The Rise & Fall of Inflation
(Updated 2011)
Israelis follow the consumer price index
(CPI) like Americans follow baseball scores. Indeed, they
pay more attention because more often than not their salaries,
their mortgages and a host of other income and expense items
are wholly or partly linked to monthly or quarterly inflation.
When inflation was raging into the triple
digits in the first half of the 1980s, checking
the CPI was a daily pre-occupation. A joke
at the time asked whether it was cheaper to
take a bus or a taxi from Jerusalem to Tel
Aviv. The price in shekels was about the same,
but the correct answer was the taxi. Why?
Unlike the bus, you paid at the end of the
one-hour trip (when the shekel would be worth
less than at the start).
The CPI was not invented in Israel, but its
utilization has certainly been brought very
close to perfection here. With inflation now
approaching levels common in Europe and America,
the CPI is a less critical part of daily life
in Israel than in the past. But the battle
to bring inflation down to those levels was
neither short nor easy; it took the better
part of 15 years - and no one can say for
certain that the fight is entirely over or
that it was entirely worthwhile.
- Origins of the CPI
- With Indepdence - Inflation
- With Inflation - Indexation
- Hyperinflation Explodes
- The Victory & the Price
- Apples & Oranges
The Origins of the CPI
The history of the CPI in
Israel goes back to 1942, in the midst of
the Second World War. As part of the war-time
economy, the Mandatory government issued an
ordinance freezing all prices, wages and rents.
When it became obvious that market forces
were stronger than government policy, and
that prices were nevertheless creeping up,
a way had to be found to compensate employees
for that price rise - without raising their
real wages.
The solution was to link salaries to the
CPI, thereby assuring that neither purchasing
power would decline nor that "frozen"
wages would rise faster than inflation. An
agreement to this effect was soon signed between
the Manufacturers Association and the Histadrut
(labor federation). By the 1950s, this linkage
had become part of the law of the land.
Thus, by and large, the salaries of all workers
were protected from inflationary onslaught.
This is, perhaps, the most fundamental insight
when discussing the history of Israeli inflation.
With Independence - Inflation
The rise of inflation begins with Israel's independence,
which was attained in 1948 only after a bitter war. In the
following three years, Israel doubled its population by absorbing
refugees from post-Holocaust Europe and Arab countries. Having to manage all this did
not allow for much attention to an economic or monetary policy.
The government printed money according to its immediate needs,
regardless of what its revenue was, in order to evade the
crises threatening its very existence.
By 1952, the government had a chance to look
ahead more than just a few weeks. Inflation
had risen from 14% the previous year to 66%,
and this leap was partly due to the New Economic
Policy initiated that year. This policy implemented
both a sizable devaluation of foreign currency
and a relaxation of much of the strict price
controls imposed, together with rationing,
during the War of Independence.
In 1953, the Bank of Israel was established.
Like all central banks, its job was to enact
an appropriate monetary policy - to be the
watchdog of the Treasury and to ensure a stable
flow of money according to the economy's requirements.
And like all central banks, the Bank of Israel
has always considered inflation to be the
primary issue to be addressed, but it was
not always successful in doing so. Still,
with its power to regulate the banking system,
the young Bank of Israel did much to offset
the inflationary effects of the government's
deficit spending - especially in times of
extraordinary need (mainly wars and extensive
waves of immigration).
The Bank of Israel took command of monetary
policy in 1954, after which the annual rise
of the CPI remained a single digit percent
throughout the rest of the 1950s and all through
the 1960s (apart from 1962, when it reached
10%). During most of these years, the economy
enjoyed a rapid growth, at an average annual
rate of almost 10%, a rate three or four times
higher than that of most Western economies
at the time. In addition, unemployment was
relatively low, and the standard of living
rose quickly. The fact that prices kept creeping
up did not cause much concern to the average
citizen, since his or her wages were protected
by linkage to the index.
With Inflation - Indexation
Over the years, more and more non-immediate
transactions - namely, the kind to be concluded
some time in the future - adopted the indexing
(or linkage) remedy. One of its first applications
was in bank savings accounts. In order to
prevent inflation resulting in a deterioration
of the real value of their savings, depositors
were assured that each deposit would be registered
at its "value" (that is, the CPI
rate) on that day. The deposit would be redeemed,
when the time came, according to its "real
value," as corrected by the rise of the
index between the two dates. Soon after, interest
accumulation was also linked in the same fashion.
