Abstract
In May 1977, a political sea change took place in Israel, when the Likud Bloc replaced the Labor Party that had ruled since 1948. The government invited Friedman to serve as an unofficial economic policy adviser. Friedman visited Israel in July 1977 and proposed a broad package of free market-oriented reforms. This chapter documents Friedman’s views, activities, and influence using a wide range of primary sources. He advocated gradual disinflation, floating the currency, phasing out exchange controls, reducing government expenditures and taxes, privatizing state lands, and abolishing subsidies and directed credit. However, before his visit, Friedman was reported as calling for “a free labor market and a certain amount of unemployment.” This led to opposition attacks; consequently, the government distanced themselves from his views. In October 1977, the government announced an “economic revolution.” It liberalized exchange controls, reduced subsidies and tariffs, and essentially floated the currency. Friedman was not informed of this in advance. Still, he lauded the government for its “courage and wisdom” and predicted a “reduction of inflationary pressures.” But the government again distanced itself from his views. The “revolution” did not succeed; inflation accelerated. Still, parts of his agenda were ultimately implemented by later Israeli governments.
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Notes
- 1.
This chapter contributes to a small but growing literature on the activities and influence of eminent economists in foreign countries: Friedman in Australia (Courvisanos and Millmow 2006), Robinson in Australia (Millmow 2009), Hayek in Chile (Caldwell and Montes 2014), Friedman in Chile (Montes 2016), and Kahn in Israel (Schiffman 2014).
- 2.
See Bruno and Z. Sussman (1979) and http://www.boi.org.il/en/Markets/ForeignCurrencyMarket/Pages/shearim48-77.aspx.
- 3.
Friedman reacted as follows: “I am for a free market in the IL … But if a devaluation [is unavoidable], a crawling devaluation is preferable to a large, one-time devaluation.” (Transcript of Israel Radio Interview [Hebrew], November 26, 1976; in Talking Points [for 1977 general election], Likud Publicity Dept., Begin Papers Folder OP-016.
- 4.
During 1967–1973, twelve Western European nations adopted the VAT (tabulated from Ebrill et. al 2001, 9–12).
- 5.
Hebrew University announced the honorary degree at the end of March. It was Don Patinkin who suggested conferring this honor upon Friedman (Friedman and Friedman 1999, 463). Patinkin also helped draft the University’s letter of invitation and defended Friedman from leftist faculty who sought to rescind the invitation because of Friedman’s March 1975 visit to Chile (Patinkin Papers, Box 38).
- 6.
The word “revolution” should not be taken literally; it is our best attempt to translate the Hebrew word Mahapach, which has no precise English translation.
- 7.
Following the 1977 election, Likud had 45 members of Knesset (MKs), which were divided among its various factions as follows: Begin’s Herut, 20; Erlich’s Liberals, 15; La’am, 8; Ariel Sharon’s Shlomzion (which ran independently but merged with Likud after the election), 2.
- 8.
Patt had met Friedman in 1969 (Blitzer 1977a).
- 9.
During the 1970s, Friedman visited the following countries (besides Israel): Yugoslavia (1973), Italy (1973–academic activities only), Australia (1975; see Millmow and Courvisanos 2006), South Africa (1976), Rhodesia (1976), Chile (1975), and the UK (1970, 1974, 1978; see Nelson 2009). His first meeting with Margaret Thatcher took place during the 1978 UK visit.
- 10.
Friedman made the same point in the Jerusalem Post (Blitzer 1977a).
- 11.
However, in an English language interview published just 4 days before the Histadrut election, Erlich took a more positive view of planned unemployment and of Friedman. On unemployment: “It’s either [controlled unemployment] or economic collapse … We have to get out of the rut, and it’s not going to be a painless process. I don’t come as an angel down from heaven, bringing balm to all. The economic body in Israel is sick. Surgery is needed, and that will hurt. The pain is part of the cure. For the next two or three years life will not be easy.” On Friedman: “We had never thought of engaging him as an adviser. The administration already has an adviser, the Governor of the Bank of Israel…[However,] we plan to set up an economic advisory board, made up of serious-minded individuals. We shall mull over the country’s problems at our meetings, and shall invite guests with special knowledge or challenging ideas to come and talk with us … Dr. Friedman has agreed to devote a fortnight each year to consultations with us. He is arriving for a first visit on July 4 [Erlich established an advisory board in August 1977, but Friedman had no connection with it—authors].” Erlich also dismissed the Chile-related attacks on Friedman (Krivine 1977).
