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Israeli economic miracle of 1985

by on 14/05/2012

Israeli economic miracle of 1985

Thank you for the article of Stanley Fisher. From late seventies and eighties of the last century I used to work in the budget department of Israeli treasury, and my point of view is very different from that of Stanley Fisher, who is central banker. S.Fisher emphasizes naturally the monetary policy as a major tool to achieve price stabilization, while I saw manly the fiscal side of the story.

To start with, it is important to understand Israeli economic and demographic development. You have to remember 1965 Israel had population of 2 million people, at 1985 about 4 million, and in 2012 about 8 million. This huge increase in population and mainly the 1990-1991 immigration of almost 1 million mostly adult, highly educated, highly motivated, ready for hardship people, from USSR, that increased the Israeli population by almost 20%, was accompanied with even higher economic growth.

Until 1974, most of the industry, and banks were directed either directly by government, or by General Union of Israeli Workers (Histadrut) and cooperative movements, both under the umbrella of the ruling Social party. Between 1973-1977 after 1973 war, ruled still the Social Party government but under new personalities. They started a process of economic change from economics of grocery store, that was based on rules specifically created to give protection to the existing economic elites, to general rules that gradually started to abolish the protectionism. On the other front this government tried gradually to reduce the inflation that picked up, like in most of the world and more in Israel, as consequence of the high oil prices after 1973 War.

At 1977 started a new era, when new conservative government won the elections, and appointed an inexperienced treasury minister, whose first act was to release the Israeli currency from fixing it to the US$ and opening it to free fluctuation and free currency market. I remember, when the reform was prepared, the main problem of the government was how to protect itself from being depleted of the limited foreign exchange reserves, but the government believed, the devaluation will be limited and will solve the problem of the Israeli economy. Yet the reality was very different. Since in Israel the annual inflation rate was still at that time about 35%, the interest rate was accordingly high. So instead of depleting the foreign currency reserves, short term speculative money flowed into the country, creating double effect of revaluation in real terms of the local currency (the Israeli currency was devaluated in one year by 20% against the US$, while the inflation in the same year was about 50%), and increased liquidity on the financial markets. This increased even more the inflation rate that caused the farther increase in the interest rate. Finally in 1980 the treasury minister was replaced when the inflation reached already annual rate of 135 %.

While the government bonds were all fixed to inflation, the private loans mainly mortgages mostly guaranteed by the government, had long term fixed interest rates, without being fixed to inflation. This brought huge increase in the net government deficit. In the same period the government found difficulty to finance its deficit by listing its bonds, since from the early seventies, the major banks regulated their share prices by purchasing their own shares in the stock exchange market, when it had tendency to decline. This arrangement was very comfortable to the government, since the money raised by the banks, anyway financed the centralized economic system of big companies related to the government.

The public get used to purchase bank shares as a secure investment, believing, (since they were managed by the General Union of Israeli Workers, the Jewish Agency and the Government) they have guaranty from the government anyway. But then when the annual inflation reached height of 400%, the banks started to lose the resource to continue to purchase their own shares and finally at September 1983 the system collapsed.

The government out of desperation changed the bank shares valued of about 7 milliard US$ (representing then almost 30% of the Israeli GDP), for  5 years non-tradable government bonds. The Government originally wanted to fix the bonds rate to the price index, but the dollar in that time looked more stable to the public, so to try to manifest reliability, in spite of their obvious mingling, they accidentally decided to fix the bonds to US dollars. At the end of this economic carnival, the public debt reached almost 250% of the GDP. (To be precise external debt of 85% and internal debt of 140% of the GDP). Greece 2012? What a joke, an economic miracle compared to this.

Finally at 1985 a new government, headed by Shimon Peres started a new economic policy, and here are its main points:

– Government budget cut of 7.5% of the GDP that was then 1.5 milliard US$.

– The defense ministry budget was deeply cut.

– Deep cut of the basic product subsidies, (some basic product prices increased by 70%).

– Cut in the subsidies for export. It was substituted by devaluation of 19%, and promised continued devaluation of 6% monthly as previous to the plan.

– 3% cut of the government stuff.

– Devaluation freeze, subject to the wage freeze for 3 month.

– Stopping of price indexation of the wages, and with it all the social payments connected to the wage. Instead there was agreed rate of wage increase with gradual reduction.

– General price freeze and price control for 3 month and then gradual and controlled increase of the prices.

– The freeze of money printing by the government, approved by law.

– Limitation on liquidity of bank deposits fixed to the price indexes.

And many other changes that may look harsh happened, but against the reality of ten to fifteen percent monthly inflation, that prevailed in the country for several years by then, all this looked as children’s game. More than that, Israeli population since its creation sees itself threatened by the enmity of the surrounding countries. So the population is more ready to make sacrifices than in any country in Europe.

And now to the price. From the long term perspective, the main sector who paid the price, was the economic establishment of the cooperation, the agricultural cooperative settlements like the kibbutz and the economic entities connected to the Unions, that traditionally were highly leveraged to the banks, mainly to bank Hapoalim, that was managed by the same organization (the bank belonged to the public and after 1983 to the government), politically inclined to the socialistic party (workers party in translation) and its credit policy was influenced by it. Some unique social phenomena gradually disappeared from the scenery, like the kibbutzim and the cooperation. It is in a way the death of the socialistic idea that was relatively successfully implemented in Israel. I feel sorry for that, even if i am not a socialists.

As to the Israeli government, it was lucky. The US$  lost within the next 5 years half of its value, and with it the debts of the Israeli government dropped accordingly. Israeli export also benefited from the cheap US$, the export to Europe could grow, with it the GDP and the reduction of external debt. As the economy started to be stabilized and the economy grow, mainly after 1990 with the big emigration from the collapsing USSR, the banks also were restructured, and the Israeli government sold the shares for favorable prices, eventually decreasing by it the public debt.

Curiously exactly in 1985 the crude oil price dropped to one third of its previous price, and the prices changed very favorable for Israel.

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