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The Role of Economic Advisers in Israel’s Economic Policy: Crises, Reform and Stabilization

Author(s):Schiffman, Daniel
Young, Warren
Zelekha, Yaron
Reviewer(s):Rivlin, Paul

Published by EH.Net (July 2018)

Daniel Schiffman, Warren Young, and Yaron Zelekha, The Role of Economic Advisers in Israel’s Economic Policy: Crises, Reform and Stabilization. Cham, Switzerland: Springer, 2017. xi +176 pp. $140 (hardback), ISBN: 978-3-319-60680-4.

Reviewed for EH.Net by Paul Rivlin, Moshe Dayan Center for Middle East and African Studies, Tel Aviv University.
This book examines the impact that economic advisors have had in Israel. The foreign advisors examined are Michal Kalecki, Raymond Mikesell, Abba Lerner, Richard Kahn, Milton Friedman, Stanley Fischer, and Herbert Stein. The only local advisor is Yaron Zelekha, who is one of the authors of this volume.

The first chapter is a theoretical introduction that examines what the role of advisors can be, with emphasis on that of foreign advisors. Well known foreign advisors may be better suited than others to promote the public interest because they are detached from local pressures and interest groups. On the other hand, they are likely to be less well informed than policymakers or local advisors. In a crisis, public interest may overcome sectoral interests. When there is a limited difference between the policymaker’s original policy and interests and the advisor’s perceptions of the public interest, then the advisor can strengthen the policy decided a priori by the policymaker. When there is a significant difference between the policymaker’s original policies and interests and the advisor’s perceptions, the latter’s recommendations undermine policies already decided on and are thus unlikely to be accepted.

Michal Kalecki, who came to Israel in the 1950s, was the only advisor who had what might be called a socialist perspective. In 1952, although there was a Labor government in office, his advice was not taken because a more liberal economic policy was favored. Raymond Micksell examined Israel’s foreign exchange needs, which were a central issue given the chronic deficits on the current account of the balance of payments. In 1953, an Economic Advisory Staff was created by the government and included a number of U.S. economists, including Abba Lerner who maintained the longest and closest association with Israel. Among other things, Lerner called for the Bank of Israel to be independent. He also made recommendations to increase economic independence through restrictions on imports, wage cuts and higher productivity. His critique of the cost of living adjustments system (COLA) that protected wages from the effects of Israel’s chronic inflation was prescient because inflation was to become a much greater problem in the 1970s and 1980s. This was to be a recurring theme in economic advice given from abroad.

In the late 1950s and early 1970s, Richard Kahn, famous for his contributions to Keynes’s General Theory, was an informal advisor. Apart from Kalecki, he was the only foreign advisor to come from Europe. Kahn noted that creation of the European Economic Community would adversely affect Israeli exports and he also recommended reforms of COLA. In his view, wage rises were not only designed to catch up with increases in the cost of living but also to maintain relative wages, as different sections of the labor force struggled to maintain their position vis-a-vis others. Given the government’s desire to avoid unemployment, unions would, according to Kahn, only accept wage moderation if the fiscal system redistributed income and invested in social services.

If Kalecki and Kahn were sympathetic to the Labor governments that ruled Israel until 1977, it was appropriate that the Likud government invited Milton Friedman to visit Israel in July 1977. He recommended a move towards free markets, the ending of foreign exchange controls, the introduction of a flexible exchange rate system, privatization, and deregulation. In October 1977 the government eliminated foreign currency controls, unified the exchange rate, introduced a value added tax, abolished a series of other taxes on imports and foreign exchange purchases, and cut subsidies. It also permitted the opening of foreign exchange linked bank accounts. Friedman welcomed the government announcement and predicted that it would be a huge success. The government distanced itself from Friedman, saying that his recommendations were unsuitable for the Israeli economy.

The measures introduced in 1977 resulted in an acceleration of inflation, capital inflows and currency appreciation and, in 1979, capital controls were re-imposed. The 1977 program failed primarily because of a lack of fiscal discipline. The governor of the Bank of Israel, Arnon Gafni, warned about this but Friedman did not. Other problems that developed were the dollarization of the economy and the rapid increase in foreign borrowing. Israel’s economic situation worsened until the economic stabilization program was introduced in July 1985.

In the early 1980s, Herbert Stein and Stanley Fischer were appointed by U.S. Secretary of State George Schultz to assess Israel’s economic situation. Two other economists, Paul McCracken and Abe Siegel, were also appointed but left the team early on. Due to the depth of the economic crisis and the need for foreign aid, the U.S. had a major impact on the development of the economic stabilization program of July 1985. Stanley Fischer, who was very familiar with the economy and also understood its politics, worked closely with a team of Israeli economists on the program. One of the leading Israelis on the team, Professor Michael Bruno, an economist who understood political constraints, became governor of the Bank of Israel in 1986 and Stanley Fischer was given the same appointment in 2005.

The U.S. advisors told Schultz that American aid should be conditional on Israeli action. He rejected explicit conditionality but warned Israel that it had to solve its own problems and only then would the U.S. extend assistance. In a joint paper published in 1984, Bruno and Fischer explained that political factors would undermine a stabilization program if measures were spread out over time. Tough medicine should be administered at once and this is what happened in July 1985. Perhaps the most significant difference between that program and its predecessors was the inclusion of a large cut in public spending, mainly in the form of a reduction in subsidies.

The control of public spending and the public sector in general is the subject of the penultimate chapter. This looks at the measures taken by Yaron Zelekha, the accountant general in the Ministry of Finance, in 2003. The chapter explains the rationale and effectiveness of controls. It also explains the need for spending cuts in terms of what are called the “negative non-Keynesian effects” of excessive government spending that had prevailed after 1985.

The choice of foreign advisors examined in this book is comprehensive but the inclusion of only one local advisor (who is one of the authors) is strange given the prominence of many others, notably Arye Gaathon (a leading authority on economic planning), David Horovitz (governor of the Bank of Israel, 1954-1971), Don Patinkin (often described as the founder of modern economics in Israel) and Michael Bruno (Governor of the Bank of Israel, 1986 to 1991, member of the Economic Stabilization Program planning team in 1980s, Vice-President and Chief Economist of the World Bank).

Chapter 4 and subsequent chapters contain “primers” or introductions, on the state of the economy in 1957, 1977, 1980-84, and 2000-2003. The first three are accompanied by statistical tables and a useful review of economic issues in the early 1950s appears on p. 126. The first chapter, however, lacks a primer and this leaves the reader who is new to the Israeli economy struggling to understand the issues without the necessary background.

This book will be of interest to aficionados of economic policy making and cognoscenti of the Israeli economy.
Paul Rivlin is a senior fellow at the Moshe Dayan Center for Middle East and African Studies, Tel Aviv University. He is the author of The Israeli Economy from the Foundation of the State through the 21st Century (Cambridge University Press, 2011).

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Subject(s):Economic Planning and Policy
History of Economic Thought; Methodology
Geographic Area(s):Middle East
Time Period(s):20th Century: WWII and post-WWII