ISRAEL: ARIDOR S ECONOMIC POLICY TURNAROUND

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP06T00412R000200820001-8
• Release Decision: RIPPUB
• Original Classification: C
• Document Page Count: 15
• Document Creation Date: December 21, 2016
• Sequence Number: 1
• Content Type: REPORT

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Directorate of Confidential
Intelligence
Israel: Aridor's Economic
Policy Turnaround
State Dept. review completed
Confidential
NESA 82-10252
June 1982
STAT
Copy 344
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Directorate of
Intelligence
Israel: Aridor's Economic
Policy Turnaround
Council.
This report has been coordinated with the Directorate
of Operations and the National Intelligence
Confidential
NESA 82-10252
June 1982
Information available as of 7 June 1982
has been used in the preparation of this report.
This memorandum was prepared by
the Office of Near East-South Asia Analysis.
Comments and queries are welcome and may be
directed to the Chief, Arab-Israeli Division, NESA,
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Israel: Aridor's Economic
Policy Turnaround F_
Summary Yoram Aridor has been the most effective of Prime Minister Begin's
finance ministers. Along with his success in taking the economic issue from
the opposition prior to the election in 1981, he achieved more rapid
economic growth, lower inflation, and an increase in foreign exchange
reserves. He has also pushed through the Cabinet, with significant help
from Defense Minister Sharon, a budget calling for a real reduction in
government expenditures and has put the country's labor organization on
the defensive in wage negotiations. Minister of Economics Meridor and
Bank of Israel Governor Mandelbaum, both in positions that could be used
to challenge Aridor, have kept in the background.
In the period ahead, however, Aridor will have to build on last year's
successes if he is to retain his political influence. He will find this
extremely difficult. The 11-percent price hike in April triggered a no-
confidence vote that Prime Minister Begin won by only a one-vote margin.
Aridor has taken an important step in dealing with inflation by securing
Cabinet approval for real government spending cuts, but the major factor
influencing future inflation will be the outcome of current wage negotia-
tions between the Histadrut-the national trade union federation-and the
Manufacturers' Association. Aridor has done little to tackle Israel's
productivity and investment problems. If they are not dealt with, the
economy's ability to sustain growth in the future will be increasingly
limited. Inflation and balance-of-payments problems are likely to lead to
requests for more US aid.
Confidential
NESA 82-10252
June 1982
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Policy Turnaround
Finance Minister Aridor has used his enhanced political influence, ac-
quired as a result of his role in helping Prime Minister Begin win
reelection, to implement policies that his predecessors had advocated but
had never been able to carry out. After taking steps that temporarily eased
the inflation rate before election day, Aridor turned to more orthodox
methods-budget cuts and wage restraints-to reduce inflation over the
longer term. Both Simcha Ehrlich and Yigael Hurwitz-Begin's first two
finance ministers-had advocated such policies but were thwarted by
cabinet nnnositinn
Preelection Economic Aridor took office in January 1981, a few weeks before elections were
Policies: Aridor's called, and immediately initiated a barrage of short-term measures that
Triumph removed the word austerity from the Israeli political lexicon. He succeeded
Hurwitz, who had become increasingly frustrated by the Cabinet's unwill-
ingness to accept much of the austerity program he launched in November
1979. When elections were called in February 1981, public opinion polls
showed that the opposition Labor Party held a massive lead over Begin's
Likud bloc. We believe Labor assumed it could be swept to victory in part
by reminding voters of Israel's triple-digit inflation rate.
To improve the position of Begin's Likud bloc, Aridor:
? Reduced the purchase tax on such consumer goods as color television
sets, cars, and cameras and eliminated those on toys and sporting
equipment.
? Revised tax brackets to increase the disposable income of middle-income
Israelis and granted tax breaks to those working evening and night shifts.
? Increased subsidies on dairy products, bread, meat, fuel, and public
transportation.
