MARKETS AND PLANNING IN THE IRANIAN ECONOMIC RECONSTRUCTION
MASSOUD KARSHENAS
The problem of how to go about reconstructing Iran’s economy goes well beyond the rebuilding of war-damaged cities and the economic infrastructure. Instead, it requires a new way of thinking about a whole host of issues, including the role of markets, price and non-price signals in the allocation of the economy’s scarce resources, trade patterns, the adoption and assimilation of new technologies, manpower training and a more comprehensive and equitable system of taxation.
Since the 1979 revolution, profound changes have taken place in the Iranian economy. The revolution itself, trade sanctions, the freezing of Iranian assets, the costly and protracted war with Iraq, as well as the vagaries of the oil market, have all made their mark on the economy.
The Islamic Republic’s response to these unfolding crisis was to follow a policy of severe import compression, internal economic isolation and reliance on bureaucratic institutions as the principle means for allocating wealth. Unfortunately, the outcome has been a deteriorating economy, rising inflation, a 20-fold premium in the black market for foreign exchange, substantial increase in rent-seeking activities at the expense of productive enterprise, a shrinking of capital stock, as well as an inadequately trained workforce and economic institutions which are badly in need of substantial reform.
Targets Not Yet Met
Not surprisingly, there is now a general consensus, both inside and outside Iran, that the Iranian economy is badly in need of reconstruction. Targets laid out by the government’s first five-year plan have not been reached, largely because the problems facing the economy have deep structural roots that have been nourished by years of neglect and economic mismanagement. Public enterprises and companies under the control of the various foundations largely function as bureaucratic institutions and are more responsive to political than economic forces. And whilst the importance of private sector investment for the reconstruction of the economy is recognised, uncertainties, legal, political and economic, surround the private sector investment.
To answer this question, the relevant theoretical considerations will be briefly reviewed. We will then address the more specific issues related to the role of markets and planning in oil-exporting countries, with particular reference to the Iranian experience before the revolution. We will discuss the problems of a move out of the controlled war economy, and examine the respective roles of planning and markets in economic reconstruction. Finally, the government’s moves to rationalise the exchange rate system and initiate policies to make the economy more responsive to market conditions, along with the policies and institutions which need to be established, will be analysed.
Markets and Planning
The literature on the respective roles of markets and planning in economic development has evolved along two different but interrelated lines; one focusing on central planning and seeing planning as an alternative to a capitalist market economy, and the second emphasising the indicative aspect of planning and seeing planning as an aid to economic development in the context of a mixed market economy.
In most of the economic literature belonging to the former tradition, market and plans have been treated as two polar modes of economic organisation, both at the academic and popular levels of discourse. This dichotomy, to a large extent, is due to the way the discussion of planning first emerged in the early debates on the possibility of constructing alternative economic systems to the capitalist mode of production.
Classical Economists
The classical political economists, from Smith to Ricardo and Marx, had already expounded the dynamic features of the capitalist system and highlighted the enormous productive powers associated with the emergence of capitalism. For these economists, the primary strength of capitalism lay in its reliance on the dynamics of competitive market forces – free from many of the social and political restrictions which characterised all the previous socio-economic systems – to enhance capital accumulation and induce rapid technological progress.
The studies of the classical political economists culminated in Marx’s critique of capitalism and his analysis of the possibility of the emergence of an alternative socialist economic system. This critique of capitalism did not, however, as yet pose the question in terms of the operational aspects of such an alternative system. That had to await the attempts to construct such an alternative economic system by the Soviet Union early this century, where central planning replaced the market as the main organising principle of the economy.
By the time the operational aspects of a centrally planned socialist economy came to occupy the economists’ attention, the economics profession had witnessed the marginalist revolution, and the Walrasian competitive general equilibrium analysis had emerged as an abstract analytical tool which was turned to the examination of the problems of socialist planning. Much of the debate which ensued, particularly during the interwar period, was concerned with examining the possibility of devising a centralised planning system which – as far as possible – was capable of emulating the efficiency features of a capitalist market economy.
The Pareto efficiency of the market economy was formalised in the form of what has come to be known as the first fundamental theorem of welfare economics, namely that in a market economy in general competitive equilibrium, it will not be possible to make any one person better off without making someone else worse off. This result follows from the fact that in such an economy, marginal return to resources in alternative uses must be equal, both across markets and inter-temporally.
