As Western diplomats debate ways to counter Iran’s nuclear program, the strategies they devise must take Iranian motives into account. If Iranian leaders see their nuclear program as essential to defending Iran’s existence—as the Israeli[1] and Pakistani[2] governments view their nuclear programs—then economic considerations would make little difference to Iran’s calculations. But defense is not the principal factor behind the Iranian nuclear program. Rather, Tehran seeks prestige and influence. Iranian leaders consistently present the nuclear program as an accomplishment of Iranian science and as evidence that Iran is an advanced industrial power.[3] They also argue that international opposition to Iran’s nuclear ambitions is motivated by a Western effort to prevent the country from assuming its rightful place as a regional leader. They play to Iranian national pride, not to the idea that Iran is so threatened that it must take desperate measures to defend itself. If the West is to convince the Iranian leadership to change course, therefore, it is necessary to persuade the Iranian leadership that its nuclear program will not advance Iranian influence. Economic instruments can play a role in this regard though they are by themselves unlikely to be sufficient.

As Iranian confidence has grown in recent years, the West’s ability to pressure Tehran has eroded. Iranian leaders are self-assured: the collapse of both the Taliban in Afghanistan and the Baath Party in Iraq has lifted the chief threats on Iran’s borders. Insurgency and Iranian-backed militias have transformed the presence of U.S. troops in Iraq into a vulnerability and liability for Washington. Pro-Iranian forces won both Palestinian and Iraqi elections. The Iranian regime has also reaped an economic windfall: oil and gas exports have shot up from US$23 billion in 2002-03 to $55 billion in 2005-06.[4] This windfall has enabled an explosion of off-budget spending that has sent economic growth shooting up on average 6.2 percent a year from 2002 to 2006, discounting for inflation. Foreign exchange reserves have reached $47 billion, more than twice the amount of Iran’s foreign debt, and will only rise further as oil prices remain high.

Because of Iran’s economic strength, many in the Iranian leadership no longer believe they must maintain strong ties with Russia and Europe. As this attitude of self-reliance prevails, it is difficult to persuade Tehran to cooperate with the international community. However, if outside powers can remind Iran about the pitfalls of isolation, the terms of the nuclear debate in Iran will change. Conceding will be difficult for Iran, but the Islamic Republic has made such difficult compromises in the past with its revolutionary principles such as when, in 1988, Ayatollah Ruhollah Khomeini agreed to end the Iran-Iraq war.

Complicating the situation has been the apparent willingness of Iranian president Mahmoud Ahmadinejad to welcome the prospect of an attack on Iran as a means to rekindle the lost fervor of early revolutionary days.[5] It would be a mistake to dismiss his rhetoric, such as his statement to U.N. secretary general Kofi Annan that while America and Britain won the last world war, Iran would win the next one.[6] But Western officials should not exaggerate his oratory. Ahmadinejad may be determined to implement Iran’s full revolutionary agenda, including the destruction of Israel, but his invocation of the Hidden Imam has more to do with slighting the clerical authority by claiming higher legitimacy than with an imminent desire to initiate a war to bring about the end of days.[7]

While the West focuses on Ahmadinejad and his rhetorical excesses, Supreme Leader Ayatollah Ali Khamene’i remains the real power holder.[8] For the last eighteen years, Khamene’i has preferred low-level confrontation with the West, just enough to keep the revolutionary spirit alive but not enough to risk open hostilities. For now, Khamene’i seems to think that the West, despite its tough rhetoric, will do nothing to stop Ahmadinejad, so there is no cost to letting him push ahead. For all its claims to be an Islamic republic, the regime’s policies reflect much more the triumph of anti-Western revolutionary views and determination to retain power over theology.

