The military confrontation between Iran and the U.S. that began with the assassination of General Qassem Soleimani on January 3 appears to have subsided as quickly as it flared up.
On January 7, shortly after Iran fired a round of ballistic missiles at American bases in Iraq (which left no casualties), Iranian Foreign Minister Javad Zarif announced that Iran has “concluded” its operation. U.S. President Donald Trump, for his part, let it be known that the U.S. did not plan further military actions.
While the broader standoff between Iran and the U.S. continues — the U.S. has imposed new sanctions and Iran threatens further revenge — the decision by Iran to deescalate the military confrontation busts two myths about the Islamic Republic of Iran that Matt Duss, the policy advisor to Bernie Sanders, has summarized well: “Iran is run by crazy suicidal apocalyptic mullahs who will crack under greater economic pressure.”
Iran’s quick retreat from the brink of war is more consistent with a leadership busy attending to the worldly needs of their people than fanatics doing them “a favor, by giving them a free pass to heaven,” as Bernard Lewis, the Princeton historian and one of the intellectual fathers of neoconservatism, is reported to have said.
The assassination of Soleimani presented Iran’s leadership with a difficult choice. While revenge of some sort seemed inescapable, a serious military conflict with the U.S. would have jeopardized Tehran’s larger goal of protecting the Iranian economy against Trump’s “maximum pressure” campaign.
The government faces three formidable challenges in this regard: maintaining national unity while people’s living standards decline, keeping public services afloat in the face of a huge decline in oil revenues, and restructuring the economy away from oil so it is more resistant to sanctions.
From the start, the maximum pressure campaign aimed to pressure ordinary Iranians to rise up and topple their government or force it to submit to U.S. demands. Iranian survey data show that the campaign has hurt Iranian living standards. In 2018/19 average real household incomes per capita fell by record amounts, 6.7 percent in urban areas and 9.1 percent in rural areas. Incomes have likely fallen by more since, which explains the intensity of anger displayed by protesters during the gasoline protests in November. Public employees have been the biggest losers as salary increases this year fell below inflation by some 20 percent.
To protect the poorest, the government has tripled cash assistance to the 10 percent of the population that is already on its welfare roll, but those just above the poverty line have taken a beating, as have the salaried middle class, whose real incomes have fallen with inflation.
Maintaining social cohesion when the effects hit different social groups differently is critical for successful economic restructuring. The widespread November protests following the hike in gasoline prices were a strong reminder of the limits to austerity in Iranian society. An extended military conflict with the world’s greatest superpower would risk squandering the rare national unity that the Soleimani assassination brought to the country. The fragility of this unity was demonstrated a week later, when security forces battled crowds protesting the disastrous shooting of down of the Ukraine jetliner on January 8.
An open letter (link in Persian) written by Iran’s leading reformists issued shortly before Iran launched missiles against U.S. bases in Iraq made a strong plea to the country’s leadership to avoid war and “put economic development and the welfare of the people first.”
The second challenge is to keep public services running. The Islamic Republic derives much of its public support from the extent and the quality of the public services it provides. Electricity and clean water are delivered to all Iranian homes and natural gas to 86 percent of them every day, and so far with regularity.
With the loss of oil revenues, the government is scrambling to find other sources of revenues. Its proposed budget for next year (starting March 21 2020) projects that only 8 percent of its revenues will come from oil, down from 30 percent projected for this year. Raising taxes in a depressed economy is not an option, so the share of taxes in the new budget is expected to remain at about one third of revenues. Instead, the government is proposing to borrow from the public. (Borrowing from the rest of the world is not possible under sanctions, though Russia has promised to chip in $5 billion.) The share of expenditures financed by bonds will double, from 10 percent this year to 20 percent. Asking people to part with their money without offering high interest rates on the issued bonds is no less dependent on patriotic public support.
The third and most important reason for not wanting to go to war with the U.S. is the need to restructure the Iranian economy. This too will be set back by a war, especially a protracted one. Iran’s strategy to restructure the economy relies on market forces, which offer flexibility, and on the private sector. This is a serious departure from the war economy during the war with Iraq in the 1980s, when price controls, rationing, and government distribution centers predominated, but it is in line with three decades of economic policy making in Iran. Markets have played an increasing role in Iran’s economy, though the private sector is still not in the driver’s seat.
The effectiveness of markets and the private sector in resisting sanctions is very sensitive to political instability. A day after the Soleimani assassination, the Tehran Stock Exchange index fell by 4 percent and Iran’s currency, the rial, lost value. It is now 10 percent below where it was before the November protests, and monthly inflation has tripled, reaching an annual rate of 46 percent.
The response of the private sector to sanctions has been relatively calm. Capital outflow, which caused Iran’s currency to devalue by 200 percent in 2018, has slowed down, as evidenced by the currency’s relative stability before November.
More importantly, employment appears on the rise. Labor force survey data show that throughout 2019 employment increased. More than a million more people were working this fall compared to the spring quarter of 2019. For the first time industry led the increase by adding 478,000 jobs, followed by agriculture (470,000 jobs) and services (189,000 jobs). The fact that tradable sectors are leading in employment recovery suggests that market-oriented policies are having an effect. This fall, unemployment was down by 1.2 percentage points compared to last fall.
Formidable challenges remain in turning Iran’s economy around, such as fixing insolvent banks and improving the business climate. There are enough encouraging signs that the market-based strategy is paying off and may have shifted the calculus of Iran’s leaders away from war.
It is in the interest of the region, Europe, and the world to help Iran succeed in managing the economic fallout from Trump’s sanctions. For if the effort at restructuring Iran’s economy were to fail, the most likely alternative for Iran would not be to negotiate with Trump, but to try to continue to bust its way out of the economic siege, as it has in the past by disrupting the flow of oil out of the Persian Gulf.