. economist, Steve Hanke, estimated the actual rate as 196%.) 

To deflect blame from the government, some supporters attribute the inflation to sanctions imposed by the West to discourage the building of nuclear weapons.  Independent analysts have also weighed in.  One at RAND says: “Of course inflation was high before sanctions against the central bank, but there are indications that sanctions have pushed Iran’s inflation much higher.”

This argument may confuse prices with their rate of increase.  I’ll explain.

Every product has its price, of course, but the one that matters most in the national economy is the average price, called the “price level”.  You can think of this as the price of a typical market-basket of goods and services bought by a consumer each year.  Suppose that the basket consists of two kefirs, each priced at 100 tenge, and three CD’s, each priced at 500 tenge.  Then the price level is 2*100 tenge + 3*500 tenge, or 1,700 tenge.  If the price of a CD rises next year to 600 tenge, then the price level will become 2,000.  Over the year, it has increased by about 18%.  That’s the rate of inflation.

Those are the basics.  But in reality, governments measure the current price level in terms of its increase since a base year.  If the base year is 2013, then they will set its price level to 100.  The price level for 2014 is 118, 18% higher than in 2013.

Masters of inflation

By reducing the supply of a wide variety of goods, sanctions cause the price level to rise.  There are fewer goods to go around, so a consumer must bid higher prices to get them.  As prices increase, the demand for goods falls -- and the supply rises, since domestic producers may profit at the higher prices.  At some point, the price level is so high that demand no longer exceeds supply.  The price level will then stop rising, since there is no longer any excess demand to propel it.  When it stabilizes, the rate of inflation becomes zero.

In short, one-time economic sanctions will permanently raise the price level, but they won’t create sustained inflation.  The inflation occurs only while the price level is adjusting to the new scarcity.  Sanctions can create long-term inflation only if they continue to tighten.  The European Union did give the screws another turn last October, but in general the sanctions have not tightened continuously since 2010.

An example may help.  Suppose that sanctions reduce the supply of goods in Iran by 20%.  Then the price level will rise from, say, 100 in 2010 to 120 in 2011.  If the new price level eliminates excess demand, then it will be 120 in 2012, in 2013 and in the years to come.  The rate of inflation from 2010 to 2011 was 20% and then fell to 0% for succeeding years.

The problem for Iran is not that the price level has sometimes spiked but that it has been rising at double-digit rates since 2000 at least and has risen by more than 26% for more than a year, according to the International Monetary Fund (IMF).  (These are consumer prices.)  As a practical matter, such sustained inflation has only one cause – the central bank keeps printing too much money.

Suppose that the central bank raises the money supply by 20%.  With more money chasing the same number of products as before, prices will rise by 20%.  If the bank does not increase the money supply again, then prices will now stabilize.  But if the bank increases the money supply by another 20% every year, then the price level will keep rising by 20% each year.  That’s long-term inflation.

Some nongovernmental organizations contend that the cure for inflation is to print more money.  Here’s the chief executive of United Against Nuclear Iran:  “By manipulating and increasing the printing volume of the rial, the regime can bolster its floundering currency and mask the disastrous impact of its political decisions, economic mismanagement and isolation.”  The NGO urged Western nations to stop printing the rial for Iran.  Tehran may find this a blessing in disguise. 

Or it may not.  Unfortunately for the Islamic Republic, a reduction in the rial supply may have subtle effects.  In general, sanctions have raised input prices in Iran, driving up production costs and output prices and thus reducing income.  The silver lining is that a recession lowers the demand for money, by reducing spending.  An excess supply of rials develops, which causes their exchange rate to depreciate -- that is, to become cheaper in terms of other currencies.  This makes Iranian exports less expensive for those countries that still consent to trade with it.  (If a euro can buy 30,000 rials rather than just 15,000, then Iranian exports become cheaper for Europeans, presuming that they will buy them.)  Eventually, exports will increase, stimulating recovery.

The Western plan to stop printing so many rials reverses these effects.  It creates an excess demand for rials.  The exchange rate will appreciate – becoming more expensive in terms of foreign currencies – discouraging exports.  The Iranian economy may take longer to recover.  

The Tehran tango

Thanks partly to these entangling effects, the central bank of Iran is losing its grip on monetary policy, a grip that has never been particularly strong.  According to the World Bank, M2 money in Iran – cash, checking accounts, and small savings accounts -- rose by more than 23% in each year from 2003 to 2009 (except for 2008, when the growth rate was 7.5%).  It then fell radically in 2010 and 2011, at the respective rates of -41.8% and -33.3%.  Such wild gyrations in the money supply cause prices to go haywire, creating uncertainty throughout the economy. Because the central bank no longer has credibility, it will have trouble eliminating expectations of inflation, even though money supply is falling.  The roller-coaster ride that is the Iranian economy will continue.   