Herein lays the opportunity. Despite the Iranian leaders’ self-confidence, the Islamic Republic is economically vulnerable. Having pegged his reputation to his ability to help the ordinary man, Ahmadinejad faces problems delivering: notwithstanding the influx of hard currency, the Iranian economy is a mess; his policies are counterproductive, and Iranians’ expectations are high. The World Bank’s 2003 report about Iran noted, “Despite the growth in the 1990s, GDP [gross domestic product] per capita in 2000 is still 30 percent below what it was in the mid-1970s, compared with a near doubling for the rest of the world.”[9]

The contrast is glaring between the Iranian economy and the soaring economies of Persian Gulf emirates such as Dubai, Abu Dhabi, Qatar, and Kuwait. Tens of thousands of Iranians living in Dubai tell their compatriots about the quality of life there. Iranians are galled that Arabs—whom they have traditionally considered inferior—thrive while they lag behind.

Rather than harness the oil windfall to close the quality-of-life gap, Ahmadinejad’s policies will exacerbate it. He seeks to erect rather than dismantle barriers to trade while he ratchets up domestic production. By creating many problems for Renault, which built a billion-dollar facility in Iran, his government has discouraged new foreign investment.[10] Even if the Islamic Republic were to change its foreign policy direction, its reputation as a high-risk place to do business would remain.

There has been an economic boom inside Iran, but this has been based upon profligate but finite government spending. For the period 2003-07, the International Monetary Fund (IMF) projects that if oil prices remain at their present high level, real GDP will grow 5.9 percent annually on average, while it forecasts that if the oil price declines to $30 per barrel, real GDP can grow at 5 percent annually thereafter.[11] In other words, the oil windfall is expected to result in less than 1 percent more growth per annum. Despite the flood of oil money, government policies are such that the IMF warns the Iranian budget will fall back into deficit within two years even if oil prices remain high.[12]

Iranian government spending has led to several years of growth, but it has barely dented the country’s long-term economic problems. While reported unemployment fell last year to an 8-year low of 10.3 percent, job creation remains insufficient to absorb the 700,000 young people entering the job market each year.[13] The IMF forecasts that even if oil prices remain at their present high level, unemployment will increase.[14] In its 2003 report, the usually understated World Bank summed up the “daunting unemployment challenge” with strong words: “Unless the country moves quickly to a faster path of growth with employment, discontent and disenchantment could threaten its economic, social, and political system.”[15]

Economic frustration feeds social problems. The Iranian government acknowledges that two million people—or 2.9 percent of the population—use narcotics; other estimates place the number at five to six million.[16] Divorce is also on the rise; one study found that 30 percent of newlyweds get divorced within three years.[17] The poor economy is also driving prostitution. While officials estimate Iran hosts 300,000 prostitutes,[18] there have been a number of corruption scandals involving judges and government social workers involved in procuring young girls.[19] Instead of enacting reforms to encourage job creation, the political elite is more comfortable with rising emigration rates, despite the brain drain’s long-term erosion of Iran’s economic vibrancy.

International economic pressure could amplify unease within the Iranian business community. Iranian authorities acknowledge as much. “The [Tehran] stock market has shown to be hypersensitive to political issues (such as the course of the nuclear enrichment negotiations), as well as domestic economic policy uncertainties,” writes the state-owned Karafarin Bank in its Survey of the Iranian Economy for October-December 2005. In 2005, the stock market index fell 26 percent. At the same time, the banking system was hit by a crisis from dishonored promissory notes, primarily by big firms unable to pay their debts.[20]

So how might the international community increase economic pressure? Western governments could pressure foreign firms to reduce their presence in Iran. There has been some success in this regard. Strict U.S. Treasury application of existing rules about fund transfers—such as those to prevent transfer of funds to terrorists and weapons of mass destruction proliferators—led the two largest Swiss banks (UBS and Credit Swiss) and a large British bank (HSBC) to stop taking new business in Iran.[21] Karafarin Bank’s recent survey acknowledged the vulnerability:

U.S. officials can also apply pressure to charities in the United States—especially the Alavi Foundation with its many millions of dollars in assets—which work closely with Iranian hard-liners.

