Foreign Policy Blogs

The Political Economy of Oil Income in Iran


Editor’s Note:

The following is a contributing guest piece.

Saeed Ghasseminejad is the cofounder of the Iranian Liberal students and Graduates (ILSG) and the International Center for Liberalism Studies (ICLS). His work on economy and politics of Iran and the Middle East and has been published in CNBC, The Weekly Standard, National Post, International Business Times, Jerusalem Post, and Times of Israel. Mr. Ghasseminejad is regularly quoted and interviewed by major international news organizations. Currently a PhD student in finance at the City University of New York, Mr. Ghasseminejad is a financial consultant and researcher focused on international finance, banking and corporate finance. He is  an expert on the topic of the Islamic Revolutionary Guard Corps and religious foundations’ role in Iran’s economy and Tehran stock Exchange (TSE).

by Saeed Ghasseminejad

In Iran, the period from the mid ‘60s to mid ‘70s, when the oil price was less than one dollar, is known as the golden age of Iran’s economy. Thanks to a continuous above 10 percent economic growth rate combined with single-digit inflation rate, the future looked bright and glorious with centuries of misery relegated to a distant past. Then along came the 1973 oil crisis, which led to an oil price-jump from $3 to $12 and the shah went mad. Mohammad Reza Shah Pahlavi always loved to be an absolute monarch and micro manager, but the jump in oil price gave the shah a false sense of security and overconfidence; he felt to be omnipotent and thought he could be what he always wanted to be: a God-King. Five years later, the economy was in bad shape again; the country was in chaos, growth rate was abysmal and inflation was high. The shah ultimately lost his crown.

Oil was discovered in Iran almost 100 years ago. For almost four decades it did not play an important economic and political role in the Iranian economy. In the ‘50s oil became subject of a crucial political challenge in Iran, leading to the overthrow of Mohammad Mosaddeq, but it wasn’t until another two decades passed that it became the main and dominant factor in Iran’s economy. Beginning in the ’70s, oil and gas income became the dominant player in Iran’s economy — now, all other sectors are either marginal or totally dependent on it. Its cyclical ups and downs caused by volatility in price or export volume define the whole economy boom and bust.

The most obvious fruit of this dominant role over the last forty years has been persistent and continuous two-digit inflation. When the oil income is high government injects all the money into the economy, causing high inflation. During the two major waves of oil price peak in the ’70s and 2000’s, oil money was injected into an economy that could not absorb it, leading to huge inflation. On the other hand, during the low oil income periods, the oil money-addicted governments borrowed money from the central bank — i.e. by publishing money, another inflationary policy. A persistent high inflation is not the only problem caused by oil income — it is one in the chain of disease discussed in economics literature under the name of natural resource curse. Natural resources curse can affect an economy in several ways which are briefly explained as follow:

  1. Dutch disease mechanism (van Wijnbergen, 1984; Sachs and Warner, 1995, 1999-2001; Bravo-Ortega and de Gregorio, 2002)
  2. Leads to wasteful, dictatorial and inefficient government (Corden and Neary, 1982; Ross, 2001; Collier and Hoeffler, 1998; Olsson, 2003; Sachs and Warner, 2001; Papyrakis and Gerlagh, 2004)
  3. Provokes rent seeker and pressure groups and reduces social capital  (Karl, 1997; Robinson et al., 2006; Baland and Francois, 2000; Krueger, 1974; Torvik, 2002; Kronenberg, 2004; Mehlum, Moene and R. Torvik, 2006; Stijns, 2002)
  4. Leads to reduction of investment and savings (Gylfason and Zoega, 2001; Sachs and Warner, 1995, 1999)
  5. Reduces motivation for the economic reform by creating false feeling of security (Ascher, 1999; Auty, 2001; Gylfason, 2001; Sachs and Warner, 1999)
  6. Reduces the rate of industrialization (Kronenberg, 2004; Sachs and Warner, 2001)
  7. Causes weakness in educational system which leads to the drain of the human capital from those countries (Gylfason, 2001; Gylfason, Herbertsson and Zoega, 1999)

When, during President Mohammad Khatami’s presidency, oil prices went up and subsequently Iran’s oil income increased significantly, serious debates emerged in Iran about what to do with this money. These debates led to two major attempts to address the issue in the years that followed.

