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June 2022, No. 100


Global Economy

Big Distortion in the Iranian Economy!

What is the main engine of destruction of production and household welfare in Iran? Although experts have provided various answers to this question and put it on the policymaking table, two prominent economists believe that a ďmajor distortionĒ is the main engine of destruction of resources, productive activities and family wellbeing in the Iranian economy.


Hashem Pesaran believes that the issue of price distortion is the most important domestic issue
of the Iranian economy, because they determine how resources
are allocated in the economy of relative prices.


Professor Hashem Pesaran and Dr. Mousa Ghaninejad consider the most important problem of Iranís economy to be the distortion of relative prices. According to this top economist, in the last five years, the distortion of relative prices by the formula of ďpricingĒ or ďsubsidizingĒ has caused both producers and consumers to be misunderstood. Under these circumstances, both the welfare of the household has been destroyed and the flow of investment in production has shifted towards speculation in assets.

In a situation where relative prices are distorted, household consumption of useful and essential goods decreases, but consumption of non-useful goods in the household basket increases. Disturbances in relative prices also justify resource degradation and speculation over productive investment.

Hashem Pesaran believes that the issue of price distortion is the most important domestic issue of the Iranian economy, because they determine how resources are allocated in the economy of relative prices. According to him, although this is done in the name of supporting vulnerable groups, it is a waste of resources with improper signaling. Mousa Ghaninejad also believes that prices contain information about the scarcity and relative utility of goods in the economy, on the basis of which economic actors, both consumers and producers, make decisions; but it should be noted that in the open market the price reflects real information without the intervention of the government and it is based on this vital information about the relative scarcity of resources that actors can make rational decisions about what they want.


Mousa Ghaninejad is another economist who emphasizes that price distortion is the most important issue in Iranís economy.


According to this economist, when the government arbitrarily sets the price of a commodity regardless of the economic logic of the market (opportunity cost), it is in fact misinforming economic actors about the scarcity of valuable resources, which in turn leads them to a wrong course in decision making in terms of public interest. To avoid wasting resources and moving in the right direction, correcting relative prices according to the economic logic of the market is the first necessary and inevitable measure.

An important issue concerning Iranís economy

Hashem Pesaran points to the issue of price distortion as the most important internal problem of the Iranian economy. He emphatically says: From foreign perspective, the most important issue of Iranís economy is the sanctions, but today most of the domestic and foreign economists agree that the issue of price distortion is the most important domestic issue. According to Pesaran, people usually understand prices in monetary terms, but what matters is how much these goods are priced relative to each other. For example, it is important for the Iranian consumer what the prices of meat, gasoline and poultry are, but for an economist it is important how relative prices work in this economy. For example, what is the price of a plane ticket compared to gasoline? The importance of this lies in the fact that the determinants of how resources are allocated in the economy are relative prices, because, for example, if the price of meat rises significantly relative to the price of chicken, investors would invest more to make more profit in producing or importing meat. According to Pesaran, the problem with Iranís economy is that these prices have been distorted. When the prices of gasoline, water and electricity are kept too low compared to the prices of other goods, the economy will face many problems; although such a policy is aimed at helping the poor, it also benefits the wealthy. At the same time, Iran is also facing problems in terms of water resources, while we are exporting agricultural products to the Persian Gulf countries.

As another example, the low-priced electricity causes economic justification for digging of deep wells and extraction of water, and use the water to cultivate and export products that are not compatible with the arid climate of Iran; here we can see how the distortion of electricity prices leads to the inappropriate allocation of other economic resources. So for half a century we have been distorting relative prices which in turn hurt the economy as a whole. 

Why are relative prices important?

Mousa Ghaninejad is another economist who emphasizes that price distortion is the most important issue in Iranís economy. According to him, the price in the market is relative, so talking about the relative price is just a reminder. Since the price in the market is always expressed in a certain currency, the suspicion arises that the price of one commodity represents a fact independent of the price of other commodities; while in reality this is not the case. Prices primarily contain information about the scarcity and relative utility of goods in the economy, on the basis of which economic actors, both consumers and producers, make decisions, but it should be noted that in the open market, prices provide real information without government intervention. It is based on this data about the relative scarcity of resources that actors can make rational decisions about what they want. Ghaninejad cites an interesting example:

ďA friend recounted that during a trip to Baku in the late Soviet era, he witnessed that the kitchen gas flame was never extinguished at home; because the cost of buying matches was higher than using the gas, which was provided to households almost free of charge.Ē

This irrational and even dangerous behavior is the result of the reflection of information far from the truth of distorted and manipulated prices that we are witnessing in our country too. When the government arbitrarily sets the price of a commodity regardless of the economic logic of the market (opportunity cost), it is in fact misinforming economic actors about the scarcity of valuable resources, which results in leading them to the wrong decision in terms of public interest. To avoid wasting resources and moving in the right direction, correcting relative prices according to the economic logic of the market is the first necessary and inevitable step.

