The political economy of petro-dollar recycling in Iran and Saudi Arabia in the 1970s

This paper seeks to explain why Iran and Saudi Arabia behaved differently in the 1970s in terms of saving their petrodollars abroad. It relates the policy divergence between the two countries to the contrasting pattern of institutional and economic development that they had been undergoing since they first began to receive oil revenues at large scales in the early 1950s. With the inflow of oil revenues after 1953, the political elite in Iran (the Shah) decided to (a) build technocratic policymaking institutions and (b) promote structural transformation in the economy. These earlier decisions, which were continuously followed throughout the 1950s and 1960s, resulted in rapid industrialisation of the economy, which in turn, strengthened the Shah’s political power. As a result, when the 1973 oil boom occurred, the Pahlavi regime had the institutional capacity and, more importantly, the political motivation to spend all the proceeding oil revenues on a “Big-Push” industrialisation at home. In contrast, upon receiving oil revenues at large magnitudes after 1950, the political elite in Saudi Arabia chose to (a) build a patrimonial and divided bureaucracy, where each ministry or agency was given to a prince and (b) narrowly focus economic policy on building infrastructure. These earlier decisions, which were practiced throughout the 1950s and 1960s, impeded the development of public administration in Saudi Arabia and kept the economy highly undiversified. As a result, at the time of the 1973 boom, the state had a weak institutional capacity for domestic spending and the economy offered limited opportunities for development. Thus, the elite had no option but to save a large portion of the proceeding petrodollars abroad. In terms of theoretical contribution, this paper shows that, once an economic policy is chosen by a petro-state, then that policy produces certain economic and political effects that can potentially shape the future policy choices of that petro-state. This paper, therefore, introduces the element of path dependency and dynamic analysis into the study of petrostates.

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Introduction

The 1973 oil boom is considered as the mother of all “oil shocks” due to the colossal size of revenues it generated for oil producers. This boom provided large windfall revenues for Iran and Saudi Arabia as the two leading oil exporters in the world. Importantly however, these countries used their oil proceedings in completely different ways; Saudi Arabia recycled a large part of her petrodollars to Western countries while Iran spent almost all of her oil revenues domestically. This policy divergence had a major impact on the economic and political trajectories of the two countries in the late 1970s, when the recession in the West reduced the demand for oil and decreased the fiscal revenues of the two countries. At that time, Saudi Arabia’s large foreign savings provided the country with considerable investment income and reserves, while Iran lacked such a financial cushion. Due to lack of fiscal savings, Iran was forced to undergo a painful fiscal adjustment at the end of 1977, which led to a drastic slowdown in economic growth. This growth decline, in turn, fuelled the political protests against the Pahlavi regime and pave the way for the 1979 Revolution. Using process tracing (i.e. analytical narrative), this paper argues that the contrasting economic behavior of Saudi Arabia and Iran in the 1970s stemmed from the different pattern of institution building and economic development that these two countries had been undergoing since the early 1950s, when they first began to receive oil revenues at large scales.

Since the early 1950s, due to its developmentalist ideology and centralised internal power structure, the Pahlavi regime had been building a cohesive and technocratic policymaking machinery and had been following an active economic diversification strategy. Therefore, by the time of the 1973 oil boom, Iran had a technically developed public bureaucracy and a relatively diversified economy with various interest groups. These factors increased the Page 2 of 32

demand among the political and business elite for massive increases in domestic spending. In contrast, because of its conservative ideology and decentralized power structure, the Saudi state had been building a patrimonial and fragmented public bureaucracy since the early 1950s and had confined its economic policy on infrastructure development (hence following no economic diversification strategy). As a result, by 1973, Saudi Arabia had an underdeveloped public bureaucracy with a low technical capacity for spending and a highly undiversified economy that offered very limited opportunities for domestic investment. These factors left the Saudi elite with no choice but to save a large part of their proceeding oil revenues. This analysis suggests that petro-states tend to exhibit path dependent behavior in a sense that their earlier policy and institutional choices generate certain reinforcing economic and political effects which, in turn, shape their subsequent choices.

This paper is organized as follow: section one highlights the logic behind choosing Iran and Saudi Arabia for comparison. Section two identifies the gap that this research aims to fill in the literature and sets out the methodology used in the paper. Sections three compares and contrasts the pattern of institution building and economic development in Iran and Saudi Arabia between 1950 and 1972. Then section four shows how these previous patterns shaped the behavior of the two countries after 1973.

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1. Comparing two similar cases with different policy choices The comparison of Iran and Saudi Arabia in this paper is theoretically informed by the resource curse literature. This literature is now concerned with explaining the wide policy and growth variation witnessed among resource-abundance countries (Torvik, 2009; Rosser, 2007). In this paper we compare two oil-abundant countries that adopted radically different policies in the 1970s. Such a small-N comparison allows us to “dig deep” and find potential factors that lead to policy divergence and growth variation across oil-rich countries.

Between 1973 and 1978, Iran and Saudi Arabia followed completely different paths from each other in terms of their saving their petrodollars abroad and oil price setting in OPEC. Regarding oil price setting, Iran constantly south to push the oil prices up in the 1970s by adopting a very hawkish stance in OPEC. This strategy resulted in the Tehran oil agreement of 1971 and more crucially, the second round of price increases in December 1973 (following the Arab oil embargo in October 1973). In contrast, Saudi elite followed a very moderate stance in OPEC and advocated price restraint all along (Skeet, 1991). They perceived any drastic price increase as detrimental for their long-term market share in the global oil market (ibid). Even in the case of October embargo, they had no intention of permanently increasing oil prices; as revealed by historians, they devised that embargo only as a temporary measure to exert diplomatic pressure on Israel’s allies in the West (Skeet, 1991, Cooper, 2011). However, Iran capitalised on the Arab oil embargo and lobbied OPEC members to keep the oil prices permanently high, thereby instigating the 1973 boom.