The first solution, adopted in Khatami’s second term was to establish a national reserve fund named Oil Stabilization Fund to save the excess abnormal income in order to control the inflow of money into the economy. The fund was inspired by the Norwegian model, but Iran was not Norway. When oil was discovered in Norway it was already a developed and democratic country, and oil was not the country’s main source of revenue. Ironically, in Iran, the accumulated money in the Fund was one of the main reasons behind the “complicate operation,” as one of the IRGC commanders called it, that put Mahmoud Ahmadinejad in presidential palace. In other words, good intention of the reformist President gave the hardliners more incentive to grab the power by whatever tools available to them.

By the end of Khatami’s term, astute analysts had understood the grave danger of the Oil Stabilization Fund posed to the reform project. They realized that the fund does not work as it did in Norway. Their solution to this danger was “direct distribution of oil income plan,” proposed by the reformist cleric Mahdi Karroubi and his advisors during the 2005 presidential election campaign. The intuition behind the plan was that the only way to control the powerful rent seekers is to put something more powerful in front of them. In Iran, that’s the power of masses.

“Let’s distribute the oil money equally among people, once the money goes to people it becomes an arduous and almost impossible task to take it back,” so went the rationale behind the policy. The intended result was a smaller, more efficient, more moderate, and less rogue state in domestic and foreign policy.

Of course, Mr. Karroubi did not win the election and was put in house arrest due to his reformist agenda, but his direct distribution of oil money promise was well received. Upon becoming president in a sham election, Ahmadinejad implemented a small scale version of the plan through his cash subsidies program. The cash subsidies program’s goal was to push energy prices toward the market equilibrium and distribute the resulting income equally among Iranians. The intended policy goal was to reduce the extremely high and wasteful consumption of fuel and improve the inequality index — or Gini index. It actually did both, but the program was combined with some bad policies made by Ahmadinejad and Khamenei.

  1. Ahmadinejad insisted on lowering the interest rate and injecting cheap oil money into the market.
  2. Instead of distributing the income from increasing energy prices, Ahmadinejad declared monthly cash subsidies. Then when the income was not sufficient, his government printed money to fill the gap.
  3. The severe international economic sanctions limited Iran’s access to hard currency, leading to significant devaluation of Rial, the Iranian currency.

The above three measures led to unbridled inflation. Many critics, backed by Iran’s bureaucrats who want the oil money in their hands, underline these three reasons and attribute inflation to a cash subsidies program. The truth is that there is not much truth in their claim. The cash subsidies program could add to inflation but not as much as the critics want people to believe. The fact that an overwhelming majority of people registered for the second phase of the cash subsidies program shows people were not convinced by the large-scale information warfare run by government and its supporters on this issue.

The inflation problem of cash distribution can be resolved through Milton Friedman’s solution. Milton Friedman suggested “I believe the first step following the 2003 invasion of Iraq should have been the privatization of the oil fields. If the government had given every individual over 21 years of age equal shares in a corporation that had the right and responsibility to make appropriate arrangements with foreign oil companies for the purpose of discovering and developing Iraq’s oil reserves, the oil income would have flowed in the form of dividends to the people — the shareholders — rather than into government coffers.” This will get rid of the inflation and the seven problems discussed above.

From a political perspective, in countries like Iran and Venezuela as long as oil income directly goes to government pockets, those countries can not complete their transition to democracy, a government that does not depend on people to fund itself will not respect their votes and opinions in running the country. From an economic perspective, oil income is people’s money; they know how, when, and where to spend, save, and invest their money better than bureaucrats, who even with the best intentions, do not have enough information to make the best decision, as Von Hayek explains.   The key to democracy and development in countries like Iran and Venezuela is to resolve the natural resource curse by transferring the ownership of oil and gas fields to citizens. That is how they can get the control of their country back into their own hands.