The next step in the argument was that, irrespective of the economic system under consideration, it was possible to require the same marginal conditions to hold for economic efficiency. This formed the basis of the arguments which questioned the possibility of central planning in a modern economy. For a central planner to ensure the maintenance of all the marginal conditions in all activities necessary for Pareto optimality, it was argued, would mean the compilation and processing of an enormous amount of information which would be too costly and virtually impossible.
This criticism of central planning could in fact be taken as the precursor of the literature which appeared a few decades later on the information and incentive problems associated with market economies. However, since, at the time, economists in general assumed that in a market economy price conveyed all the necessary information for efficient resource allocation, such criticism of central planning paradoxically formed the basis for the development of solutions to the information problem of the central planner. This consisted of developing decentralised models of planning following Oscar Lange’s suggestion that the central planner could solve the intricate allocation problem through an iterative process of trial and error analogous to the role of the fictitious auctioneer in Walras’s atonement process.
The proponents of central planning argued that in fact it is only under such an iterative planning process that the condition for Pareto efficiency can be assured, as the central planner in effect fulfils the role that the fictitious auctioneer is supposed to play in the market economy a la Walras, and that at the same time it can take care of distortions introduced by the monopoly practices prevalent in capitalist countries as well as ensuring a more equitable distribution of income. This argument also implied that the question of economic efficiency appeared to be independent of the legal ownership of productive assets by the state or the private sector.
Limitations of Theory
It is noteworthy that the debate over the two alternative economic systems was conducted at an abstract level with highly idealised institutional set-ups which had little resemblance to the actual economies being considered. The central planning institutions in the Soviet Union were far from the idealised auctioneer in Lange’s decentralised planning construct, as they were also far from the ideals advocated by the socialist thinkers. Similarly, the institutions of capitalist market economies were far from the idealised perfectly competitive economies.
It also seemed that in gaining more precision, modern economics had left behind some of the important insights of the classical political economists into the workings of the capitalist market economy, particularly the central role they attributed to competition in the processes of technological change and capital accumulation. The emphasis in modern general equilibrium analysis was shifted to the efficiency aspects of a market economy under the conditions of full employment and stationary equilibrium.
This gain in precision, however, was important in that it clearly pointed out the limits to what economics theory could establish by precisely defining the conditions necessary for Pareto efficiency in an economy in perfectly competitive equilibrium. Notable among these conditions were the following: First, in proving the existence of a competitive market equilibrium, economies of scale and externalities had to be assumed away. Second, even if the economy was assumed to be in perfect competitive equilibrium, for this equilibrium to be efficient one needed to assume the existence of a complete set of markets for all contingencies.
Market Failure
Failing these assumptions, it can be shown that perfect market equilibrium, even when it exists, will not be efficient. These instances of ‘market failure’ clearly apply to the decentralised planning schemes suggested by Lange and others. In fact, some of the early analyses of market failure – due to incomplete information and incentive incompatibility – were conducted in the context of the decentralised planning literature.
The problem is that the central planner can at best acquire partial information about the conditions of production and demand in different sectors of the economy, and the agents may not have the incentive to reveal the correct information. As a consequence, the iterative process of exchange of information on prices and quantities between the central planner and the numerous economic agents can lead to an inefficient solution. As this example demonstrates, information and incentive problems which lead to market failure can be equal, if not more important, causes of ‘government failure’ as well.
Of course, planning and markets have not always been treated in the literature as two opposite and mutually exclusive forms of economic organisation, as may have been suggested. In the large body of literature which emerged in the post-World-War-II period on the economics of developing countries, planning and markets were treated rather as complementary mechanisms of economic organisation within a mixed economy framework.
Dealing with Reality
In contrast to the debate on central planning, where the analysis was conducted at a highly abstract level, the conventional development literature had its starting point in the concrete economic conditions in the under-developed countries and their institutions.
It began with the important observation that the underdeveloped economies tended to exhibit persistent disequilibria particularly visible in the form of a substantial and persistent surplus agricultural labour, and that missing or incomplete markets were much more prevalent than typically assumed in mainstream economics. A further important consideration was the existence of substantial economies of scale associated with industrialisation.