After the boom, Saudi Arabia saved a considerable proportion of its oil revenues abroad in the form of portfolio investments (i.e. bonds and stocks) by running a large budget surplus while Iran saved very little of its oil revenues (table 1). This policy divergence, in turn, Page 4 of 32

produced a large gap between the investment incomes of the two countries between 1973 and 1978 (table 2). As indicated in figure 1, Saudi Arabia’s investment income, in time, turned into a major source of foreign exchange, even becoming comparable to her oil revenues. This income source later helped the Saudi regime when the oil prices dropped in the mid-1980s. In contrast, the lack of major foreign investment by Iran in the early 1970s kept the Pahlavi state increasingly reliant on oil revenues and, in consequence, made it vulnerable to any price drop (or strikes in the oil industry) in the late 1970s.

Other than saving their petrodollars abroad, the Saudi royal family also recycled a considerable portion of their oil revenues in the form of aid to developing countries, while Iran refrained from doing so. Between 1974 and 1978, the total aid outflows from Saudi Arabia accounted for 6.4% of GDP in contrast to 0.5% of GDP in Iran (Amouzegar, 2001). Again, this difference shows that Saudi Arabia was more committed to the recycling of oil revenues than Iran.

This paper seeks to offer a novel explanation for the policy differences listed above. Scholars often relate these policy divergences to the different factor endowments of the two countries (ibid). For instance, they point out that size of the boom was much bigger in Saudi Arabia ($5,000 per capita) than Iran ($625 per capita); therefore, as a capital abundant country with a small population, Saudi Arabia naturally saved large portion of its oil revenues while Iran refrained to do so. However, the main flaw of this argument is that it naively assumes that when the political rulers receive windfall revenues, they have an incentive to follow the optimal economic policy, which in this case entailed saving surplus oil revenues. But this argument does not clarify why the political elite should have this incentive in the first place; if anything, large windfall rents should encourage rent seeking and budget maximisation Page 5 of 32

among actors who are operating inside or outside the state (Olson, 1982, 1965). As a defence, advocates of the explanation mention above point out that that the Saudi policymakers were wary of the dangers of spending beyond “the absorptive capacity” of their economy and, therefore, they had an incentive not to inject all the oil revenues domestically. However, the empirical evidence refutes this claim because, as described by Mallakh (1982), the Saudi policymakers spent well beyond the absorptive capacity of their economy in the 1970s anyway. The total expenditures of the government massively increased in 1973 and 1974 (figure 2) and, like Iran, this massive fiscal expansion led to severe bottlenecks in ports, roads and manpower (Nilbock & Malik, 2007). This outcome is inconsistent with the supposed concern of the Saudi elite for the limited absorptive capacity of their economy. Alternatively, this research goes beyond the reductionist economic explanation reviewed above and relates the policy divergence between Saudi Arabia and Iran to their contrasting path of institutional and economic development since the early 1950s.

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2. Literature review and research methodology

The main contribution of this paper is to the political economy of oil, particularly to the “resource curse” literature. Initially, this literature treated oil as an unconditional curse for economic growth. However, this deterministic framework was empirically inconsistent with the large variation in growth performances witnessed across resource-rich countries (Mohades & Pesaran, 2013, Torvik, 2009, Brunnschweiler, 2009, Lederman & Maloney, 2007). It is now established that the resource curse can be easily avoided by choosing appropriate economic policies, especially by following prudent fiscal, monetary and exchange rate policies during commodity booms. Now, the pressing political economy issue is to find out why some resource-rich countries have been better than others in responding to the booms. This paper lies within this strand of the literature as it seeks to explain why Saudi Arabia and Iran chose opposite policies in the 1970s. As a theoretical contribution, it employs the concept of “path dependency” (Pierson, 2004) to explain the policy divergence between the two countries. Here, path dependency means that once a development policy is chosen by a petro-state, then that the policy generates certain economic and political effects that can possibly shape the future policy choices of that state. Therefore, this paper offers a dynamic explanation for the economic behavior of petro-states.

In terms of research approach, this paper employed the historical method and engaged with a wide variety of primary and secondary sources to uncover the politics of policymaking in the two countries. In the case of Iran, these sources include:

(a) The UK Foreign Office and Foreign and Commonwealth Office archival documents between 1963 and 1977, referred to as FO or FCO in the text. Page 7 of 32

(b) Central Bank of Iran’s Bulletins (CBB) between 1963 and 1977. This source includes speeches given by major policymakers at the Central Bank.

(c) US Foreign Relations documents on Iran from 1960 to 1977. These documents, which are referred to as FRUS (Foreign Relations of the United States) in the text, gather the correspondence between the State Department and US embassies in Iran concerning the political and economic matters, including macroeconomic policymaking.

(C) Oral History Collections gathered by Harvard University and Foundation for Iranian Studies, respectively referred to as IOHCHU and OHCFIS in the text.

(d) A series of unstructured interviews conducted with several high-ranking officials: 1. Dr Khodadad Farmanfarmaian 2. Dr Alinaghi Alikhani 3. Dr Abdolmadjid Majidi 4. Dr Gholamreza Moghadam 5. Mr Farokh Najmabadi 6. Dr Hasanali Mehran 7. Dr Firouz Vakil. These individuals were at the heart of economic policymaking in Iran, holding governorship, ministerial or sub-ministerial positions in the Central Bank, Planning and Budget Organisation and Ministry of Economy. In addition, Professor Hashem Pesaran, who headed the Central Bank’s Research Department, were interviewed.

In the case of Saudi Arabia, the paper relied on:

(a) The annual reports published by Saudi Authority Monetary Agency (SAMA) between 1964 and 1978.

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(b) The World Bank policy documents for the 1970-1978 period. These documents reflected the views of foreign advisors regarding the policy choices in Saudi Arabia.

(c) Secondary sources, particularly Hertog (2010, 2007), Mallakh (1982) and Niblock and Malik (2007). These studies primarily focus on the political economy of development in Saudi Arabia.

The arguments put forward in the paper are the outcome of careful cross-examination of these sources with each other. This method provides high empirical richness to the proposed theoretical claims.

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3. Oil inflows and initial policy and institutional choices in the 1950s

The early 1950s represents a “critical juncture” in the history of Saudi Arabia and Iran because during this time these two countries started to receive oil revenues at massive scales for the first time. To be sure, both countries had discovered oil in the early 20th century, but the magnitude of oil revenues was not very large until 1950 due to the unfavorable sharing agreements with foreign oil companies and the steady global demand for petroleum1. This section focuses on the choices made by Iranian and Saudi elite at the time when oil revenues first began to flow into their country at large scales and shows how these choices shaped the subsequent trajectory of institutional and economic development in the two countries.