Iranian voters have the right instincts.  They sense that the government is to blame for long-run inflation, and they are almost certainly correct.  A decade ago, the central bank should have resisted the temptation of creating an illusion of easy wealth by printing rials.  It should have stabilized prices, by holding down the long-run rate of change in money to the long-run rate of change in output (which the IMF projects at -1.3% for 2013).  Instead, the bank chose go-go monetary policy.  As a consequence, today in Tehran, anything goes.  –Leon Taylor, tayloralmaty@gmail.com

Notes


"Money demand” may seem a strange expression. Don’t we all demand an infinite amount of money?

In economics, the term refers to the demand to hold money rather than other assets like stocks and bonds. We don’t want to hold an infinite amount of money, because we could exchange it for an asset that earns interest.

Good reading

Krugman, Paul, and Maurice Obstfeld.  International economics: Theory and practice.  Boston: Addison Wesley.  2009.  Discusses macroeconomic adjustments in product and asset markets.

   

      

References

Gladstone, Rick.  Double-digit inflation worsens in Iran.  The New York Times.  April 1, 2013.  The source of the RAND quote.

Gladstone, Rick.  Iran cites I.M.F. data to prove sanctions aren’t working.  The New York Times.  October 9, 2012.  The source of the Hanke estimate.

Gladstone, Rick.  Iran sanctions may cut supply of currency.  The New York Times.  October 16, 2012.

International Monetary Fund.  World economic outlook.  Online.

Kanter, James, and Thomas Erdbrink.  With new sanctions, European Union tightens screws on Iran over nuclear work.  The New York Times.  October 15, 2012.

Gross Domestic Unhappiness

Is national income good for the soul?

In Central Asia, when political leaders want to brag, they usually spout statistics about gross domestic product – the value, when sold on the market, of goods and services produced by the nation in a year.   One can hardly blame them.  Double-digit rates of growth in GDP have been common in the region since the turn of the century.

There are other ways to judge our performance.  We may measure how well that our national economy is doing, per person, in terms of wealth or income.  “Wealth” is the accumulation of savings, which in turn is unspent income.  Suppose that you made $6,000 in your part-time job this year.  Of that amount, you put $2,000 in your savings account; bought $2,000 of KazKommerzbank stock shares; and spent $2,000 on food and clothes.  Then your savings are $4,000.  The stock doesn’t count as consumption, because you can’t enjoy it in the same way as a cone of ice cream; it’s just a parking lot for your money.  If you also saved $10,000 from past years, then your wealth is $14,000.  This figure indicates the lifestyle that you can support in the future.  The $6,000 of wages is your annual income, indicating how well that you can live this year without dipping into your wealth.  Income is a yearly inflow into your accounts; wealth is a stock, the value of your assets at a given time.

  

Before The wealth of nations appeared in 1776, scholars had thought that the nation’s wealth depended on its gold or silver.  Spain was rich because it had hauled tons of the precious metals from the New World.

We owe our modern notion of national wealth to Adam Smith, who attributed it to labor productivity – the amount that a typical worker can produce.  If she can figure out how to produce shirts more cheaply, then we can buy more shirts with given savings.  Wealth  increases in terms of what it can buy. 

Popes and Marxists

Productivity shapes income as well as wealth.  A Nobel-laureate economist, Robert Solow, pointed out that you could produce more cheaply if you had more capital to work with.  (“Capital” is anything man-made used in production: Machine tools, office towers, knowledge of accounting.)  Nations with more capital per worker can sustain higher levels of income per person.  Ethiopia is poor partly because its workers have few machines. 

Human capital – such as education and training – are particularly important to growth, noted the Nobel laureate Robert Lucas. Although this sounds obvious now, it was revolutionary.  The classical world didn’t appreciate knowledge about production and offered no means by which you could profit by it, wrote Ronald Wirtz.  In contrast, Americans have accumulated human capital rapidly in part because their universities compete for students.  The strength of private universities in the U.S. is virtually unique in the world, according to economists Claudia Goldin and Lawrence Katz.

These perspectives presume that wealth or income per capita is the most reliable measure of human well-being because they are material.  A 19^th-century pope dissented.  In countering Marxists of the 1890s, who threatened to revolutionize Europe, Leo XIII defended property rights but added:

"...[I]n the case of the worker, there are many things which the power of the state should protect; and, first of all, the goods of his soul. For however good and desirable mortal life be, yet it is not the ultimate goal for which we are born, but a road only and a means for perfecting, through knowledge of truth and love of good, the life of the soul."

