Israel's Stabilization Program of 1985, Or Some Simple Truths of Monetary Theory

Abstract

T he period since World War II has seen many instances-particularly in Latin America-of repeatedly unsuccessful attempts by governments to eliminate three-digit inflation, not to speak of hyperinflation. A frequent pattern has been that the governments in question adopted policies which at first achieved near-stabilization of the price level, but which then led to such political pressures that after a short time the governments resumed their expansionary inflationary policies. These failures, in turn, generated a lack of credibility of the government in the eyes of the public that further militated against the success of subsequent attempts to achieve stabilization (Bruno, Di Telia, et al., 1988; Bruno and Meridor, 1991).For this reason, Israel's 1985 stabilization program has rightly generated an extensive literature.1 Despite the failure of several earlier programs, within a period of two months, and with minimal adverse effects on employment and the real functioning of the economy, this program reduced the annual rate of inflation from close to 500 percent to less than 20 percent (corresponding, respectively, to average compounded monthly rates of 16.1 and 1.5 percent), and has maintained that situation until now (1992). The major purpose of this paper is to use this inflationary experience as an illustration of some of the simple truths of traditional monetary theory. At the same time, this experience also illustrates the advantages of a heterodox policy (that is, one that in addition 1 See, for example, Bruno

Dependent and Accountable: Evidence from the Modern Theory of Central Banking

“…30. See Patinkin (1993) and his account of the positive role that nominal contracts had in Israels' disinflation process. 31.…”

Virtual Deficits and the Patinkin Effect

“…Computed in gold marks, the total expenditure also diminished considerably from July 1919 to February 1920 and more rapidly than the income. Patinkin (1993) shows how pressure among political coalitions can lead to the use of inflation to erode the real burden of conflicting nominal expenditure demands by different ministries, as in the case of Israel before 1985. Guardia (1992) reports that during high inflation years in Brazil, realized real deficits were always smaller than the programmed real deficits.…”

Taxing Deficits to Restrain Government Spending

“…This confronts the various political agents with a prisoner's dilemma, since it is those who secure supplementary funding who find most favor with their lobby group or the voters, provided the others honor the prearranged deficit ceiling. As a result, the incentive for each individual agent to deviate from the plan is extremely large (see Roubini and Sachs 1989;Patinkin 1993; or Krogstrup and Wyplosz 2006). 1 Indeed, the "old" EU member states' government debt ratio has multiplied in recent decades and has now reached a level in excess of the 60% reference value stipulated in the EU Treaty.…”