3.1. Iran The oil revenues first began to flow into Iran at large magnitudes in the aftermath of 1953 coup in Iran, when a new 50-50 profit sharing agreement was signed with a consortium of foreign oil companies. At that time, the newly installed Pahlavi regime had the following attributes: it had a centralised power structure where all the power was monopolised in the hands of the Shah and a developmentalist ideology that favored promoting economic growth and “catch-up” industrialisation. Also, in terms of social structure, three classes were active in the economy: the landlords, the merchants and a new-born industrialist class (which had been slowly emerging since the Reza Shah’s period). This political and economic condition provided a suitable structural environment for the Shah to embark on a “catch-up”, in line with his developmentalist ideology.

1 Saudi Arabia and Iran signed 50-50 profit sharing agreements with foreign oil companies in 1950 and 1954 respectively. Page 10 of 32

As a result, he engaged in building technocratic policymaking institutions that could kickstart the state-led industrialisation project. Accordingly, he supported the creation of a competent and technocratic planning institution called the Plan Organisation with the technical and financial support of the US. The task of this institution was not only to invest in infrastructure but also promote structural transformation in the economy. Additionally, the Industrial and Mining Bank of Iran (IMDBI) was formed with the support of the World bank and the domestic industrialists to foster the process of industrialisation. Although this process of technocratic institution building was only limited to some parts of the public bureaucracy, it still represented a significant move towards rationalisation of economic policymaking.

In short, with the inflow of oil revenues after 1953, the Shah made two important choices: (a) building the preliminary institutional infrastructure for technocratic economic policymaking and (b) following an economic diversification policy (beside investing in infrastructure). These choices paved the way for implementation of the Second Development Plan (1956-1962).

3.1.1. Negative external shock (balance of payment crisis)

However, the Second Development Plan was implemented in the absence of effective macroeconomic policymaking institutions. For instance, in the realm of monetary policy, the country had no functioning central bank that could discipline the banking sector. This institutional weakness led to uncontrolled monetary expansion and accumulation of foreign debt, which eventually culminated in a balance of payment crisis in 1959 (ibid). The trigger for this crisis was the decision of foreign oil companies (Esso in particular) to reduce oil prices by 14 cents from $1.90 to $1.76 (Skeet, 1991). This crisis, which led to an IMF bailPage 11 of 32

out and imposition of a harsh austerity package, plunged Iran into economic and political instability between 1960 and 1962. Influenced by “declining terms of trade” hypothesis, the Shah and the technocrats associated the crisis with Iran’s excessive reliance on oil exports and her dependence on foreign petroleum companies (FO 371.172359, 1963). This interpretation made the Shah more determined than before to diversify Iran’s economy from oil through promoting “catch-up” industrialisation, hence materializing his developmentalist vision. For this purpose, he engaged in further institutional reforms, which entailed putting in place a cohesive technocratic policymaking body that could promote economic diversification more effectively. This institutional body was comprised of the Ministry of Economy, the Central Bank and Plan Organisation. Accordingly, the Pahlavi regime initiated a policy of import-substitution industrialisation (ISI) from 1963 in alliance with the nascent industrialist class.

It is important to add that the existing domestic political and economic conditions were conducive for such a policy decision. The Shah had already nurtured the rise of a young technocratic elite who could design a coherent economic plan and at the same time, the economy possessed a certain degree of diversity and industrial development that was necessary for technological learning (table 3).

3.1.2. The pursuit of ISI (1963-1972) In 1963, the Pahlavi regime embarked on the Third Five-Year Development Plan (19631967), which focused on development of consumer goods industries (the first stage of ISI). To encouraged private investment in these industries, the government offered cheap credit, tax breaks and tariff protection to big businesses. At the same time, it helped finance the import of needed machinery and intermediate components for these industries out of Page 12 of 32

petrodollars. During the course of this plan, Iran constantly pressed the foreign petroleum companies to increase her oil production and royalty (FCO 17/351, 1967). In parallel to this unilateral bargaining, Iran formed OPEC together with the other leading oil-producers to exert multilateral pressure on oil companies. Overall, thanks to the steady increasing oil revenues and effective economic management, the Third Plan generated a high rate of industrial growth2 (11%).

The political effects of ISI The initial economic success of ISI had important political effects. Firstly, it generated political stability and allowed the Shah to maintain his full grip on power. Secondly, it strengthened the developmentlist discourse of the regime and increased the reliance of the elite on rapid economic growth as their main source of legitimacy. Finally, and more importantly, it encouraged the US administration to reconsider the nature of its relationship with Iran. Back in the 1950s and early 1960s, the US treated the Pahlavi state as one of its typical “client states” in the Cold War (Alvandi, 2014). However, the remarkable success of the Third plan changed Pahlavi’s image in Washington; in fact, by the end of the Third Plan, Iran was praised as a development success story by the World Bank and Washington (Popp, 2011). According to Rostow’s assessment in 1968, Iran was at the “point on the development ladder where the “take off” is just about finished and the nation is beginning to diffuse its resources and technology into a broad range of new industries” (Saunders, FRUS, 1968a). Similarly, Johnson praised the Shah for his effective economic leadership by mentioning that 2 This high rate of industrial growth, however, is not surprising given that the first stage of ISI is easy to implement. This is because development of consumer goods industries does not require large investments at the level of firm or government (pubic infrastructure) (Di John, 2009). In addition, scale economies and learning costs are relatively low in these industries and the government does not need to coordinate investment across different sectors (ibid). Page 13 of 32

“he did not know any country…where the leadership has been wiser or more effective. Some people talk about development. Some people do it” (Saunders, FRUS, 1968b). In effect, the US began to view Pahlavi state as a powerful partner in the Cold War that could potentially guarantee the security of Persian Gulf after the British withdrawal from that region in the late 1960s.