Need for Government Intervention
The combination of these factors clearly indicated the need for government intervention and industrial planning, not so much as an alternative to a capitalist market economy but as an aid to its development.
Government intervention was seen to be complementary rather than a substitute for the market mechanism. For example, major infrastructural investments and institutional reforms were considered necessary to introduce market relations and commercial norms into the traditional subsistence agriculture. Industries with increasing returns, and those with major learning economies needed to be initiated and subsidised, at least over the initial stages of their development.
Economic Strategy
This highlighted the need for the formulation of an appropriate industrial policy and an overall economic strategy, as well as the need for the development of appropriate financial institutions, promotion of investment in education and training and other support activities. In this context, government investment, even when directed towards the production sectors of the economy, was seen as complementary rather than as a substitute for private investment.
As long as the reasons for market failure were seen to be factors such as economies of scale, or non-economic reasons such as the persistence of traditional institutions, as emphasised in conventional development economics, then state intervention – when well directed – could be shown to enhance economic performance.
However, if market failure in the first instance is due to information asymmetries and incentive problems, then the government may face similar information problems and hence may not be able to intervene effectively, even if some form of intervention is deemed necessary. In other cases where information problems are due to intrinsic or endogenous uncertainties that are inherent in the functioning of the decentralised market economies, then government intervention may be effective in bringing about some degree of coordination between the decision-making process of different agents, and hence improve efficiency.
Such intervention can take the form of the creation of an institutional framework for the exchange of information and coordination of plans amongst different agents. In fact, prior announcement of the medium-term government expenditure plans can itself play an important role in promoting such a co-ordination. This was, for example, an important reason for the popularity of indicative planning in post-war European economies.
On the other hand, if the market failure is due to information asymmetries between different economic agents and problems of monitoring an incentive incompatibility, then direct government involvement need not necessarily improve the situation. In fact, if such intervention leads to an increase in the degree of centralisation of decision-making, it is likely to add to the difficulties. As we noted above, these types of information problems may be an even more important source of ‘government failure’ than market failure.
This point, which was to a large extent neglected in conventional development economics and has been an important addition to the development literature in the past two decades, cautions against the adoption of policies to deal with other instances of market failure, such as economies of scale, through an ever-increasing centralisation of economic decision-making within the state. Such policies may replace the market failure by a ‘government failure’, which may be even more inefficient, and politically difficult to reverse. This, of course, does not necessarily imply a non-interventionist stance, but it has important implications for choosing between different forms of government intervention.
No Ideal System
What post-war development economics has contributed to the debate on planning and markets is the important realisation that planning and markets need not be viewed as two competing ways of organising the economy. A consequence of this realisation is that the search for an ideal economic system suited to all countries at different stages of their economic development may be futile.
Each country, learning from its own past experience and the experience of economic development in other countries, may arrive at a different ‘optimal’ organisational set-up which is particularly suited to its own stage of development and economic debate as discussed above. The rest of this section will enumerate some of the main issues which are important to planning and markets in Iran.
Markets and Efficiency
Markets are important mechanisms for the efficient transmission of information and coordination of activities between different economic agents operating on a decentralised basis.
Furthermore, competitive market forces play a crucial dynamic role by inducing technological change and capital accumulation in profitable activities, and by continuously subjecting the producers to market forces and the financial discipline that generally accompanies them.
Political Preconditions
Markets are social institutions, and hence the effective operation of market forces has important social and political prerequisites. The establishment of stable political and legal systems within which property rights can be clearly defined and secured are particularly important among such preconditions. We refer to property rights here in a sense which is broader than the legal term. For example, arbitrary and unexpected intervention by the government which affects the value of the assets of individual agents in the economy could be said to reduce the security of property rights. Similarly, laws which may give power to social groups, other than the government, to intervene may have the same implications.
However, if such interventions were based on a social consensus and took place through some stable and routine mechanisms of consultation and legitimisation, their destabilising effects would be – to a large extent – mitigated, leading to a more secure system of property rights. In general, if government economic intervention is dominated by considerations other than economic rationality, and in particular if such considerations are tied to the factional interests of particular interest groups, it can lead to instability and insecurity of property rights, which diminishes the credibility of the government and hinders the efficient functioning of the market forces, even if all other conditions for the proper functioning of markets hold.
