July 1, 1985: The Day Israeli Capitalism Was Born

30 years ago the economic stabilization plan extricated Israel from spiraling inflation and imminent bankruptcy, changing both the economy and society.

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Shimon Peres holding a news conference outside the Prime Minister's Office, July 1985.
Shimon Peres holding a news conference outside the Prime Minister's Office, July 1985.Credit: GPO

Israel’s economic watershed moment occurred exactly 30 years ago this week. It was the day Israel’s modern economy was born. The socialist Israel of the 1950s and 1960s went bankrupt and was replaced by the capitalist country we live in today.

The modern Israeli economy was born out of two deep crises linked to one another. One was the shock of the 1973 Yom Kippur War, which brought about the political upheaval that ended the rule of the Mapai labor party and movement. The other was the hyperinflation of the 1970s and 1980s, which led to the final collapse of Mapai’s economic system. The “big bang” itself occurred on July 1, 1985 at the end of a dramatic cabinet meeting that lasted for 19 hours, with then-Prime Minister Shimon Peres presiding.

Anyone pining for good old Israel or lamenting the loss of social solidarity that came in the years that followed should face the fact that the transition was not made out of choice. The highly centralized, government-controlled economy based on Mapai principles could no longer manage in the modern world. One symptom of the disease was the triple-digit inflation Israelis suffered in 1984-85, which reached a rate of 450% at its peak. The inflation snowballed over the course of a decade, starting with the Yom Kippur war in 1973 and accelerating with the political upheaval that brought Menachem Begin’s Likud party to power four years later and the irresponsible policies it pursued.

Several inflation-linked measures, such as a transition to inflation-adjusted savings plans and cost-of-living wage adjustments, made life under the shadow of inflation tolerable, so that addressing it was seen as something that could wait for some distant future. For almost a decade the political system in Israel could not muster the courage to take the harsh measures needed to bring an end to spiraling prices and the cumulative damage it caused, which brought the country to the brink of bankruptcy.

The constant need to raise money for government operations led to a de facto nationalization of capital markets, crowding out the business sector and hurting economic growth. The uncertainty created by inflation was a second blow to business. Insane distortions created by hyper-inflation – such as gimmicks to protect public savings by investing in bank shares, whose price was manipulated by the banks – ended with a collapse of the stock market and nationalization of four out of the five big banks.

The government’s share of the economy grew to as much as 76%, while fiscal deficits and the national debt skyrocketed. Estimates are that in 1985 the ratio of debt to gross domestic product, as far as this can be calculated, reached 220%. By comparison, Greece’s debt-to-GDP ratio today is just 180%. The budget deficit by 1985 was 12-15% of GDP, and foreign currency reserves were rapidly shrinking. The treasury was already making provisions for the day the Bank of Israel ran out of dollars.

A model to emulate

In 1985, Israel was heading toward the abyss with its eyes wide open. At this point, as it turned out, intervention by Peres – one of the last remaining Mapai titans – was needed in order to save the country from itself. Behind him was the not-so-delicate pressure applied by the Americans, who were watching the crisis with concern.

A sympathetic U.S. president, Ronald Reagan, along with an even more sympathetic secretary of state, George Schulz, offered to extricate Israel from its financial straits and help it with a $1.5 billion grant. The condition was that Israel undertakes to overhaul its economy and do it by using professionals in the lead. They appointed their own team of economists – Herbert Stein and Stanley Fischer – and demanded a comparable lineup on the Israeli side.

Shimon Peres holding a news conference outside the Prime Minister's Office, July 1985. GPO.

Thus was born that wondrous team that came up with the economic stabilization plan, with Profs. Michael Bruno and Eitan Berglas as its architects, along with Prof. Nissan Liviatan. For some of the time they were joined by Profs. Yoram Ben-Porath and Haim Ben-Shahar. In Israel’s entire history there was never such a concentration of its brilliant economic minds working for the state at the same time.

In retrospect, after the plan succeeded so well, serving as a model studied in universities around the world, its details seem amazingly simple. All that was needed was a big freeze of prices, wages (while allowing the latter to erode) and exchange rates (although not a deep freeze, in order to stimulate exports). Meanwhile, interest rates were hiked and the budget slashed.

Package deals fail

It sounds simple, but in fact this plan came about only after the failure of two package deals signed with the Histadrut labor federation, which ended up causing a further increase in inflation. With hindsight one can see why these deals failed whereas the stabilization plan worked: The difference was the amount of pain inflicted.

The package deals tried not to hurt anyone. There were no real budget cuts, wage erosion or harsh interest rate hikes. The package deals tried to restrain inflation by delicately influencing expectations. In other words, they created an illusion of an economic plan which, the designers hoped, would convince the public of their seriousness. People would not expect constant price hikes, which would cool inflation.

Surprise, surprise! It turned out that the public wasn’t so stupid. It didn’t buy the package deals and instead bought dollars and rushed to shop, expecting prices to rise the following day.

