Analysis | Iran's Wizard of Oz Economics

There's every sign of a bubble that's about to burst.

[ comment ] Iran has been subjected to increasingly stringent sanctions over the past four years. Earlier this year, the Islamic Republic was tossed out of the SWIFT system, one of the most important global financial clearing mechanisms. The Central Bank of Iran has been sanctioned, as has many of the country's other major financial institutions. Iran's oil production and exports have been squeezed under Western pressure. And just today, the European Union announced yet more sanctions against Iran's banking, shipping, and industrial sectors.

And yet since 2008, the Tehran Stock Exchange index has grown from just below 9,000 to more than 28,000, an astonishing rise of over 300 percent.

Believable unemployment and inflation statistics seem nearly impossible to find for Iran. Most public data from the country are politically defined. The Central Bank, a source for many statistics, is far from independent of political pressures. Unemployment may be in the 15-25 percent range. Inflation prior to the collapse of the rial may have been in the 20-25 percent range -- to be very conservative. After the collapse of the rial, both of these statistics are likely going to get much worse, unless the government can pull victory from the jaws of financial defeat, but I have serious doubts they can do this given the constraints they are under.

So what is driving the Tehran Stock Exchange? It is certainly not foreign portfolio investment. It could be that many Iranians with ready cash and savings, largely from the elite or the upper middle class (or the government), have been putting their cash into the stock exchange due to a lack of other investments -- in particular, sanctions have severely limited their investment opportunities outside of Iran. Those same persons have been pumping up domestic housing prices.

Iran has a very high savings rate. It has also had a hyperexpansionary monetary policy, especially since 2007. Money supply has been growing in the 20-30 percent range annually, yet real GDP has been growing in the mid-single digits. Money supply growth should be at about the same pace as real economic growth.

With such high growth in the money supply, yields on Iranian government debt instruments and other medium- to long-term bonds are pushed down. The lower yields in these potential investments push people toward stocks and other non-bond investments. Even though nominal yields on some debt instruments seem to be going up the key yield is the real yield. That is the nominal yield minus inflation. Those yields do not look so good. Of course, pumping huge amounts of money into the economy to inflate the government out of its debt to its own people has been a common policy since the development of money and governments.

Is the Tehran Stock Exchange in a bubble? It does seem that way. Whenever I see any index, stock, or housing price increasing way beyond what the fundamentals say it should be, I start thinking "bubble." There have been thousands in history and they all pretty much run the same way. People and companies catch the contagion and experience "irrational exuberance." Many get caught out.

I suggest the Tehran Stock Exchange will have a precipitous fall -- and fairly soon. It is a synthetic market built on the air of a monetary policy on steroids, and is in part driven by sanctions that reduce other investment options. This synthetic market can be pumped up at the same as the government continuously tries to prop up the rial exchange rates. But the propping up will run into the simple laws of supply and demand. You really cannot battle those.

Much of the Iranian economy was distorted greatly for years by massive subsidy programs and seemingly haphazard government policies to bolster one industry over another. The government also controls much of the legal foreign trade through an almost impossibly complex system of regulations and laws that are sometimes formally and sometimes informally applied, depending on who is involved.

It seems that the pressures of increased sanctions on many aspects of the economy have shown how weak this system really is. The leadership seems to be clueless about the economy's true state. President Mahmoud Ahmadinejad said recently that foreign trade is not a large part of the economy. It is one third of the economy officially. Add in the smuggling that is really keeping the economy going and it accounts for a substantially larger share.

Recently, the government decided to put a cap on the trading of rials for dollars. Some people seemed surprised that exchange markets froze up. This makes perfectly good sense. As a commodity or currency pops its bubble, you really cannot hold back the tides of supply and demand by capping its value. Once again, the Iranian government has shown that its Achilles' heel is its understanding and application of economics.

There are many curtains behind which the powers that be in Iran try to manipulate the economy and keep it moving forward. Now that forward motion is in grave question. For years, they seemed to have been furthering economic development, even under sanctions. Now the time is due to see who is really behind the curtains and to ask them what their next steps will be.

The single biggest drain on the Iranian economy has been the nuclear program. It is a massively wasteful and unnecessary expense to construct almost the entire nuclear cycle for an economy that is still trying to develop. For the sake of the Iranian economy and, more importantly, for the Iranian people, it is time the leadership dealt with reality came clean on what is really going on. It should cut back on the development of the entire nuclear fuel cycle, focus on the expansion of its nuclear electricity capacity as allowed under the Non-Proliferation Treaty, and start to invest in real human and economic development with more commonsensical policies.

The Iranian people would likely appreciate more meat and bread on the table, more freedoms, and more acceptance in the world.

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