The Agency Problem
From the (production) efficiency point of view, in a market economy the private assets are immaterial if both private and public enterprises are subject to the same commercial norms. For example, if the government needs to invest in a large-scale industry – for example steel – because the private industrialists do not have the necessary capital or are not prepared or able to bear the risks of such a large-scale investment, then as long as the plant is subject to the same commercial profitability norms as the private sector, there will be no efficiency loss.
This latter condition can of course break down, as in the case of public sector enterprises where the government may find it politically difficult to apply commercial norms and has to automatically finance the losses incurred. An important aspect of the inefficiency of state enterprises in the former centrally planned economies of Eastern European countries appears to have been closely related to their having a ‘soft budget constraint’ in this sense.
Market Failure
There are important cases of market failure associated with the existence of externalities, incomplete markets and information asymmetries, which may entail government intervention to counter the implied inefficiencies in the market economy. These instances of market failure are particularly important in the early stages of economic development where major industrial expansion is associated with substantial economies of scale and economies of learning. The particular form that government intervention may take under these circumstances depends on the specific problem at hand and cannot be decided on the basis of some general universal prescriptions and rules.
It can be argued, however, that all else being equal, tax/subsidy methods of dealing with market failures are preferable to quantitative restrictions, as the latter may lead to additional costs by encouraging rent-seeking activities in the economy. If for any reason quantity rationing cannot be avoided, the expected benefits of government intervention need to be set against the likely costs arising from rent-seeking activities that follow.
Information Problems
In the case of market failures which are associated with information asymmetries and incentive problems, the transfer of activities associated with the market failure to the public sector would not solve the problem and can easily turn into a source of government failures. Many of the problems of the former Soviet and East European economies were indeed connected to this type of information and incentive problem. If the source of market failure, however, is behavioural uncertainties arising from missing future markets, government coordination (e.g., through indicative planning and the announcement of medium-term government expenditure programmes) can play an important part in alleviating such problems.
Nature of the State
Whatever the degree of the market orientation of the economy, the efficient functioning of the economy ultimately depends on the nature of the state and the attributes of the political process. We have already mentioned some of the political preconditions for efficient functioning of the markets.
The role of politics arises from the fact that there is no readymade model of optimal economic organisation which societies can emulate, and that the process of constructing efficient economic institutions is one of learning from past experience and from the experience of other nations. This process of learning depends on the nature of the state and its political and administrative institutions.
Flexible and open-state institutions are obviously more conducive to learning and change than centralised, rigid and closed systems, where lack of transparency and flexibility precludes effective learning and an appropriate response to internal and external shocks. A further precondition for effective learning, as well as for the efficient functioning of the economic institutions once in place, is to achieve an optimum level of decentralisation of decision-making and control, and the establishment of a system of democratic checks and balances. As the experience of the Eastern European economies shows, over-centralised and non-democratic systems can become extremely unresponsive and inefficient over time.
To go beyond the general points discussed above, we need to examine more specific issues related to economic planning in oil exporting mixed economies, which we shall attempt to do in the context of the Iranian experience.
There are certain important points to be kept in mind when dealing with planning and markets in oil-exporting economies. The first of these is that in an oil-exporting country – such as Iran – where the government directly receives a large part of the national income in the form of oil revenues, planning assumes a more important role than in non-oil exporting economies. The government’s expenditure plans give direction to the economy as a whole as well as promoting private investment.
Of course, the government’s planning has to cover much wider issues than medium-term expenditure, particularly because it has to deal with complications arising from the specific characteristics of oil as a source of revenue. One of these complications is that oil is an exhaustible resource and cannot be relied upon indefinitely. Consequently, it would be misleading to refer to oil as part of the national income – rather it should be treated as national wealth which is being depleted.
Structural Change
It is therefore imperative for economic development in the long run that the depleted oil wealth is replaced by human and man-made physical capital. This highlights the significance of structural change, and industrial strategy as an integral part of planning in an oil-exporting economy.
Over the past few decades, much attention has been paid to the question of structural change in oil-exporting economies or de-industrialisation, in particular the ‘Dutch Disease’ phenomenon. According to this theory, in an economy in full employment equilibrium, a permanent increase in the inflow of external funds leads to a change in relative prices in favour of non-traded goods (such as services) and against traded goods (such as agriculture and industry) thus leading to the crowding out of traded goods sectors by non-traded goods sectors.