Insurance companies were next to use this
idea: they offered to pay claims, pertaining
to both life and general insurance, which
would include compensation covering the decline
in the value of money (that is, the rate of
inflation) from the time the policy was signed.
This was calculated on the basis of the difference
between the CPI on both dates, so the payment
of the claim would be at its original value.
Naturally, this kind of business transaction
could only take place provided that insurance
premiums too were to rise with the CPI.
The property market followed suit. An indexing
clause was the most natural solution for new
homes, where contracts are signed months or
years before buyers take possession, or full
payment is made. Each installment was computed
according to the CPI rise since the signing
of the contract.
The second-hand and the rental property market,
in most cases involving deals between individuals,
refined the system still further. As the CPI
is published two weeks after the end of the
month it refers to, the property market began
to link prices to the dollar. Since the foreign
exchange rate is published daily, this gave
buyers and sellers an instant if inexact linkage
mechanism. The actual payment is always made
in local currency, according to the rate of
exchange on that day. With the rise of the
rate of inflation in the 1980s, this method
of setting prices extended to the consumer
durables market, as well.
It was not long before the government began
to index the budget. After paying index-linked
salaries to its employees and then agreeing
to insert indexation clauses into the contracts
it signed with its suppliers, the government
finally found this to be justified as a tool
of stability.
Then, indexing began to encompass income-tax
brackets. With high inflation, a wage earner
would rapidly move into a higher tax bracket
simply because his or her nominal income kept
pace with inflation. Thus tax brackets were
also linked to the CPI so that a wage earner
only paid a higher rate if his or her income
really grew more than inflation.
A similar indexing of a variety of social
transfer payments followed, from child allowances
to maternity, old age, widowhood, disabled
and unemployment benefits. These payments
are augmented periodically during the fiscal
year, so as to make sure that the purchasing
power of this assistance is not diluted by
inflation, and that the needy receive the
real value of the originally allocated benefit.
The linkage system was very successful. In
major economies around the world, consumers
often feel the pinch of just 2-7% annual inflation.
But Israelis, who had to deal with a much
higher inflation rate, went about their business
practically unaffected. For three and a half
decades, their real income was protected by
this index-linked mechanism. Furthermore,
over this period the standard of living rose
at an average rate of close to 4% annually.
Hyperinflation Explodes
Inflation accelerated in the 1970s, rising
steadily from 13% in 1971 to 111% in 1979.
Some of this higher inflation was "imported"
from the world economy, instigated by extreme
oil price rises in 1973 and 1979. This introduced
a new phenomenon in world economy, which came
to be known as "stagflation" - an
unprecedented combination of rising unemployment
and economic stagnation (always accompanied
in the past by deflation) now coupled with
inflation. In Israel, a post-1973 full-employment
government policy postponed this depressing
development until the 1980s.
But inflation kept gathering pace. From 133%
in 1980, it leaped to 191% in 1983 and then
to 445% in 1984, threatening to become a four-digit
figure within a year or two. Meanwhile, the
linkage system was functioning satisfactorily
and, moreover, private consumption rose impressively
by 28% during the 1980-83 period.
Nevertheless, it became obvious that the
party was over. However perfect, the linkage
machine itself was fueling the fire of inflation
at an increasing pace. As inflation evolved
into hyperinflation, the price spiral was
taking a toll on economic output. Dealing
with daily linkage adjustments and their repercussions
was draining the time and resources of households
and businesses.
In July 1985, the government adopted the
Economic Stabilization Policy, which called
for interference in the economy to an extent
that would be considered "reactionary"
among economic theorists. A total freeze of
prices of all goods and services was imposed
and the linkage mechanism was suspended. Everything
from price tags in shops and stores, charges
for services, prices specified in contracts,
wages and public budgets to foreign exchange
rates, remained fixed at the exact nominal
quotation on the day the policy was declared.
It worked. In 1985, inflation fell to 185%
(less than half the rate in 1984). Within
a few months, the authorities began to lift
the price freeze on some items; in other cases
it took almost a year. In 1986, inflation
was down to just 19%.
The linkage system was reinstated as soon
as the stabilization policy showed signs of
success, although the Bank of Israel began
to take stricter measures to supervise the
monetary aspects of the economy. The stabilization
policy won worldwide admiration and is still
studied in university faculties of economics
- as, indeed, is the linkage mechanism. The
criticism and doubt with which the policy
was greeted in the summer of 1985 turned into
overwhelming praise.