Combination of the political effects listed above motivated the Shah to start building intermediate and heavy industries such as steel and aluminum in the Fourth Development Plan (1968-1972), alongside promoting consumer goods industries. It was believed that this ISI deepening would not only reduce the import needs of the industrial sector in the future (FO 371/186690, 1966; CBB, No 49, 1965) but also direct the industrialisation program towards sectors that had high geopolitical importance. Naturally, this move towards heavy industries during the Fourth Plan put further pressure on Iran’s fiscal and current account balance (table 7) since it required massive imports of intermediate and capital goods and large upfront investments in infrastructure. These growing macroeconomic deficits encouraged the state to exert pressure on foreign petroleum companies to increase Iran’s revenues by rising oil prices. For this purpose, Iran started to mobilise support in OPEC to negotiate a new multilateral deal with the oil companies. In the end, these multilateral negotiations bore fruit under Iran’s leadership and led to “Tehran Agreement” in 1971. Under this agreement, the oil companies agreed to a 55% tax rate on their profits, an immediate raise of oil prices by 35 cents to $2.15 a barrel and further successive price increases in the future (Skeet, 1991). This agreement, which marked OPEC’s first major victory against the oil companies, lifted Iran’s position among oil-producing nations. As a result of this agreement, Iran’s oil revenues jumped by 60% in 1971, relieving pressures on the balance of

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payments (Mehran, 2013). This financial boost enabled the policymakers to successfully implement the fourth plan and again achieve an impressive rate of industrial growth (13%).

Again, this economic success had positive spillover effects on Iran’s domestic political stability and foreign relations with the US. Impressed by Iran’s industrial growth, the US administration (under Nixon) became increasingly supportive of the Shah and helped him gain military supremacy in the Persian Gulf (Alvandi, 2014). The success of the fourth plan also encouraged the Shah to tie the legitimacy of his rule to the ongoing industrialisation project more than before3. Combination of these political effects, in turn, increased the Shah’s desire to press the ISI process further towards heavy and capital good industries. It was believed this policy would reduce the import demands of the industrial sector in the future and help the county build strategic industries and, in effect, cement her geopolitical supremacy in the Gulf region.

The above analysis shows that once chosen, the ISI generated certain economic and political effects that encouraged the elite to constantly push for higher oil prices to use the proceeding petrodollars on ISI deepening. As will be explained in the next chapter, this growing desire for ISI deepening shaped Iran’s economic behavior after 1973.

3 Towards the end of the Fourth plan, the Shah declared that Iran’s rapid economic and social progress had become unstoppable. He firmly claimed in 1971 that Iran would become an industrial country within twelve years and famously envisioned an era of Great Civilisation for the country (Ansari, 2007). Page 15 of 32

3.2. Saudi Arabia The distinctive feature of the Saudi state is that it was established by a large tribal family. From the beginning, this large dynasty generated an intense internal competition for power within the state, especially among the sons of Abdul Aziz, the founder of Saudi Kingdom (Hertog, 2010). This dynastic politics, in turn, shaped the formation of the public bureaucracy as Abdul Aziz gave control of each public agency to specific factions among his sons, in effect, turning the institutions into personal “fiefdoms” of Saudi princes (ibid). This gave rise to a fragmented public bureaucracy within the state, which persisted until 1950, when the power was transferred to Saud, the second son of Abdul Aziz. The other important feature of the Saudi state was its conservative ideology; indeed, Wahhabi religion played a major role in state-formation and identity building in the country from the beginning.

The year 1950 marks a critical juncture for Saudi Kingdom as a new profit-sharing agreement was signed with Aramco and oil revenues started to flow into the country at unprecedented scale. Two possible options were then available for the political elite: keeping the fragmented public bureaucracy intact and follow limited economic change (infrastructure investment for instance) or engage in technocratic institution building and actively channel the oil revenues towards structural transformation. The latter option entailed changing the status quo inside the state and overhauling the existing institutional “fiefdoms”. However, Saud did not have the ideological preference nor the political power to embark on a major institutional reform and initiate late-development process. At the same time, there was no existing modern sector in the economy that could play an active role in technological learning and structural transformation; the Saudi economy was dominated by domestic trade and merchant capitalism. So due to these political and economic conditions the elite chose the following institutional and policy options: (a) the fragmented public bureaucracy was kept in place and Page 16 of 32

no planning agency was established to coordinate economic policymaking across ministries and (b) economic policy was narrowly confined to infrastructure building. As will be discussed, these initial decisions shaped the pattern of state-formation and economic development in the country during the 1950s and 1960s.

3.2.1. Negative external shock (balance of payment crisis)

With the growing oil revenues in the 1950s, the public bureaucracy continued to expand along its fragmented structure; as before, the control of each new ministry or agency was given to a prince. Naturally, this pattern of institution building impeded the rationalisation of public administration and made the coordination of development policy very difficult. In the absence of rational economic policymaking, the country struggled with growing fiscal deficit, foreign borrowing and corruption. Ultimately, this trend culminated in a balance of payment crisis in 1957 (Hertog, 2010). In response, the IMF bailed out the Kingdom and imposed an austerity package on the government that included fiscal cuts and import restrictions. This crisis led to transfer of power from Saud to Faisal, who was ideologically in favour of economic modernisation (Yizraeli, 1997).

After the crisis, a conflict emerged between the reformist and conservative factions of the family over the economic model that the kingdom should pursue in the future (ibid). On the one hand, the reformists, headed by Faisal, favoured a shift towards active intervention in the economy and lobbied for creation of a strong planning institution and administrative reforms in the ministries (Hertog, 2010, 2007). On the other hand, the conservative faction argued for the maintenance of the status quo and opposed any administrative change. In the end, to maintain the balance of power between different factions of the family, Faisal decided to Page 17 of 32

stick with the previous economic model of the Kingdom, which narrowly focused on infrastructure investment, and discard the idea of development planning and economic diversification (ibid). Nevertheless, the elite consensually agreed to empower policymaking institutions that were responsible for safeguarding economic stability such as the Saudi central bank (SAMA) to avoid the possibility of similar balance of payment crises in the future.

Other than political factors, the avoidance of a major institutional and policy overhaul after the crisis can also be related to the economic condition of the country. As shown in table 4, the economy was still dominated by oil and traditional services sectors and therefore, there was no modern private sector that could take part on technological learning and “catch-up” industrialisation.