? Instituted a new savings scheme that guaranteed a real rate of return of 5
percent annually on funds deposited for two years.F__1 25X1
Aridor did nothing to attack the underlying causes of Israel's inflation, but
his moves temporarily reduced the rate just before the election. The
inflation rate for May, announced two weeks before election day, was a rel-
atively low 3.3 percent (an annual rate of 48 percent). The improvement
was due to the reduction in purchase taxes, which are included in the
consumer price index, and to increased subsidies. We believe Labor's
inability to successfully counter Aridor's tactics was one of the factors in its
defeat at the polls. FI 25X1
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Postelection Policies With his political influence enhanced by the election results, Aridor has
increasingly turned to policies that his predecessors had advocated but
were never able to implement. His budget for FY 1982 (April 1982 to
March 1983), as approved by the Cabinet, calls for a real spending
reduction of 5.6 percent. The Knesset-miffed that the budget was
submitted later than usual-is now reviewing these proposals, having
passed a three-month interim budget that is consistent with Aridor's FY
1982 plans. The Cabinet also authorized Aridor to draft legislation that, if
approved, would give him unprecedented power over spending and hiring in
other ministries.
Defense Minister Sharon has been an invaluable ally in Aridor's efforts to
reduce government expenditures. Attempts by previous finance ministers to
cut back spending have foundered because other defense ministers have
been able to block cuts in the traditionally sacrosanct defense budget. With
Sharon cheerfully advocating defense spending cuts-domestic defense
spending has been cut by 2.3 percent in real terms for FY 1982, and the
overall defense budget, including military imports, has been slashed by 17
percent-other ministers are finding it difficult to resist cuts in their own
budgets. Sharon has long advocated a lower level of defense spending
Aridor has repeated Hurwitz's call for a 100-percent cost-of-living adjust-
ment, with any additional wage gains tied to increased productivity. The
change is aimed at keeping real wages constant, curtailing a major impetus
to inflation. This has put the Histadrut, Israel's trade union federation, on
the defensive. Under the current linkage formula, wages have been
adjusted quarterly to compensate for 80 percent of the rise in the consumer
price index, and the Histadrut has been successful in bargaining for wage
gains that more than compensate for the difference. Except in 1980, real
wages have risen each year since 1976; the real increase in 1981 is
estimated at 13 percent.
The Deputy Secretary General of the Histadrut told a US Embassy officer
that the federation would have agreed to the same formula again. It,
however, cannot appear to demand less for its members than Aridor is
willing to give and is now demanding 100-percent linkage coupled with
freedom to bargain for additional increases at industry and plant levels.
This would ensure continued real wage increases.
Aridor has publicly threatened to introduce legislation imposing 100-
percent linkage if the Histadrut and the Manufacturers' Association do not
agree. According to the US Embassy, Aridor's minimum objective is to
achieve 100-percent linkage for government employees in order to limit the
government's wage bill. Recent press reports-confirmed by US Embassy
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sources within both the Histadrut and the Manufacturers' Association-
indicate that the linkage formula for other workers will vary between 80
and 90 percent, depending on inflation. Since the Histadrut would not
agree to this formula without freedom to bar ain at industry and plant
levels, real wages could continue to rise.. 25X1
After increasing subsidies significantly before the election, Aridor is
following through on his postelection pledge to reduce them gradually-
although he let them rise during November and December to keep inflation
for the year to a minimum. Tampering with subsidies has always been
hazardous. Hurwitz tried without success to cut them, and an attempt by
his predecessor, Ehrlich, to eliminate them eventually cost him his job. So
far Aridor has eliminated subsidies on fuel, which had not been subsidized
until the preelection period, and those on basic foodstuffs, such as bread,
milk, and eggs, have been reduced. 25X1
On 17 March an adviser to Aridor announced that prices on subsidized
items would be raised by slightly more than the increase in the consumer
price index each month; the policy may have been implemented even
earlier since the price hikes that accompanied the announcement were the
third in three months. The government, however, did not raise prices again
until 4 May, apparently because it wanted to hold down the consumer price
index increase for April when the CPI rise is traditionally higher than
normal. In addition, Aridor was probably reluctant to raise prices just
before Passover and Independence Day. Although a step toward greater
fiscal responsibility, the inflation rate could accelerate in the short run as
these price hikes spread through the economy. 25X1
Policymaking Aridor has been given virtually free rein to make economic policy decisions.