- 12.
On July 6, Friedman told Israel Television: “Unemployment is not a cure for inflation. But inflation is not a cure for unemployment.” He also stated that curing an economy afflicted by inflation is similar to curing an alcoholic: A short-term rise in unemployment is the inevitable result of disinflation, just as the cure for alcoholism entails unavoidable short-term pain (Friedman 1977e).
- 13.
On this occasion, Friedman did not revisit the labor mobility justification for higher unemployment. But as we shall see, in his subsequent public statements, he unequivocally advocated reforms that would increase both labor mobility and unemployment.
- 14.
The seminar was advertised in the newspapers and open to the public.
- 15.
Meshel apparently did not participate.
- 16.
When Friedman was introduced to the Finance Ministry’s Supervisor of Foreign Currency, he said with a laugh: “The first thing that you need to do is to fire this man” (Flomin 1978). This anecdote is consistent with Friedman’s remarks at the Hebrew University seminar the day before: “The final requirement, establishing confidence in the continuance of freedom, is the hardest. There would be only one effective way to do that: eliminate and disband the agencies now charged with enforcing controls and manipulating exchange rates. In principle, that is the right thing to do—but you won’t do it. And I recognize that I would be spitting in the wind to suggest that you should” (Friedman 1977a).
- 17.
Friedman had already advocated some of these measures during previous visits. In 1969, Friedman advocated currency liberalization and floating, abolishing tariffs, and making all subsidies transparent (Har Gil 1969). In 1972, Friedman advised Israel and other developing nations as follows: First-best policy—close the central bank and unify the currency with “a large, relatively stable developed country with which [the domestic country] has close economic relations.” In Israel’s case, this meant dollarization. Second-best policy—float the currency and adopt a monetary growth rule. Friedman recognized that his second-best policy “has far greater political feasibility in the present climate of opinion” (Friedman 1973, 59). He reiterated these points in the Israeli context during his Hebrew University seminar of 5 July 1977. Friedman’s remark concerning the political infeasibility of currency unification proved to be prescient: In 1983, the government was forced to abandon its dollarization plan after it leaked to the media and encountered overwhelming opposition (Gross 2008, 110–111).
- 18.
Friedman did not deny this. He argued that Israel’s economic problems were the same as in other countries such as the UK and Italy (Barnea 1977; Kiviti 1977). Apparently anticipating criticism on this point, he argued as follows: “When the doctor establishes that a child has rubella, he does not need to know the father’s name in order to prescribe medicine. In principle, the problem is identical, only the details are different. Israel suffers from a very common disease” (Kiviti 1977). Meltzer (2011) sums up Friedman’s modus operandi as an adviser to foreign countries: “In each of these countries, and many others, he gave the same general advice, modified in most countries by the institutional arrangements.”
- 19.
Because the interview was broadcast in English without Hebrew subtitles, Friedman was unable to make his case directly to the Israeli public. However, Davar published a brief summary in Hebrew.
- 20.
Friedman likened Begin to Winston Churchill, who was “clearly a great man, but every time he touched an economic issue, he came down on the wrong side, from 1908 until he left office.”
- 21.
Erlich stated that these measures were conceived and prepared in complete secrecy. Apparently, Erlich’s July 7 statement that subsidy cuts would be considered in 2 months was a smokescreen.
- 22.
