Atom Crash Part 2 - Where Neoclassical Economics Fails
The Federal Reserve Bank of Dallas put out a paper on the Strait of Hormuz which projected that if the closure continues for three quarters, oil could hit $132 per barrel and annual GDP growth would fall by 1.3 percentage points for the full year. Essentially, what they are saying is that roughly 20% of global oil being cut off for nine months would translate into a recession shallower than 2008. Much of what is being projected about the economy today rests on this kind of modeling. However, this data is based on neoclassical economics which makes fundamentally incorrect assumptions about economic outcomes when dealing with commodities with inelastic supply and demand, and my view is that the impact is far more profound.
The neoclassical economist will say that over the last few decades, the share of the US economy that comes from oil has declined substantially and thus the impact of less oil will be minimal. This misses the systemic and fundamental nature of commodities like oil which are non-substitutable and that cause serious knock-on effects. The error is what's called the "cost-share" assumption - the idea that an input's importance to the economy is roughly equal to its share of GDP. It sounds reasonable until you apply it to water. Water is basically free and thus barely registers in GDP, but remove water and the economy doesn't shrink by 1% - it collapses entirely. Oil isn't water, but it sits much closer to water on that spectrum than the cost-share models suggest.
This effect can be easily demonstrated through simple modeling. Imagine an individual has an income of 100 units and every year spends 3 units on oil products and 8 units on discretionary spending. If all of a sudden there is a 20% reduction in the amount of oil products in the marketplace, the neoclassical economist would say that the individual would cut their usage of oil by around 20% and thus the system would come to an equilibrium.
The reality is that individuals are very unlikely to cut their usage of oil by 20% unless there is a substantial increase in price - i.e., demand destruction. Commuting to work, heating your home, running the electricity grid - these are not things households ramp down 20% because prices rose. Historical oil shocks in 1973 and 1979 saw prices rise 200-400% before consumption materially adjusted. If you assume that oil prices merely double, the 3 units spent on oil turns into 6 units and the 8 units spent on discretionary spending drops to 5. Currently, discretionary spending makes up roughly 25-30% of GDP and thus a 37.5% reduction in discretionary spending would drop GDP by about 10%. And this does not even consider the knock-on effects - electricity prices, food prices (which depend on diesel-powered agriculture and trucking), shipping costs, airline capacity, and every other component of the household budget that inflates when oil prices spike.
This is the piece the cost-share models completely miss. Oil is only 3-4% of household spending directly, but oil shocks transmit through the 25-30% of GDP that's discretionary. When gas doubles, you don't cut your commute - you cut restaurants, travel, clothing, entertainment, durable goods. One household's cancelled vacation is another household's lost income, which becomes another household's cancelled vacation. This is how modest direct shocks become compounding recessions.
Now, many will say that this price increase won't materialize because of the substantial amount of buffer built into the system itself. Today, we have a roughly 3 billion barrel supply of oil sitting in tanks across the world which can certainly buffer against the 15 million barrels of oil that are missing per day because of the Strait of Hormuz. This is true to some degree, but to put it in perspective, that inventory is only about 200 days of the Hormuz shortfall - and only if every barrel on earth could be redirected to the right place, which it can't. This storage itself has several major issues:
It is not evenly distributed. Many countries that depend heavily on Gulf oil have virtually no strategic supply at all.
There is not proper infrastructure to move stored oil from countries that have it to countries that need it.
Not all oil and oil products are the same, nor can all refineries process every grade of crude.
Many oil and LNG carrying ships are still stuck in the Gulf and cannot be used to transport anything.
Therefore, the time to a real, painful shortage is much less than 200 days. The question to ask then is: what happens next?
Ideally, the Strait is opened tomorrow and everything goes back to normal. However, I find that to be a very unlikely outcome, and if we take a step back, we have one group that wants the Strait open and one that wants it closed. The question becomes who can take the pain of the closure longer.
The conventional Western answer is that Iran breaks first because they need oil revenue. This analysis is wrong in a way that matters, and it's worth walking through carefully because it's where most commentary goes astray.
First, consider Iran's export position. Iran has essentially no meaningful way to export oil that bypasses the Strait. Their only alternative, the Jask terminal on the Gulf of Oman, has a nameplate capacity of 300,000 barrels per day but has been effectively non-operational since September 2024 due to infrastructure problems. Pre-war, Iran was exporting around 1.5 million barrels per day, virtually all of it through Hormuz to China. Overland pipelines to Turkey, Pakistan, or via Russia are negligible in volume. This means that when the US naval blockade of Iranian ports began in mid-April, Iran lost something close to 80-85% of its oil revenue regardless of whether the Strait is open or closed.
Iran has already absorbed the revenue hit where keeping the Strait closed costs Iran almost nothing additional economically while imposing maximum pain on the West. This asymmetry where the target has already swallowed the punishment and the punisher hasn't yet is the source of Iranian leverage.
