Israel 1983: A bout of unpleasant monetarist arithmetic
📄 Summarized from the full manuscript · Human-reviewed for faithfulness before publication
In brief
Israeli inflation jumped from about 130 to 400 percent a year in October 1983, with no rise in spending or the deficit. Sargent and Zeira trace it to a bank bailout that month: after the banks' share-price manipulation unravelled, the government promised to buy the collapsed shares back four or five years later, adding obligations worth about a quarter of GDP. Expecting the promise to be financed partly by printing money, Israelis ran down their money balances at once. A calibrated model shows a perceived bailout probability near 50 percent generates a jump of the observed size. It matters as an unusually clean case of expected future deficits driving inflation.
What this paper finds — and why it matters
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.
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Questions & answers
Q1. What historical puzzle motivates the paper?
“The sudden upward jump of inflation in October 1983 has puzzled economists because it was not accompanied by any significant contemporaneous rise in the government deficit or in government expenditures” (Section 1, p. 1). Unlike earlier jumps in Israeli inflation, which the authors tie to fiscal and monetary responses to the 1967 and 1973 wars, the October 1983 jump “did not seem to be related directly to any intensification in the [Israeli-Arab] conflict,” and the concurrent Lebanon war “was much less costly than previous wars” with little change in the defense budget or public deficit (Section 1, p. 1).
Q2. What theoretical mechanism does the paper invoke to explain a jump in inflation with no contemporaneous fiscal change?
The paper invokes the “unpleasant monetarist arithmetic” of Sargent and Wallace (1981): “an anticipated future monetary expansion triggers an immediate rise in inflation coming from rational expectations and a negative dependence of money demand on expected inflation” (Section 1, p. 2). Because agents know that a future increase in government obligations will eventually be financed partly through money creation, they reduce their money holdings immediately in anticipation, and that reduction in money demand itself raises the current price level and inflation rate – so the causal event (the anticipated future deficit) and its effect on prices (a jump in inflation) can be separated in time from the actual future deficit spending.
Q3. What was the “Hesder” (Bank Shares Arrangement), and how large was the implicit increase in government obligations?
After Israeli banks, having illegally manipulated their own share prices for years to make them attractive to cautious investors, could no longer sustain those prices amid a stock-market downturn and a scramble for foreign-currency alternatives, the government negotiated the “Bank Shares Arrangement” in October 1983, under which it took responsibility for the fallen bank shares and promised to repurchase them from the public at their pre-crash (October 6, 1983) dollar-indexed value, either in 1987 or 1988 (Section 3, pp. 12-15). The paper estimates that “the government increased its obligations by a huge amount of $5.44 billion” after accounting for a 25 percent devaluation on the announcement date, against a 1983 GDP of about $24 billion – roughly a quarter of GDP – and that the eventual net cost of the bailout, accounting for the banks’ true intrinsic value recovered through later privatization, was about $3.46 billion in 1983 prices, or 14.4 percent of GDP (Section 3, pp. 16-17).
Q4. How does the paper establish that the public assigned a high probability to the bailout actually occurring?
By comparing the realized rate of return on the (now dollar-indexed) bank shares after the arrangement – 17 percent by December 1983 and roughly steady through 1984 – with the return on alternative safe dollar-denominated assets, about 8.8 percent, the paper calculates that “the imputed probability that the bailout would be implemented by the government was 43% by the end of 1983 and during 1984,” rising to “50% or even more” once a risk premium on the risky bonds is taken into account (Section 3, p. 17). The authors also note that most of the public chose to keep their shares tradable for five years rather than the higher-interest, non-tradable four-year option, “which indicates that people did not fully trust the ability that the government would be able to bail out the shares” (Section 3, p. 15) – consistent with a probability well below certainty but well above zero.
Q5. How does the paper account for Israel’s earlier inflation history using a standard inflation-tax model?
Inflation rose from under 10 percent before the 1967 war to about 40 percent after 1973 (the costlier Yom Kippur War, which pushed defense spending above 30 percent of GDP) and then to about 120 percent after a 1978 financial liberalization reduced money demand and thus raised the required inflation-tax rate (Section 2, pp. 4-10). Using the identity relating the monetized deficit to the product of real balances and the inflation rate, the paper estimates that during 1976-1978 “the deficit financed by printing money was on average 5.6% of GDP,” implying that of the roughly 15 percent of GDP average deficit after 1973, “around a third…was financed by printing money” and debt financed roughly two-thirds, based on reconstructed government-debt estimates for 1976-1986 (Section 2, pp. 9-11).
Q6. What is the structure of the paper’s formal monetary model, and how does the probability of a future bailout affect current inflation?
The model is a closed Ramsey economy with a continuum of infinitely-lived consumers holding money and one-period indexed bonds, a government that runs a constant monetized deficit G financed entirely by money creation, and a possible one-time future payment B in some period T, occurring with probability q and financed, if it occurs, by an additional monetary expansion in that period (Section 4, pp. 18-20, eqs. 2-9). Solving the model shows that expected future real balances depend on q and B (eq. 13), and that raising the probability of the future bailout from qa to qb in the current period causes real balances to fall and the inflation rate to jump immediately (eqs. 17-19), even though the payment itself, and the associated monetary expansion, will not occur until period T: “inflation jumps already in period 0, since real balances are reduced” (Section 4, p. 21).
Q7. What does the calibrated model imply about the probability of bailout needed to generate the observed inflation jump?