In the Sixties, Pope Paul VI reinforced the point: "Increased possession is not the ultimate goal of nations nor of individuals. All growth is ambivalent."  Income per capita is merely a means to a spiritual end.

Income per capita is a limited measure of human well-being because it fails to account for leisure, notes Robert Forrestal.  Over the past few decades, the entry of women into the labor market has increased.  In Kazakhstan, the number of women in the labor force rose 12.7% in seven years.  Even over the period of financial crisis, 2008 to 2010, the number rose 1.5%.  Such a surge into the labor market may raise income per capita, but at the loss of leisure (see the Notes).  “Economists simply cannot tell whether society is better off or worse off in this case.”  But women choose to work, so on average they surely must gain.

Bhutan’s way

The larger point – that income per capita does not fully measure well-being – is well-taken.  The United Nations measures human welfare with the Human Development Index, which reflects life expectancy, educational standards and individual purchasing power.  For example, Costa Rica has ranked much higher in its human development score than in its total output per capita. In the early 2000s, Costa Rica placed 76th by total output per capita but 42nd by human development. The discrepancy occurred because the average Costa Rican lived longer, learned more, and drank cleaner water than did residents of other nations with similar average incomes.  In 2004, the United States placed only eighth among all nations, in terms of the index.  Norway and Sweden led the list, reported the Financial Times..

One Nobel laureate economist uses death rates to analyze economic performance.  To Amartya Sen, the way that nations handle famine, health care, sexual and racial inequality, and poverty may reflect economic progress more truly than does income.

Skeptical of income estimates, some nations have adopted alternative measures of well-being.  The tiny nation of Bhutan judges its economy annually by a measure of Gross National Happiness.  One of its indicators is environmental quality, reported The Economist.  Conventional measures of gross domestic product do not subtract environmental damages; in fact, a rise in pollution will boost GDP, by increasing demand for health care.  To the contrary, Bhutan regards forests – which cover nearly three-fourths of its land -- as contributing to its Gross National Happiness.  But another indicator of its Happiness, the preservation of culture, may measure xenophobia.  Bhutan discourages Hindu immigrants from Nepal. 

To measure national income, economists sum up payments to input owners: Wages and salaries, profits, interest payments and rent.  Another approach is to sum all spending on production, since a tenge of spending is a tenge of income to someone.  Total spending is gross domestic product.  In developing countries, estimates of national income may fall short of GDP when people don’t report all of their income to the tax agency.  The difference measures the underground economy.  In Nigeria, Egypt, and Thailand, the underground economy has accounted for nearly three of every four dollars spent, noted economist John McMillan. –Leon Taylor, tayloralmaty@yahoo.com

Notes

Denote the number of adults in the labor force as LF, the number not in the labor force as NLF, total wage income as WI, and total nonwage income as NWI.  Then income per adult is a weighted sum of the sources of income, where the weights are the labor force share of all adults and 1 minus that share:

YPC = [LF/(LF + NLF)](WI/LF) +  [NLF/(LF + NLF)](NWI/NLF).

Denote the average labor wage as w, a decreasing function of LF, and the average nonlabor wage as nw, assumed constant.  Then, by definition,  

YPC = [wLF + nwNLF]/[LF + NLF]

Assume that NLF is a constant.  Then

dYPC/dLF = [1/(LF + NLF)][w + (dw/dLF)LF – (wLF + nwNLF)/(LF + NLF)].

For simplicity, set nw = 0.  With manipulations, dYPC/dLF is positive if

(w/LF)[NLF/(LF + NLF)] > dw/dLF.

An increase in the labor force raises income per adult if the magnitude of the wage response is less than the ratio of the wage to the labor force, weighted by 1 minus the labor force share of adults.  This is most likely when the wage is high and the labor force share of adults is small – conditions that may describe a resource-intensive developing economy.

Good reading

The Economist.  The pursuit of happiness.  December 18, 2004.

Goldin, Claudia, and Lawrence Katz.  The shaping of higher education in the United States and New England.  Regional Review.  Federal Reserve Bank of Boston.  Q4 2001.  On line.

Forrestal, Robert.  Economic development for the 21^st century: New measures of well-being.  The region.  Federal Reserve Bank of Atlanta.  June 1994.  The source of the papal quotes. 

Lucas, Robert.  Lectures on economic growth.  Harvard University Press.  2004.