The ministers were not informed of the agenda in advance (Begin 1977). The reform that would become known as “The Economic Revolution” was prepared in extreme secrecy. Of the approximately 200 individuals involved, only five had the full picture: Erlich, Flomin, Finance Ministry Director-General Amiram Sivan, Industry and Trade Minister Igal Horowitz, and Gafny (Flomin 2014). These officials communicated via handwritten notes (Davar, Oct. 30; Arye Naor, personal communication) and met in Erlich’s hotel suite (Flomin 1978). But Begin revealed the secret to an American audience, just before his first meeting with Carter. As the Christian Science Monitor reported on July 19 (Ofner 1977): “In New York Prime Minister Begin announced that Israel would soon take a further step toward implementing Professor Friedman’s ideas—a far-reaching relaxation in foreign currency controls.” Apparently, Begin’s desire to impress the Americans with his commitment to reform overcame the need for secrecy; perhaps he intended to publicize in advance what he was planning to tell Carter at the White House. (It is unclear when Begin and Erlich first informed the Carter Administration of their plans; we do know that Erlich informed US Treasury Secretary Michael Blumenthal on October 26, 2 days before the reform was announced). Luckily for Begin and Erlich, the Christian Science Monitor story was not picked up by the Israeli media.
- 23.
As Flomin said (The New York Times 1977), many Israelis were unable to comply with the currency laws, including former Prime Minister Rabin, who had been forced to step down as Labor’s candidate for prime minister in March 1977 because he and his wife had held an illegal US dollar bank account in Washington. Under the currency laws, Rabin should have closed the account in 1973, when he concluded his term as Israel’s ambassador to the US (Jewish Telegraphic Agency 1977b).
- 24.
The categorization of the various measures is our own.
- 25.
As Friedman (1977f) would later state, “reports in the media that the Israeli pound has depreciated by 30–50 per cent … are extremely misleading.” Taking the changes in subsidies and tariffs into account, the effective rates of devaluation were 20.4% for exports (goods 6.3%, services 43.9%) and 17.1% for imports (goods 9.4%, services 47.0%) (Tov 1988).
- 26.
In the weeks before October 28, the BOI was so concerned about a possible flight from the IL to the US dollar that it arranged $600 million in standby credit from the IMF and the BIS (Davar, October 30; see also Gross 2007, 108–110 and Flomin 1978). The BOI’s deputy governors also consulted with the Bank of England, the National Bank of Austria, and the IMF regarding the practicalities of floating (Flomin 1978, 2014; Davar, October 31). Immediately after October 28, the BOI declared that it would intervene in the foreign exchange market if necessary, so as to maintain long-term economic stability, minimize risks to exporters, and prevent speculative profits (Davar, October 31).
- 27.
Three days later, Erlich told the Knesset that abolishing export subsidies had “removed the threat of sanctions that various countries are threatening to impose on Israeli exports” (State of Israel, The Knesset 1977).
- 28.
Previously, the foreign currency-linked accounts known as TAMAM and PAZAK had been legal only for recipients of Holocaust restitution payments and were not highly liquid.
- 29.
Similarly, Friedman had attributed excessive significance to a September 1976 speech by UK Prime Minister Callaghan, in which Callaghan seemed to adopt major elements of Friedman’s macroeconomic framework (Nelson 2009).
- 30.
Friedman was silent regarding the VAT increase, despite his strong general opposition to VAT (Friedman 1972). Not only that, he never recommended that Israel reduce or eliminate its VAT. But just 2 years later, Friedman would brand UK Prime Minister Thatcher’s VAT increase a “retrograde step” (Friedman 1979). This ostensible inconsistency can be resolved as follows: (a) Friedman (1972) was willing to tolerate a VAT increase if it was associated with reduction or elimination of taxes that are even more distortionary than VAT. Erlich’s reform package appears to have met this condition; (b) Israel’s fiscal deficit/GDP ratio was approximately 15%, vs. 4% in the UK (UK data from Keep 2015). Because Friedman saw Israel’s fiscal deficit as inflationary, he may have viewed the VAT increase as a necessary evil.
- 31.
This prediction turned out to be correct. Initially, the public converted foreign currency into IL, in response to the large devaluation. But this phase lasted just 2 weeks (Bank of Israel 1977).
- 32.
Israel did not borrow from the IMF in 1977.
- 33.
Export incentives were increased in April 1977 (Davar, April 17) and indexed to a currency basket instead of the US dollar in May 1977 (Davar, May 4).