“Life is based on taking real actions,” says Yoram Gabay, a former head of State Revenues Division in the Finance Ministry and part of the team that supervised the stabilization plan. “The package deals tried to work through psychology and influence expectations. That’s bluffing. Psychology doesn’t work in economics, only real actions.”

In contrast to the package deals, the stabilization plan was suffused with pain. Not only were wages deliberately eroded by 12-14% in real terms, they were done so by fiat, not as a result of an accord with the unions. The Histadrut tried to bring the economy to a standstill in protest, but after three days capitulated when it realized that the public was not supporting it. In total contrast to the expectations of politicians and the Histadrut leadership, the public turned out to be smart and courageous. It understood the gravity of the situation and expected its leaders to take bold steps that would extricate Israel from the morass it was mired in.

Another significant move was to slash the state’s budget. Most of this was done by removing subsidies on basic products, which predictably led to skyrocketing prices. The rises were quite significant, amounting to as much as $1 billion.

Moshe Mandelbaum, then governor of the Bank of Israel, who today is still teaching academic courses on the plan, says the team of economists wanted to slash 10% of the budget, a cut that “no democratically-elected government had ever made before.” However, at the end of that dramatic cabinet meeting only a 4% cut remained after then-Defense Minister Yitzhak Rabin managed to curtail the cuts to the defense budget.

Emmanuel Sharon, then the Finance Ministry’s director general and the man responsible for putting the plan into effect, remembers how the cuts to the defense budget were moderated. Thirty years have passed, and it seems that as far as the government’s determination to cut defense budgets are concerned, not much has changed. In any case, a cut of 4%, amounting to 15 billion shekels ($3.8 billion) in today’s terms, was very severe, sending a clear message that the government was willing to pay a steep price for success. The objective set up by the plan’s designers was attained in less than a year. Nevertheless, the reasons this objective was met are disputed.

This dispute hints at one of the surprising and problematic aspects of the stabilization plan – the boycott imposed on the Bank of Israel by the plan’s designers. The economists who worked on the plan – Berglas, Bruno, Leviatan and Mordechai Fraenkel, with political and professional management by Sharon and Amnon Neubach, who was then the economic adviser to Peres, and with the long-distance oversight of Stein and Fischer – worked in total secrecy.

Treasury departments not included in the planning process, such as the budgets division under Aharon Fogel, didn’t know about the plan or its details. Mandelbaum at the Bank of Israel and the head of his monetary department Victor Medina were also kept out of the loop. Only at the end of June 1985, three days before the plan was revealed to the cabinet, were they briefed regarding its details.

How can it be that the most important economic reform in Israel’s history was sewn together behind the back of the Bank of Israel? What is even more surprising is the fact that Fraenkel, a member of the team that prepared the plan, was the head of the research department at the central bank. But for months Fraenkel participated in meetings preparing the stabilization plan without his boss, Mandelbaum, knowing about it.

There are a number of versions of the story as to why Mandelbaum was kept in the dark. Neubach and Sharon say many distrusted Mandelbaum on a personal level and feared the proceedings would be leaked to the press. Mandelbaum claims the Bank of Israel’s hectoring the government to stop printing money and balance the budget put it out of favor with the politicians. In any case, this strange behavior, which it is difficult to describe as professional, short-circuited communications and led to the third painful step of the stabilization plan: The murderous real interest rates.

Both Sharon and Neubach claim they had no intention of forcing up interest rates, and that the Bank of Israel, with Medina as the head of the Monetary Department, went too far. “They caused enormous and unnecessary damage,” says Neubach, citing the collapse of the kibbutzim and moshavim in the following years.

To this day Mandelbaum and Medina fiercely defend their interest rate policies and claim they were the main factor behind the success of the stability program. “There were other countries that had similar economic plans to ours and they failed,” says Mandelbaum. “This is because during the implementation stage they did not pass on the message of determination and seriousness, and therefore did not succeed in changing the public’s inflation expectations. We succeeded because the Bank of Israel pressed and insisted on a deep cut in the budget and on very high real interest rates.

“We took upon ourselves the heavy yoke of real interest rates of 80%, truly destructive interest, since we had to pass on a message of determination to the public. High interest rates convinced the public that we were serious this time, causing a drop in demand and the huge pressure on the business sector to pay back credit. Businesses that found themselves suddenly with high-interest loans did everything to move up repayment. In order to do so they sold their inventories early, and at any price. It was a mechanism that lowered prices,” he says.

The public hurried to made their tax payments earlier, too, which is how Israel achieved a balanced budget.

“I was under attack from all directions,” recalls Medina. “I didn’t receive support from the stabilization plan team – only Mandelbaum backed me. We understood that the budget cutbacks could very well rein in demand but only at a later stage; the only way we could suppress demand immediately was through the interest rate. Therefore, interest rate policy took upon itself the central role of stopping prices [from rising]. We shrunk credit by a third within three months. It was the strictest instance of monetary restraint ever seen in Israel, and maybe in the entire world.”