Washington can amplify pressure further by working with its allies to apply more vigorously existing restrictions on financial transactions and trade with Tehran. U.N. Security Council resolutions 1373 and 1540 call on countries to adopt and enforce effective controls on funds and services that contribute to terrorism and weapons of mass destruction proliferation respectively.[23]

The State Department might approach countries to ask how they are implementing these resolutions, especially in light of the International Atomic Energy Agency (IAEA) finding that Iran has violated its safeguards agreements.[24] The U.S. Treasury Department’s Office of Foreign Assets Control and equivalent European departments could warn industrial firms about dual use items which could be diverted from their declared peaceful intentions to be used instead in the nuclear program. Banks can be cautioned about negative publicity as well as regulatory complications if they facilitate shady businesses.

European governments excel at using quiet warnings, which can be very effective at persuading firms that the Iranian market is not worth the risks; indeed, a number of European governments seem to be passing such warnings already. The U.S. Treasury has well-oiled machinery to implement restrictions, and its warnings to banks can be particularly effective since few banks in the world are willing to risk being cut off from dealings with the U.S. financial system. That same pressure could be exerted on firms considering investments in the Iranian oil and gas industry.

De facto sanctions have advantages over formal U.N. sanctions. Russia and China have no veto over tightening restrictions. In the best of cases, obtaining U.N. Security Council consensus for action takes a long time whereas tightening restrictions can be done quickly. Action by the Security Council provides Ahmadinejad with a banner around which he can rally nationalist reaction, but tighter restrictions operate under the public’s radar screen while their impact is felt by the business community which, in Iran, means the revolutionary elite that exerts as much control over the economy as it does the political system.

Many former U.S. officials and policy analysts have argued that rather than pressure Iran via economic sanctions, Washington could better influence Iranian behavior by offering Tehran incentives. Madeleine Albright, Richard Haass, and a number of influential policy makers have made public statements encouraging the Bush administration to engage in dialogue with the Iranian regime.[25] Both Moscow and Beijing adopt similar logic.[26]

Such inducements will not lead Iran’s leaders to change their nuclear program and, indeed, could backfire if they reinforce the view of some Iranian policymakers that their tough stance works. Economic inducements look like bribes paid for bad behavior. They make intransigence more profitable than good behavior. Inducements may also undercut desired internal reforms. Under Muhammad Khatami’s administration (1997-2005), self-described reformists could not secure a trade agreement with Europe or substantial U.S. rapprochement. If anti-Western hard-liners achieve those objectives, it suggests that the Islamic Republic should be confrontational rather than cooperative.

Many senior officials and policymakers in both the United States and Europe suggest that the West cannot apply significant economic pressure because Tehran has too much leverage over oil supplies. They argue that were Iran to cut off its oil exports of 2.5 million barrels per day, the West might have no choice but to mitigate its pressure against Iran’s nuclear program.

Perhaps—but perhaps not. Firstly, there is no evidence that the Iranian government has been able to use its oil to influence other countries to turn a blind eye to its nuclear violations. Secondly, even if Tehran did throw its oil weight around, it could not do so for long. Production outside of the Organization of Petroleum Exporting Countries (OPEC) is increasing, in part in response to the stimulus of high prices, and the return of Hurricane Katrina-damaged facilities will only add to the higher output.[27] Despite the red-hot Chinese and Indian economies, world demand is growing more slowly as price influences consumption. It was the experience after both the 1973-74 and 1980-81 price increases that, within four years, the oil market softened. Iran’s strategic leverage regarding oil may well decline with time.

In April 2006, world oil production was one million barrels per day higher than demand according to the prestigious Petroleum Intelligence Weekly. OPEC countries had excess production capacity of about 1.5 million barrels per day.[28] Further, the world refinery situation is changing so that heavier Saudi crude oils can be more readily absorbed whereas before, refineries were unable to take advantage of low Saudi prices because they simply could not refine its heavy crude. These two factors alone more than offset any potential cutoff of Iranian oil exports.

