Boom,Bust, and
Reboot
The Israeli Currency Crisis
Overview
• First there was the Israeli pound, then
the old shekel.
• After frequent devaluations against the
US dollar and other foreign currencies
during the 1960s and 1970s the result
was hyperinflation in the the 1980s.
• Inflation was contained as result of the
1985 Economic Stabilization Plan, the
new shekel was introduced replacing
the old shekel on 1 January 1986 at a
rate of IS 1,000 to NIS 1.
• Crisis of Israeli government.
• Involved U.S. deeper into Israeli affairs.
Actors
• Simon Peres
• George Schultz
• Minister of Treasury, Aridor
• Governor of the Bank of Israel,
Mendelbaum
• Joint-Economic Group
Decision-type
• Bureaucratic
• Government of Israel
• Treasury
• Knesset
• Bank of Israel
• Rational choice
• Israeli Prime Minister
• George Schultz (Joint-Economic Group)
Economic Priorities
• After statehood (1949 onwards), government priority was
given to establishing industries in areas slated for
development, among them Latish, Ashkelon, the Negev
and Galilee.
• The expansion of Israel's textile industry was a
consequence of the development of cotton growing as a
profitable agricultural branch.
• By the late 1960s, textiles were one of the largest
industries in Israel, second only to the foodstuff industry.
• Textiles constituted about 12% of industrial exports,
• In its first two decades of existence, Israel's strong commitment to
development led to economic growth rates that exceeded 10% annually.
• However, after 1973, growth stalled, inflation soared and government
expenditures rose significantly.
• There was the 1983 Bank stock crisis.
• By 1984, the economic situation became almost catastrophic with inflation
reaching an annual rate close to 450% and projected to reach over 1000%
by the end of the following year.
The cause?
• The year 1973, marked an unprecedented event and juncture for the economy, which
plunged into a long recession. Since that year also saw the world economy sink into a
drawn out crisis.
• With the recession, the question was asked:
• To what extent Israel’s economic woes to external factors, or whether they resulted
from can be attributed to properly respond to the international crisis and policy which
failed adjust the structure of the economy to the new economic environment.
• The fact that during the rapid growth years (1960-1973), the economy developed faster
than its inflation groups in terms of GDP and GNP.
• Investments were made in unprofitable activities.
• At least part of the investments were made in un-utilized capital stock, financed at a high
negative real interest rate.
• Large scale subsidization of investment did not lead to viable economic growth as seen
in excessive priced market credit, and waste of resources.
• Manifestations of the failure to adapt.
• Two major events to the changing environment.
• 1. failure by the government, but also business and households to
balance incomes and outlays which lead to attempts to live beyond
ones means.
• post-War of Attrition, welfare issues dominated domestic politics
• National Insurance Transfer (child allowances)
• 2. related to the first, payment of excessive real wages relative to labor
productivity resulting in progressive drop in rate of return on capital in
the business sector.
• Excess of labor
• Most important to the failure though is the evolution of the public
sectors income and expenditure system
The cause?
• The government failed to change.
• External (raw material, price shocks)
• Internal (heavy increase in defense expenditure) and cut to direct government
investment in national infrastructure.
• “crowding” out of the private sector from the capital discouraged private finance of
investment and growth
• limited degrees of freedom of monetary policy
• Result was large deficit.
• External and internal debt.
• prevention of labor force movement into the private sector.
• Problems then within balance of payments. Requirement of price level adjustments,
devaluations and subsidy cuts that forced sustained shifts in the inflation rates.
• It is interesting to note the substantial rise in the size of the overall public sector
deficit even while the economy was still growing.
• From rear balance during the first half of the 1960s, the economy went into a 12.6 percent
(GNP) deficit during the so-named “Golden Age” between 1967-1972.
• There was a rise in civilian consumption, investment and subsidies and predictably defense
expenditures.
• The economy did not increase tax rates since the rapid growth made easy borrowing possible
both domestically and abroad.
• The Israeli Treasury borrowed substantial amounts from the Bank of Israel, print money, during
this period of boom characterized by relative stability and growing demand.
• Increased government spending in all sectors of Israeli life. “Wave the flag” (defense,
development, social welfare) that fit the expansionary period and psychological mood ‘we can
do anything’.
• From 1973 to 1985 was known as the “Lost Decade” of Israel’s economic
history.
• The period was characterized by significant growth in the government
deficit, which was in large part due to the increase in defense expenditure.
• The decade can be summarized as follows:
• Economic growth fell off sharply as a result of the oil crisis, which began
simultaneously with the Yom Kippur War,
• Inflation accelerated rapidly until it reached levels bordering on hyperinflation
just prior to the Stabilization Plan of 1985.
• The level of debt, both internal and external, reached proportions that
could not be financed in the long term and which brought the economy to
the brink of collapse in the financial and foreign currency markets
• see Ben Porath, The Israeli Economy – Growth Pains.
Bank crisis
• The Bank stock crisis in 1983, was when the stocks of the four largest banks in
Israel collapsed.
• As a consequence, these banks were nationalized by the state.
• In the beginning of 1983, a crisis occurred in the free stock market (all the nonbank
stocks), and large supplies in all market sectors forced the banks to invest
very large sums of money maintaining their stocks' stability.
• From January through March some regulators, among them the Minister of
Treasury, Aridor, and the Governor of the Bank of Israel, Mendelbaum, approached
the banks several times, trying to get them to gradually reduce their adjustments.