T h e mechanism through which this change takes place is based on the fact that in an economy in full employment equilibrium and with static technology, the external funds can be translated into real domestic expenditure only if the flow of imports is increased. But since goods and services from the non-traded goods sector cannot be imported readily (or only at a very high cost) a contraction takes place in the traded goods sectors.
This process of structural change would be inevitable for an economy in full employment and with given technology. However, for less developed oil-exporting countries, such as Iran, rapid growth of oil export revenues is normally associated with high investment and economic activity in the traded goods sectors, and slumps in oil revenues have coincided with slower growth and lower investment in industry and agriculture. In fact, it was precisely during the oil price collapse of the 1980s that the share of services in Iran’s economy increased dramatically. Clearly, the problems of structural change here have rather more to do with the type and productivity of investment.
Stability
The medium-term plans of the government – provided they are credible – should help reduce behavioural uncertainties, increase the co-ordination of economic activities across different sectors and improve the over-all stability of the economy. This is crucial in an oil economy, as oil prices are extremely volatile and careful government planning can help to insulate the economy in the short-run from the resulting instability of foreign exchange revenues from oil exports.
The evidence, however, suggests that in the case of Iran, despite medium-term planning, short-term fluctuations in the oil export revenues were very quickly translated into government investment with rather short adjustment lags. The destabilising effect and wastefulness of this phenomenon was all too clearly seen in the aftermath of the 1973-74 oil price boom.
This signifies the importance of the political factors for an oil economy; if the state cannot be insulated from the pressures of interest groups, the consequences will be of a more far-reaching nature than in the non-oil economies. These consequences are not only related to short-term economic stability, but also have a significant effect on the efficiency and long-term viability of the economy.
Production Efficiency
The ready availability of large amounts of oil revenues may make it easy for the government to compensate for organisational and production inefficiencies by directing an increasing amount of funds into economic activities. While in the short run the effect of such inefficiencies may be cushioned, in the long run they can make development non-sustainable.
Iranian agricultural development during the two decades before the revolution provides a good example of this point. The problems of agricultural development were not because the sector was deprived of investment resources – as in the ‘Dutch Disease’ phenomenon – or from the industrialisation bias of the government; but rather because the substantial resources directed towards agriculture were utilised in an inefficient and wasteful manner.
This was partly due to price distortions which led to the misallocation of resources within the sector and the wrong choice of techniques of production in the private sector. But other major reasons were also lack of organisational capacities and the wrong choice of investment by the government, as well as a dearth of technological capabilities within the farm sector.
Industrial Strategy
Another crucial aspect of structural change is the extent to which the industrial sector can take over the foreign exchange provision role of the oil sector. This largely depends on the industrial strategy of the government. Paradoxically, the import substitution policies pursued by the Iranian government during the 1963-79 period increased the economy’s dependence on oil. The highly protected manufacturing industries which grew rapidly behind tariff walls did not have the incentive to export, nor did they develop the efficiency required for competing in the international markets.
And, as research on newly industrialising countries shows, participation in export markets forces learning and efficiency gains, from contact with foreign markets and customers.
Of course, the argument here is not to remove all protection from the domestic industry, but rather to move towards an industrial policy which provides neutral incentives between domestic and foreign sales, and one which is committed to the gradual relaxation of the protection of ‘infant’ industries along their learning curve as they expand and grow. As it happened, the industrial policy in Iran did not fulfil any of these conditions. The level of protection was high, granted in an ad hoc manner to a host of domestic industries without any coherent selection policy.
Income Distribution
Due to the triple role that oil revenues play in oil-exporting countries – the provision of foreign exchange, addition to national savings and contribution to government revenues – the income distribution in these economies can be a far more serious problem than in other developing economies. The increased oil revenues – by adding to domestic savings and government revenues – have also tended to alleviate the need for mobilising domestic savings and augmenting government revenues through taxation. This has, in turn, weakened the redistributive effects of the tax system in Iran, and, combined with protective industrial policies favouring capital intensive technologies, has worsened the distribution of income in the economy.
