Tyranny of numbers

The recent inflation data from Iran’s Central Bank is higher than expected and has the potential to undermine the country’s bold attempt at subsidy reform.  The latest published monthly increase in prices of 3.4% for Esfand 1389 (21 February-20 March 2011) is nearly twice what was reported for the same month last year (1.8%), and 30% higher than for the previous month of Bahman.  The widely reported “12.4% annual inflation rate” for the year, or the year-on-year average, is misleading because inflation has been accelerating in recent months.  The monthly inflation rate has increased steadily from 1.5% in Azar, just before the subsidy reform went into effect, to 3.4% in Esfand.  Even the much higher month-on-month (Esfand 1388 to Esfand 1389) increase of 19.9% in the price level underestimates the extent of inflationary pressures: the annualized rate (=(1+monthly rate)^12) has gone in one month from 34% in Bahman to 49% in Esfand.  These numbers probably overestimate inflation because of rising Nowruz expenditures, but the fact that the monthly increase in the price level this year is twice what it was last year suggests strongly that the annual inflation rate has at least doubled in recent months, to over 20%.

Except for a few ardent supporters of the subsidy reform, everyone had expected some additional inflation arising from the price reform.  (This is the inflation rate I thought as a good outcome, a price worth paying to correct the historic distortions in consumption and production in Iran.)  The important question now is how much of the current inflation is due to the increase in energy prices and how much to other factors such as rising global food prices.  Since the increase in energy prices is a one-time cost increase it should blow over, especially if wages do not rise as fast causing a chain reaction of cost and price increases that can continue into the future.

On the positive side, this year the leading contributor to inflation was rising food prices, which has its source in the global marketplace and, at least until March, was unrelated to energy price reform.  Food prices worldwide increased by about 50% last year but may slow down in the coming year.  Some easing of the drought condition that has plagued Iran’s agriculture in the last few years would also go a long way to ease inflationary pressures.

Still, rising prices undermine the price reform for a simple reason: the government may not have the stomach for another round of energy price increases while people are still struggling to adjust to the first round.  However, the greater danger is in responding to the accelerating inflation by tightening credit, further depressing the economy instead of stimulating supply.  The larger hope for the subsidy reform (in line with its actual name, “the Economic Transformation Act”) has been that putting energy prices right is a beginning for untangling the myriad of problems that afflict Iran’s economy.  Clearly, a gigantic prices increase, which the reform has so far been, cannot on its own stimulate supply.  True, the cash back program has the potential to increase demand for domestic production, but for it to outweight the contractionary effect of the price increase complementary macro and micro policies must go into effect.  On the macro side, monetary policy should not just target inflation, but allow credit to flow to enterprises that try to take advantage of changing relative prices to increase production.  On the micro side, selective subsidies to employment (no preference for college graduates!) can help maximize the potential gain from the price reform. Energy is more complementary with capital than labor.  So it is likely that, as producers find ways to substitute away from energy using technology and products, they will hire more workers.  They are more likely to do this if they have the flexibility to manage their workforce, something that only informal producers have now.   With the right policies in place, producers can turn the negative shock of energy prices into positive job creation.

When announcing the price hikes three months ago, President Ahmadinejad promised to turn his attention to jobs in the year 1390.  Hopefully, what he has in mind is not the easy path that Egypt’s finance minster, the economist Samir Radwan, took last month: he issued a call for the unemployed to send in their cv’s, resulting in 6 million applications and one million new public employees!  Public jobs as a solution to education and employment problems is a thing of the past, not the way of future.  Where Iran should be heading is toward an economy that relies on its creative people to hire its skillful workers; government managers have demonstrated the limits of their creativity by ascending the safe ladder of the bureaucracy.  Reliance on the private sector is still politically difficult in Iran, because of the country’s past experience with growth and rising inequality, and because it takes a lot more in terms of administrative ability to pull it off.  socially compatible, private-sector-led growth requires appropriate social policies and investment in infrastructure (such as urban transport and the internet), as well as a social compact that allows the middle class to flourish.  These changes may prove much harder for the Islamic Republic than the previous challenges that it has successfully met in the past three decades– in beating back Iraqi aggression, building the rural health infrastructure, family planning, education, and poverty reduction.  But if the coming year is to be the year of “Economic Jihad,” as Iran’s Supreme Leader has declared, charting bold new direction and taking tough decisions would not be so unusual.