What about Iran’s threats to disrupt oil shipments from the Persian Gulf? On June 4, 2006, Khamene’i warned, “If the Americans make a wrong move toward Iran, the shipment of energy will definitely face danger, and the Americans would not be able to protect energy supply in the region.”[29] The Iranians have persuaded themselves that they have this capability. Ali-Ashgar Kazemi, a retired Iranian admiral now a political science professor at Tehran University, said, “Iranians are preparing for guerilla war at sea ... In an enclosed, narrow, and rather shallow region such as the Persian Gulf, this tactic can be very decisive against large units and can deny the enemy from effective deployment, sea lines of communication, and power projection.”[30] Such a threat demonstrates Iran’s ambitions: it wants to be a regional power whose wishes are accommodated by its neighbors. Defense News writer Riad Khawaji warned, “Iran could sortie nearly 400 small, high-speed craft armed with rocket launchers, torpedoes, and mines.”[31]

But the Iranian government cannot cut off oil exports without considerable harm to its economy. The Iranian government relies on oil revenue to fund 75 percent of its expenditures. While Iran’s foreign exchange reserves would cushion the impact, those reserves could only pay for a year’s imports.[32]

Perhaps Iran’s most immediate vulnerability is its dependence on imported gasoline, which provides about 40 percent of the 350,000 barrels of gasoline sold daily.[33] This vulnerability may be less than meets the eye. The price of gasoline at the pump is 800 rials per liter, or about 35 cents a gallon. Such a cheap price encourages gasoline smuggling to neighboring countries where gasoline prices are more than ten times higher and leads the Iranian government to hemorrhage revenue. Customer payment does not even cover the cost of fuel distribution. The Iranian government is, however, preparing. It is well along with gasoline ration plans to allow a quick response in the event of a gasoline import cutoff. Nevertheless, oil rationing remains politically unpopular.[34]

Economic instruments alone are unlikely to persuade the Islamic Republic to freeze its nuclear program. The principal levers of power in Iran are in the hands of revolutionaries who are not motivated primarily by economic concerns. Those who care about the state of the economy do not have sufficient influence to persuade the real power-holders to change policies. Success at influencing Iranian policy is more likely if the economic front is combined with other actions.

The security apparatus—especially the Revolutionary Guards—need to understand that their current nuclear policies are threatening the viability of the Islamic Revolution. If the Iranian leadership makes the Persian Gulf more dangerous, then the United States and other powers will deploy more powerful military assets to the region. Further, if the Iranian government develops nuclear weapons, it could start an arms race which culminates in a nuclear Turkey and Saudi Arabia. Both countries are richer and have better ties to the world’s principle arms suppliers.

Much more appropriate would be security inducements. Policymakers should design security inducements to counter the argument that Iran needs nuclear weapons for its defense. There are many arms control measures that would provide better security for both Iran and the West such as an agreement to reduce the risk of incidents at sea between the U.S. and Iranian navies.

Iranian officials also suspect that the Bush administration remains committed to regime change in Iran and that Washington may use force to that end. Such complaints sound peculiar coming from an Iranian government that sponsored a conference on October 26, 2005, on the theme, “The World without Zionism and America,” and a regime which leads chants of “Death to America” at mass demonstrations.

It would be inappropriate for the U.S. government to offer any security guarantees to the Iranian or any other government; what government is in power is up to the people of that country to decide. But what Washington could offer Tehran would be a more conditional security assurance: “We will not attack you if you do not attack us.” The Bush administration could further clarify to the Iranian leadership that Washington will gauge its spending on media broadcasts to Tehran’s own, and likewise, calibrate its trade to Tehran’s own boycotts and restrictions.

Washington should at the same time augment security pressure on Iran. The U.S. government should step up its already considerable efforts to deter and contain Iran. The Pentagon has actively supported ballistic missile defenses in Israel, and Washington is promoting missile defenses in Europe for the same purpose.