Second, even if Iran were losing revenue on the margin, who would they need to appease? Iran's foundational foreign policy principle is "neither East nor West." Their relationship with China is transactional and not an alliance. If high oil prices hurt Beijing, that is not a decisive factor in Tehran's calculus. Meanwhile, a sustained Hormuz closure is a massive windfall for Russia, which can sell its own crude at $150+ per barrel. Russia has every incentive to extend Iran financial support to keep the closure going. The axis that benefits from closure (Iran, Russia, and to a lesser extent North Korea) is already operational and has been providing mutual backing for years.
Third, and this is what Western analysts systematically fail to grasp is that Iran has spent the last 45 years deliberately building an economy designed to survive exactly this scenario. It's called the Resistance Economy (Eghtesad-e Moghavemati), and it was codified by Supreme Leader Khamenei as official state doctrine in 2010. The entire structure of the Iranian economy is optimized for siege conditions:
Food: Iran produces about 90% of its own caloric needs. Sanctions-era stockpiling has built significant buffers. Basic food security doesn't depend on any shipping route.
Medicine: Domestic pharmaceutical production is near self-sufficient for common drugs.
Fuel: Iran is a net fuel exporter. Domestic gasoline, diesel, and electricity are not supply-constrained.
Manufacturing: Forty years of sanctions have built domestic production in appliances, automobiles, textiles, and basic consumer goods. Quality is poor by international standards, but availability is there.
Finance: Iran has been operating outside the Western financial system for decades. Domestic alternatives to SWIFT, extensive hawala networks, crypto channels, and gold reserves function regardless of sanctions status.
Shadow fleet: The infrastructure to move oil, goods, and money around sanctions was built over decades and continues to operate.
Parallel economy: The IRGC controls an estimated 20-40% of the economy through construction arms, religious foundations, and affiliated companies. This parallel state functions outside normal market mechanics.
Iran has already tested this system multiple times. During the 2012-2015 sanctions, oil exports collapsed from 2.5 million bpd to 1 million bpd. During the 2018-2020 "Maximum Pressure" campaign, exports fell to 300,000 bpd. Each time, the regime didn't just survive but maintained its nuclear program, its missile program, its proxy network, and its political control throughout. Ordinary Iranians suffered enormously, but the structure of power remained fully intact.
And this brings us to the final, decisive piece which those in the West don’t understand at all. The Islamic Republic has built an entire ideological architecture around the idea that material suffering is spiritually redemptive and nationally unifying. The foundational story of Shia Islam is Hussein's martyrdom at Karbala and triumph through defeat. The Iran-Iraq war is memorialized as the "Sacred Defense," a war in which Iran sent teenage boys into minefields with plastic keys to paradise around their necks and which continued for eight years against an enemy using chemical weapons.
This is the same regime whose founder, Khomeini, declared: "Either we shake one another's hands in joy at the victory of Islam in the world, or all of us will turn to eternal life, and martyrdom. In both cases, victory and success are ours."
When a society's founding ideology frames suffering as evidence of righteousness, economic pain doesn't produce the political pressure that Western models assume. Instead, the pain gets absorbed, redirected, and used as a legitimating force.
On one side we have a group of Western consumer economies optimized for efficiency, dependent on discretionary spending for 25-30% of GDP, with electorates that respond to $6 gasoline the way an allergic person responds to peanuts. On the other side we have a regime that has lost 80% of its revenue already, has a doctrine designed for siege, has an ideology that treats suffering as sacred, has Russian financial backing and higher prices on remaining exports, and has survived worse before. Now ask yourself: if Iran has the ability to keep the Strait effectively closed (and it appears that they do) why would they not keep it closed? Every day that passes they gain more leverage. Every day that passes the West's strategic oil reserves draw down. Every day that passes the ripple effects through discretionary spending compound. Every day that passes Russia's war chest grows. And every day that passes costs Iran almost nothing that it hasn't already paid.
This is the scenario the cost-share models don't price in because the entire framework assumes both sides calculate like Western consumer economies. The gap between how the West thinks Iran will behave and how Iran actually behaves is where the real economic shock lives.
The question isn't whether Iran can endure nine months without oil revenue. The question is whether the West can endure nine months without Iran's oil and the problems that continue after.
To end on a positive note though, I see there being two possible "solutions" to the current conflict which minimize the economic fallout where both are non-ideal:
We Won, It's Over: The US just leaves and uses propaganda to pretend it won the conflict. In this scenario, Iran will likely keep the Strait closed and the US would use economic tools (i.e., minimization of exports) to buffer against economic fallout. This would effectively end the US power projection in the middle east and would leave Europe and Asia with the economic effects of US actions.
Sorry, We Made a Mistake, Let's Be Friends: The US offers to pay for all damages to Iranian military and civilian infrastructure provided the funds are utilized for non-miliary purposes. Additionally, the US lifts sanctions on Iran and moves towards normalizing a relationship while establishing international controls and monitoring on nuclear material. While the bill for these damages would be large, the economic damages causes to the US to extend the conflict would be 10X this cost.
