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.
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.
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.
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.
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.
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.
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