If the White House wants to grab Tehran’s attention more actively, it might reinforce NATO’s commitment to the defense of Turkey from threats to the east. This commitment became murky after pre-Iraq war disagreements about NATO deployments to Turkey.[35] This is necessary because a nuclear-armed Iran could with impunity return to sponsoring Kurdistan Workers Party (Partiya Karkerên Kurdistan, PKK) terrorists or again support armed Islamists opposing Turkish secularism. It would be helpful if European Union members promoted such NATO planning for, if the accession talks succeed, the EU will have a three-hundred mile border with Iran. Strengthening trans-Atlantic cooperation about the Iranian threat would be a good way to point out to Iran how their nuclear activities are driving the United States and Europe together to oppose Iranian dreams of being the regional superpower over the objections of their neighbors.

A second area for more active steps now would be in the defense of shipping in the Strait of Hormuz and the southern Persian Gulf. There is ample recent precedent for assembling a coalition to defend Persian Gulf waters. A January 2004 Proliferation Security Initiative exercise, Sea Saber, tracked a dummy proliferation shipment from the northern Persian Gulf through the Strait of Hormuz to the north Arabian Sea. Participants included the United States, Great Britain, Canada, France, Spain, Italy, Netherlands, Japan, and Australia, with observers from Denmark, Germany, Poland, Turkey, and Portugal.[36]

In addition, beginning in October 2001, Task Force 151 has patrolled the Persian Gulf and Arabian Sea querying over one thousand ships a month and boarding more than twenty-five each month with ships from the United States, Great Britain, Canada, France, Italy, Greece, and New Zealand. Were a similar force to be assembled—or even just an exercise announced—to protect Persian Gulf shipping from mine and missile threats, Iranian officials would learn that their bellicose statements were cementing a coalition against them.

Lastly, given Iran’s threats to Persian Gulf shipping, Washington might, through public statements, display its commitment to the defense of the Strait of Hormuz. It might put on view its plans to deploy in the strait the new littoral combat ships, the first of which is due to enter service soon with advanced mine countermeasure capabilities, including unmanned underwater vehicles. It would be useful for the State Department to urge other maritime powers and the Persian Gulf states to demonstrate, in deeds and not just words, their commitment to the defense of this vital sea lane of communication. Iran needs to be told in no uncertain terms that threats to the Strait of Hormuz will be met by a massive and broad international effort.

At the end of the day, diplomacy may not be enough. The best explanation about why force has to remain an option comes from the IAEA director general Mohamed ElBaradei, who, on January 23, 2006, said “Diplomacy has to be backed up by pressure and, in extreme case, by force. We have rules. We have to do everything possible to uphold the rules through conviction. If not, then you impose them. Of course, this has to be the last resort, but sometimes you have to do it.”[37]

To be sure, preemptive military force would be a highly undesirable option—but it would be less undesirable than the alternative, which could be both nuclear weapons in the hands of ideological hard-liners bent on confrontation and a nuclear arms race across the Middle East.

That said, it would be premature to write off the prospects for a diplomatic resolution of the crisis. If the United States and its allies can effectively demonstrate that Iran is paying a high price for its confrontational stance, the cautious instincts of Khamene’i and many Iranian leaders could lead them to freeze the overt conversion and enrichment programs, regardless of Ahmadinejad’s attitude. While Iran would almost certainly continue with covert activities, the need to keep those hidden would slow development. In this case, delay could be victory, because the long-term prospects for the Islamic Republic look poor: it has done a miserable job of winning the hearts and minds of young Iranians and, meanwhile, social and regional developments suggest more pressure for democratic governance.[38]