Calibrating the model to Israeli data (a discount rate of 5%, pre-announcement inflation of 122% in 1980-1982, high-powered-money-to-GDP of 4.4%, a monetized deficit G of 2.4% of GDP – inferred from the model itself to be consistent with a plausible pre-announcement bailout probability of about 19% – and a net anticipated bailout cost equal to 5.6% of 1988 GDP), the simulated inflation rate rises sharply as the assumed post-announcement bailout probability increases (Section 4, pp. 22-24, Table 2). At a probability of 0.50, simulated inflation reaches 711 percent (immediate jump) settling toward 468 percent; the authors note the actual monthly inflation rate in the last three months of 1983 implied an annualized rate of nearly 600 percent, so “the estimate of π0 = 711% in Table 2 is not far from reality” (Section 4, p. 24) – concluding that “both the size of the bailout and the rise in the probability that the public assigned to the bailout were sufficient to cause the significant jump in the rate of inflation” (Section 4, p. 24).
Q8. What alternative explanations does the paper consider, and why does it argue they do not fit the facts as well?
The paper reviews four alternatives and finds each wanting on the specific facts of October 1983. Liviatan and Pitterman’s (1985) balance-of-payments-crisis-and-accommodation story is questioned on theoretical grounds, since Zeira (1987) shows inflation reverts to a unique long-run rate unaffected by temporary price shocks (Section 5, p. 25). Bruno and Fischer’s (1990) multiple-equilibria account, in which a shock pushes the economy from a low- to a high-inflation equilibrium, is noted but not directly tested. Drazen and Helpman’s (1987) suggestion that a “Southern Cone”-style disinflation policy (slowing currency depreciation, financed by rising public debt) drove the jump is rejected on three grounds: foreign reserves barely changed (14.5% of GDP at end-1982 versus 14.8% at end-1983), the paper’s own reconstructed debt series shows no significant 1983 debt increase, and the disinflation policy itself had already collapsed two months before the October jump, so the timing does not fit (Section 5, pp. 25-26). Bental and Eckstein’s (1990) anticipated-stabilization mechanism, which requires post-stabilization real-balance demand to fall, is rejected because Israeli real balances actually rose sharply after the 1985 stabilization, from 3.6% to 6.3% of GDP by 1989 (Section 5, p. 26).
Q9. What does the paper claim as its two main contributions?
“First, it provides a new explanation for the dramatic October 1983 rise in inflation in Israel that has been difficult to account for previously,” locating the cause not in contemporaneous fiscal accounts but in “expectations of future deficits financed by a future money expansion” created by the bank bailout promise (Conclusions, p. 26). “A second thing this paper does is to supply a good example of a situation when a rise in future government expenditures seems to have raised inflation immediately” – the authors frame the episode as an unusually sharp natural experiment because the government pre-announced a specific, massive (about 10 percent of GDP) future obligation, and “the economy reacted as the theory of rational expectations indeed predicts, by running away from money immediately, raising inflation immediately by almost 300%,” while noting ruefully that “it is too bad that this neat illustration of unpleasant monetarist arithmetic was associated with a bank share scandal that disrupted many lives” (Conclusions, p. 26).
Key terms in this paper
Definitions below follow the paper's own usage.
- Unpleasant monetarist arithmetic
- the mechanism from Sargent and Wallace (1981) that the paper treats as its organizing theory: because money demand depends negatively on expected inflation, an anticipated future monetary expansion -- needed to finance an anticipated future increase in the government's real payment obligations -- causes rational agents to reduce their money holdings today, raising the price level and the inflation rate immediately, well before the anticipated deficit or monetary expansion actually occurs.
- The Bank Shares Arrangement ("Hesder")
- the October 1983 government rescue of Israeli bank shareholders after years of illegal share-price manipulation by the major banks came to a head; the government promised to repurchase shareholders' shares at their pre-collapse (October 6, 1983) value, indexed to the dollar, but only in 1987 or 1988, four to five years later. The paper treats this as an overnight, implicit increase in government obligations of roughly $5.44 billion (about a quarter of 1983 GDP), which the public rationally understood would ultimately need to be financed, at least in part, by future money creation.
- The 1983 bailout as a natural experiment for rational expectations
- the paper's framing of the episode as an unusually clean test of rational-expectations theory: the government pre-announced, on a specific date, a massive (about 10 percent of GDP) increase in its future financial obligations, and "the economy reacted as the theory of rational expectations indeed predicts, by running away from money immediately, raising inflation immediately by almost 300%" -- a sharper test than most historical episodes because the size and approximate timing of the anticipated future payment were both known with unusual precision.
- Calibrated Ramsey model linking bailout probability to the inflation jump
- the paper's closed-economy Ramsey monetary model in which consumers hold money and indexed bonds, the government runs a constant monetized deficit G except for a possible one-time payment B (financed by a monetary expansion) in some future period T with probability q; solving for the equilibrium price path shows that a rise in the publicly perceived probability q causes real balances to fall and inflation to jump immediately, even before period T arrives. Calibrated to Israeli data (ρ = 0.05, pre-announcement inflation of 122%, high-powered-money-to-GDP of 4.4%, and a net bailout cost equal to 5.6% of 1988 GDP), the model implies that a bailout probability of roughly 50% -- matching the probability implied by bank-share yields after the announcement -- generates an inflation jump to around 400-700%, matching the actual jump observed in the data.