Open Access
Journal Article
A Virtual Economics Laboratory: What Generated High Inflation? 14 Different Explanations to One Inflation Period
a
Cohn Institute for the History and Philosophy of Science and Ideas, Tel Aviv University, Tel Aviv, Israel
*
Author to whom correspondence should be addressed.
JEA 2023 2(2):24; https://doi.org/10.58567/jea02020003
Received: 5 March 2023 / Accepted: 31 March 2023 / Published Online: 2 April 2023
Abstract
A high inflation period of seven years (1978-1985) in Israel, which turned into a hyperinflation, puzzled Israeli economists, who tried to understand its causes and mechanisms. As a result, they provided fourteen different explanations. Although all of the explanations were based on the same data, the researchers’ conclusions were either different or contradictory. This situation provides a virtual laboratory for the study of the ways and methods of economic thought; it is a classical Ceteris patribus situation. This laboratory further raises other subjects and questions. Are there principal differences between the economists' explanations? Is it possible to classify these differences? How do economic explanations for inflation differ from non-economic ones? In this article, I classified thirteen economic studies and one non-economic study into five clusters. This was the methodological tool used to inquire into the economic thought in this virtual laboratory.
Keywords:
Inflation;
Hyperinflation;
Deficit;
Rational expectations;
Indexation;
Economic theory;
Economic evidence;
Copyright: © 2023 by Barak. This is an open-access article distributed under the terms of the Creative Commons Attribution License (CC BY) (Creative Commons Attribution 4.0 International License). The use, distribution or reproduction in other forums is permitted, provided the original author(s) or licensor are credited and that the original publication in this journal is cited, in accordance with accepted academic practice. No use, distribution or reproduction is permitted which does not comply with these terms.
Cite This Paper
APA Style
Barak, Y. (2023). A Virtual Economics Laboratory: What Generated High Inflation? 14 Different Explanations to One Inflation Period. Journal of Economic Analysis, 2(2), 24. doi:10.58567/jea02020003
ACS Style
Barak, Y. A Virtual Economics Laboratory: What Generated High Inflation? 14 Different Explanations to One Inflation Period. Journal of Economic Analysis, 2023, 2, 24. doi:10.58567/jea02020003
AMA Style
Barak Y. A Virtual Economics Laboratory: What Generated High Inflation? 14 Different Explanations to One Inflation Period. Journal of Economic Analysis; 2023, 2(2):24. doi:10.58567/jea02020003
Chicago/Turabian Style
Barak, Yair 2023. "A Virtual Economics Laboratory: What Generated High Inflation? 14 Different Explanations to One Inflation Period" Journal of Economic Analysis 2, no.2:24. doi:10.58567/jea02020003
1. Introduction
During the years 1963-1972, the average annual inflation rate in Israel was six to seven percent. This period has been defined, from the Israeli inflation history perspective, as the Pre-inflation Period. Between 1973 and 1977, the inflation rate ascended to a yearly average rate of 40%. That was the Inflation Period. During the years 1978-1983, it rose to an annual average of 130%. The shift to triple digit inflation occurred in the third quarter of 1979. In October 1983, it jumped to an annual rate of 445%. That was the High Inflation Period. In the first half of 1985, its rate skyrocketed to 700%. That was the Hyper Inflation Period.
The clear shift from the Pre-inflation Period to the Inflation Period was fundamentally caused by the monetary reform introduced by the new Minister of Finance, Simcha Ehrlich, who conceived, promoted and implemented the reform six months after the dramatic change that occurred in Israeli politics, due to the 1977 elections (May 17, 1977). This was when the right-wing coalition, led by the Likud, replaced the hegemony of the Labor party that had been led by the Ma’arach.
Up until 1977, the inflation process and rate were similar to the process and rate in the OECD countries. Even when Israel’s inflation rate accelerated afterwards to 40%, due to the economic results of the October 1973 war (called the Yom Kippur War in Israel), it slowed down in the first half of 1977 to 25%. The 1978 annual report from the Bank of Israel (BOI) (Israel’s official central bank) directly connected Ehrlich's reform to the rise of the inflation rate: "The reform affected the inflation rate by influencing the demand and by raising prices of the imported products… The main short-term target of the economic policy should be to decelerate the high inflation" (BOI 1978, 8-9).
The 1979 BOI report was deeply concerned about the rise of the inflation rate. In the 1980 report, it stated that the inflation "is one of the reasons for the non-growth of productivity during the last years since it diverted the economic activity focus from production to the finance sector. In this way, the reciprocal connections between the technological productivity, the economic efficiency, the revenues and the wage level had been weakened" (BOI 1980, 4).
The very sharp transition of the Israeli economy from an economy, with a high growth rate, which was one of the highest in the world (1951-1960 – 11.1% - annual GNP growth; 1967-1971 – 7.7% - annual GNP growth; 1973-1977 – approximately 3%), into an economy with very high inflation rates, attracted the attention of economic researchers, most of whom were Israeli. They wondered how this change happened and were interested in understanding the economic forces that caused the rapid ascent to high inflation in such a short time.
Don Patinkin summarized the various aspects and results of the Israeli inflation in a comprehensive paper, that encompassed the history of the inflation process and the stabilization program that ended the inflationary period on July 1st, 1985. He wrote:
"The older textbooks generally listed four functions that money serves: unit of account, medium of exchange, standard of deferred payment, and store of value… The (Israeli) inflation from 1970 to 1985 gradually eroded the function of the nominal Shekel as a medium of exchange… The shekel lost its function even more rapidly as a store of value. At the same time, it lost its function as a standard of deferred payment being indexed to either the consumer price index or the dollar. In transactions involving real estate or durable goods, the shekel also lost its function as a unit of account – the prices of such goods becoming denominated in dollars. Gradually all the prices - for goods, services and the sums quoted in contracts – were fixed in US dollars and paid in shekels, according to the exchange rate at the moment of the payment. … The continued inflationary process generated financial innovations in the form of liquid assets that coped with its adverse effects by virtue of their being shorter maturities and bearing nominal rates of interest that vary with the rate of inflation. In particular, 1980 saw the introduction of certificates of deposit and time deposits of week or even days, which largely compensated for the inflation… When the rate of inflation reached its peak in the middle of 1985, less than 7% of total liquid assets were in the form of nominal money, with the remainder consisting of assets that provided protection against inflation either by being indexed or by bearing more-or-less compensating nominal rates of interest" (Patinkin 1993, 103-112).
2. High inflation Led to Many Studies
In my opinion, the intensive Israeli research, which contributed about 14 articles and publications that found different reasons for the inflation, advanced the Israeli academic status of economics in the international economic research community. The inflation episode, which lasted for approximately 12 years under two different governments and diverse political-military conditions, was the motivation for the undertaking of so many different studies. This unique situation turned the publication corpus into a kind of a virtual research laboratory. The present study examines this ‘laboratory’ by comparing the economics epistemology (is there one epistemology?) to other disciplines; discerns the scientific objectives; explores the methodology and the interdisciplinary relationships between theories, models, and empiricism in the realm of economic science; and asks whether the various studies are separate, contradictory or complementary. Last, but not least, this study further nvestingated the explanatory power of the different studies from a historical perspective.
While the researchers based their work on the same data base and the same information, their conclusions differed. In some cases, they even contradicted one another. Do these different findings cast doubt on the economists’ desires to have their discipline perceived as similar to physics, as noted by Gerard Debreu? He wrote that, “before the contemporary period of the past five decades, theoretical physics had been an inaccessible ideal toward which economic theory sometimes strove. During that period, this striving became a powerful stimulus in the mathematization of economic theory” (Debreu 1991, 2). Is the discipline of economics as rigorous as physics, or is it more flexible, given that it creates numerous narratives, like in the social sciences? I was interested in exploring the power of economic explanations, by confronting the different explanations concerning the rise in inflation, with historical, political, scientific and sociological insights, in spite of the fact that this phenomenon was seen by economists as being an exclusive economic domain.
Though the researchers offered different explanations for the Israeli inflation, I was able to classify the explanations into four economic clusters, according to methodology, narrative or approach. The fifth cluster includes non-economists, whose perspective was entirely different. Unlike the economists, their basic research question was not “How?” as is the main interest of the economists, but rather “Why?” Why did the political leaders engage in inflationary politics, though they were aware of its problems, faults, results and opposition to it?
2.1 The five clusters are classified by three different research methods
The first methodological premise avers that it is best to create or adopt a theory that explains inflation or relates to local inflation as a metahistorical phenomenon. Theory comes first and then the researcher searches for supporting facts, which either confirm or refute the theory. In other words, theory precedes empirical evidence.
A metahistorical approach excludes Israeli inflation from its local history and context and sees more similarities to inflation episodes than to uniqueness.
