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.
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