- 34.
This was a routine meeting, not a special meeting that was motivated by IMF concerns about the state of the Israeli economy (H. Onno Ruding, personal communication).
- 35.
- 36.
BOI economist Richard Ablin (1978) argued that this was a serious mistake.
- 37.
According to Bruno (1986), the government squandered the opportunity to implement structural reforms in 1977–1979, between the first and second oil shocks (e.g., unlike Finland).
- 38.
As Michaely (2007, 79) puts it, this episode “was, in effect, the only significant setback to the continuous fifty-year process of liberalization of current account or capital account transactions.”
- 39.
Erlich resigned as deputy finance minister on 30 July 1979 and publicly called for Erlich’s dismissal. Flomin had privately urged Erlich to resign together with him, but Erlich had refused (Flomin 2010).
- 40.
Other factors may have contributed to the debacle. Bruno (1986) and Michaely (2007, 79) argue that the devaluation of October 28 was excessive; O. Sussman (1992) disagrees. Frenkel (1984) emphasizes that the acceleration of inflation was caused by the interaction of the devaluation and subsidy cuts with the CLA system. Sylvia Piterman points out that Erlich was guilty of poor planning but also suffered from bad luck—the implementation of his reforms coincided with the second oil shock (Gross 2007, 115).
- 41.
Gafny consistently demanded deficit reduction without tax increases, both before and after the elections (Davar, various issues). The following economists also advocated deficit reduction (among others): former BOI Governor David Horowitz, chair of the BOI advisory council (Davar, 22 July 1977), and the academic economists Michael Bruno, Haim Barkai (both staunch Laborites), Eitan Berglas (who was about to be appointed by Erlich as budget director) (Davar, 15 December 1977), and Michael Michaely (Hanoch et al. 1977).
- 42.
Gafny publicized Erlich’s commitment on more than one occasion (Gross 2007, 109). Apparently, Gafny saw publicity as a commitment device—with publicity, it would be more difficult for Erlich to renege.
- 43.
Alternatively, it is arguable that significant deficit reduction was unachievable as long as defense expenditures remained above 20% of GDP.
- 44.
Only in August 1978, after the failure of the 28 October 1977 reform had become painfully obvious, did Friedman reiterate the need to “reduce government spending” (Friedman 1978).
- 45.
- 46.
This paper was based on Cagan’s Ph.D. dissertation, which Friedman supervised. Cagan wrote in the acknowledgments: “I owe a great debt to Milton Friedman for his helpful suggestions at every stage of the work.”
- 47.
This is why the BOI arranged $600 million in standby credit from the IMF and the BIS.
- 48.
For further details on the boom in foreign borrowing and the BOI’s regulatory response, see Zilberfarb (1991).
- 49.
“So far as the big sums of money are concerned, I would not be surprised if freeing exchange transactions would produce an inflow of capital. If you really abolished overnight your foreign exchange controls, if overnight you allowed the exchange rate to go free, and if you could establish confidence that the policy would be maintained, the package would surely attract capital not repel it … But even if you don’t establish full confidence that the policy will be retained, many people might be induced to bring capital into this country from the outset. And over a period of time, the promotion of international financial transactions would almost surely produce an inflow of capital into the country not an outflow. So I would not be at all surprised to see the true exchange rate of the Israeli pound appreciate rather than depreciate, if you were to follow such policies. Again, I don’t mean to predict that it will happen, because as I say prediction is very unreliable in this area” (Friedman 1977c).
- 50.
Friedman almost certainly saw Nichols’ paper; it appeared immediately before Friedman’s own paper in the March–April 1974 issue of the Journal of Political Economy.
- 51.
In this context, DC includes earmarked deposits, which the BOI defines as “deposits for which the depositor determines to which borrower or group of borrowers the amount of the deposits will be granted as loans” (http://www.boi.org.il/en/BankingSupervision/Data/Pages/DefinitionsAndExplanatoryCurrent.aspx).
- 52.
On the Friedman-Galbraith relationship, see Burgin (2013).
- 53.