The second method is empirical. Facts come first, then interpretations, explanations and conclusions. Some investigations, which are based on real economics’ material, support a known theory and model or formulate an original model derived from the empirical findings.
The third method, which is rooted in the premise that inflation is a medium or tool to overcome distributional socio-economic problems, is based on an understanding of socio-political reality, rather than on pure monetary facts. Its methodology is taken from political science and sociology. It grasps economy as a societal tool and relates to it as one social science, and not as an exact science.
The less fruitful and convincing methodology is the methodology that states that “theory comes first,” since it uses facts, which are supposed to serve its target.
There are as many conclusions of empirical investigations as there are of investigations themselves. This is because the conclusions are derived from different perspectives, even though all of them are exposed to the same facts and figures. This is a classical Ceteris patribus situation: the same historical episode has been studied from various methods, aspects, perspectives, angles, attitudes, and weltanschauungs.
3. The First Cluster – The Metahistorical Model
Economists and researchers, in this group, used a theoretical frame to explain the Israeli inflation as one that could be viewed/understood as any other historical episode of hyperinflation. For these researchers, hyperinflation was a unified frame. They excluded the local, temporal and political circumstances and did not refer to the actual protagonists and the particular human forces that generated the process, or that tried to prevent or restrain it. They approached inflation as an economic phenomenon that was not tied to a real context. This group of economists formulated a universal uniform model that could explain any instance of hyperinflation in the past (and, perhaps, would also be applied in the future).
Although hyperinflation (approximately 50% a month) was a rare monetary phenomenon in modern history (there were approximately 12 periods of hyperinflation during the 20th century) and occurred in different continents, countries, political regimes and eras, this cluster was characterized by one epistemic regime. This epistemology averred that economy is the same everywhere, at all times, and its rules are the same. All economic phenomena resemble one another other and are even identical. As a result, they can be reduced into universal unified models. This conceptualization was (and remains) the prevailing and hegemonic economic research task: modelling. Milton Friedman, the spokesperson for this approach, said, “Inflation is always and everywhere a monetary phenomenon” (Friedman and Friedman, 1970, 272). It has no historical context and is an Epi-historical model.
“The Dynamics of Inflation with Constant Deficit under Expected Regime Change,” written by Benjamin Bental and Zvi Eckstein (1990), is an article that belongs to this a-historical context cluster. The researchers begin with the sentence, “The economic theory of high or hyper-inflation is motivated by observations on major historical inflationary episodes. These episodes tend to display some important common features” (Bental and Eckstein 1990, 1245). Their paper claimed that since researchers are interested in finding common features, they intend to construct a model.
The first feature in the chain of some similarities, which is the “most dramatic feature,” is the behavior of monthly inflation rates. “These rates have a clear upward trend for a while and finally drop abruptly to zero when a sustained stabilization program is enhanced” (page 1245). This behavior was described as exemplifying cases, such as Germany, Austria, Hungary and Poland after World War I and Greece after World War II. More recently, it also explained the Israeli and Bolivian cases. A second common feature is “the decline of real balance of high-powered money during the inflationary episode… This feature is present in all of the episodes mentioned above” (page 1245). The third common feature is the government’s revenue from increasing the quantity of high-powered money (seignorage). “Finally, the stabilization politics adopted by the governments in the diverse countries and historical periods mentioned above seem also to be strikingly similar” (page 1245).
The authors referred to the wide geographical distances and time gaps between Germany in the 1920s and Israel in the 1980s, claiming that the historical period has no importance, since “the goal of our paper is to provide a framework that is compatible with all the common characteristics of inflationary episodes under the discipline of rational expectation” (page 1248). In other words, the authors were interested in proposing a meta-historical inflation framework that would be compatible with an axiomatic meta-model (this will be discussed in the next cluster).
In addition, the authors were not especially interested in explaining past inflationary periods in their model. “We want to concentrate on the trends of the different variables and choose accordingly to construct a deterministic environment” (page 1248). Determinism in science, in general, and in social sciences, in particular, is a disputable issue. For these Israeli authors, inflation is an instrument that can be employed to develop a deterministic medium, which can be applied to all inflationary periods, whether in the past or in the future. Inflation, for this cluster, is a universal economic episode, not tied to any one particular period or country.
Dani Rodrik related to this pretension to formulate a universal epi-model: “What makes a model useful is that it captures an aspect of reality. What makes it indispensable, when used well, is that it captures the most relevant aspect of reality in a given context. Different contexts – different markets, social settings, countries, time periods, and so on – require different models” (Rodrik 2015, 11).
4. The Second Cluster – Inflation Expectations
This group of economists described, characterized and analyzed the Israeli inflation period by applying an economic paradigm to the specific Israeli data and events. They collected local data and analyzed it, by employing universal tools. They were equipped with tools that led them to identify the economic and institutional facts that supported and proved their pre-prepared general theory.
The best representative of this economist cluster is the paper “Israel 1983: A Bout of Unpleasant Monetarist Arithmetic,” written by Thomas Sargent and Joseph Zeira (2011). The paper was published a few weeks after Sargent became a Nobel laureate due to development of his theory “Rational Expectations and the Dynamics of Hyperinflation” (1973), a theory developed together with the late Neil Wallace.
4.1. “Israel 1983: A Bout of Unpleasant Monetarist Arithmetic”
Thomas Sargent and Joseph Zeira’s article “Israel 1983: A Bout of Unpleasant Monetarist Arithmetic” related to the five-year period of the Israeli inflation rate of approximately 120%, which suddenly jumped in the middle of October 1983 to an annual rate of 400%. The rate of inflation fluctuated around that level until July 1985, when a comprehensive governmental scheme stopped the hyperinflation. The authors wrote:
We claim that the October 1983 jump in inflation was caused … by the announcement of a massive bailout of bank shares by the government of Israel. In October 1983 the government promised to reimburse shareholders for the high values their shares had fallen from, but only after four or five years. That promise increased the government debt overnight by 5.5 billion dollars, about a quarter of the Israeli GDP (Sargent and Zeira, 2011, 419).
The theory of “unpleasant monetarist arithmetic” states that it is not the contemporaneous rate of money growth that causes inflation, but rather the amounts of future government deficits the public expects to be monetized.
In a press release, issued by the spokesperson of the Hebrew University, Zeira explicitly added that:
The public believed rationally and reasonably that the government would quickly print more and more money in order to cover the debt and by doing so the money’s value decrease. People sold local currency in order to prevent losses. The prophecy realized itself and caused an inflation rate of 400% (7.2.2012).
How did the authors know about public expectations of an inflation that would occur five years later? “We can learn about those expectations from rates of return on bank shares after the bank shares arrangement, which is called in Hebrew, hesder (see Appendix A). The ex-post rate returns these banks shares, which were like dollar indexed bonds, was quite high” (pages 423-424).
Why did the authors believe that the public expected the bailout to be financed by money creation? They answer that “unlike other public debt, which in principle could be rolled over later periods, here was an obligation to pay within a short period of four to five years, making it more likely to be monetized” (page 424). They summarized the sudden jump in the inflation rate that occurred in October 1983 by asserting: “we view the sudden increase in anticipated financial obligations of the government as offering a promising explanation for the rise of inflation in October 1983” (page 424).
There is no direct objective evidence of public expectations in their paper. The authors inferred the expectations from monetary facts that do not necessarily relate to expectations. They related to a million Israelis as if they were comprised of one million sophisticated economists, who were qualified to project what would happen in five years’ time and to respond immediately to such an accurate forecast. This is absurd.
Later, the authors admitted that the implementation of the great stabilization program of July 1985:
… upset the October 1983 expectations that we are attributing to the public. As a result, the bailout was not monetized and the reason why that stabilization program was not anticipated by the public in October 1983 is the substantial changes in the political landscape… (page 424).
Is it possible that the sophisticated public, who expected an inflation, that would happen five years later, could not rationally expect the change in the political arena that happened just one year later? There is also a contradiction between the paper and the university press release: Zeira noted that the government would compensate the shareholders five years later. Therefore, why did he claim in the press release that the public believed that the “government would quickly print more and more money?” Is this explanation real and rational?
What was the empirical evidence for a public rational anticipation of a higher inflation rate? Zeira responded to my personal question, in our long e-mail correspondence, in the following way: “There is not any empirical infrastructure, except the fact that there was an arrangement and a commitment to pay the bailout.”
I asked: “What is the empirical basis for the rational inflation expectations that generate inflation?” “It’s a theory,” he answered, “and a theory is never established on empirical foundations. A theory is checked by comparing its ability to predict the empirical reality and then the theory is confirmed or refuted.”