A fundamental dispute

The fallout from the sour relations between the treasury and the central bank have not healed to this day. Nonetheless, looking back it is possible to state that the stabilization plan led to the birth of an independent and modern Bank of Israel. Before that, the bank was a prisoner of the government. The government printed money by taking out unlimited amounts of loans from the Bank of Israel, which found itself creating inflation through churning out money. The central bank tried to counteract the effect by placing limits on bank credit, but the capital markets simply migrated outside of the banks.

This is why in 1982 the Bank of Israel found itself without any way of asserting control over the money supply. At this stage, Mandelbaum established the Monetary Department in the central bank (and it’s funny to think that it did not exist before), and put Medina in charge of it.

In the wake of the stabilization program, two things happened: First, a law was passed banning the government from taking out loans from the Bank of Israel. “Israel and Germany,” says Mandelbaum, “are to this day the two countries with such strict laws banning the government from printing money.” In practice, the law granted the Bank of Israel its independence from the government. Second, the bank used its new independence to make use for the first time ever of its interest-rate weapon. The enormous power of this tool was revealed for the first time, and since then it has become the central bank’s most powerful instrument.

Other economists who participated in preparing the program disagree that interest rates was the key to the stabilization plan’s success. They speak of a combination of budget cuts, wage erosion and the interest rates, which together sent the message that the government was serious.

In any case, the message was internalized to an astonishing extent. Within a year Israel saw inflation tumble from 450% to only 20%, and a budget deficit of 15% of GDP shrink to zero. The massive failure of businesses shook up the private sector. The economic role of the kibbutzim and moshavim were cut down to size and the Histadrut’s economic and business empire disappeared.

From the ruins of the hyper-inflation were born new institutions, which started to lead the nation. Not only was the Bank of Israel reborn as an independent institution, five years later then-Governor Jacob Frenkel reduced inflation to single digits. Then too, by the way, there were serious disagreements between the central bank and the Finance Ministry.

The Finance Ministry also changed its stripes and became the all-powerful ministry it is today, giving it vast power to manage the state budget in order to prevent a return to the huge deficits and debt of the 1980s. The new budget policy, which has limits placed on its spending targets and deficit levels, has been at the heart of Israeli economic policy ever since and was one of the reasons Israel made it through the 2008 world financial crisis successfully.

180-degree reversal

The bitter lessons of the Bank of Israel and the Finance Ministry from the era of hyper-inflation brought about tighter rules for managing the economy, guided by exacting targets and goals, as well as a change in the concept in which the government can do everything itself, whether it is running companies or allocating capital.

“We understood that we cannot allow the government to manage, and even though it took another five years afterwards, we started then to think about privatization,” recalls Neubach.

In retrospect, it is easy to see the roots of the present dispute over economic policy: Should Israel have a small government with low taxes and few services? Or a large government with a lot of services and a lot of taxes?

Today, the government’s share of GDP is about 40%. The efforts to reduce the government’s part in the economy have led to reforms in the capital markets and pension savings,which are no longer the government’s responsibility but the public’s. The move to a monetary policy forced Israeli money markets to become much more sophisticated, which led to the reform of the capital markets in the 1990s with the liberalization of foreign currency trading and the end to fixed exchange rates. Along with reducing the government’s share of the economy, steps were also taken to improve the performance of the private sector by opening the economy to competitive imports.

Along the way there was also a change in values that many do not appreciate – the loss of social solidarity and mutual support. But that begs the question whether the change in values was due to the changes imposed on the economy, or whether changing values caused the collapse of the previous economic order. In 1980, five years before the stabilization plan was imposed, Finance Minister Yoram Aridor set off a consumer storm by lowering taxes on durables like color televisions and VCRs, bringing the “socialist” economy to its knees.

The one lesson of the stabilization plan, which is still controversial to this day, concerns the political leadership. Bruno and Berglas, who were behind the plan, and Sharon and Neubach, who put it into effect, were all important partners in its success. But there is no disagreement that the person who made the plan politically possible was Peres. “We were the architects, but Peres was the general who lead us to victory,” says Neubach.

There is no doubt that a political leader of the first rank, like Peres, was needed in order for a difficult, dangerous and painful plan to be carried out. Nonetheless, Peres, too, was dragged into the plan almost against his will, under pressure from the Americans and the threat of an imminent collapse of the Israeli economy.

It took an entire decade of deterioration to get Israel’s leaders to act – and only then when Israel was just a small step away from bankruptcy. Even then, the success of economic stabilization hinged to a large extent on Peres’ stature. Looking back 30 years, when the political system in Israel has not a single leader equal to Peres, it is hard to feel optimistic about the ability of today’s political leadership to make such fateful decisions – even if they are truly critical.

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