Rent-Seeking
The large amount of subsidies distributed by the government in the form of cheap inputs and credit subsidies, combined with industrial and trade policies, generated substantial rents for those who could obtain access to government resources. Some rents had originated from policies that had been introduced for genuine economic reasons, but over time gave rise to strong patronage ties. This meant: 1) a loss in the cost of resources devoted to obtaining access to such rent, as well as resources spent on lobbying for their maintenance; and 2) the static efficiency losses arising from the misallocation of resources between different activities.
In addition to these two sources of allocative inefficiency, there is also the issue of dynamic inefficiencies, which arise because of the presence of supernormal profits in certain sectors of the economy due to government intervention and protection. This type of long-term distortion not only encourages the flow of resources to the protected sector, but also can have a detrimental effect on its productive efficiency. There is little or no incentive on the part of the protected sectors to rationalise their production and management methods, or to embark on inventive activities, all of which are essential for the successful integration of the domestic economy into the international marketplace.
One of the peculiarities of the oil exporting economies lies in the fact that oil revenues can allow the capture of rents on a magnitude and for a duration of time not sustainable in non-oil economies, leading to additional long-run costs and rigidities. Some of the problems of the Iranian economy in the 1980s, when oil export revenues, after many decades of rapid growth, came to a halt, have their origins in these structural problems.
Post-Revolutionary Period
Since the 1979 revolution, profound changes have taken place in the Iranian economy as a result of a combination of external and internal factors. The revolution itself, the eight-year war with Iraq, fluctuations in the output and the price of oil, economic sanctions by Western countries and the blocking of Iran’s foreign assets were amongst the main factors which had a detrimental effect on Iran’s economy during the post-revolutionary period. Of course, the final outcome was heavily conditioned by the pre-existing structure of the Iranian economy as well as the policy responses of the post-revolutionary government.
One of the important institutional changes which took place as a result of the revolution itself was the nationalisation of a considerable part of Iran’s modern industry as well as the entire banking and insurance industries. The government’s control over the economy increased continually, particularly spurred on by the exigencies of running a war economy.
Foreign exchange shortages – which became especially acute from the mid-1980s – led to a policy of strong ‘import compression’ and strict foreign exchange controls and rationing. The shortfall in the government’s oil revenues at a time of increasing demand on government resources led to substantial budget deficits. This heightened inflationary pressures in the economy, and was intensified by the growing shortages resulting from import restrictions, increasing production inefficiencies, economic sanctions and war damage.
To mitigate the impact of inflation and shortages of major commodities, the government introduced an intricate system of rationing and direct subsidies for a large number of commodities throughout the war period. Government controls in other economic spheres also increased significantly during this period. This did not reflect a shift of balance between private and public ownership, but showed itself through direct intervention in the market place – e.g., foreign exchange controls, maintenance of a system of multiple exchange rates, control on interest rates and bank credits, as well as direct price controls in a large number of product markets.
However, the growing government intervention in the market did not mean an introduction of planning; on the contrary, this was indeed the only period during the past four decades when medium-term development planning was virtually non-existent in Iran. The Iranian economy in this period can be best characterised as a managed war economy rather than a centrally planned command economy of the Eastern European type. Government interventions during this period were largely myopic, dictated by circumstances, and not a coherent economic plan. Over time, substantial price distortions started to develop, with serious consequences at all levels of economic activity.
The economic reform programme initiated by the government in the post Iran/Iraq war period was intended to deal with some of these consequences, and the problems which these reforms have faced can only be understood in the light of the events of the preceding eight years. To appreciate some of these problems we must first consider the extent of price distortions and their likely consequences in some of the key markets.
Exchange Rates
Much attention has been paid to the government’s maintaining of exceedingly overvalued exchange rates. Th e growing overvaluation was a result of the maintaining of a fixed nominal exchange rate by the government despite the series of adverse economic shocks mentioned above; the oil price collapse and the substantial reduction in oil exports, the freezing of Iran’s foreign assets, the increased foreign exchange needs of Iran’s war economy and the resulting inflationary pressures.
The growing disequilibrium in the foreign exchange markets was reflected by the ever-growing wedge between the controlled official exchange rate and the black-market rate. The premium on the black-market rate increased rapidly from low levels at the time of the revolution until it stood at the phenomenal rate of over 2000 per cent by the end of the decade. Whilst the development of parallel exchange rates is not an uncommon phenomenon in developing economies, few other countries have maintained such substantial premiums over such a lengthy period of time. The government was able to do this through its direct control over the main source of foreign exchange revenue in the country.