4.2. Refutation of “Israel 1983: A Bout of Unpleasant Monetarist Arithmetic”
Since Sargent and Zeira’s 2011 paper is a historiographical one, which discussed events occurring in 1983, it should follow the discipline of history and methodology. The core methodology of historical research, as an empirical and positivistic discipline, relies, as much as possible, on primary sources. Therefore, a claim concerning public expectations should stem from primary evidence. The authors did not rely on such evidence; Zeira even claimed that theory comes first, then come facts, if there are any at all.
The authors also Ignored how the I”rael’ Central Bureau of Statistics (CBS) calculates the monthly index. By ignoring this procedure, this led them to their major false claim. The calculation is based on a collection of monthly price changes in certain sectors of products and services, which are collected during the entire month. Foreign money exchange is not included among the measured items. The monthly price is fixed as the average price of the entire month and not according to any peak or exceptional event.
An accurate track of consumer events after October 1983, and the CBS announcement about the October 1983 index, clearly explain the index jump with no need for speculative models. The rise of the index was due to the price increases of food (+24.7%), housing (+20%) and furniture (+17%). Most of the price increases happened before the announcement about the bank shares bailout.
Sargent and Zeira’s claim is that the bailout announcement caused the public’s rational expectations about inflation, which generated a sudden jump in the inflation rate. They did not explain how the expectations were realized in the market and activated inflation. What did the public do that caused an inflation to surge? The university press release stated, “People sold the local currency in order to prevent losses.” But currency sales is not one of the items measured in the Israeli index basket. In any event, the people who exchange local money for foreign currencies do not generate inflation. Sargent and Zeira ignored such a basic fact.
All the facts and figures, which were relevant to October 1983, entirely refute Sargent and Zeira’s thesis. It remains speculation without any empirical support.
4.3. REH – The Rational Expectation Hypothesis (REH) as a “Wrong Theory”
Frydman and Goldberg (2007) chose REH as the paradigmatic model of contemporary economics. The scholars claimed that modeling had become the main instrument to understand and predict economic phenomena. The REH model was criticized, since it was presented as being a perfect tool in an epistemic reality of imperfect economic knowledge. Indeed, Frydman and Goldberg entitled their book Imperfect Knowledge Economics.
The authors wrote, “In real world markets, where knowledge about the future course of market outcomes is imperfect, REH, too, implies that individual market participants ignore obvious systematic information in their forecast errors and thus REH models are the ‘wrong theory’” (Frydman and Goldberg 2007, 41-2). “We must conclude that REH models are the ‘wrong theory’ for modeling aggregate outcomes on the basis of individual foundations” (page 11). The REH model was a perfect model for imperfect economic knowledge.
5. The Third Explanation Cluster – Adhering to the Israeli Economic Reality
The common denominator of the explanations included in this cluster is the understanding that the 1980s’ inflation was caused by the Israeli economic reality. It was due to the policy, the economic activities and the arrangements that were implemented by the economic forces and institutions. The researchers’ basic investigation method was empirical and was based on local statistics and data. The economists understood the inflation episode as a stand-alone episode and not as part of a meta-inflation model or theory.
There was disagreement among the scholars, rather than the opposite: each study included in this group understood the episode in a different way and interpreted the data from a different perspective. Some of the scholars even contradicted one another, though their work was based on identical databases. This variety can be understood from different scientific points of view and also due to the exceptional and unusual economic episode in the history of Israel.
The scholars grouped In this cluster agreed that governmental budget deficits had no exclusive or decisive impact on the high inflation rates. All the Israeli studies that examined the correlation between the deficit’s fluctuations and the inflation rates found that there was neither a correlation nor a connection between them. Furthermore, in some cases, the deficit was lower, and the inflation rose. They identified other mechanisms and policies that caused inflation, other than the cliché of budget deficits as the central generator of inflations.
5.1. Shiffer: The Endogenous Nature of the Money Supply in Israel
Shiffer (1982) related the high inflation in Israel (the approximate annual rate was 130%, the year his paper was published) to its local conditions and history. However, he explained it by using Cagan’s methodological frame, which was “Endogenous Money Growth Nature.”
Shiffer found that the public (that is, the economy) was the inflation’s generator (an endogenous factor) rather than the institutional sector (an external factor): “The quantity of money was largely endogenous – that is, determined by the economy rather than by explicit policy decisions. Thus, a recent econometric study has shown that the rate of money growth was significantly affected by past price changes. This does not mean, of course, that the money supply played no crucial role in the inflationary process. It merely indicates that under the institutional arrangements prevailing in Israel, the growth of money accommodated and validated prior price changes. The endogeneity of the money stock has an important bearing on the dynamics of the Israeli Inflation process” (Shiffer 1982, 34).
Shiffer’s main and original argument was that “accelerations in the rate of price increases have tended to precede accelerations in money growth. Two factors especially have contributed to this mechanism in Israel: a) The extensive system of indexation transfers price increases from one sector to another quickly and inflates the nominal values of indexed financial assets; and b) The experience with high and rising inflation has increased the speed with which prices adjust and shortened the lag between present price experience and changes in inflationary expectations” (page 34).
Shiffer adopted a universal economic tool, the “Endogenous Money Growth Nature,” to analyze “the Historical Record of Money and Inflation in Israel” (the fifth chapter of his paper). A universal tool was used in order to understand local economic reality.
5.2. Litvin, Meridor and Spivak: The Government and the Bank of Israel Generated the Inflation
Three economists from the research department in the Bank of Israel – Uri Litvin, Leora Meridor and Avia Spivak (1984) – provided an opposite approach to Shiffer’s approach. Their article, “Inflation and Money Creation in Israel in the 1970s,” which was first published in Hebrew, maintained that the Bank of Israel’s policy generated the inflation. The authors did not find causal connections between governmental budget deficits and inflation. “[I]nstead, we found a strong statistical association between inflation and central bank injection” (Litvin et al. 1988, 57). In other words, their argument was that the Bank of Israel was the generator of the money that caused the inflation.
The mechanism mployyed subsidized loans, given to the private sector, as an unindexed credit. This raised inflation along with the nominal interest adjustment lag that increased the implicit credit subsidy. The authors state, “this subsidy accounts for a large part of the central bank injection … The subsidy is important for our understanding of the behavior of the money supply” (page 57). According to the researchers, by creating money, the Bank of Israel increased the difficulties of financing the budget deficit, aggravated the country’s economic problems, and allowed inflation to rise. The bank had a dual motivation for adopting such a policy, according to the researchers. The bank wished to support exporters and other favored sectors, through the provision of cheap and unindexed credit, and/or to “lubricate economic activity – because of, inter alia, unemployment aversion – whose instruments were cheap credit to exporters and other favored sectors which got into difficulties” (page 58).
The creation of money, termed “printing money” In the research, aimed to protect the business sector and, at the same time, to bridge the gap between the unindexed governmental credit to the business sector and the decreased value of the refunds. The researchers called the central bank’s contribution to the creation of money “the compensation element,” which was an “exogenous rise in inflation” (page 70).
Litvin, Meridor, and Spivak concluded that inflation was due to an exogenous source, which contradicted Shiffer’s endogenous approach.
5.3. Liviatan and Piterman: The Balance of Payments Crisis as an Inflation Generator
Esther Alexander (1980) was an unconventional economist, whose academic approach went against the mainstream. As a result of this, she preferred to publish her ideas and analyses in the popular media. When writing about the cause of the inflation on May 20th, 1980, she stated the following. “As a result of the frequent devaluations the dollar exchange rate is always connected to the increase in prices. Because of the fluctuation in the dollar’s value, the increase in the cost-of-living index and the increase in the dollar occur simultaneously. … The economy is like a dog trying to catch its tail; it’s impossible to know if the head is chasing the tail or if the tail is chasing the head… Without breaking this vicious circle of the increase in the value of the dollar leading to an increase in the cost-of-living index, it is impossible to stop the inflation.”
Although Alexander was an economic outsider, she shared her ideas with many of the economists who maintained that budget’s deficit was not a main cause or a generator of the inflation, as is demonstrated in the following section:
5.4. The Academic Twist
Four years later, the economists, Nissan Liviatan and Sylvia Piterman (1984 in Hebrew and 1986 in English) tested Alexander’s proposal by undertaking empirical, academic research. Their paper was entitled “Accelerating Inflation and Balance of Payments Crises 1973-1984.” The paper opened with the premise that confirms the accepted economists’ doxy:
The inflation process in Israel over the past decade (1973-1984) has been a puzzle to economists. The increase in the government’s budget deficit, traditionally considered to be the main cause of inflation, may explain part of the rise in inflation in 1974, but does not seem to explain its sharp acceleration in the second half of the decade. In fact, this chapter presents evidence for an opposite tendency, namely, that the recent acceleration of inflation has been associated with a reduction in the real budget deficit… Another indicator of the fiscal approach is the government’s revenue from printing money. The data show that this component of the deficit did not increase with acceleration of inflation. There is also some doubt as to whether the revenue from inflation was offset by losses of revenue as a result of inflation. (Liviatan and Piterman 1986, 320)
Since the researchers explicitly declared that they had doubts regarding the ability of the prevailing common conventional theories to explain the Israeli inflation episode, they further stated that, “we must look for other mechanisms. Monetary accommodation is certainly a necessary condition for inflation, but we have to identify the force driving it” (page 320). The inflation mechanism they found was a “clear empirical relation between inflation and balance-of-payments (BOP) crises. It also describes the mechanism by which the BOP crises are translated into inflation. (page 320).