Begin, who neither understands nor takes an interest in economic issues,
rarely becomes involved in disputes among Cabinet members involving the
economy. The two people in positions that could be used to challenge
Aridor-Minister of Economics Meridor and Bank of Israel Governor
Mandelbaum-have kept low profiles. 25X1
The potential power struggle between Aridor and Meridor never material-
ized. Meridor-a longtime close friend of Begin-emerged in the final
weeks of the campaign as Begin's choice to be "economic czar," and a new
ministry was established for him. Meridor has not actively involved himself
in economic decisionmaking, however; his public image has suffered from
press reports of scandal involving his association with an Israeli entrepre-
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In January Aridor selected Moshe Mandelbaum, who has embraced
Aridor's policies, to be Governor of the Bank of Israel-Israel's central
bank. Mandelbaum's predecessor, Arrion Gafny, was not reappointed when
his term expired in October, reportedly because he had been publicly
critical of many of Aridor's policies. Mandelbaum indicated at a press
conference at the time of his appointment that, whereas the Bank of Israel
had been previously critical of national economic policy, he would now
clear his views with the Finance Ministry. He specifically criticized the
Bank's currency devaluation policy-a major bone of contention between
Aridor and Gafny-as inflationary. Mandelbaum has been very discreet,
and we do not believe he is playing an active role in his first few months in
office.
Impact
Aridor has been the most effective of Begin's finance ministers. His role in
helping Begin win'reelection and the fact that he is a member of Begin's
party have combined to give Aridor the political support necessary to
implement policy-assets Ehrlich and Hurwitz both lacked. As a result
Aridor has been able to ipfluence economic activity to a degree his
predecessors could not.
Aridor's spendthrift economic policies before the election contributed to a
23-percent real increase in government spending and pushed the budget
deficit for FY 1981 to $2.7 billion compared with $765 million in FY 1980.
Subsidies rose 80.9 percent in real terms. Aridor apparently was successful
in coercing ministers to reduce their spending in the second half of the fis-
cal year by holding up contracts until the minister acquiesced. The lagged
impact on the money supply of the earlier deficit spending, however, was
reflected in resurgent inflation in September and October. In response
Aridor again used higher subsidies to limit the rise in the consumer price
index in November and December, holding last year's inflation rate to 102
percent compared with 130 percent in 1980.
Government spending in combination with a 10-percent increase in private
consumption pushed economic growth in 1981 to 4.6 percent compared
with 2.7 percent the previous year. The boost in consumption was spurred
by large real wage gains.
Unemployment increased slightly last year to 5.1 percent despite rapid
economic growth. Until 1980 Israel traditionally experienced tight labor
markets, with employers reluctant to lay off workers during periods of
slack economic growth for fear of being caught short when demand
strengthened. In 1980, however, we believe employers assumed that the
government would stick to the austerity program launched by Hurwitz.
Since then they have evidently discovered that they can operate efficiently
without the laid-off workers
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Real Wages
Percent
a Estimated.
b Projected.
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Israel's foreign payments have benefited from falling oil prices, an increase
in the diamond surplus, and growing defense exports. These factors
prevented the goods and services deficit from sharply deteriorating last
year when Aridor's preelection purchase tax cuts led to a buying spree-
particularly for cars and color television sets. Consumer durable imports
doubled in the first half of 1981 compared with the same period in 1980.
The surplus in the diamond trade, however, increased by $366 million 25X1
when imports fell more sharply than exports as cutters worked off large in-
ventories. Oil price declines reduced Israel's oil bill by about 7 percent.