3.2.2. Focusing on infrastructure building (1960-1972)

Continuing their previous development model, the Saudi state confided their economic policy on investment in infrastructure, mainly in roads, hospitals, schools, ports and dams (Niblock & Malik, 2007). Thanks to the growing oil revenues in the 1960s, the fiscal expenditures steadily grew from 2.1 billion riyals in 1960 to 13 billion riyals in 1972 with transport, communication, education and health accounting for the highest share of expenditures (30%) (Mallakh, 1982). As before, these expenditures were budgeted in the absence of a planning agency.

An important institutional problem surfaced during this period. Due to lack of technical capacity, the ministries were unable to spend a large share of their allocated development Page 18 of 32

expenditures (SAMA, 1972, 1970). This created “the problem of budgetary surplus”, which according to the central bank’s assessment stemmed from the “weakness of project execution machinery” (SAMA, 1964: p3). Many of the ministries lacked the necessary manpower and technical know-how to conducted project surveys and feasibility studies. Figure 3 highlights the wide gap between the allocation and actual development expenditures in the 1960s. This gap clearly indicates the low technical capacity of public administration in Saudi Arabia, which was the path dependent outcome of the decisions made earlier in the 1950s.

Nonetheless, the positive economic effects of growing oil revenues did offset the negative effects of the institutional problems in spending. Indeed, Saudi Arabia’s economy grew by 9% annually between 1960 and 1972 while inflation only averaged 2.6% (Niblock & Malik, 2007; WDI, 2015). Yet, the economy remained extremely reliant on oil revenues due to the absence of an active diversification strategy (tables 5 & 6). Given this overreliance on oil, the elite did not push for high oil prices in OPEC since such a policy would encourage oil supply from non-OPEC countries and jeopardise the country’s long-term economic survival by reducing its market share in the global energy market. Also, as pointed out, the country did not have the required institutional capacity to spend the inflowing petrodollars domestically anyway.

The political effects of the selected development model

The relative success of the chosen development model in achieving high rate of economic growth and ensuring economic stability during the 1960s strengthened the existing political order inside the state and allowed the Saudi princes to hold on to their personal institutional “fiefdoms” as before (Hertog, 2007). Also, the lack of technical capacity in fiscal spending Page 19 of 32

meant that the Kingdom had a surplus budget that it could spend on aid provision to neighboring Arab countries and, in this way, gain geopolitical influence in the Middle East region. This geopolitical strategy became more pronounced in the aftermath of the 1967 Arab-Israel war. Overall, these political effects encouraged the elite to stick to their chosen development model and confine their economic policy to infrastructure building. As will be shown, this policy pattern shaped the economic behavior of Saudi Arabia after 1973.

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4. Policy choices after 1973

This section discusses the policy divergence between Saudi Arabia and Iran after the 1973 oil boom. Firstly, it concentrates on how the oil boom was created in the first place. Then, it delves into macroeconomic policymaking in the two countries after the boom, paying particular attention to their fiscal policymaking.

4.1. Instigation of the 1973 oil boom The origins of the 1973 oil shock go back to the third Arab-Israel war in October 1973. In response to this war, the Gulf countries, headed by Saudi Arabia, raised their posted price of crude oil from $3.12 per barrel to $5.12 per barrel and placed an oil embargo on Israel’s allies including the US (Amouzegar, 2001). This embargo was devised as a temporary measure by Arab countries to induce a change in the international relations of the Middle East; these countries, especially Saudi Arabia, had no intention to permanently increase oil prices (Cooper, 2011; Skeet, 1991). Indeed, the Arab embargo was driven by geopolitical motives rather than economic ones. Importantly however, Iran saw the embargo as a good opportunity for permanently increasing oil prices in order to acquire sufficient funds to drive its ongoing ISI project forward and make a “Big Push” leap towards heavy and strategic industries. Adopting this hawkish oil stance, Iran sought to orchestrate a second round of price increase at the next OPEC meeting in Tehran. In that meeting, Iran proposed to increase oil prices to $17 per barrel. This proposal was based on the calculations made by OPEC’s Economic Commission Board regarding the “real cost of an alternative energy” (Amouzegar, 2001). Naturally, the Saudi elite were against this proposal since they believed that such a drastic price increase would create an economic downturn in rich countries and reduce the demand for oil in the future (Skeet, 1991). Zaki Yamani, the Saudi oil minister expressed this view in Page 21 of 32

the following way: “Saudi Arabia believes that rising oil prices at this time will reduce demand and consequently, weaken the relative position of the oil-producing countries because, clearly, increasing demand is the foundation of the latter’s ability to maintain price stability” (Afkhami, 2009: P282). Alternatively, Saudi Arabia came up with the proposal of $7 per barrel. However, thanks to Iran’s effective lobbying, the OPEC’s ministerial committee finally voted for $11.65 per barrel, which amounted to a drastic price increase from $5.12 (Skeet, 1991). This clearly indicates that the Shah’s ambition to instigate a “Big Push” industrial leap at home played a major role in generating the oil boom in the first place. The following remark by the “Financial Times” captures the Shah’s mood at the Tehran meeting (Graham, 1978: p1):

“It was a performance to match the occasion. On 23 December 1973, while the Ministers representing the Gulf members of OPEC were still in formal session, Mohammad Reza Pahlavi, Shah of Iran, called a press conference. His announcement was a staggering new increase in the price of oil. The Shah displayed his usual mannered polish but his tone had a new confidence- the confidence of a man who knew that his country’s financial resources had quadrupled in just over two months”. The above analysis shows that quadrupling of oil prices in 1973 was caused by respective actions taken by Saudi Arabia and Iran.

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4.2. Macroeconomic policymaking and oil price setting after the boom The quadrupling of oil prices in 1973 led to a massive transfer of wealth to OPEC countries and at the same time, created economic instability in Western countries. Alarmed by this situation, the US started to pressure the oil-producing countries to “recycle” their petrodollars to Western countries in order to counter-balance the negative effects of the shock on the global economy. This required oil-rich countries to invest their petrodollars, which were kept as short-term deposits in commercial banks, on long-term assets such as bonds and stocks.