There were different causes for the BOP crises. “The 1974 crisis was largely a fiscal one, combined with a deterioration in the terms of trade; the 1979 crisis was strongly influenced by monetary factors; and the 1983 crisis was associated with the exchange rate policy (page 321). The causal connection between those crises and inflation was explained in the following manner. “In ordinary times, the government stabilizes the level of inflation by managing the exchange rate, determining changes in government-controlled prices, and setting monetary targets. When a BOP crisis develops, the government temporarily suspends its stabilizing policies and resorts to drastic devaluations and similar increases in controlled prices” that cause a rise in the general price level due to the widespread indexation schemes in the labor and capital markets. The result was “a new level of inflation” (page 321). In the original Hebrew paper, it was phrased in the following way: “The Israeli experience shows that such price shocks that occurred during the BOP crisis were translated into an inflation jump to a new level.”
“The conclusion, which is inferred from a historical point of view, is that the inflation was not caused by the government’s requirement to finance the budget, but due to the government’s refusal to adopt a yoke of a monetary fiscal discipline, as it was necessary under an exchange rate rule.” That remark appeared only in the original Hebrew paper. Therefore, the question is, why did the government refuse to accept such a discipline? The authors presumed that the government did not take into consideration that the policy of using the price shock policy as a temporary measure to cope with the BOP crisis caused long-term consequences in the form of new inflation degree. The reason was that it “has not been realized until recently” (page 340). When the authors used the term “recently,” they were referring to the publication date of their article in Israel (November 1984).
5.5. Bruno and Fischer: High Inflation was Due to Institutional Adaptations and the Monetary and Fiscal Policy
The economists Michael Bruno and Stanley Fischer were members of the American-Israeli staff that had been organized by George Schulz, the US Secretary of State, in the end of 1983. The staff aimed at planning and implementing a stabilizing plan to end the Israeli hyperinflation. They published their joint NBER working paper in October 1984 when, coincidentally, the annual inflation rate increased to 700%. Their paper can be viewed post factum as scientific preparation for their coming stabilization plan, since it analyzed the inflation’s roots, according to their understandings, and they proposed a scheme to restrain it. The paper describes the process of inflation and the authors undertook a broad and in-depth analysis of its phases, causes, the forces that tried to retard inflation, and the reasons for their failures. The paper provided a history of the inflation, from an economic perspective, and to some degree, from a political perspective as well.
“There has been no shortage of explanations of inflation: it has been ascribed to indexation, to monetary policy, to the budget deficit, to the introduction of floating exchange rates, to ‘bubbles’ – self-justifying expectations of inflations provide necessary conditions for continuation of the process” (Bruno and Fischer 1984, 1). This paragraph provided a concise list of some of the inflation’s causes that have been raised by economists and politicians since 1977. “Taking as given successive governments’ reluctance to force the inflation rate through a restrictive policy that might produce a major recession, there remain serious economic questions about the forces driving the inflationary process and the institutional adaptations that permit the economy to operate at a reasonable level of efficiency despite inflation” (page 2). This sentence reflects the idea that the Israeli government could have restrained the inflation, but refused to do so. In other words, whatever the economic reasons for the massive inflation, it could have been tamed by implementing political means. However, Bruno and Fischer preferred to focus on the political-economic causes rather than on the political causes:
In a nutshell, our explanation of the inflation will be that because of institutional adaptations, and as a result of accommodating monetary and fiscal policies, the stabilizing forces in economy are very weak, leaving the inflation rate a meta-stable equilibrium. This means that the inflation rate could come down as well as rise, but the underlying thrust of fiscal and monetary policies during the period has been expansionary, with the result that the adaptation of the inflationary process, including expectations formation, has been smoother upwards and more rigid downwards, even when cost-reducing factors were occasionally operative. The socio-political-economic infrastructure was the indexation and on top of it came the financial structure, exchange rate system in determining the economy and the fiscal and monetary policies that have permitted the inflation to continue. (page 2).
In the last chapter, “Stabilization Programs,” which I suspect was their paper’s telos, as a preparation for the forthcoming plan. The authors wrote that reducing the inflation rate to the low double-digit range “could only be carried out through a comprehensive stabilization program that attempts to make adjustment rapidly rather than gradually… The conclusion that the program should be comprehensive and rapid has been reached on political economy and not purely economic grounds” (pages 36-37). They repeat that conclusion in a later version of their publication that appeared after the successful application of the stabilization program on the 1st of July 1985 (Bruno and Fischer 1986, 370).
By positioning politics before economy, they admitted that political considerations come first and then implementation of economic steps are needed that are adapted to the social-political environment. In other words, economic models and theories are not disconnected from the political context, social needs and preferences, as they often are in the academic economic environment. Some theories are mobilized in order to understand the economy and to adapt economic means, which can satisfy political needs. Therefore, economics functions both as a science and as engineering, as noted in the original and fruitful insight offered by Gregory Mankiw (2006) in his article “The Macroeconomist as Scientist and Engineer.”
Bruno and Fischer’s last conclusion forms the premise of the discussion of the fifth cluster. The researchers were on the threshold of this cluster but did not cross it.
5.6. Yoran: The Inflation Gap is the Gap between Two Aggregates – Income Demands and the Economy’s Whole Income
Yosef Yoran’s article was also published in October 1984 in The Economic Quarterly. The editors added an unusual remark to the publication: “the author expresses an unconventional opinion by claiming that the Israeli economy suffers from schizophrenia…”
Yoran explained the Israeli inflation as part of an “exceptional economic arrangement” (Yoran 1984, 218) that had governed the economy since 1974 and generated a frozen product growth, non-growth and a rise in the real per-capita income and inflation. “The irregular economic arrangement enabled the achievement of the targets that were impossible to gain within a sound system: an increase of the real income in conditions of a frozen product increase. The real income per-capita rose during the years 1972-1982 by 24% and private consumption per capita rose by 32%. However, the net business product, decreased by 8%-9% per capita.” That was the “economic schizophrenia” (page 218).
Those impossible contradictory targets were achieved by a “pathological formation,” which was obtained by a selective restraint of the business sector in an unrestrained economy. That process caused a sharp investment decrease that released real resources. This enabled enlargement of private consumption. Private consumption replaced investments.
In a non-growth situation characterized by a policy that aimed at maintaining private consumption by shifting resources from production to consumption, the government became an absorption-injection pump: it absorbed resources from the productive sector and injected them into consumption. When a gap was created between the real income and the salaried employees’ demands to maintain real salaries, the government injected resources from its deficits and issued governmental financial assets (bonds) to satisfy the demands in order to sustain private consumption. This injection generated inflation. “The inflation gap was not the gap between demand and supply in the commodities market, but rather the gap between the aggregate of all income demands and the income aggregate of the economy as a whole”(page 229). That was an unconventional original view that directly combined social policy with economic policy. “The initial push of inflation – the above-mentioned gap – still continued to move the inflation process” (Yoran 1984, 230). Yoran wrote this in 1984 when the inflation annual rate was more than 400%.
Yoran’s original insight and his analysis regarding the inflation generator and process was close to the fifth cluster. However, I have not included him in this cluster since he did not explain why the governments preferred private consumption over the business sector.
5.7. Beenstock and Ben-Gad: Application of a Cointergrated Analysis
The study, “The Fiscal and Monetary Dynamics of Israeli Inflation: A Cointegrated Analysis 1970-1987,” was written by Michael Beenstock and Michal Ben-Gad (1988). This paper summarizes the second and the third clusters for four reasons. To begin with, it relates to most of the above-mentioned cluster’s topics. Secondly, it explicitly discusses some of them. Thirdly, it relates to the entire period of inflation and post-inflation (1970-1987). Finally, it analyzes detailed data within a unique analytical framework, the “cointegration principle in econometrics,” which is exceptional among all other publications.
There were a number of main implications of the model as follows. Public sector borrowing was the fundamental determinant of the core rate of inflation for the period 1970-1987. However, monetary accommodation tended to reinforce inflationary shock. Rational expectations of inflation aggravated the rate of inflation. The inflation was homegrown; external factors played a negligible role. Monetary growth was both a cause and a consequence of the inflationary process. Monetary growth reflected the fiscal deficit and the requirement of public sector borrowing (Beenstock and Ben-Gad 1988).
