The Iran Primer

            Of the thorny economic problems which Iran is going to face in the coming year, independent of sanctions, almost all are self-induced. They are rooted in a wrong-headed populist strategy of combating endemic inflation by hoodoo remedies. Faced with protracted double-digit price rises caused by perennial budget deficits and excess spending, President Ahmadinejad decided early in his administration to combat this demand-caused economic disequilibrium by focusing on the supply side. Thus, instead of trying to raise revenues or reduce wasteful expenditures, he chose a crowd-pleasing, short-term economic policy of controlling costs - with scant regard for its harmful long-term implications. To keep household and business expenses in check, the government proceeded to hold three vital cost factors -- the exchange rate, interest rates and the basic energy prices— in check through government diktats. The outcome has been a near disaster in all three areas.

 

            The short-sighted policy of keeping the exchange rate artificially overvalued in order to hold import costs down led to a number of troublesome consequences such as: (a) reducing domestic producers’ ability to compete with foreign suppliers; (b) bringing down domestic production capacity of import-competing industries by some 30-40%; (c) idling thousands of workers with each additional billion dollar of imports; (d) worsening Iran’s non-oil trade balance; and (d) giving a hefty subsidy to foreign farmers and manufacturers  The over-valued exchange rate also resulted in increased national dependence on the world economy (even for essential food items). Thus, with the imposition of new tough sanctions on Iran’s oil exports and its central bank operations announced in late 2011, the long dormant pressure on the rial blew up and the current era of exchange instability ensued.

            The government’s extensive interest rate regulation must take its share of the blame. Holding interest rates on saving deposits below the inflation rate and keeping bank charges on commercial and investment loans below free-market levels in the bazaar have inflicted immeasurable damage to the economy. Low (and negative) returns on deposits have discouraged savings and parsimony, stifled productive investments had led savers to move their funds from bank accounts to such other outlets as real estate, precious metals and US dollars.  Losing savings deposits has led the banks to steadily borrow from the CBI for their voluntary as well as state-mandated loans. Government dictated loans to favored, but money-losing, projects have been a main cause of the banks’ non-performing assets. Sizeable differences between mandated bank interest rates and the rates prevailing in the bazaar, combined with the small penalty for late repayments of loans, have induced some well-connected businessmen to borrow money from the state banks at rates in the low 20s, lend the borrowed sum in the bazaar at percent rates in the 30s, and postpone repayments of the loans for years at an annual penalty of only 6%! Poor and unprofessional assessments of borrowers’ proposed projects and the concentration of bank loans on a few selected mega borrowers have been other causes of the banking system’s problems. Nearly 80% of the total bank loans are now reportedly in the hands of less than 12% of active businessman.  In the absence of real banking system reforms in the coming year, the situation is likely to get worse - particularly if the sanctions are not removed.

            Finally, keeping energy prices artificially down for years has resulted in profligate energy consumption, the continuation of energy inefficiencies, the rise of energy-intensive industries vulnerable to external shocks, a growing need for energy imports, intolerable air pollution and a clear rise in energy smuggling to neighboring countries.

 

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            Much has been accomplished through pressure, but the results have fallen short of expectations in several ways, and unintended consequences may pose risks.

 

            Successes. U.S. policies have developed and preserved strong commitments from friends, allies, and partners; underscored the United States’ commitment to non-proliferation of nuclear weapons; blocked Iran’s efforts to modernize its military; weakened Iran’s economy; possibly slowed the expansion of Iran’s nuclear program; and possibly helped add some momentum within the existing framework for nuclear negotiations with Iran.

 

            Shortfalls. U.S. policies may have slowed but they have not stopped the advancement of Iran’s nuclear program. They have not led to a breakthrough in nuclear talks (sanctions have weakened Iran’s economy but not yet led to changed policies or actions); nor have they improved Iran’s human rights practices (in fact, they may have empowered anti-reform factions). Efforts to isolate Iran have not markedly reduced its influence in the region.

 

            Risks. U.S. policies may have narrowed the options for dealing with Iran by hardening the regime’s resistance to pressure; contributed to an increasing repression and corruption within Iran; distorted trade patterns and encouraged the expansion of illegal markets in the region; and possibly contributed to sectarian tensions in the region by pushing an isolated Iran further toward dependence on its Shia allies. Sanctions-related hardships may be sowing the seeds of long-term alienation between the Iranian people and the United States...

