Israel 1983: A bout of unpleasant monetarist arithmetic

Israeli inflation, which had held near 130 percent annually for the previous five years, suddenly jumped to about 400 percent in October 1983 – a jump economists had found puzzling because it was not accompanied by any significant contemporaneous rise in the government deficit or expenditures, nor by any intensification of the Israeli-Arab conflict that had driven earlier inflation surges. Sargent and Zeira argue the jump was instead caused by a different event that also occurred in October 1983: a massive government bailout of Israeli bank shareholders, after it emerged that the country’s major banks had illegally manipulated their own share prices for years and could no longer sustain them. The government’s “Bank Shares Arrangement” (the “Hesder”) promised to repurchase the affected shares at their pre-collapse, dollar-indexed value, but only after four or five years (in 1987 or 1988); the paper estimates this implicitly increased government obligations overnight by roughly $5.44 billion, close to a quarter of 1983 Israeli GDP. Because forward-looking Israelis understood that such a large future payment would eventually be financed, at least partly, by printing money, the paper argues they reacted immediately by reducing their money holdings, driving up the price level right away – a textbook instance of the “unpleasant monetarist arithmetic” of Sargent and Wallace (1981), in which money demand’s negative dependence on expected inflation means anticipated future monetary expansions cause inflation to rise well in advance of the expansion itself. The paper first uses a standard inflation-tax model to account for Israel’s earlier inflation history (rising from under 10 percent before 1967 to roughly 40 percent after the 1973 war and 120 percent after a 1978 financial liberalization), estimating that money creation financed only about a third of the large fiscal deficits of the 1970s and early 1980s, with debt issuance financing the rest. It then documents the bank-share episode in detail, showing from the yield differential between the (now dollar-indexed) bank shares and other safe dollar assets that the public assigned the bailout a probability of roughly 50 percent or more once the arrangement was announced. A calibrated closed-economy Ramsey monetary model, in which a constant monetized deficit is occasionally supplemented by a one-time future payment financed by a monetary expansion, shows that raising the perceived probability of that future payment from a pre-announcement estimate of about 19 percent to roughly 50 percent is sufficient to generate an inflation jump of the same order of magnitude as the one observed, from about 120 percent to between roughly 400 and 700 percent depending on the exact probability assumed. The paper reviews and rejects several competing explanations for the October 1983 jump – an exchange-rate-management story in which reduced depreciation rates were financed by rising public debt, and a story in which inflation rises in anticipation of a future stabilization – arguing that neither fits the timing or the debt and reserve data as well as the bank-bailout channel. The authors conclude that the episode is both a new explanation for a previously puzzling historical event and an unusually clean natural experiment for rational-expectations theory, since the size and approximate timing of the anticipated future government payment were both known with unusual precision at the moment inflation jumped.

Joseph Zeira | Macro Paper Warehouse

Israel 1983: A bout of unpleasant monetarist arithmetic