Iran: A Good Time for Goodbye to Subsidies
by Djavad Salehi-Isfahani

See the Oil Wars blog for a similar perspective on the contradictions of populist political economy (especially the difficulty of making a sensible trade-off between consumption and investment) in Venezuela.  How do you respond to the kind of perspective represented by Djavad Salehi-Isfahani (regarding Iran) and Oil Wars (regarding Venezuela)?  Thoughts on this question will be most welcome at MRZine. -- Ed.

Everybody acknowledges that Iran's $50-billion subsidy program cannot continue forever, but many don't think that the time to undo past excesses is now.  Iran's economy is in deep recession, external threats of sanctions and military strikes are on the rise, and internally the nation is in the grips of an unprecedented political crisis.  Yet this week the bill to reform the vast subsidy program became law and the Ahmadinejad government is getting ready to take the plunge.

A few weeks ago the New York Times noted that while the outside world is focused on Iran's nuclear crisis, policy makers in Iran were busy drafting reforms to end subsidies for energy products and other necessities.  Since then, as the US deadline for reaching a deal with Iran through negotiations came and went, and with it the threats of new, crippling sanctions heightened, the government and the parliament in Iran hammered out a compromise over how to spend the savings from the gradual removal of subsidies, so this week the "Economic Transformation Bill" (Tarhe Tahavol Eghtesadi) finally became law.

The compromise allows the government some discretion in spending the money it saves from not paying subsidies while the parliament maintains oversight.  The parliament had wanted the money to enter the annual budget and be subject to the same rules and regulations, but President Ahmadinejad put up a hard fought (at one point reportedly saying that he was willing to give up his life for the bill!) to maintain some control over the money.  The compromise is for up a special fund that allows him to have that control.  He has hailed the bill as historic and the most ambitious policy challenge the Islamic Republic has undertaken since its inception, one that will transform the country.  The critics predict dire economic and social consequences.

There is never a good time to raise prices on basic goods by factors of 5 to 10, much less during a deep economic recession and while a grave political crisis rages.  Most economists with a pro-market disposition counsel delay because they believe that the economy is in such a poor shape and so badly managed that it cannot tolerate the price hikes.  The resulting economic and political crisis, they argue, will give price reform a bad name and thus prevent future attempts at market reform (read an informative debate of these views in Persian in Rastak).  They prefer to first see the numerous distortions that plague production go away before the economy is subjected to the shock of higher energy prices.  Administratively set low interest rates and overvalued rial are among the chief distortions that they frequently mention.  Others, from a leftist persuasion, offer grander preconditions for improvement, such as legal and cultural reform.

Sequencing of reforms is of critical importance for their success but getting the sequencing right is more of an art than a science.  It is very hard to know from deductive reasoning alone, especially when you mix in political economy considerations, if it is optimal to wait for other elusive reforms to happen before raising energy prices.  There is the danger of a chicken-and-egg cycle here with no end.  As I have noted in my earlier posts on this subject, political economy considerations are the most compelling reasons for supporting the energy price reforms that are on the table now.  I would not want to pass up a unique opportunity offered by a populist administration courageous enough to raise prices to market levels, which also happens to enjoy the credibility among the poor to calm their fears that the cost of correcting the nation's past excesses in energy use will fall disproportionately on them.  The icing on the cake will be if the government can combine price reform with achieving a greater equality in the distribution of income.

Now to allay the fears that the sequencing is all wrong, consider the possibility that removing energy subsidies can stimulate the very comprehensive reforms that the reform bill's critics view as preconditions.  If higher energy prices further depress industries because they cannot borrow to finance the temporary shock to their costs, it would be one more reason to re-think the interest rate ceilings that at present dissuade banks from lending to producers.  If export markets disappear when producers have to pay world market prices for their energy, there is a greater chance that the policies that have led to the highly over-valued rial will come under scrutiny.  Perhaps there will be increased pressure to expand public transportation in major cities by allocating more funds to such critical projects as the Tehran subway.  If the cash transfer scheme proves wasteful, as it may well do, perhaps the government will use its savings in more effective ways to help the poor, such as by investing in infrastructure in poorer neighborhoods.

Having said all this, once the reform bill goes into effect, the country should brace itself for what the Chinese call interesting times.  Inflation will come roaring, so caution and gradualism in raising prices is advised.  Greater use of smart cards (as those now widely used at the gas pumps) and restraint in massive cash transfers will also help smooth the inevitable shock.  Knowing the low tolerance of Iranians for inflation, which is in the long run a good national trait to have, it is extremely important for the government to avoid the temptation to fight it with fixing prices by decree, be it the interest rate, the exchange rate, or the price of melons.  Such temptation is especially high for populist governments who practice going after the usual suspects -- speculators, middlemen, and small retailers -- as a sort of political sport.  There is plenty of evidence globally that such tactics do not work, and Iran's own past experience with administrative attempts to restrain prices (in the 1970s and mid 1990s) confirms it, but, as the current events in Venezuela prove, blaming others for the poor management of the economy never quite goes out of fashion.

Djavad Salehi-Isfahani is a Dubai Initiative research fellow at the Belfer Center for Science and International Affairs at Harvard University.  This article was first published in his blog Tyranny of Numbers on 16 January 2010; it is reproduced here for non-profit educational purposes.  See, also, Djavad Salehi-Isfahani, "Iran: Reform of Energy Subsidies" and "Off Target in Subsidy Reform."
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