It is difficult to distinguish between a “monetarist” model, in which only money matters explain inflation, and a “Keynesian model,” in which non-monetary assets also influence inflation. The cointegration method enabled the authors to integrate the inflationary factors and both exogenic and external inflationary dynamics by exploring various data sources and economic methods that can summarize the two clusters.
6. The Fourth Explanation Cluster – Negative Inflation Tax
This small cluster regarded the state budget deficit as the initial generator of inflation. That deficit was examined under the notion of Inflation Tax. It is common knowledge that the function of the budget deficit is to finance the government’s activities, which are not covered by the government’s income, that is, the taxes. Therefore, it is possible to relate to the deficit as a kind of tax. Due to the common belief that the governmental deficit is an inflation generator (however, according to most of the studies, which are presented in this discussion, that belief is not acceptable and even refuted) the deficit could be perceived as a substitute for a special tax – Inflation Tax. In this case, the government is obviously its beneficiary. Apart from the issue of surplus money, which from the government’s perspective is like a non-interest loan, a positive injection enables the government to enlarge tax levying caused by price increases, due to the rise of inflation that had been caused by the deficit. Generally, during an inflationary episode, all the people who borrow money are inflationary winners, if their loans are not adapted to the index, while the lenders are the losers, if the interest rate is less than the inflation rate.
However, in the budget year that ran from April, 1949 through April, 1950, the first unique situation occurred when the Inflation Tax was a negative Inflation Tax. At that time, the public won, and the government lost (Morag 1967, 261). According to Meir Sokoler, this inverted situation repeated itself during a dozen years.
6.1. Sokoler: 1970-1982 – The Government Paid a Negative Inflation Tax
According to Sokoler’s research (originally published in Hebrew in June 1984), the government – which in the research included the national government, the local authorities, national institutions and the central bank – allocated un-indexed credits both to the private sector and to the business sector. This entire credit was a subsidy; its source was the government’s losses, which emanated from the un-indexed credits. The credits were specifically aimed at investments, housing and export funds. These loans were returned to the lender, and were fully unindexed, up to the inflation rates. The total amount of the subsidized credit was 4.2% of the GNP in 1971; 9% in 1973; 15% in 1974; 10.4% in 1979; and 5.1% in 1982 (Sokoler 1987, 14). Unindexed credit arrangements were phased out from 1979 onwards.
Sokoler wrote, “In Israel, money creation and inflation did not serve as a source of deficit finance. This was due to the asymmetry of the indexation procedure that was in effect until 1979: the government borrowed fully indexed funds at a positive real interest rate, whereas it granted credit at a subsidized nominal rate whose adjustment to inflation was partial and slow. In such a situation, at least some of the credit subsidy is attributable to inflation; therefore, it can be defined as a subsidy that reduced net government revenue from inflation.” (page 23)
Apart from subsidized credit, Sokoler proposed that money creation and inflation, among other factors, were responsible for increasing liquidity of the domestic public debt. This enabled the government to enlarge the debt without raising interest rates on incremental borrowing. Thus, while inflation did not fulfil its conventional financing role, it may have indirectly allowed the debt to increase in the absence of a rise in the real interest rate.
“The government and the Bank of Israel took steps to increase the liquidity of the domestic debt by undertaking some local actions …The central function of inflation in Israel, at least in the late 1970s, was the prevention of unemployment due to a rise in public debt interest rather than the mobilization of sources through erosion of real balances” (pages 22-23).
Sokoler argued that the social aim of Israel’s inflation was based on the concept of the Philip Curve, discussed below. By claiming that prevention of unemployment was the government’s reason for creating a policy that drove inflation. Sokoler’s perspective partly fits into the fifth cluster.
6.2. Why is there a Need for a Model?
Sokoler concluded his unique empirical research with the following statement, “We tried to show that Israeli inflation does not conform to the conventional explanation.” However, he added that, “the definition and measurement of this inflation-induced subsidy requires a model of governmental behavior that can explain why it chose to give subsidies through cheap credit and why, for such a long time, it was ready to accept the persistent decline in the real interest on the credit it granted” (page 23).
Why is there a need for a model that formulates an alternative to detailed empirical research that has its own merits and power of explanation? According to Mary Morgan (2012, 399), one reason is the following:
If (making models) comes to be ‘the right way’ to do that science, it becomes a community commitment. So, when economists became linked by their shared commitment to modelling, as an epistemic genre, they were first and foremost linked by the practices and techniques of that shared technology… And of course, once modelling became the way to reason rightly in economics, any new question or topic that was taken up had to be developed into a modelling project, not as a matter of professional habit but as a signal of professional quality. Since the acceptance of a new way of doing science is community matter, it depended on disciplinary training, norms, and purposes that reinforced, but also constrained or even policed, professional practices.
May be that the motivation for modeling was, and remains, that the economists relish speaking in the “family language” of economics fraternity, in part at least, because the audience they care about is other economists who may be impressed by… modeling.
Dani Rodrik understands the economists’ modeling quest as a professional psychological need: “If you want to grievously wound an economist, say simply ‘you don’t have a model. Models are source of pride” (Rodrik 2015, 10).
6.3. Patinkin: Negative Inflation Tax as an Unintended Generation of Inflation
Don Patinkin wrote: “Why do governments cause inflationary processes to occur or do not take actions to stop them? The answer that is usually given is the one that Keynes gave in his Tract on Monetary Reform (1923) – namely, inflation as a tax, as a seigniorage from which the government benefits by being able to finance its expenditures by supplying the increase in the nominal quantity of money that the public demands as the inflation continues: by being able, as it were, to finance these expenditures by issuing what is in effect an interest-free loan that in an inflationary situation the public desires to acquire and hold”(Patinkin, 1993, 114).
The policy described above Is the ”usto’ary policy. However, "this cannot be the explanation for the Israeli inflation. For over the years the government had – without tying them to any index – made extensive loans both to firms from its development budget and to the public at large for housing. So, the seiniorage it earned from the inflation was more than offset by the loss in the real value of repayment that it received on account of the aforementioned loans, so that the net inflation tax was negative. Indeed, in the years 1980-82, this negative tax was most significant and averaged about 5% of the GNP” (Page 114).
Patinkin accepted Sokoler’s understanding that Israel was unique in that the negative inflation tax was as a central generator of inflation. However, he did not accept Sokoler’s claim that the Israeli government “made a deliberate decision to undertake an inflationary policy with full awareness of all it implications” (Pape 115).
7. Summary of the Economists’ Four Clusters
Economists, who shared the same approach regarding inflation, provided the explanations for the four clusters. They perceived inflation either as an undesirable economic situation or as a negative one (either implicitly or explicitly). Most economists connected the main sources of inflation to the monetary mechanisms that had been employed both by the government and the Bank of Israel for years. They saw budget deficits, a result of fiscal policy, as having played a minor role, if these deficits played one at all. The main research question posed by the economists was “How?” How had inflation been caused, and what were the monetary forces that pushed it up and raised it for such a long period, that lasted seven years?
7.1. Is Inflation Always Bad? Is it Always an Undesirable Monetary Episode?
In the 1960s, an evolutionary change regarding the function of inflation occurred among mainstream economists, especially among the Keynesians. This change could be attributed to two studies that were published in 1958 and 1960. A. W. Phillips published the first article, which was entitled “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom 1861-1957.” Phillips arrived at the conclusion that “there is a clear tendency for the rate of change of money wage rates to be high when unemployment is low and to be low or negative when unemployment is high” (Phillips, 1958, 290). Two years later, Paul Samuelson and Robert Solow published the article, “Analytical Aspects of Anti-Inflation Policy,” that applied Phillips concept to the American economy.
In order to have wages increase at no more than the 2.5% per annum characteristic of our productivity growth, the American economy would seem, on the basis of twentieth-century and postwar experience, to have to undergo something like 5 to 8 per cent of the civilian labor force’s being unemployed… In order to achieve the nonperfectionist’s goal of high enough output to give us no more than 3% unemployment, the price index might have to rise by as much as 4 to 5 per cent per year. That much price rise would seem to be the necessary cost of high employment and production in the years immediately ahead (Samuelson and Solow 1960, 192).