To cover Israel's current account deficit, the Begin government has
increasingly relied on borrowing from foreign banks-primarily in the
United States. Unilateral transfers and Israeli bond sales account for a
significant portion of foreign exchange inflows. Although Israel passed
legislation designed to attract foreign investment several years ago, the
results have been extremely disappointing. We believe investors who wish
to exploit the Middle East market are reluctant to locate in Israel because
of the continuing Arab boycott
Capital inflows have enabled foreign exchange reserves to increase from
about $1.5 billion at the end of 1977 to $3.5 billion at the end of 1981-
equivalent to seven months of nonmilitary merchandise imports.
Shortcomings A combination of policies designed to restrain domestic demand while
providing incentives for investment in productive capital and more efficient
utilization of Israel's manpower is required if Israel is to attack its
economic problems. While Aridor has taken the first steps to tighten fiscal
policy, he has done little to tackle Israel's productivity and investment
problems. If these problems are not dealt with, the economy's ability to sus-
tain growth in the future will be increasingly limited.
Lagging productivity has added to inflationary pressures. Productivity
declined by 1 percent on average each year between 1975 and 1980, far
short of the target of 4- to 5-percent annual growth. These shortfalls in ef-
ficiency were due to a reduction in the share of GNP for new plant and
equipment; the traditional hesitancy of Israeli employers to lay off workers
for fear of being caught short when demand strengthens; and greater use of
unskilled Arab labor to compensate for the increase in military conscrip-
tion since 1973. Moreover, very high marginal tax rates tend to inhibit
overtime.
In order to protect Israelis from inflation, the government has devised a
pervasive system of indexation. Most financial assets, as well as wages, are
linked to increases in the consumer price index. Long-term savings are
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Israel: Balance of Payments Million US $
Goods
Services
Self-financed military
imports
Military import payments
US military assistance
Debt repayment
Financial gap
Sources of financing
Unilateral transfers
US economic assistance
Israeli bonds
Other capital including
borrowing short-term
Net foreign investment
Change in reserves
a Estimated.
b Projected.
5,665
6,735
8,289
10,119
10,841
11,250
11,850
3,404
4,075
6,125
6,450
2,261
2,660
3,572
4,319
4,912
5,125
5,400
7,145
8,495
13,700
14,400
2,670
3,213
4,091
4,879
5,601
5,850
6,150
210
293
250
250
497
-141
- 76
1,325
1,690
1,420
2,018
2,404
2,055
1,958
1,115
1,397
1,170
1,768
1,907
2,196
2,034
730
900
893
1,025
1,730
1,545
1,470
2,420
2,953
3,861
3,489
4,446
3,854
3,944
2,613
4,057
4,299
3,777
4,591
3,954
4,085
1,153
1,231
1,400
1,471
1,521
1,575
1,700
822
875
980
785
785
785
785
355
430
436
432
400
375
400
189
1,407
1,456
1,082
1,885
1,219
1,200
94
114
27
7
0
0
0
193
1,104
438
288
145
100
141
fully linked, and government-issued bonds are indexed at either 80 or 100
percent. Savers are thus guaranteed a real rate of return. Investors, who
are reluctant to invest in physical projects because of uncertainty over
expected cost and price increases, instead put their money in these "safe"
investments. As a result, investment in plant and equipment has declined
from 20 percent of GNP in 1971 to only 14 percent in 1981.
While some of Aridor's preelection moves ostensibly were designed to
increase productivity and investment, they have had little real impact.
Aridor reduced taxes to a maximum 35 percent for those working evening
shifts and to 25 percent for those on night shifts to encourage Israeli
workers to overcome their well-known reluctance to work during off hours.
At the time a US Embassy official believed that this would encourage the
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Triple-Digit Inflation: Causes and Iffeets
Israeli inflation has been above single-digit levels since 1969:
? Prices jumped sharply after the 1973 war; inflation was in the 30- to 40-
percent range during the mid-1970s'.
? Inflation accelerated again in late 1978, reaching a peak exceeding 130
percent in 1980.