The twenty-fold premium in the parallel exchange markets reflected the enormous subsidies that the government was providing to those economic activities which benefited from the government’s exchange rationing system. To what extent these subsidies benefited the traders, industrialists and public agencies involved or to what extent they benefited the final consumers varied from market to market. However, what is clear is that its overall income distribution was most likely to have been negative, and from an efficiency point of view, it amounted to considerable losses being made in a number of ways.
First, given the importance of exchange rates for relative prices in the economy as a whole, the existence of two – or more – highly divergent exchange rates, neither of which can be said to reflect the fundamentals of the economy, makes rational decision-making extremely difficult. Also, the uncertainties that are associated with such substantial differences between the official and ‘free market’ rates cause further difficulties. The price distortions associated with a hugely overvalued official exchange rate and the associated rationing process by the government also lead to allocative inefficiencies, and the rent-seeking activities associated with this led to a further diversion of resources from productive activities.
In fact, during this period, there was a rapid increase in the share of services in Iran compared with other countries in similar stages of development. What is, however, even more remarkable is the increase in the share of trade in total services in Iran from about 18 per cent in 1980 to more than 47 per cent in 1989, which is an indication of the extent to which the considerable subsidies given to such activities have diverted the country’s increasingly scarce resources away from production industries and into trade.
T h e problems associated with the exchange rate – and the resulting inefficiencies in the economy – intensified during the war years brought home to the government that a comprehensive liberalisation and restructuring programme must be instituted after the war, a feeling heightened by the government’s determination to play a more active role in the international arena. The government recently implemented a unified exchange rate, and although it represents a step in the right direction, more complementary economic – and political – measures also need to be taken.
Price Subsidies and Their Effects
An important aspect of the relative price movements during the 1980s is related to the question of the price subsidies that kept the prices of commodities regarded as essential, or of strategic importance, at relatively low levels.
By looking at the example of fuel, a basic commodity that affects the relative costs of all other economic activities, it is possible to get an idea of the extent to which price subsidies affected the relative price structure in the domestic economy. Government subsidies to energy consumption in Iran largely take the form of hidden subsidies, as the government is the main producer of energy products. These hidden subsidies, which have been increasingly manifested in the losses made by the Iranian Oil Company (NIOC), despite free access to crude oil supplies, become visible when we compare the prices of various petroleum products in Iran with their international counterparts.
However, in such a price comparison we face the problem of the choice of an appropriate conversion of international prices into domestic currency. Given exchange rate induced distortions and other structural disequilibrium prevailing in the Iranian economy, it may be more informative to compare the trends in the price of oil products relative to other products over time.
With the exception of petrol, prices of all other energy sources in Iran had remained virtually the same over the past three decades until very recently. The result was that the real price of energy followed a declining trend, particularly during the inflationary decades of the 1970s and the 1980s.
The inflationary process rapidly neutralised the considerable petrol price increases in the early 1980s, so that by 1990, the real price of petrol showed a 65 per cent decline as compared to 1959.
These price distortions are particularly serious given that the scope for the expansion of oil production and refinery capabilities is very limited, and that oil is readily convertible into badly needed foreign exchange revenues.
Both the unification of the exchange rate and the correction of substantial price distortions will have major social and economic implications. The extent of the price distortions and the period of time they have been allowed to persist imply that their adverse influences on the economy have reached an entrenched position, and their removal, even if carried out gradually, cannot be achieved without, initially at least, causing major social and economic dislocations.
But for the exchange rate policy to be effective and durable, it is essential that it be accompanied by a number of other financial and budgetary policies as well as long term structural policies aimed at increasing the country’s growth potential. In the short term, the credit and interest policies of the financial institutions must be made more responsive to the inflationary consequences of the unification and the effective devaluation of the Riyal that inevitably follows.
The unification of the exchange rate first results in a substantial increase in demand for credit by firms who previously have had access to the preferential exchange rate. This in turn places the banking system under considerable pressure.
The credit and interest policy of the banks can clearly have important consequences for the eventual success of the exchange unification policy, at least in the short term. This can be particularly serious if the cost of credit is kept artificially low, as such a policy will most likely increase the credit rationing problem and lead to more undesirable rent-seeking activities.