These two publications averred that reasonable inflation produces employment and that there is a tradeoff between inflation and unemployment – reflected in the Phillips Curve. Governments can deliberately choose between inflation and unemployment. Inflation, thus, becomes a legitimate social-economic-political instrument, instead of a curse or an epidemic. Therefore, it is not surprising that Milton Friedman chose the Phillips Curve as the main target of his critique in his lecture, when he received the Nobel Prize on the 13th of December 1976. “The natural-rate hypothesis contains the original Phillips Curve… in its present form [it] has not proved rich enough to explain a more recent development – a move from stagflation to slumpflation in recent years, higher inflation has often been accompanied by higher unemployment – not lower unemployment, as the simple Phillips Curve would suggest, nor the same unemployment, as the natural-rate hypothesis would suggest.”
Friedman continued: “Government policy about inflation and unemployment has been at the center of political controversy. Ideological war has raged over these matters. Yet the drastic change that has occurred in economic theory has not been a result of ideological warfare. It has not resulted from divergent political beliefs or aims. It had responded almost entirely to the force of events: brute experience proved far more potent than the strongest of political or ideological preferences.”
The fifth cluster of scholars did not accept Friedman’s call to exclusively leave the analysis of inflation to economists; they asked different questions. These included, “Why do governments promote inflation?” “Why do they refrain from trying to stop it, or at least, refrain from restraining it?” Are they opportunists, as Hemingway claimed (see below), or do they strive to attain social, political and even economic goals?”
8. The Fifth Cluster: Non-economists Ask, “Why is there Inflation in Israel?” They Identify a Number of Reason
The fifth cluster was composed of non-economists, who searched for answers outside of the discipline of economics. They conducted their discussion in a wider disciplinary space, in social, political or historical disciplines. As Fred Hirsch claimed: “Economic factors, and they alone, can explain how inflation happens, but economic factors alone cannot explain why” (Hirsch 1978, 263).
Most economists, except some Keynesians, either explicitly or tacitly consider inflation to be a monetary phenomenon that harms economic growth. This negative approach to inflation can be inferred from the development of the Friedman-Phelps Curve, the response of anti-inflation monetarists to Phillips Curve. As noted above, this curve demonstrated that there were some positive results of inflation, which were derived from an anti-unemployment point of view. The Phillips Curve was a pro-inflation curve, while the Friedman-Phelps Curve was an anti-inflation curve.
Years before, Ernst Hemingway, who was not an economist, had an insight concerning inflationary policy. His insight provides a succinct summary of the approach that saw inflation as negative: “The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring permanent ruin. But both are the refuge of political and economic opportunists” (September 1935).
This negative approach, nourished by economics, makes it difficult to evaluate the influence that different historical contexts have on inflation. Therefore, we can argue that political leaders deliberately select inflation in order to respond to political needs. The researchers grouped in the fifth cluster explained inflation by using perspectives, other than economics, such as political science, sociology and history. The researchers do not see inflation as being an accident or as a temporary economic solution to economic issues. Instead, they view it as a means for solving macro-social problems.
8.1. Gordon: The Demand and Supply of Political Cost-Push Inflation
One of the first publications that criticized the mono causal explanation of inflation as a simple cost-push one – as an endogenous monetary growth generator – was written by Robert Gordon. The article, entitled “The Demand for and Supply of Inflation,” proposed that there were political demands for inflation and that these demands could provide a better explanation of inflation, especially concerning its dynamics. Gordon (1975, 819) defined this phenomenon as “Political Cost-Push Inflation.” “Inflation caused by cost-push could fluctuate across time periods and could differ across countries, since inflation depends not only on pressure placed on the government by demanders of inflation, but also by the supply of inflation provided by government in response to a given amount of pressure… The cost-push literature is rather thick on description and thin on the analysis of causation.”
What causes the political demand for inflation? Gordon’s thesis is that accelerations in money and prices are not thrust upon society by a capricious or self-serving government, but rather represent the vote-maximizing response of government to political pressure exerted by potential beneficiaries of inflation. His analysis of the political economy of inflation can be fruitfully divided into two major sub-topics, the “demands for” and “supply of” inflation. The demand for inflation could emanate from taxpayers who resist tax increase, or a policy that prefers to finance budget deficits by inflation rather than by heavier levy (page 808).
8.2. Inflation Could Function as a Means of Relief
Fred Hirsch, a central proponent of this cluster, developed an inter-disciplinary perspective on inflation. The title of the pioneering collection of various articles, “The Political Economy of Inflation,” (Hirsch and Goldthorpe, 1978) summarizes the research direction of the scholars in this cluster: inflation is a preferred political phenomenon. Hirsch claimed that economic factors are technical factors. Therefore, they cannot explain the governmental decisions to adopt inflationary tracks. The economic factors cannot tell who benefits or loses from inflation. The economic figures do not refer to the social or political functions of inflation, as an economic means.
The scholars, who shared this unconventional approach, also agreed that inflation is an efficient mechanism for sharing out the cost of stagnation and recession among different social groups. They claim that when there is a societal conflict concerning the just distribution of resources, inflation can function as a means of relief. Inflation can ease the struggle over communal resources. Social structures help shape inflation and alter collective social roles. “No economic theories, so far as I know, incorporate these reciprocal influences” (Maier 1978, 39).
Maier described and analyzed the social-economic advantages and limitations of using inflation. He wrote, “In societies with a cohesively organized working class – common economic advantages of an inflationary policy bind industrials and labor together, even if politically they remain at daggers down” (page 47). He continued, “Hyperinflation thus involved an implicit coalition of labor and industry at the expense of rentiers, professionals, the civil service and modest entrepreneurs” (page 52) and followed with “When growth could not keep up with expectations, inflation helped disguise the lag. But beyond a certain rate, inflation cannot play this role as social lubricant and instead aggravates the very distributional conflicts it helped assuage” (page 71). Maier analyzed and described the social-economic advantages, using inflation as a medium and its limitations.
Hirsch summarized the historical approach to inflation: “I am suggesting that an implicit ideological underlay of inflation has been created by the confrontation or counterpoise of more direct ideological struggles. It is then no accident that inflation has been most entrenched in societies and periods in which the underlying ideological struggle has been most intense. Put in another way, containment of latent distributional struggle without financial stability requires either efficient authority, or sufficient consensus on the values or principles underlying the distribution of income and other aspects of welfare. The solution is an inflation as a substitution of authority” (page 276).
8.3. Reuveny: Israeli Inflation was a Political Solution for Problems of Distribution of Resources
Yaakov Reuveny, a political scientist, explicitly connected himself to the contextual explanation approach, which is represented in the fifth cluster. He explains Israeli inflation as being a political solution, rather than an economic problem. Reuveny (1985) asserted that the Likud party, which headed the government after 1977, was comprised of two forces. These forces were based on diverse and contradictory socio-economic sources and economic and social preferences – the Liberal party and Herut (liberty) party. The Liberal party electorate was composed of people with high income, who were industrialists, contractors, farmers, and merchants. These voters believed in a classical, liberalist social-economic ideology. Herut’s electorate, on the other hand, came from the lower class, who espoused the idea of the liberal welfare state that promotes free competition, while protecting the poorest people against extreme poverty.
The first outcome of the financial reform, which was launched by the new Likud government on October 31st, 1977, immediately improved the lot of specific social groups: capitalists, rentiers and importers. This reform was advantageous for the upper socio-economic class, the traditional supporter of the Liberal party. On the other hand, the reform harmed the lower class because of the immediate price increases, which were caused by the high devaluation of the Israeli Pound, an integral part of the reform.
A policy that would restrain the budget, which was the next necessary and complementary step of the new policy, was rejected, since it was perceived as negatively affecting the three lowest deciles, which heavily supported the Herut party. The political-economic conclusion was to support full employment, to promote cheap import goods, to ease outgoing tourism, to enlarge transfer payments, to implement free secondary school education and to offer some other welfare entitlements. Reuveny claimed that all these steps were the result of a political compulsion that had been caused by the liberalization in 1977. This motivated the political-economic forces to work in an unintended direction, which caused a confluence of two contradictory trends – the liberal one versus the populist one. Paradoxically, the extreme monetary reform compelled an extreme popular policy, on the other hand.
According to the insights of the scholars who compiled the anthology, “The Political Economy of Inflation,” Reuveny concluded that, “inflation and hyperinflation tend to be connected with new systems that cannot easily cope with distributive conflicts. It occurs when a new government rises to power and its preferences contradict one another. Inflation is the best short-range solution to moderate the conflict … Israeli inflation was a kind of solution to the distributive problems that had arisen, due to a new economic regime.” (Reuveny 1985, 237-247)
8.4. The Gini Index Confirmed that Inflation Lessened Inequality
Data from the Gini Index support Reuveny’s claim that Israeli inflation was an efficient tool for the bridging of social-economic conflicts: inequality decreased during the inflation period.
