Iran Sanctions: A Double-Edged Sword

05/09/2010 05:12 am ET | Updated May 25, 2011

A year after the Obama Administration's decision to attempt a new policy of engagement with Iran, the U.N. Security Council is considering new proposals for a fresh round of sanctions against Tehran over its nuclear program. Increasing labor unrest and economic unease, Washington claims, make the country more vulnerable to economic sanctions. Since President Mahmoud Ahmadinejad came to power in 2005, Iran has witnessed rampant double-digit inflation and unemployment, and continues to experience decelerated growth.

As a result of economic mismanagement at home, Iran is currently experiencing extensive stagflation. Although the country holds the world's second-largest natural gas reserves and the third-largest oil reserves, the balance of its Oil Stabilization Fund actually decreased during the recent period of exceptionally high oil prices. President Ahmadinejad's administration is widely criticized for imposing inflationary economic policies including the distribution of money to the poor in an effort to combat poverty and gain political support (which also hindered the country's ability to increase productivity by creating jobs). Fiscal policies that lowered interest rates and encouraged banks to lend further fed the high levels of inflation. According to official estimates, Iran's unemployment rate reached 11.8% in 2009 and its inflation rate reached 16.8% (unofficially believed to be much higher).

In order to combat this supply-sided recession, the Iranian government recently initiated contractionary monetary and fiscal policies to reduce the money supply and contain the inflation rate. In its efforts to combat inflation, the government is attempting to remove three zeros from the country's currency. While a depreciated currency could increase the country's real GDP by increasing exports, economic sanctions are likely to impede this to a certain degree. The government also recently announced it would begin cutting food and energy subsidies. While such moves are likely to improve the country's long run potential for growth and help contain the inflation rate, they will likely hurt the government politically in the short run at a time when it already faces stiff opposition. Consequently, this could lead to further political instability and discourage foreign investment to a greater degree.

Some analysts argue that Iran's fragile recovery makes it more vulnerable to further economic sanctions. Sanctions that would hinder direct investment, however, would actually help Iran in the short run to contract its economy and reduce the inflation rate. When a central bank increases interest rates to contain the inflation rate, the initial increase in the interest rates puts a damper on investment spending, which causes a drop in direct investment. With or without further economic sanctions, Iran's economy is going to get worse before it gets better.

Once the inflation rate is contained, Iran can then initiate expansionary fiscal policies to stimulate the economy, create jobs, and reduce the unemployment rate. High unemployment--among other factors--feeds a rapid outflow of human capital. According to the IMF, over 150,000 of the best young minds leave Iran on a yearly basis. This massive "brain drain" has a huge impact on the country's productivity and long run potential for growth. While the country maintains many support factors that enable increases in productivity, such as an advanced education system, infrastructure, and research and development, it lacks political stability and property rights, and foreign direct investment is limited in part because of international sanctions. Foreign direct investment in Iran at the end of 2009 was less than half of what it was in 2005. [1]

While economic sanctions may discourage foreign direct investment, Iranian firms conduct much of their business abroad and maintain an ability to work in a black market economy. The United Arab Emirates contributes the highest percentage to Iran's imports, followed by China and Germany. Furthermore, Iran's rich oil supply makes it difficult for international sanctions to have a significant impact on its economy. If implemented on an international level, petroleum sanctions would ultimately be the most effective in 'crippling' the Iranian economy; however, it will be difficult to get countries like China on board for such measures, and without full international cooperation, petroleum sanctions might hurt the economies of those who are implementing them (who could otherwise benefit from trade with Iran) more than their intended target.

In terms of the economy, Tehran appears to have learned some lessons from its past blunders and it is currently taking steps in the right direction by reducing subsidies and attempting to contain the inflation rate. Whether it is able to achieve its goals and what policies it will subsequently enact to increase productivity will prove its ultimate ability to not only survive, but prosper, under sustained international economic sanctions.

[1] See UNCTAD World Investment Report