Iranian currency. The largest Iranian bill is 20.000 Rials, roughly about US$2.26, can buy a kebab including a drink and more. Photo courtesy basheem/flickr.com

US presidents invariably point to Iran’s human rights record, support for terrorism, and the regime’s incendiary rhetoric as the basis for admonishing Iran, which has been designated a founding member of the Axis of Evil during the second Bush Administration. The real concern, however, is Iran’s regional policies, because they threaten US interests and national security. Iran has supported a number of anti-American entities, whether in the Middle East, the Far East, or Latin America. It has tried to undermine Middle Eastern governments friendly to the United States. It has doggedly pursued nuclear enrichment and a high-profile missile program. With only one short-lived exception in 2003, Iran has thumbed its nose at the United States with impunity. In all the years since the Iranian Revolution, the United States has made little headway in changing Tehran’s behavior.

The United States has launched covert operations against Iran, has financially and politically supported the regime’s opponents, and has attempted to isolate Iran from the world community. For the past thirty years, Washington’s weapons of choice, however, have been economic sanctions. But until recently, US and UN sanctions have had a limited effect on Iran’s export earnings and import needs. US economic sanctions have had a significant impact in reducing Foreign Direct Investment (FDI), in raising Iran’s cost of capital, in delaying the exploitation of Caspian Sea oil and gas, and in eliminating Iran’s attractiveness as a transshipment center of oil and gas. But overall these actions have left Iran’s oil export earnings and ability to import relatively intact.

For decades, many US experts on Iran have been predicting the imminent collapse of the regime in Tehran. While some have labeled Iran as a regional superpower that must be immediately engaged, others have vaguely suggested that the regime would eventually fall with tighter sanctions. A number have even recommended military action against the Islamic Republic if it does not change its policies. These recommendations are largely based on armchair theorizing, affording little or no weight to the mindset of the few that run Iran or to Iran’s prevailing socioeconomic conditions and vulnerabilities to specific pressures.

Since the election of Barack Obama, some US foreign policy experts have been urging the incoming administration to quickly open negotiations with Tehran, while others recommend a ban on gasoline imports and more stringent financial sanctions. Though a ban on Iranian gasoline imports sounds threatening, it is just silly. To actually cut off the flow of gasoline into Iran, the United States would have to initiate a dangerous naval and land embargo or enlist unlikely multilateral support. More important, if the United States was successful in this quest, it would hand the regime in Tehran a big favor. The government has tried for over two decades to eliminate this wasteful subsidy, but fear of a domestic backlash has precluded action. If the United States tries to ban Iran’s gasoline imports, the regime would blame the “Great Satan” while forcing a tightening of belts. Such off the cuff recommendations, if taken, will lead to yet another misinformed chapter in US policy toward the mullahs in Tehran.

It is time to proceed in a deliberate, thoughtful manner in engaging Iran. It would be prudent to start by examining Iran’s economic failures--its glaring vulnerability--to determine Iran’s position and US options. Recognizing the regime’s susceptibilities could give the United States an advantageous Iran strategy.

A Brief History of Iran’s Self-Inflicted Economic Failures

In the aftermath of the Revolution, the regime nationalized much of Iran’s private sector. The structural changes brought about by nationalization have increased economic inefficiency. Explicit and implicit subsidies, such as high tariffs, support most of Iran’s industrial and manufacturing production. Although a privatization process started in the 1990s, it has achieved little. Today, the public sector is responsible for well over 60 percent of Iran’s total employment.

Iran’s economic failures have been exacerbated by widespread, regressive government subsidies and administered prices. These were a legacy of the Iran-Iraq War, but the subsidies have been continued for political expediency. The single largest subsidy, namely that for gasoline, has been in the range of 10 to 25 percent of GDP during 1997-2007. Explicit (budgeted) consumer subsidies have amounted to at least another 5 percent of GDP in recent years. If everything were added up, subsidies have, on average, amounted to about 25 percent of GDP over the last seven years.

The regime in Tehran has been unable to adopt an efficient and equitable tax system and continues to rely largely on oil revenues to finance its expenditures. It is estimated that oil and gas revenues constituted over 80 percent of total central government revenues in 2007. The absence of an effective progressive income tax and a capital gains tax have in turn been a major determinant of Iran’s income distribution, which has only become more glaringly unequal since the Revolution.

Iran’s macroeconomic policies over the last decade defy logic. With rising oil revenues, the Iranian government has increased government expenditures freely, resulting in inflation rates that have been in the 20 to 30 percent range and real interest rates of minus 5 to 15 percent during the last seven years. At the same time, the exchange rate, although categorized as a managed float, has moved in a narrow range of about 15 percent to the US dollar over the last ten or so years. Prices for imported goods have increased along with global inflation, but prices of non-tradables have increased at a much faster rate (with Tehran‘s real estate prices increasing by about 1,500 to 2,000 percent over the last ten years). The result has been a highly overvalued currency that has damaged Iran’s competitiveness. The wealthy have gained through a real estate bubble that dwarfs that of the US, prompting the rich to sell, with oil revenues subsidizing their capital flight at an essentially fixed exchange rate.

Meanwhile, the average citizen suffers, receiving little benefit from oil depletion. The government continues injecting more and more credit into the market to keep the bubble from bursting, in turn opening the floodgate of domestic demonstrations against the regime. Iranian citizens and future generations have essentially been fleeced in favor of the wealthy. The estimated size of this massive capital flight over the last seven years has been about US$250 to US$300 billion, or roughly two-thirds of Iran’s oil revenues over the period. Simultaneously, the government touts its commitment to economic justice.