[1] See Shai Feldman, Israel Nuclear Deterrence (New York: Columbia University Press, 1983).
[2] See Stephen Cohen, The Idea of Pakistan (Washington, D.C.: Brookings Institution, 2004).
[3] Mustafa Kibaroğlu, “Good for the Shah, Banned for the Mullahs: The West and Iran’s Quest for Nuclear Power,” The Middle East Journal, Spring 2006, pp. 207-34.
[4] Unless otherwise noted, economic data comes from the most recent International Monetary Fund (IMF) reports about Iran: Islamic Republic of Iran: 2005 Article IV Consultation, International Monetary Fund Country Report 06/154, Apr. 2006, (hereafter: Article IV Consultation); Islamic Republic of Iran: Statistical Appendix, International Monetary Fund Country Report 06/129, Apr. 2006.
[5] Mehdi Khalaji, “Perils and Promise of U.S.-Iranian Negotiations,” Policywatch, no. 1101, The Washington Institute for Near East Policy, May 10, 2006.
[6] The New York Times, Sept. 11, 2006.
[7] Interviews with Mehdi Khalaji, The Washington Institute for Near East Policy, who studied in Qom seminaries for fourteen years, Sept. 2006.
[8] Wilfried Buchta, Who Rules Iran: The Structure of Power in the Islamic Republic (Washington, D.C.: The Washington Institute for Near East Policy and Konrad Adenauer Stifung, 2000), p. 46.
[9] Iran: Medium Term Framework for Transition: Converting Oil Wealth to Development—A Country Economic Memorandum, Report 25848-IRN, World Bank, Apr. 30, 2003, (hereafter: Converting Oil Wealth to Development), p. 13.
[10] Iran Times (Washington, D.C.), June 2, 2006.
[11] Article IV Consultation, p. 24.
[12] Ibid., p. 15.
[13] Ibid., p. 31.
[14] Ibid.
[15] Converting Oil to Development, p. ii.
[16] Radio Free Europe/Radio Liberty, Dec. 3, 2003.
[17] Sussan Tahmasebi, “Moving Forward: Prospects for Iranian Youth in the Post-Reform Period,” in Post-Khatami Iran (Washington, D.C.: Woodrow Wilson Center Press, 2000), pp. 10-2.
[18] Islamic Republic News Agency, Dec. 7, 2002.
[19] Islamic Republic News Agency, July 14, 2001.
[20] Survey of the Iranian Economy, Oct.-Dec. 21, 2005, Karafarin Bank, Tehran, p. 8.
[21] Ibid., p. 15.
[22] Ibid., p. 13.
[23] “Threats to International Peace and Security Caused by Terrorist Acts,” U.N. Security Council resolution 1373, Sept. 28, 2001; “Non-proliferation of Weapons of Mass Destruction,” U.N. Security Council resolution 1540, Apr. 28, 2004.
[24] “Implementation of the NPT Safeguards Agreement in the Islamic Republic of Iran,” IAEA, Sept. 24, 2005.
[25] For example, see The Washington Post, May 11, 2006.
[26] The Washington Post, Mar. 8, 2006.
[27] Petroleum Intelligence Weekly (New York), Mar. 13, 2006.
[28] Petroleum Intelligence Weekly, June 5, 2006.
[29] Jomhuri-ye Islami (Tehran), June 6, 2006.
[30] Defense News (Springfield, Va.), May 8, 2006.
[31] Defense News, May 8, 2006.
[32] Article IV Consultation, p. 24.
[33] Islamic Republic of Iran: Statistical Appendix, pp. 13-4.
[34] Radio Free Europe/Radio Liberty, Aug. 7, 2006.
[35] Sebnem Udum, “Turkey’s Position in the Iraq Operation: Bridge or Barrier?” Center for Nonproliferation Studies, Washington, D.C., Mar. 26, 2003.
[36] Patrick Clawson, “Iran’s Motives and Strategies: The Role of the Economy,” testimony before the U.S. Senate Committee on Foreign Relations, May 17, 2006 .
[37] Mohammed ElBaradei, interview, Newsweek, Jan. 23, 2006.
[38] Mohsen Sazegara, “The Point of No Return: Iran’s Path to Democracy,” Policy Focus, no. 54, The Washington Institute for Near East Policy, Apr. 2006.