Table 1 shows correlations between the inflation rates and the Gini Index figures: the combination of inflation and transfer payments reduced the inequality gap, that had grown in the following years of lower inflation, due to the stabilization program that was activated on July 1, 1985. The dramatic increase of labor’s share in the gross national income, from 60% in 1975 to 71% in 1986, further support Reuveny’s claim. Labor’s share in the gross national income gradually dropped from 1986 (Kristal 2013, 103-104), when the inflation was much lower than it had been during the seven inflation years. Therefore, inflation was a central instrument for increasing income from labor, and it decreased inequality.
Shimon Peres, the leader of the Ma’arach, who was then Prime Minister, promoted the stabilization program, which stopped the inflation (going against the opinions of the majority of Likud ministers in the unity government). He once said that his housekeeper explained why she voted for the Likud party: “I vote for them because they invented inflation”.
8.5. Economists Describe the Positive Social-Economic Results of Israeli Inflation
Some economists, who described or analyzed the social-economic results of the seven years of inflation, can be seen as belonging, in part, to the fifth cluster. These economists referred to non-economic factors and motivations that were connected to the process.
Fischer and Bruno (1984): By taking into consideration public opinion concerning inflation, Fischer and Bruno asserted that, “there has not been any overwhelming pressure of public opinion in Israel to end the inflation. In part this has been because there are pressing non-economic issues before the electorate; in addition, the costs of inflation are not perceived to be great” (page 35).
At least two facts supported their evaluation. To begin with, the indexation system protected the public from loss of money value. Secondly, although inflation was accompanied by slower growth, it was also accompanied by a rapidly rising standard of living. “Under these conditions the public may be excused for not seeing a pressing need to end inflation.” The authors wrote, “particularly when the adjustment process would require a transitory period of unemployment” (page 36).
Fischer and Bruno’s claims explain that the inflation’s ‘winner’ was the public. In a separate article, Fischer (1985, 82) added that, “the argument that Israel cannot afford unemployment has meant that restrictive policy has not been applied consistently. The government has been searching for tricks to get out of inflation without running the risk of unemployment and also without reducing living standards.”
From September 1983 through July 1985, Fischer and Bruno were active participants in the joint American-Israeli group that designed the stabilization program. They discussed the public’s and government’s reticence to end inflation, due to the probable costs of such a policy – unemployment and a potential decrease in the standard of living. While they did not explicitly explain that inflation relieved some of the social and political problems, they were aware of inflation’s advantages, from the public’s perspective.
Yakir Plessner described the inflation by asserting that by 1978 “the public was actually benefitting from the process… Inflation at the rate it existed in Israel also created a tremendous opportunity for quick profits in the financial markets… Largely as a consequence, both the gross and net worth of the public grew by about 14% in real terms from 1980 to 1981. This made people feel richer, leading to accelerated growth in private consumption, which leaped by 12.6 percent from 1980 to 1981 (and was attributed to Aridor’s election bribery)” (Plessner 1994, 233, 246, 247-257)[1].
Although Plessner was aware, as a witness, advisor and as an economic historian, of the social results of the inflation policy, he wrote, “I believed then and still do that Israel’s inflation was primarily of the cost-push sort” (page 239).
8.6. Inflation Was Not a Problem, But Rather a Solution
The seven-year period of inflation, whether seen as being an asset or an “inflation carnival,” was not a problem, according to the researchers who were grouped into the fifth contextual inflation understanding cluster, which was best represented by Reuveny. Inflation was not perceived as a problem, but rather as a solution. The inflation was an immediate monetary bridge over a social gap that could not be bridged by another long term social-economic policy, since the longest interval between elections in Israel was only four years. The fifth cluster understands inflation to be a reason and not as a result; as a desirable tool and not as a rejected means.
In the Israeli case, inflation was a tool used by the governments that ruled between 1978-1985 to overcome the political and social gaps between the higher and lower deciles; between the settlements in the occupied territories and the small towns in the periphery; and between left and right-wing supporters.
9. Five conclusions
9.1. Narratives
Since all the economists were exposed to the same data and facts, but interpreted them in diverse and even contradictory manners, this points to the idea that the third and fourth empirical clusters should be considered as narratives.
Mary Morgan's idea that models should be viewed as economic interpretations can be applied here as well. "What can models tell us about the world we live in?" Morgan asks this question and then answers: "In creating the model, economists represent or denote the situation in the world in such a way as to incorporate their theoretical claims or hypotheses about the world" (Morgan 2012, 242). By interpreting models in such a way, she strips the model of its objective status, which is backed by mathematical formulations, and relates to its subjectivity, since the models express personal approaches and hypotheses of the researchers. Her implicit argument becomes explicit by concluding that "The explanatory function of narratives, and the level of account of the world that narratives offer, can be understood as an epistemic claim, rather than a cognitive one" (page 245). Economic models could be related to as economic narratives.
9.2. Theory and Empirical Inquiry
Rational Expectations theory demands a discussion about the relation between empirical evidence and theories or premises. The main problem is that the expectations became facts, without any positive proof. They are post factum prophecies.
Milton Friedman related to the status of theory in economics by claiming that "theory is to be judged by its predictive power for the class of phenomena which it intends to 'explain'. Only factual evidence can show whether it is 'right' or 'wrong' or, better, tentatively 'accepted' or 'rejected'… Empirical evidence is vital at two different stages: in constructing hypotheses and in testing their validity" (Friedman 1953, 8, 12).
There is an important difference between Expectations Theory, which does not rely on facts, and the two research clusters, which are based on empirical data.
9.3. The "How?" and the "Why?"
The narratives included in the third and fourth clusters are limited by monetary mechanisms that aimed at explaining inflation as an economic process. Its goals were to achieve certain economic results, such as a better balance of payments, promotion of export and assistance of the production sector. The third and fourth clusters center on "How?" narratives, while the fifth centers on "Why?" Researchers working from this approach explored the political and/or social objectives that could be achieved by the economic policy, or by certain economic means. Inflation was one instrument available for implementation in certain socio-political situations. It was an instrument that could be used to bridge social gaps and contradictory political needs.
The study of Israeli inflationary politics was a proper case study to answer the question "Why?" Why did political leaders choose inflation as the preferred economic tool when they aimed to solve the non-economic problems?
9.4. Inflation - An Economic Issue Understood as a Social-Political Problem
From a historical perspective, the economic narratives per-se supply partial explanations, since they leave one unexplained problem: what prevented the Israeli governments from restraining inflation? Why did they, at times, even let it reach hyperinflation rates? The economists and the political decision-makers knew how to stop inflation, so why did they fail to act? In order to answer this question, we need to address both the "how" and the "why." Incorporating both kinds of questions into the historiographical discussion can produce a more comprehensive and meaningful discourse.
9.5. Economics is a Social Science
The conclusion of this study is that economics is a social science. It is not physics. Economics is a partial map of the social territory. By incorporating it into other disciplines, it can improve its explanaory power. In other words, the third, fourth and fifth clusters need to be merged. As Gustav Schmoller noted, "Economics is social science." This central idea, expressed by the German economist in 1881, has lost none of its relevance. Schmoller, one of the founders of the German Historical School, also stated that, "Exact science must always tolerate a different explanation of things as its equal…one shaped by an image of the whole and premised on the value of the past that seeks to understand and interpret individual phenomena in their context and organize the material through reflective judgment according to a general point of view" (Schmoller 1881).
Funding Statement
This research received no external funding.
Acknowledgment
Acknowledgments to anonymous referees' comments and editor's effort.
Declaration of Competing Interest
The author claims that the manuscript is completely original. The author also declares no conflict of interest.
Appendix A: The Bank Shares Crisis and the Bailout Program
On October 6, 1983, the Tel Aviv Stock Exchange (TASE) was shut down for 18 days. The closure followed several weeks of heavy selling by shareholders of six banks and one bank’s holding company, representing virtually all commercial banking in Israel, and more than 60 percent of the total market capitalization (equivalent to 40 percent of the GNP). The banks reacted, as they had during previous episodes of excess supply, by making large-scale purchases of their own shares. In the fall of 1983, however, the sell-off was much greater than in the past. As a result, share purchases strained bank liquidity, raising concerns about overall banking stability. These concerns threatened to cause a run-on deposits and a decline in foreign exchange reserves, which, together with other political considerations, led the government to close the Exchange.
During the closure, the government devalued the Shekel and took control of five of the banks, converting their shares into government guaranteed zero coupon bonds, which would mature within five to six years at face values of 85 to 117 percent of pre-closure dollar market values (in Hebrew – the hesder). Bank share prices declined by 40 percent after the TASE reopened.
In a verdict by the Israeli High Court, Justice Miriam Naor found that the banks were responsible for the crisis and were guilty of providing fraudulent guarantees that share prices would continue to rise. She sentenced prominent bank officials to prison and sentenced the officials and the banks to pay fines. The verdict was the culmination of an extended period of investigation, which began almost immediately after the collapse.