Saudi Arabia responded positively to this demand because of two reasons. Firstly, the Saudi state lacked the institutional capacity needed for injecting all the windfall revenues domestically, as the elite had previously ruled out the creation of strong technocratic institutions. Secondly the domestic economy offered limited opportunities for investment, due to lack of diversification. Thirdly, and relatedly, as an overly oil-dependent country, the Saudi elite perceived their long-term economic prosperity as entangled with the economic stability of oil-consuming nations; accordingly, they believed that by recycling their petrodollars to Western countries, they could reduce the economic instability in these countries and therefore, pre-empt a fall in oil demand in the future. Due to these economic and political conditions, the elite decided to run large budget surpluses after the boom (table 1) and invest their savings in long-term assets, especially in the US treasury bonds4. Also, as 4 From 1974, Saudi Arabia entered into secret negotiations with the US regarding their petrodollar recycling (Spiro, 1999). During these negotiations, the Saudi royal family agreed to invest their oil surplus in US government bonds and Washington agreed to supply the Kingdom with arms and security training to help them catch up with Iran militarily (Cooper, 2011; Spiro, 1999). Accordingly, an agreement was signed between the US and Saudi Arabia on June 1974 announcing that “[they] are prepared to expand and give more concrete expression to cooperation in the field of economics …and in the supply of the Kingdom’s requirements for defensive purposes” (Spiro, 1999: p 107). Meanwhile, the US treasury made a secret offer to Saudi Arabia to sell treasury bonds at a discount price outside of the normal auctioning process (ibid). The details of this deal were finalised by 1975 and from then Page 23 of 32

before, they gave large sums of aid to Arab countries to increase their geopolitical influence in the Middle East. Finally, they continued to adopted a moderate oil pricing strategy in OPEC.

It is important to add that despite running large fiscal surpluses, the Saudi government still dramatically increased its domestic expenditures and loosened the monetary policy (figure 1). As before, the government strictly focused on investing in physical infrastructure and education and followed no active diversification strategy. Unsurprisingly, the massive fiscal expansion that accompanied the boom in 1973, 1974 and 1975 resulted in soaring inflation and large infrastructure bottlenecks. Again, a gap started to emerge between the allocated and actual fiscal expenditures (figure 3), indicating the overall weakness of the public bureaucracy. In short, the pattern of institutional and economic development that had been underway in Saudi Arabia since the early 1950s had shaped the economic and political conditions of the country in a way that by the time of the 1973 boom the elite had no option but to save a large part of their petrodollars abroad.

However, the story was different in Iran. The previous pattern of institutional and economic development in this country had not only given the Shah the possibility, but the motivation, to spend a large parts of the windfall oil revenues domestically. Accordingly, the Shah viewed the 1973 oil boom as a unique opportunity to accelerate Iran’s ongoing industrialisation program towards building heavy and intermediate industries to seal the economic and military dominance of the country in the Persian Gulf. Following from this onwards, Saudi Arabia started to diversify her portfolio away from short-term dollar deposits to treasury bills. By 1977, 30% of her portfolio was invested in US treasury bonds and 80% of its total investment was held in dollars (ibid). In effect, by 1977, Saudi Arabia held 20% of all the T-bills held by foreign central banks and accounted for 90% of the total Middle East investment in US treasury bonds (ibid). Page 24 of 32

view, he believed that Iran should not waste her opportunity to “catch-up” with the West by saving her petrodollars abroad. As a result, he firmly rejected the US demands for petrodollar recycling as recalled by then Economic Officer in the US Embassy (Lehfeldt, OHCFIS, tape one):

“..after the oil price increases and money started rolling in, one of the preoccupations of the US government naturally was to the recycling of petrodollars. It fell to my lot, on instructions from Washington, to go over to see the then head of the Central Bank, Dr Mohammed Yeganeh, to break the news that the US government was not going to support a couple of World Bank loans to Iran that they had in the process, and that indeed we would like to suggest to the Iranian government that they start putting their oil money in places where it would whirl around the world and help some of those nations especially that had no oil and were badly off and could use some funds somehow. Well this upset him greatly. He rushed to the palace to tell the Shah all about it, and the Shah got all over Helms [the US Ambassador]”. Indeed, the Shah had created the boom in the first place for the purpose of using the proceeding oil revenues domestically. Accordingly, he ordered the technocrats to plan for a “Big Push” industrial leap right after the boom. The result was the revised Fifth Plan, which was four times larger than the Fourth Plan in total expenditures (Alizadeh, 1984; Karshenas, 1990). This plan was comprised of a series of mega industrial projects, which many of them had high geopolitical importance for the country such as nuclear and military industries. As many of these projects required massive upfront investment in infrastructure and machinery, the Fifth Plan resulted in a dramatic rise in fiscal spending in 1973 and 1974 and generated budget deficit (table 1). Naturally, following this fiscal explosion inflation soared and various infrastructure bottlenecks emerged in the economy. The most important turning point, however, came in 1975, when the global demand for oil dropped due to the recession in the West and Iran’s oil revenues fell, creating a wide fiscal deficit (5.5% of GDP) in that year. Hence, the Fifth Plan ran into financial difficulties within two years. Yet, despite the large Page 25 of 32

budget deficit and growing inflation, the Shah refused to slowdown the process of ISI deepening and adopt prudent fiscal and monetary policies. This is because the economic and political costs of such a policy reversal was so high for the Pahlavi regime. Slowing down the ISI would entail a reduction in economic growth and cancellation of many large-scale industrial projects that were of high geopolitical importance for Iran. This is while the Shah had already promised to turn Iran into an industrial country by the end of the 1970s and, at the same time, he was determined to ensure Iran’s economic and military supremacy in the Gulf. Based on these reasons, a switch to fiscal and monetary discipline would entail large geopolitical and legitimacy costs for the regime. Thus, instead of slowing down the pace of ISI deepening, the Pahlavi regime continued to cling on to its usual aggressive oil strategy to raise prices in OPEC in order to acquire sufficient funds to continue the Fifth Plan. This policy, however, ultimately failed and Iran was forced to undergo a painful fiscal adjustment in 1977, paving the way for the subsequent political turmoil in 1978.