 

            A more assertive and sustained diplomatic initiative with Iran would need to focus first on achieving greater transparency and control over Iran’s nuclear program, thereby inhibiting Iran’s ability to make a rapid “breakout” toward the production of a nuclear weapon. Excluding other issues of concern to Iran could prove difficult, however, since Iran is not likely to agree to a comprehensive—or perhaps even a limited—nuclear agreement unless it is assured about the United States’ long-term intentions.

            No change in U.S. policy will be possible unless President Obama makes the negotiation of a nuclear deal with Iran one of his top priorities. To reiterate, strengthening the diplomatic track of U.S. policy toward Iran does not mean abandoning the pressure track, including maintaining the option of using military force should the Iranians move quickly to build a bomb. But if the President decides to try to work with Iran, he will have to take into account the political and strategic challenges of managing those different policy tracks and the irrespective goals, benefits, and costs.

 

            Whether Iranian leadership has taken seriously President Obama’s stated willingness to take military action to “prevent” Iran from getting a nuclear weapon has been called into question by critics. Their doubts would increase if the President decided to negotiate directly with Iran and put a serious offer on the table. Yet the more the President threatens the use of force, the more difficult it will be for Iran’s defiant leadership to consider any offer, and the more the President will be under pressure to use military force. 

 

            Maintaining sanctions while using them as bargaining chips. During negotiations, the United States will need to use the gradual lifting of sanctions as a bargaining chip; Iran will push for more and faster relief. Yet there are limits to what the President can deliver by Executive Order, without Congressional consent—and it will be critical to match the easing of pressure with verifiable Iranian cooperation on key nuclear issues.

 

            Evaluating Iran’s intentions. The latest U.S. intelligence assessments conclude that Iran could not divert safeguarded materials and produce enough weapons-grade uranium for a bomb without those activities being detected. But as Iran continues to develop its enrichment program, the evaluation of Iranian intentions becomes more urgent and more problematic.

 

            Weighing the future value of engagement against Iran’s present antagonistic behavior. Iran’s continuing support for the Assad regime, to take one example, leads some experts to argue that talking with Iran would be unwise and fruitless. Yet some form of cooperation with Iran may be essential in post-Assad Syria. Near-term tactical issues will compete with and complicate long-term strategic opportunities on almost every issue in dealing with Iran.

 

            Preparations for talking with Iran: The belief of Iran’s Supreme Leader that the United States’ underlying objective is regime change has become an obstacle to progress in any negotiations. Once the President has made a decision to strengthen the diplomatic track of America’s Iran policy, the U.S. government will need to take active steps—rhetorical assurances will not suffice —to convince the Supreme Leader that the United States does not seek to overthrow his regime. Other early challenges for the President and his team, in addition to establishing a bilateral channel for regular talks, might be:

 

            Understanding what the U.S. wants, what Iran wants, and what both countries want. Iran likely wants respect, recognition of its role in the region, its full “rights” under international law and the Nuclear Non-proliferation Treaty, U.S. forces out of the Middle East, lifting of all sanctions, and a single-state solution to the Israel–Palestine conflict (some Iranian leaders have said they would support any solution that is acceptable to the Palestinians), among other objectives.

            The United States likely wants full transparency of Iran’s nuclear program and constraints on Iran’s enrichment of uranium, cessation of Iranian threats against Israel and support for Hezbollah and Hamas, improved human rights practices, and a two-state solution to the Israel–Palestine conflict, among other priorities.

Iran and the U.S. both want a stable Iraq and Afghanistan, defeat ofAl Qaeda and Taliban, no military conflict In the region, Gulf stability, and cooperation on drug trafficking.

 

            Understanding problematic language and concepts. Iranians and Americans attach different interpretations to many words and phrases. The differences are not trivial and can disrupt and confuse discourse. For example, Iran wants “talks” and the U.S. seeks “negotiations”; Iran wants to begin by focusing on past complaints, while the United States prefers to focus right away on “practical next steps.”