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11 STABILIZATION AND MISSED OPPORTUNITIES Stabilization: The Program and Its Impact In recent years, the economics literature has devoted considerable space to the question ofhow best to stop inflationary processes, so much so, that the debate exceeded the boundary of strict academe and spilled over to, for instance, The Economist. In particular, the debate centers on the question of whether orthodox or "heterodox" policies work better in stopping inflation. Orthodox means, in this context, tight fiscal and monetary policy. Heterodox means a policy that, in addition to employing traditional means, opts for some unconventional instruments, such as income policy, price controls, exchangerate stabilization, and so forth. 1 Israel opted for the heterodox alternative. In doing so, the architects of stabilization adopted to a considerable degree the reasoning that provided the conceptual underpinning of the dollarization plan.2 Stabilization started on July I, 1985, about ten months after the new government had come into office. In terms of design, the plan was based on two core parts. First, the shekel was devalued by about 19 percent relative to the dollar and COLA was suspended temporarily. The effect slashed real wages to their lowest level since 1978, see Figure 10.4. In fact, the average real wage in the last quarter of 1985 was equal to the 1978 average. When COLA came back later on, it had a different formula: from then on indexation payments at a rate of 80 percent of inflation were made either every three months or whenever the cumulative increase in the consumer price index reached 4 percent, whichever came first. With wages sharply reduced, it was no longer necessary to keep devaluing, and so the exchange rate was fixed at IS 1,500 to the dollar. The second part of the plan consisted of reducing an array of government expenditures. By far the most important was the reduction of two subsidy items: to exports and to basic goods and services. Both cuts were facilitated largely by the first part of the plan. The large devaluation, unaccompanied by wage increases, increased the profit margin on exports and import substitutes, to the point where part of the subsidization could be eliminated. The govern- 270 The Poftical Economy ofIsrael ment could increase food and other prices without thereby generating several rounds of indexation payments. Price increases of staples and essential services averaged 45-75 percent and in some cases doubled.3 In addition to these main components, a price freeze was instituted, and a price control mechanism set in motion. It is widely recognized that artificial price controls, if they work at all, are effective only in the short tem1. If they do work for a while, then they can be very useful for a stabilization program of the sort under consideration, because the success of such a program depends on its credibility. And there is nothing like quick initial success to generate the needed credibility. A new currency was also issued, the new shekel, a unit of which is equal to 1,000 units of the old currency, the shekel (which had been introduced in 1980 and denominated at I shekel =10 Israeli pounds). The program proved an instant success, which is plainly evident from Table 11.1, an extension of Table I0.3. In the third quarter of 1985 inflation still raged at an annual rate of 375 percent, but it tumbled in the fourth quarter to only 40.6 percent. In the first quarter of 1986, at 5.2 percent, it was getting close to a par with inflation rates in the developed economies. In Chapter 10, we interpreted the tremendous increase in the budget deficit in 1984 as supporting the view that the deficit was more an effect of inflation than a cause thereof. This is further reinforced on inspection of the deficit developments after July 1985. The relevant comparison is between 1984, the last full year prior to stabilization, and 1986, the first year following it. The deficit declined dramatically: from 14.4 to minus 0.3 percent of the GNP between the two years.~ But the really remarkable fact concerning the decline is that it was facilitated more by increased revenues than by reduced spending. Revenues increased by an amount equal to 9.4 percent of the GNP, whereas spending declined by 8.4 percent of the GNP. The two numbers together exceed the total improvement. This is because interest payments on the national debt took a leap, increasing by 3.2 percent of...


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