Page 26 of 32

Conclusions The 1973 oil boom provided an unprecedented surge in revenues for Iran and Saudi Arabia as two leading oil exporters in the world. However, these two countries responded differently to this boom: one country saved a large portion of her oil revenues aboard and the other spent almost all her petrodollars domestically. Using process tracing (analytical narrative) this paper related this important policy divergence to the contrasting pattern of institutional and economic development that these two countries had been undergoing since the period when they first began to receive large oil revenues.

The oil revenues first began to flow into Iran at large magnitudes after the 1953 coup. At that time, the newly installed regime in Iran had a centralised power structure, where all the power was monopolised by a leader (the Shah), who was inspired by developmentalist ideology. Accordingly, the Pahlavi regime decided to engage in (a) technocratic institutionbuilding and (b) promoting economic diversification and industrialisation upon receiving oil rents after 1953. This institutional and policy decisions generated impressive economic results over time, thanks in part to the growing oil revenues. Iran’s economy experienced rapid industrialisation and structural transformation in the 1960s, and in effect, the Shah’s domestic political power and geopolitical influence grew. This further encouraged the Shah to move down the path of import-substitution industrialisation. As a result, when the 1973 oil boom occurred, the Pahlavi regime had the institutional capacity and, more importantly, the political motivation to spend on all her windfall oil revenues domestically on a “Big-Push” industrialisation project. At the same time, there were many interest groups in the economy (the industrialists in particular) that demanded such policy.

Page 27 of 32

On the other hand, when Saudi state first began to receive oil inflows at large magnitudes in the early 1950s, it had a fragmented internal power structure and a conservative ideology. Due to these attributes, the elite chose to (a) build a patrimonial and divided bureaucracy, where each ministry or agency was given to prince and (b) confine economic policy to infrastructure building. With the growth of oil revenues, these policy and institutional choices produced desirable economic outcomes: the country experienced a high economic growth together with economic stability in the 1960s. Nevertheless, the economy stayed extremely reliant on oil as before and the institutional capacity of public bureaucracy remained very weak. These factors left the elite with no option but to save a large portion of their petrodollars abroad after the 1973 oil boom.

In terms of theoretical contribution, this study shows that petro-states can exhibit path dependency in their economic policymaking. In this context, path dependency means that once a policy is chosen by a petro-state, then that policy can produce certain economic and political effects and influence the future policy choices of that state. This notion of path dependency highlights the importance of decisions made at “certain junctures” for the subsequent

economic

and

political

trajectory

of

petro-states.

This

method

of

historical/dynamic analysis can potentially help us explain many economic and political variations across oil-rich countries during commodity booms.

Page 28 of 32

Primary sources Central Bank of Iran, Monthly Bulletins (1965), Sanat va Tosee Eghtesaadi: Sokhanrani Aghaye Dokto Mohammad Yiganeh, Moavene-e- Eghtesaadi Vezarat Eghtesaad Dar Sio Chaharomin Jalaseye Sokhanrani Mahaneye Banke Markazi (In Farsi), No 49- 3, Mehr, 1344. Central Bank of Iran (1978), Annual report for 1977, Published on March 1978. Foreign Commonwealth Office (1967), Annual reviews for 1966 and 1967, UK Public Record Office, FCO 17/351. Foreign Office (1966), Economy, UK Public Record Office, FO 371/186690. Foreign Office (1963), Economic planning and development, UK Public Record Office, FO 371/172359. Foundation for Iranian Studies, Oral history of Iran Collection, Available at: http://www.fisiran.org/en/oralhistory/browse?page=2 Harvard University Iranian Oral History Project, Iranian Oral History Collection, Available at: http://ted.lib.harvard.edu/ted/deliver/home?_collection=iohp International Bank for Reconstruction and Development (IBRD) (1974), The economic development of Iran, Volume III: Statistical appendix, the World Bank Group, Washington: US. Accessible at: http://go.worldbank.org/V93KV20P80 Sanders, H (1968) a, Memorandum of Conversation, Foreign Relations of the United States, 1964– 1968, Volume XXII, Iran, Document 298: http://history.state.gov/historicaldocuments/frus196468v22/d298#fn1 Saunders, H (1968) b, Memorandum of Conversation, Foreign Relations of the United States, 1964– 1968, Volume XXII, Iran, Document 321: http://history.state.gov/historicaldocuments/frus196468v22/d321#fn1

Saudi Arabian Monetary Agency (SAMA), annual reports published from 1964 to 1977.

Page 29 of 32

Bibliography Afkhami, G, R (2009), The life and times of the Shah, University of California Press, Berkley, California. Alizadeh, P (1984), The process of import-substitution industrialisation in Iran (1960-1978) with particular reference to the case of the motor vehicle industry, unpublished DPhil thesis, University of Sussex. Alvandi, R (2014), Nixon, Kissinger and the Shah: The United States and Iran in the Cold War, Published by Oxford University Press, Oxford.

Amouzegar, J (2001), Managing the oil wealth: OPEC’s windfalls and pitfalls, Paperback edition, Published by I.B Tauris & Co, New York. Ansari, A, M (2007), Modern Iran, Second Edition, Pearson Education Limited. Brunnschweiler, C (2008), Cursing the blessing? Natural resource abundance, institutions and economic growth, World Development, Vol 36, No 3, pp 399-419. Cooper, A, C (2011), The Oil Kings: How the US, Iran & Saudi Arabia changed the balance of power in the Middle East, Oneworld Book Publication: Oxford. Di John, J (2009), From windfall to curse?, Oil and industrialisation in Venezuela, 1920 to the present, The Pennsylvania State University Press: University Park, Pennsylvania.

Graham, R (1978), Iran: The illusion of power, First edition, Groom Hell, London, UK. Hertog, S (2010), Oil and the state in Saudi Arabia: Princes, brokers and bureaucrats, Published by Cornell University Press: New York. Hertog, S (2007), Shaping the Saudi State: Human agency’s shifting role in rentier state formation, International Journal of Middle East Studies, Vol 39, pp 539-563.