Friedman would reiterate this point in 1987 (Friedman 1987). Galbraith published a rejoinder (Galbraith 1978b). The Friedman-Galbraith debate over Israel continued into 1979 and was featured prominently in the Israeli press.
- 54.
Like many economists, Friedman did not foresee that the Camp David Accords would make possible a large, permanent defense cut. Between 1980 and 1990, total government expenditures as a percentage of GDP declined by 16.5 percentage points; the defense cut accounted for 56.4% of that decline (Table 5.4).
Table 5.4 Fiscal indicators, 1980 and 1990 (% of GDP) The large expenditure cut made it possible to combine tax cuts with deficit reduction; as is well known, deficit reduction was the key to the success of the 1985 stabilization.
- 55.
Erlich died in 1983; there is no record of his recollections of the meeting.
- 56.
The latter claim is problematic for three reasons: (a) Flomin, who was present at the Friedman-Erlich meeting, identifies the translator as Finance Ministry spokesman David Ben-Haim. Although Ben-Haim’s English was “average,” it was adequate for the task; no ideas were lost in translation (Yehezkel Flomin, personal communication); (b) it strongly contradicts Friedman’s contemporaneous account on Israel Television (Friedman 1977e) (however, this contradiction may be resolved by hypothesizing that Friedman was speaking diplomatically in 1977 but candidly in 1985); (c) it does not appear in any of Friedman’s pre-1985 communications, public or private, including those that excoriated the Begin government.
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Appendix: Chronology of Major Events, 1977–1979
Appendix: Chronology of Major Events, 1977–1979
1977 | |
March | IMF mission visits Israel and is reportedly “alarmed” by the state of the economy. Finance Ministry and BOI officials promise action after the May 17 elections. |
March 31 | Rabin’s caretaker government loses access to IMF standby credit, due to its inability to negotiate ceilings on bank credit and BOI credits to the government, as previously agreed with the IMF. |
May 17 | Menachem Begin’s Likud Party defeats the Labor Alignment in the general elections (the “political revolution”). Labor (in its various incarnations) had been the ruling party since Israel’s founding in 1948. |
May 22 | Finance Minister-designate Simha Erlich announces that Milton Friedman will advise the soon-to-be-formed Begin government. |
May 24 | Friedman causes a firestorm by calling for an increase in unemployment during the Histadrut election campaign. |
June 20 | The Begin government is sworn in with a narrow Knesset majority of 62-58. The coalition parties are Likud (45 Members of Knesset), National Religious Party (12), Agudat Yisrael (4), and Moshe Dayan’s one-person faction (1). |
June 21 | The Begin government takes office. In the Histadrut election, Secretary-General MK Yeruham Meshel (Labor Alignment) (57%) is reelected, defeating MK David Levy (Likud) (28%). |
June 22 or 23 | Begin asks Erlich to move forward on currency liberalization and floating. |
June 26 | Erlich meets with IMF Executive Director H. Onno Ruding in Jerusalem. |
July 3 | Friedman lands in Israel. |
July 4 | Friedman receives an honorary Ph.D. from Hebrew University in the presence of Israel’s President, Prof. Ephraim Katzir. Speaking on behalf of the other honorary Ph.D. recipients, he delivers an address on capitalism, freedom, Jewish history, and the State of Israel. |
July 5 | Friedman lectures on “Floating Exchange Rates for Israel” at the Hebrew University economics department. At the Finance Ministry, he meets with Finance Minister Simha Erlich, Deputy Finance Minister Yehezkel Flomin, and Director-General Amiram Sivan. He meets separately with senior Finance Ministry staff. |
July 6 | Friedman is interviewed on Israel Television. |
July 7 | Friedman meets with the Knesset Finance Committee. |
July 3–8 (exact date unknown) | Friedman meets the leaders of the major economic associations—the Manufacturers’ Association, the Histadrut, and banking and agricultural associations. |
July 8 | Friedman meets with Prime Minister Begin in the early morning and then departs from Israel. |
July 17 | Erlich announces a cut in defense spending, cuts in food and fuel subsidies, and a devaluation of 2%. Friedman expresses his support. |
July 19–21 | Begin meets President Carter and other US officials in Washington. |