McMillan, John.  Reinventing the bazaar.   Norton.  2002.

Sen, Amartya.  Development as freedom.  Anchor.  2000.

Solow, Robert.  Growth theory: An exposition.  Oxford University Press.  2000.

Williams, Frances.  Diversity “must be embraced” to ensure stability in globalizing world.  Financial Times. July 16, 2004.

Wirtz, Ronald A.  The new (and improved) economy.  The Region.  Federal Reserve Bank of Minneapolis.  June 2000.  On line.

References

The statistical agency of Kazakhstan.  Labor indicators by gender 2003-2010.  Online. 

Taking it back

Can transition economies handle inflation?

 

Around the world, governments balk at spending more for fear of racking up debts that they cannot easily repay.  They leave it up to the central bank – which manages the nation’s money supply -- to stimulate the economy, effectively by printing money.  The Federal Reserve in the United States and the European Central Bank have pledged to provide enough dollars and euros to keep low the interest rate, which is the price of holding money (since this is what you forego by holding rather than lending).  The Bank of Japan is doubling the supply of yen -- although, unusually for a central bank these days, especially for Japan’s, this is to accommodate the government’s largesse.  In Kazakhstan, M2 money -- which includes cash, checking accounts and small savings accounts -- has tripled since the beginning of the banking crisis in 2007.

As a rule, new money eventually raises prices, since people use it to bid more for products.  When the economy operates at full capacity, it cannot create more goods and services, so increased demand for them merely drives up their prices.  At the moment, the world economy is well below capacity, so inflation is not a problem.  But the day will come when that may change.  Are central bankers ready?

They usually argue that they can easily soak up excess money, by exchanging securities for them.  By selling a public bond (basically an IOU issued by the government) for $50,000, the bank can withdraw that many dollars from the economy.

This may work in Western countries, which have well-developed financial markets.  In the U.S., the market for overnight loans, called “repos”, has run into trillions of dollars and is quite sensitive to changes in demand and supply.  The Federal Reserve can quickly withdraw from it a precise amount of money by selling loans.

But in transition economies, financial markets are embryonic.  Their central banks cannot rely on exchanges of securities for money (“open market operations”) to manage the money supply.  They must fall back upon cruder tools.

The folly of ’37

One is to raise the interest rate that the central bank charges on loans to commercial banks.  (In Kazakhstan, this is the “refinancing rate”).  These banks will respond by borrowing less money, which reduces the amount that they can provide to people to spend.  Unfortunately, bank demand for loans depends not only on the interest rate but also on such factors as the banks’ expectations of economic growth, since they will re-lend the money only if they expect to get paid back.  In a recession, impoverished borrowers may default rather than pay interest.  Since expectations are hard to measure in times of uncertainty, the central bank may misjudge the response to a given increase in interest rates.

Another tool for central banks in transitional economies is to reduce the share of deposits that commercial banks can legally lend out.  (This is the “required reserve ratio”).  Again, it’s hard to anticipate precisely how this tool will affect the money supply; it depends on the behavior of banks, depositors and borrowers – behavior that we don’t understand well.  When the Fed doubled the ratio in 1937, the U.S. economy plunged back into depression, recovering only when World War II boosted government spending.

Even central banks in transitional economies that use open market operations may face hurdles.  In some countries of the Commonwealth of Independent States, the central bank has sought (or was required) to discourage the government from borrowing, by refusing to buy many of its securities.  When the day comes, those banks may not have enough securities on hand to sell in order to reduce the money supply sharply.

Most central banks today probably should not withdraw much money from circulation.  Unemployment still matters more than inflation.  But accommodation has long-run consequences.  Central banks in the CIS may prepare by developing securities markets; ensuring that they have enough securities to buy back lots of money;  and by researching effects of monetary policy.  Central banks can take the money back – without taking it on the chin. –Leon Taylor, tayloralmaty@gmail.com   


Good reading


Cole, Harold L., and Lee E. Ohanian. The Great Depression in the United States from a neoclassical perspective. Federal Reserve Bank of Minneapolis Quarterly Review. Winter 1999. The source of the story about Fed policy in 1937.

Friedman, Milton, and Anna Schwartz. A monetary history of the United States, 1867-1960. Princeton. 1963.

References

Ewing, Jack.  A rate cut in Europe, and a hint of limits.  The New York Times.  May 2, 2013.

National Bank of Kazakhstan.  Monetary aggregates.  www.nationalbank.kz

Tabuchi, Hiroko. Japan initiates bold bid to end years of tumbling prices.  The New York Times.  April 4, 2013.