Reference: Blass, and Grossman, 3 May 1996. A Harmful Guarantee? The 1983 Israel Bank Shares Crisis Revisited. Discussion Paper No. 96.
Notes
1
Yoram Aridor was the finance minister between the years 1981-1983. Dr. Yakir Plessner was his senior economic advisor. ↑
References
- Alexander, Esther. (1980). The Puppy Tail. Haolam Hazeh, May 20, 1980 (in Hebrew) [Google Scholar ]
- Alexander, Esther. (1990). The Power of Equality in the Economy – The Israeli Economy in the 80s. Tel-Aviv, Hakibutz Hameuchad Publishing House. (in Hebrew) [Google Scholar ]
- Bank of Israel. Annual Reports 1978, 1979, 1980. Jerusalem. (in Hebrew) [Google Scholar ]
- Beenstock Michael and Ben-Gad Michael. (1988). The Fiscal and Monetary Dynamics of Israeli Inflation A Cointegrated Analysis 1970-1987. Jerusalem: Eiunim Becalcala1988 (in Hebrew) [Google Scholar ]
- Bental Benjamin and Eckstein Zvi. (1990). The Dynamics of Inflation with Constant Deficit under Expected Regime Change. The Economic Journal 100: 1245-1260. https://doi.org/10.2307/2233971 [Google Scholar ][Crossref]
- Blass, and Grossman, (1996). A Harmful Guarantee? The 1983 Israel Bank Shares Crisis Revisited. Discussion Paper No. 96. [Google Scholar ]
- Bruno Michael and Fischer Stanley. (1984). The Inflationary Process in Israel: Shocks and Accommodations. NBER Working Paper #1483. https://doi.org/10.3386/w1483 [Google Scholar ][Crossref]
- Cagan. Philip. (1956). The Monetary Dynamics of Hyperinflation. In Studies in the Quantity Theory of Money, edited by M. Friedman, 25-91. Chicago and London: The University of Chicago Press. [Google Scholar ]
- Debreu, Gerard. (1991). The Mathematization of Economic Theory. The American Economic Review 81, no. 1: 1-7. https://www.jstor.org/stable/2006785 [Google Scholar ]
- Fischer, Stanley. (1985). Inflation and Indexation: Israel. In: Inflation and Indexation – Argentina, Brazil and Israel, edited by J. Williamson, 57-94. Washington, D.C.: Institute for International Economics. [Google Scholar ]
- Friedman Milton and Friedman Rose. (1990). Free to Choose: A Personal Statement. Journal of Economic Literature, 19(2), 568-570. https://www.jstor.org/stable/2724157 [Google Scholar ]
- Friedman, Milton. (1953). Essays in Positive Economics. Chicago: University of Chicago Press. [Google Scholar ]
- Gordon, Robert, J. (1975). The Demand for and the Supply of Inflation. The Journal of Law and Economics 18, no. 3: 807-836. https://doi.org/10.1086/466845 [Google Scholar ][Crossref]
- Gottlieb, Daniel, Melnick Rafi, and Piterman Sylvia. (1985). Inflationary Expectations in Israel: A Multiple Indicators Approach. Journal of Business & Economy Statistics 3, no. 2: 112-117. https://doi.org/10.1080/07350015.1985.10509438 [Google Scholar ][Crossref]
- Hemingway, Ernst. (1935). Notes on the Next War: A Serious Topical Letter. Esquire, September 1935. [Google Scholar ]
- Hirsch, Fred, and Goldthrope H. John (eds.), (1978). The Political Economy of Inflation, Cambridge MA Harvard University Press. [Google Scholar ]
- Hirsch, Fred. (1978). The Ideological Underlay of Inflation. In The Political Economy of Inflation, edited by F. Hirsch and J. H. Goldthrope, 263-284. Cambridge MA Harvard University Press. [Google Scholar ]
- Kristal, Tali. (2013). Slicing the Pie: State Policy, Class Organization, Class Integration, and Labor's Share of Israeli National Income. Social Problems 60, no. 1: 100-127. https://doi.org/10.1525/sp.2013.60.1.100 [Google Scholar ][Crossref]
- Litvin, Uri, Meridor Leora, and Spivak Avia. (1988). Inflation and Money Creation – Israel in the 1970s. Economic Review (Bank of Israel), 62: 56-73. [Google Scholar ]
- Liviatan, Nissan, and Piterman Sylvia. (1988). Accelerating Inflation and Balance of Payments Crises 1973-1984. In The Israeli Economy – Maturing through Crises, edited by Y. Ben-Porath, 320-46. Cambridge MA and London: Harvard University Press. [Google Scholar ]
- Maier, Charles, S. (1978). The Politics of Inflation in the Twentieth Century. In The Political Economy of Inflation, edited by F. Hirsch and J. H. Goldthrope, 37-71. Cambridge MA: Harvard University Press. [Google Scholar ]
- Mankiw, Gregory N. (2006). The Macroeconomist as Scientist and Engineer. Journal of economic perspectives. 20(4), 29-46. https://doi.org/10.1257/jep.20.4.29 [Google Scholar ][Crossref]
- Morag, Amotz. (1967). Governmental Finance in Israel – Problems and Development. Jerusalem: Magnes Publishing House. (in Hebrew) [Google Scholar ]
- Morgan, Mary, S. (2012). The World in the Model - How Economists Work and Think. Cambridge, New York and Melbourne: Cambridge University Press. [Google Scholar ]
- Patinkin, Don. (1993). Israel's Stabilization Program of 1985, or Some Simple Truths of Money Theory. Journal of Economic Perspectives 7(2), 103-128. https://doi.org/10.1257/jep.7.2.103 [Google Scholar ][Crossref]
- Phillip, A. W. (1958). The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom 1861-1957. Economica, New Series 25(100): 283-299. https://doi.org/10.2307/2550759 [Google Scholar ][Crossref]
- Plessner, Yakir. (1994). The Political Economy of Israel – From Ideology to Stagnation. Albany: State University of New York Press. [Google Scholar ]
- Reuveny, Yaacov. (1985). The Political Economy of the Likud 1977-1984: A Diagnostic Examination. The Economic Quarterly 34, no. 126: 237-247. (in Hebrew) [Google Scholar ]
- Rodrik, Dani. (2015). Economics Rules – The Rights and Wrongs of Dismal Science. New York and London: W.W. Norton & Compamy [Google Scholar ]
- Samuelson, Paul. A. and Solow M.Robert. (1960). Analytical Aspects of Anti-Inflation Policy. The American Economic Review 50, no. 2: 177-194. https://www.jstor.org/stable/1815021 [Google Scholar ]
- Sargent, Thomas and Wallace Neil. (1973). Rational Expectations and the Dynamics of Hyperinflation. International Economic Review 14, no. 2: 328-350. https://doi.org/10.2307/2525924 [Google Scholar ][Crossref]
- Sargent, Thomas, and Wallace Neil. (1981). Some Unpleasant Monetarist Arithmetic. Federal Reserve Bank of Minneapolis Quarterly Review 5:1-17. [Google Scholar ]
- Sargent, Thomas, and Zeira Joseph. (2011). Israel 1983: A Bout of Unpleasant Monetarist Arithmetic. Review of Economic Dynamics 14: 419-431. https://doi.org/10.1016/j.red.2011.03.002 [Google Scholar ][Crossref]
- Schmoller, Gustav. (1881). On the Purpose and Aims of the Journal. Schmollers Jahrbuch, 1881. [Google Scholar ]
- Shiffer, Zalman, F. (1982). Money and Inflation in Israel: The Transition of an Economy to High Inflation. Federal Reserve Bank of St. Louis Review: August/September 1982, 28-40. [Google Scholar ]
- Sokoler, Meir. (1987). The Inflation Tax on Real Balances, the Inflation Subsidy on Credit, and the Inflationary process in Israel. Economic Review (Bank of Israel), 59: 1-26. [Google Scholar ]
- Yoran, Yosef. (1984). Inflation and Construction Change in the Israeli Economy. The Economic Quarterly 31, no. 122: 217-245. (in Hebrew) [Google Scholar ]
Table 1. Data from the Gini Index.
Table 1. Data from the Gini Index.
| Inflation Rate | Gini Index pretransfer payments | Gini Index post transfer payments | Year |
| 111% | 0.3075 | 0.2167 | 1979 |
| 102% | 0.3202 | 0.2195 | 1981 |
| 191% | 0.3217 | 0.2142 | 1983 |
| 445% | 0.3475 | 0.2305 | 1984 |
| 20%-16% | 0.4618 | 0.3151 | 1986/7 |
| 16% | 0.4493 | 0.3160 | 1988 |
| 17% | 0.4800 | 0.3264 | 1990 |