September 26–30 | Erlich attends the IMF annual meetings in Washington and holds discussions with IMF Managing Director H. Johannes Witteveen, World Bank President Robert McNamara, and US Treasury Secretary Michael Blumenthal. According to one account, Erlich consults formally with IMF officials Ruding and Whittome and receives their blessing for his planned reform. |
October 17 | At a top secret meeting held in Erlich’s Jerusalem hotel suite, Erlich, BOI Governor Arnon Gafny, and their staffs hammer out the details of the impending reform and choose October 28 as the date for implementation. |
October 23 | At a second meeting in Erlich’s hotel suite, the reform is finalized, and a green light is given for implementation. |
October 24 | The 15-seat Democratic Movement for Change (Hebrew: Dash), a centrist party led by Yigael Yadin, joins the government, broadening the government’s Knesset majority to 77-43 (Dash would leave the government after less than one year, then disintegrate). Begin informs Yadin of the impending reform. |
October 24–26 | US Treasury Secretary Michael Blumenthal visits Israel. On October 26, Erlich informs Blumenthal of the impending reform. |
October 28 | Erlich announces an “economic revolution.” The main elements are as follows (for a complete list, see the main text): Almost all exchange controls are abolished, export subsidies and import tariffs are reduced, and the IL is devalued by 47% and floated. The VAT rate is increased from 8% to 12%. Gafny notifies the IMF in writing. |
October 31 | Friedman lauds the government for its “courage and wisdom.” Begin and Erlich deny taking Friedman’s advice. Erlich makes a statement to the Knesset on behalf of the government. After a stormy debate, the Knesset votes 53-32 (with two abstentions) to enter his statement into the Knesset record. |
November 20 | Egyptian President Anwar Sadat addresses the Knesset, which leads to the signing of the Camp David Accords on 17 September 1978. In the Israeli economic discourse, the peace process with Egypt was often cited as a significant factor in the expansion of the budget deficit. |
Mid-December | Several leading academic economists join the BOI in calling for a major fiscal consolidation. Erlich goes even further and tells Gafny that he is committed to eliminating the budget deficit. But Begin caves in to pressure from his coalition partners, and the government adopts a deficit target of 10% of GDP. Gafny publicly criticizes the government and is reprimanded by Begin. |
1978 | |
August 15 | Friedman publicly denies J.K. Galbraith’s accusation that he is responsible for high inflation in Israel. He stands by his original advice and maintains that it was only partially implemented. |
1979 | |
Early January | Short-term foreign borrowing is temporarily prohibited. |
February | The BOI prohibits short- and medium-term foreign borrowing for 60 days. Soon afterwards, it extends the prohibition to all foreign borrowing. |
Early March | The BOI announces that it will intervene (if necessary) to maintain the PPP of the IL. |
April | Foreign borrowing is permitted, subject to a penalty: Israeli banks must pay a 12% surcharge and also deposit with the BOI the amount of 30% of the foreign credit, at a (penalty) interest rate of −17%. Thus, the capital account liberalization of 28 October 1977 is partially reversed. |
Mid-1979 | By now, the capital account liberalization of 28 October 1977 has largely been reversed. The only remaining provisions are partial freedom of capital movements (subject to a penalty and to foreign exchange intervention) and the $3000 foreign exchange allowance for Israelis traveling abroad. |
July 18 | Erlich informs Begin (in writing) that he is considering resigning as finance minister. Begin strongly dissuades Erlich. |
October 16 | Erlich asks Begin (in writing) to accept his resignation. Erlich explains that he cannot continue, due to his failure to develop a cooperative working relationship with many of his ministerial colleagues. |
November 7 | Erlich resigns as finance minister, but remains in the cabinet as deputy prime minister. |
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Schiffman, D., Young, W., Zelekha, Y. (2017). Politicization of Policy Prescriptions: Friedman and Israeli Economic Reform, 1977. In: The Role of Economic Advisers in Israel's Economic Policy. Springer, Cham. https://doi.org/10.1007/978-3-319-60682-8_5
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