• Although some bank managers realized they could not continue this for long, they
did not stop.
• Fearing a market collapse, Ministry of Treasury officials kept knowledge of this
from the public.
• Failing to stop the banks, Ministry of Treasury heads wished to execute
a large devaluation of the Shekel, serving as an excuse to stop the
adjustments.
• However, the August 1983 8% devaluation was far too small for that
end.
• Additionally, the supplies in the stock market grew steadily, and
reached new heights in September. The public unremittingly sold bank
stocks, and purchased US dollars.
• The crisis erupted fully on October 2. That day, the first day of trade
after the Sukkot holiday, the public sold more bank stocks than in the
entire month of September.
• On October 4, the Minister of Treasury appeared on television saying to
say the large supplies would not bring about a devaluation or change
of policy.
• On October 5, the stock exchange again opened with large numbers of
sell offers, and on October 6, 1983, nicknamed "Black Thursday",
brought an onslaught of sales.
• A collapse was imminent, since the banks declared that day they would
be unable to absorb additional supplies without government assistance.
• That night, in a meeting in Aridor's home, it was decided that the
government would purchase the banks' stocks from the public, to
prevent the loss of their investments.
• On Sunday, October 9, the stock exchange remained closed, and
stayed closed till October 24.
• In the meantime a devaluation of 23% was executed.
• The stocks sold by the public were bought by the Bank of Israel at an
average loss of 17%. 35% of the stocks' value was lost.
Losses
• An immediate consequence were the loss of a third of
the public's investments in them.
• The acquisition of the banks by the government, at a
total cost of $6.9 billion (for reference, Israel's entire
GDP in 1983 was about $27 billion), and
• The nationalization of the major banks (Leumi,
Hapoalim, HaMizrachi, Discount, and Clali).
• Blass, A. and Grossman, R. (2001), ASSESSING DAMAGES: THE 1983 ISRAELI BANK
SHARES CRISIS. Contemporary Economic Policy, 19: 49–58.
Limping forward
• Bank crisis 1983
• Austerity program July 1984
• Stabilization Plan 1985
• Armored cars arriving at the Bank of Israel, to pick up their daily
allotment of shekels for distribution to banks across the nation,
were filled with $20 billion worth of the new shekel in 1986.
• That was the second new currency to be introduced in Israel’s
inflation-riddled economy in five years.
• Officials expected the change from old to new shekel to have no
impact on the economic austerity program.
Stabilization Plan
• The Economic Stabilization Plan was implemented in Israel in 1985 in
response to the dire domestic economic situation of the early 1980s.
• After Israel suffered “the Bank stock crisis” and in1984 inflation was
reaching an annual rate close to 450% and projected to reach over 1000%
by the end of the following year.
• The Knesset implemented an economic stabilization plan aimed at
generating “sharp disinflation” after smaller, so-called "package deals" were
negotiated with selected entities in the Israeli economy proved ineffective in
stemming the rise of inflation.
• The plan was devised by Yitzhak Moda and Michael Bruno.
• Joint Economic Group
• MOUs
• This wider-scale stabilization plan brought together all the main players in
the Israeli economy: government, labor unions, and the central bank and
the stabilization plan helped make inflation successfully brought to under
20% in less than two years. Some of its main points included:
• A significant cut in government expenditures and deficit.
• Reaching an agreement with the then-powerful Histadrut labor union to
enact wage controls, thus decoupling rampant wage from price inflation.
• Emergency measures imposing temporary price controls over a broad
range of basic products and services.
• A sharp devaluation of the Shekel, followed by a policy of a long-term
fixed foreign exchange rate.
• Bank of Israel strictly controlled in its ability to print money to cover
government deficit.
• Such steps, with the subsequent introduction of market-oriented structural
reforms successfully reinvigorated the economy, paving the way for its rapid
growth in the 1990s and 2000s.
Outcomes• Avoided the 2008 crash
• Strict regulations.
• The Bank of Israel and the government of Israel have maintained much more
careful and conservative fiscal and monetary policies
• Two developments have helped to transform Israel's economy since the beginning
of the 1990s.
• The first is waves of Jewish immigration (1million), predominantly from the
countries of the former Soviet Union. These new immigrants, many of them highly
educated, now constitute some 16% of Israel's 7.5 million population.
• The second development benefiting the Israeli economy is the peace process
begun at Madrid in October 1991.
• Oslo Accords
• Peace treaty between Israel and Jordan (1994).
Outcomes
• The second development helped in the signing of free trade agreements which
helped the Israeli economy become more competitive.
• While heavy investment in its industrial and scientific base allowed the country to take
advantage of opportunities associated with the rise of the global knowledge economy.
• Increasing exports and opening new markets for its products and services since
2000 has occurred.
• As a result of these factors, inflation has been relatively low and the country now
maintains a positive balance of payments and in 2010 a current account surplus
equivalent to about 3% of its GDP.
• As a consequence, the currency has risen approximately 20% in value relative to the
US dollar in the 2000s decade.
• A complete reversal on the trend of historical weakness for the Israeli currency
shown in previous decades.
Recommend readings
• Turmoil and Triumph: My Years As Secretary of
State. George Schultz
• The Israeli Economy – Growth Pains. Ben Porath
• Israel’s Crisis and Economic Reform: Historical
Perspective. Michael Bruno