Karshenas, M (1990), Oil, state and industrialisation in Iran, First edition, Cambridge University Press: Cambridge. Katouzian, H (1998), The Pahlavi regime in Iran, in Sultanistic regimes by Chehabi & Linz, John Hopkins University Press: Baltimore. Lederman, D & W, Maloney (2007), Natural Resources: Neither curse nor destiny, The World Bank, Stanford University Press: Stanford. Mallakh, R, G (1982), Saudi Arabia: Rush to development, Profile of an energy economy and investment, Published by Croom Helm London & Canberra: London.

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Mehran, H (2013), The goals and policies of the Central Bank of Iran 1960-1978, Ibex Publishers: Washington DC. Mohades, K & H, Pesaran (2013), One hundred years of oil income and the Iranian economy: A curse or a blessing? Ludwing-Maximilian University’s Centre for Economic Studies and the Ifo Institute, CES ifo Working Paper No 4118. Moliver, D, M & P, J, Abbondante (1980), The economy of Saudi Arabia, Praeger, Praeger Special Studies, Published by Praeger Scientific. Niblock, T & M, Malik (2007), The political economy of Saudi Arabia, Published by Routledge: New York. Olson, M (1982), The rise and decline of nations: Economic growth, stagflation and social rigidities, First edition, Yale University Press: New Haven. Olson, M (1965), The logic of collective action: Public goods and the theory of groups, First edition, Harvard University Press: Cambridge, Massachusetts. Popp, R (2011), An application of modernisation theory during the Cold War? The case of Pahlavi Iran, The International History Review, Vol 30:1, pp 76-98.

Pierson, P (2004), Politics in time: History, institutions and social analysis, Princeton University Press: Princeton NJ.

Rosser, A (2007), Escaping the resource curse: The case of Indonesia, Journal of Contemporary Asia, Vol 37:1, pp 38-58.

Salehi-Esfahani, H, S & F, Taheripour (2002), Hidden public expenditures and the economy in Iran, International Journal of Middle East Studies, Vol. 34, No. 4 (Nov., 2002), pp. 691-718. Skeet, I (1991), OPEC: Twenty years of prices and politics, Published by Cambridge Energy and Environment Series, Cambridge University Press: Cambridge. Spiro, D (1999), The Hidden Hand of American Hegemony: Petrodollar recycling and international markets, Cornell Studies in Political Economy, Published by Cornell University Press: New York.

Torvik, R (2009), Why do some resource abundant countries succeed while others do not?, Oxford Review of Economic Policy, Vol 25, No 2, pp 241-256. World Bank (2015), World Development Indicators. Published by World Bank: Washington DC. Yizraeli, S (1997), The remaking of Saudi Arabia, Dayan Centre Papers 121, Published by The Moshe Dayan Centre for Middle Eastern and African Studies.

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Table 1: Fiscal balance (% of GDP) Iran

Saudi Arabia

1971

-5%

9%

1972

-9%

13%

1973

-3%

40%

1974

-3%

40%

1975

-5%

13%

1976

-3%

3%

1977

-6%

-2%

1978

-9%

-5%

Source: Salehi Esfahani & Taheripour (2002) and Niblock & Malik (2007).

Table 2: Investment income ($ Millions) 1973

1974

1975

1976

1977

Saudi Arabia

200

1,200

1,900

2,900

4,000

Iran

63

507

766

611

796

Source: Central Bank of Iran (1978) and Niblock and Malik (2007)

Table 3: Structure of Iran’s economy in 1963 % of total GDP Agriculture

25.2%

Oil

20.6%

Manufacturing

12.6%

Construction

4.5%

Trans & communication

8.6%

Domestic trade

7.1%

Banking & insurance

2.3%

Services

11.8%

Rest

7.3% Source: IBRD (1974)

Table 4: Structure of Saudi Arabia’s economy in 1965 % of total GDP Agriculture

8.5%

Oil & gas

44%

Petroleum refinary

6.4%

Manufacturing

1.9%

Utilities

1.3%

Constuction

4.9%

Trans & communication

7.2%

Other services

25.8% Source: Mallakh (1982)

Table 5: Structure of GDP in 1972 Saudi Arabia

Iran

Agriculture

4.6%

14.7%

Oil

54.1%

27.4%

Manufacturing & mining

2.2%

14.4%

Services

39.1%

43.5%

Source: IBRD (1974) and Moliver & Abbondante (1980)

Table 6: The importance of oil in Iran and Saudi Arabia in 1972 Oil exports as % of GDP

Oil revenues as % of total government revenues

Oil exports as % of total exports

Iran

22%

59%

59%

Saudi Arabia

56%

92%

88%

Source: Central Bank of Iran (1978) and Niblock and Malik (2007) and Mallakh (1982)

Table 7: Macroeconomic indicators for Iran Current Account balance (% of imports)

Budget Balance (% of GDP)

Inflation

1963

12%

-2.2%

1.0%

1964

-8%

-3.3%

4.5%

1965

-12%

-1.8%

0.3%

1966

-13%

0.2%

0.8%

1967

-15%

-2.7%

0.8%

1968

-25%

-4.2%

1.6%

1969

-27%

-5.5%

3.5%

1970

-28%

-4.9%

1.5%

1971

-9%

-5.8%

5.5%

1972

-5%

-9.2%

6.3%

Source: Karshenas (1990), IBRD (1974) and Salehi-Esfahani & Taheripour (2002)

Figure 1 : Saudi Arabia oil and investment revenues ($ billions) 120 96 72 48 24

1970

1972

1974

1976

Oil revenues

1978

1980

1982

1984

Investment income

Source: Niblock & Malik (2007)

Figure 2: Fiscal spending (% of GDP) 60%

45%

30%

15%

0% 1970

1971

1972

1973

1974

Saudi Arabia

1975

1976

1977 Iran

Source: Salehi-Esfahani & Taheripour (2002) and Niblock and Malik (2007)

1978

1979

Figure 3: Project expenditures in Saudi Arabia 6000

3000

1500

1964

1965

1966

1967

1968

Allocation

1969

1970

1971

1972

Actual

Source: SAMA Annual Report (1973, 1972, 1964)

Figure 4: Total fiscal expenditures in Saudi Arabia 200000

150000

Million Riyals

Million Riyals

4500

100000

50000

1973

1974

1975 Allocation

Source: Niblock and Malik (2007)

1976

1977

1978

Actual

1979