The Victory - and the
Price
Throughout the 1990s, the level of inflation
decreased further, though not in a straight
line. The government undertook to restrain
deficit spending and to liberalize markets.
Many restrictions on imports were lifted and
monopolies were broken up, helping to bring
prices down. The Bank of Israel, especially
from the middle of the decade onward, adopted
a restrictive monetary policy, raising interest
rates often to punishingly high levels. The
economy slipped into a recession in 1996 and
growth slowed significantly - by Israeli standards
- while unemployment rose almost to double-digit
levels. But the result was that in 1999 inflation
was only 1.3%, the lowest figure in over three
decades.
Economists have debated the cost to Israel of
bringing down inflation. Was it worth bringing
economic growth to a near-halt and putting people
out of their jobs to cut inflation from 10%
to 2%? Hyperinflation certainly comes at a cost
to the economy, but does low double-digit inflation
demand strong counter-measures? Other countries,
including the United States, have had to ask
themselves the same questions.
Fortunately for Israel, the fight against
inflation came at a propitious time when other
factors helped offset the worst effects. Nearly
a million immigrants - mainly from the former
USSR - arrived in the 1990s creating new demands
and swelling the labor force with skilled
professionals. The high technology boom also
got under way, creating thousands of new businesses
and jobs. At the same time, the Middle East
peace process opened new doors for Israeli
exports.
As Israel's economy has begun showing stronger
growth, the inflation debate has softened.
Yet, there are still challenges ahead. Not
everyone is convinced that the final victory
over inflation has been won. After so many
years of double-digit price rises, high inflation
is viewed as the norm, and any signal that
inflation may be on the upswing elicits a
rapid response. Indexation is still common
practice throughout the economy, which makes
it hard to keep inflation down. The persistence
of monopolies and other non-competitive market
situations creates inefficiencies and high
prices. And, as a small, trade-reliant economy,
Israel is more vulnerable to imported inflation
than a bigger economy.
Nevertheless, Israel's experience until now
is instructive, both in how to live with high
inflation and how to bring it down. If Israel
can tackle the remaining obstacles in the
coming years, it will certainly have more
to teach.
Apples and Oranges
In Jerusalem's markets in the early 1940s,
the price of a kilogram of Jaffa oranges was
two mils. There were then 1000 mills to the
lira (pound) which, in 1980, was converted
to the shekel at a rate of 1:10, and the shekel
was then converted to the New Israeli Shekel
(NIS) at a rate of 1:1000 in 1985. Last winter,
the average price tag attached to a kilogram
of oranges was NIS 3. In other words, the
nominal price of that juicy local product
has risen 15 million (!) fold. Now, that is
inflation.
On the other hand, in those early years one
could purchase 5000 kilos of oranges with
the average monthly wage (around 10 liras),
whereas with NIS 6,150 (the average monthly
wage in the winter of 1999), one could only
acquire 2,050 kilos, a third of that amount.
So, does this mean that Israelis are worse
off than they were more than half a century
ago? Well, the answer is yes - but only with
regard to oranges. As for everything else,
there is nothing further from the truth. To
conclude this point: developments in an economy
should never be measured on the basis of a
single item.
The reason for this discrepancy is as follows:
citrus fruit was Israel's main export for
many years. Even as late as 1967, it still
constituted 20% of all exports. However, in
the first half of the 1940s, the Second World
War curtailed the movement of civilian shipping,
and there was nothing one could do with all
that fruit but to sell it locally at the best
possible price.
The Consumer Price Index (CPI) was contrived
to avoid exactly such irregularities and exceptions
in price calculations. Israel's Central Bureau
of Statistics measures the real average change
in the prices of a thousand or so of the more
popular items of expenditure. The price rise
(or decline) of oranges, for example, is given
its actually measured weight in the total
"basket" of goods and services of
the average consumer. This CPI basket is updated
every so often: it could not have included
TV sets or kiwi fruit in the 1940s, and today
it would not include then-popular items such
as silk stockings.
Thus, however fast the rise in the price
of oranges, or any other single item may be,
it would have very little bearing on the total
standard of prices, or the purchasing power
of a wage earner.
Sources: Israel
Ministry of Foreign Affairs |