Inflation in Israel is now running at an annual rate of 400%. The balance of payments shows a huge deficit, which cannot be sustained using the lines of credit now available to the Israeli banking sector. The causes of these economic difficulties and the choices facing Israeli policy makers were discussed by Professor Eytan Sheshinski at a lunchtime meeting organised by CEPR (jointly with the RIIA) on June 1st. Professor Sheshinski, of the Hebrew University of Jerusalem, is distinguished in the field of public economics and has advised Israeli policy-makers for several years.

What causes so rapid an inflation in Israel? Sheshinski argued that the indexation of the economy and accommodating monetary policy made inflation almost self-perpetuating. Indexation made inflation easier to live with, but almost impossible to eliminate. Could the economy be de-indexed now? This would almost certainly destroy both the capital and labour markets and severely depress output and employment. It would only be possible to de-index the economy after a monetary reform.

Who were the gainers and losers from inflation in Israel? Sheshinski argued that 'true' cost of living indices calculated for different income groups showed little variation. The main losers were neither the poorest nor the richest, but young couples at the lower end of the wage scale, who faced difficulties in obtaining mortgages and suitable housing.

If most income groups were affected in the same way by the inflation, and the economy was indexed, then what costs did inflation impose on the economy? Sheshinski argued that at a microeconomic level the problem was the lack of synchronisation in the indexation. Not all prices were adjusted simultaneously. This led to marked fluctuations in relative prices in the short term and to increased uncertainty (see the summary of CEPR Discussion Paper no.19 in this Bulletin).

The main difficulty caused by Israeli inflation was at a macroeconomic level - in the balance of payments. Even though the terms of trade had become much less favourable for Israel, indexation had prevented fall in real incomes, which increased by over 4% in 1983. As a result the balance of payments deficit had worsened, since high levels of private and government spending had prevented the transfer of resources into the export sector. Nominal devaluations in the Israeli exchange rate were eroded almost immediately by adjustments in indexed prices and incomes, so the export sector could not regain its competitiveness.

Professor Sheshinski argued that continued inaction would be impossible for the next government in Israel. In autumn 1983, the priorities of policy shifted from inflation to the balance of payments - it had since become clear that a substantial reduction in inflation was a necessary condition for progress on all fronts in the econonmy.

One possible choice would be a monetary reform, perhaps involving 'dollarisation' of the economy. This would replace the Israeli currency by the American dollar, which would become the 'high powered money' in the new system. Sheshinski maintained that the idea merited more serious consideration than it had received when the previous finance minister proposed it. It would not rule out independent monetary policy, since the Central Bank could still vary reserve ratios and conduct open market operations. Would dollarisation allow a flight of capital abroad? He believed that dollarisation did not require that capital be convertible, but if it were, then US and Israeli interest rates would have to be linked.

Another policy option for Israel was quantitative controls like import licences. Such controls existed in the 1950s, and were again viewed with some nostalgic favour by the Labour party. Sheshinski argued that they would create serious distortions.

Labour has also proposed a trilateral agreement between government, business and unions. This would involve a freeze on wages and prices. Sheshinski noted that there was no agreement on the 'initial conditions' for such a freeze: everyone wanted an adjustment to their incomes - merely to restore appropriate differentials, of course - and then a freeze! A further difficulty is $40 billion in liquid assets held by the public. What would they do with these assets as the freeze came to an end and prices were expected to rise? They would clearly attempt to spend them on goods before prices rose. It would be necessary to convert these assets to longer-term and less liquid assets, by offering higher rates of return.

Professor Sheshinski concluded that a reduction in the government budget deficit was essential, in order to release resources into the export sector. He would eliminate indexation, but only in the context of a monetary reform. Dollarisation was a possible monetary reform to be taken seriously.