Keeping the cost of borrowing and lending artificially low can also have undesirable consequences for the mobilisation of domestic savings for investment activities.
The aim should be not to let the real rate of interest decline even further than it already has. Even if it is assumed that the supply of domestic savings in a country like Iran is not very responsive to interest rate changes, the adverse impact of large negative real interest rates on the mobilisation of domestic savings for investment should not be underestimated. The budgetary implications of the exchange rate unification also require special attention. Given the importance of oil revenues in the government budget, a nominal devaluation of the Riyal increases the government revenues denominated in the Riyal, and in the short term can result in a substantial reduction in the government’s budget deficit.
This apparent improvement in the government budget should not, however, be regarded as being permanent as it can be easily reversed, as the effect of devaluation starts to feed into higher domestic prices and wages. What is needed is a close monitoring of the level and the composition of government expenditure. Expenditure-switching policies that direct resources away from consumer imports and towards domestic investment and production are needed.
Considering that the unification policy has been put into effect in stages and over a number of years, and bearing in mind that a large proportion of the consumer goods are already imported at Tree’ or parallel market rates, which are likely to be close to the unified rate, it follows that the immediate impact of the unification will be on prices of raw materials and equipment, rather than on prices of imported consumer goods.
To the extent that higher raw material and input prices are passed on, the result is likely to be higher prices of domestically produced consumer goods, relative to imported consumer goods (rather than lower relative consumer prices, which is often the immediate consequence of devaluation).
This initial adverse price effect on domestic producers of consumer goods needs to be followed with policies designed to make domestic production more efficient and competitive, and demands for the introduction of further protective measures, through higher tariffs and other restrictions on consumer goods imports, should be strongly resisted. It is worth noting that this adverse cost effect moderates the high level of profits enjoyed by domestic producers over the last few years in view of the large differential in the exchange rate applicable to their imported inputs and the imported consumer goods.
What is important in the transition period is for the government to resist the pressure groups, both within the government itself and from outside, who press for either higher government expenditure or protection as a response to the economic reforms – because yielding to either would intensify inflation and neutralise the effect of the reforms. The immediate expenditure of all the increase in the domestic currency value of the government oil revenues would be inflationary – even if the overall budget were kept in balance.
This would be particularly so if the increase in government expenditure took the form of current account spending and wage salary increases, rather than investments in the economy. The inflation which would result could also defeat the original purpose of the unification by pushing the parallel or free market rate even higher. The exchange rate unification and other reform policies also need to be accompanied by an appropriate long-term industrialisation strategy.
Whether by design or by default, over the past three decades Iran has followed an import substitution industrialisation strategy, which focuses on protection of industries by means of high tariffs on the import of finished products, investment licensing, credit subsidies, and cheap raw materials. As the example of Iran, and many other countries following such policies, shows, the industries developed in this manner tend to be inefficient and very slow in the adoption of new production and management technologies.
An alternative industrialisation strategy would be to abandon the inward orientation of the old strategy for a more balanced outward oriented industrialisation strategy focused on promotion of non-oil exports, particularly in the industrial sector where economies of ‘learning by exporting’ are highest. In the case of Iran, the move towards a more outward oriented strategy will be particularly beneficial, as it releases oil revenues used to protect inefficient industries for greater investment in human capital and infrastructure, which are essential for growth and industrialisation. The outward orientation of such a strategy also has the additional advantage of subjecting domestic producers to the discipline of foreign competition.
It is, however, important to recognise that the implementation of such a policy does not imply a laissez-faire approach, and still requires a considerable degree of government intervention and subsidisation of domestic industries. The primary difference between the two strategies is the degree to which domestic producers under each strategy are subject to foreign competition. Industrialisation under both strategies requires some form of government protection and support in order to exploit the economies of scale and take proper advantage of the most recent advances in technology.
Finally, it is worth emphasising that the success of any development strategy within a mixed economy framework requires a stable legal and political environment, within both the public and private sectors. In the absence of a comprehensive reform programme which encompasses such broader institutional requirements, economic measures, such as the unification of the exchange rate and the removal of price distortions on their own will remain ineffective, and can even lead to further economic hardship without any long-term benefits.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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