Finally, Ghaninejad underlines a key point: ĚĚĚ ďMonetary and fiscal policies must be defined in a general and consistent manner in the context of relative price reform. Subjecting price reforms to improve macroeconomic conditions, such as reducing inflation, is virtually a suspension of making total reforms impossible; Because one of the main causes of inflation is the same government budget deficit caused by the unreasonable auction of national resources, including petroleum products and foreign exchange resources. A necessary and, of course, not sufficient condition for monetary and financial discipline is the correction of relative prices according to the economic logic of the market.Ē

Two destructive effects of price distortion

Distortion of relative prices in the Iranian economy, in addition to disrupting signaling to members of society, has caused two important harms; first, it has reduced investment in production and increased the share of unproductive investments in the economy. As a result, many households have been struggling to reduce their calorie intake over the past decade.

In an economy, prices play a key role in the coordination between economic resources, and any disturbance in these prices would confuse economic actors and would lead to inefficient and incorrect allocation of economic resources. Iranís economy has witnessed widespread government interference in the pricing of various goods and services for many years. Despite the negative consequences of this action, the losses caused by these pricing were mainly compensated by government resources derived from the sale of oil, and it was possible to continue the policy of price control in spite of all its losses.

Diversion of economic incentives

The behavior of economic actors in the country has led to a situation where we see excessive investment and development of some activities and insufficient investment in other sectors; A form of unbalanced development among different sectors of the economy that has led to significant anomalies and loss of capital. While government control of some prices has led to better consumption of energy and energy-producing goods, a significant decline in household welfare in the consumption of basic goods and housing indicates the failure of these one-sided efforts with price control tools.

Comparison of relative prices in Iran and other countries

For the effect of price intervention, the prices of several goods in Iran and other countries can be compared. For example, the ratio of the price of one kilogram of meat to one liter of gasoline in most countries is about 10Ě, while in our country this figure reaches 92; as another example, studies show that the price per square meter of house to gasoline, in Iran is very high compared to other countries. This shows that due to the prescribed price of energy carriers and inflation turnover to food or housing, this ratio in the Iranian economy is different compared to other countries. This will send a destructive signal both on the household table and in the industrial sector.

Consequence of ďplaying with pricesĒ

Price control by the government has been the mainstay of the economy in recent decades, where the government tries to control the prices of various goods under the pretext of achieving various goals, from improving household livelihoods to creating opportunities for domestic industries against foreign competitors; an action that seems to be in the policymakerís lack of understanding of how prices work in the economy and causes them to never be aware of the possible consequences of their action. The manipulation of prices has had its effect both in the corporate and industrial sectors and in the household table sector.

The reduction of investment in production and the inflow of capital into unproductive activities, i.e. assets, is one of the main consequences. Controlling energy prices has led to the expansion of energy-intensive industries in the country, industries that do not see any economic justification for improving technology and productivity due to low fuel prices; and therefore over time, their profit margins depend on this cheap energy. In addition to unprofitable production, this also makes new investment irrelevant. This strengthens the incentive to invest in the unproductive sector and speculative activities.

On the other hand, the consequences of this price control do not only affect the industries but households also suffer from them, while due to low-priced energy, household consumption of goods related to this sector increases, while in terms of inexpensive use in other sectors it decreases considerably. Because if we consider inflation as one of the main causes of declining household welfare, the main cause of inflation is the same government budget deficit resulting from the unreasonable auction of government oil resources.

The problem is exacerbated by the fact that this production, based on cheap energy and household consumption, exceeds the energy production capacity, and we see that in the middle of summer, the country suffers from power outages and gas supply to power plants is cut off. It is a rare occurrence for a country that is one of the largest producers of oil and gas in the world to cut off electricity and gas supply to its households and industries. Now, if the level of energy consumption of enterprises and households was balanced and the government could export its energy resources, it would not suffer from budget deficits and inflation, and it could invest these resources in the infrastructure sector.

 

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