The major impetus for inflation has come from union ability to negotiate
real wage gains. Other factors include:
? An extensive indexation system that, while protecting most Israelis from
higher prices, perpetuates the inflationary spiral.
? Sluggish productivity growth.
? Depreciation of the currency, which boosts the price of imported goods
and services.
Under the government's comprehensive indexation system:
? Salaries are adjusted quarterly to compensate for 80 percent of price
hikes.
? Pensions, welfare payments, and long-term savings are fully linked to
the consumer price index.
? Government-issued bonds are indexed at either 80 or 100 percent.
In the long run this approach carries heavy costs:
? Government tendency to temporize by resorting to indexation reduces
incentive to attack underlying causes of inflation.
? Plant and equipment investment is debilitated as investors divert their
funds to financial assets where a real rate of return is guaranteed.
tax evasion and that workers would claim
to have worked these shifts w en, in fact, they had not. There is no
evidence to suggest that the official was wrong, and since low-income
workers are already in the 25-percent: tax bracket, there is no incentive for
them to work nights. While the response to the new savings plan was
strong, a large portion of the funds was shifted out of other financial assets.
Little new savings were generated to finance new investment
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productivity gains cannot be sustained.
Preliminary data suggest that productivity may have increased on the
order of 2.5 percent last year, since GNP rose by 4.6 percent while
employment went up by only 2 percent. This is likely to be an aberration,
however, which could be explained by employers' reluctance to hire new
workers. We believe many worried that Aridor might reverse course once
the election was over, and that they then discovered they did not need
additional employees. Last year's increased productivity was therefore
probably a one-time phenomenon. While total investment declined last
year in real terms, investment in machinery and equipment rose by 10.8
percent. Although this is a positive step, until investment spending
increases over a long period-which Aridor has done little to encourage-
To retain his influence and support, Aridor has to reduce the inflation
rate-prices have risen at an annual rate approaching 140 percent through
April-without damaging economic growth. While he was able to accom-
plish this feat last year by increasing subsidies, this approach probably will
not work over a long period because the deficits generated are themselves
inflationary. The Begin government survived a no-confidence motion
triggered by the 11-percent price rise in April by a margin of only one vote.
spending and hiring is enacted.
25X1
Aridor has taken a major step in dealing with Israel's economic problems
by getting the Cabinet to approve real spending cuts, but it remains to be
seen whether his FY 1982 budget will survive. The delay in final Knesset
approval of the budget may give opponents time to alter it, although such
attempts have not yet materialized. Furthermore, based on past experience,
ministers may spend more than the budget authorizes simply through
ineptness; the Defense Ministry is the only ministry with a reputation for
sound fiscal management. Aridor's ability to directly control other minis-
tries' expenditures will be enhanced if the legislation he is drafting on
cent years. Real wage gains will fan inflationary fires.
The outcome of the wage negotiations will be a major factor in Aridor's
ability to achieve his goal of an 85-percent inflation rate this year. If the
Histadrut is free to engage in additional bargaining over and above
indexation at industry and plant levels, it is unlikely that employers will be
any more successful in holding the line on wages than they have been in re-
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If Aridor fails to hold the line on the budget and real wages, the foreign
payments deficit for civilian goods and services will continue to widen. To
prevent this, export volume gains would have to outstrip substantially the
growth in import volume. This is unlikely, however, because the growth in
domestic demand-in addition to boosting imports-would allow Israeli
manufacturers to expand sales without looking to export markets.
Implications for Some Israelis believe that indexation has nullified the effectiveness of
the United States standard economic tools-such as interest rates and the government
deficit-according to a State Department official. These Israelis believe
that, given political realities-Israelis will not accept higher unemploy-
ment, for example-little can be done to solve Israel's economic problems.
A small,group ready to try to tackle the inflation and investment problems
exists, but they have no clearly defined way to accomplish this. The
common denominator among them seems to be a need for additional US
aid.
Debt servicing is a major concern to the Israelis; more than half of the debt
owed the US Government is from defense loans that were used to pay for
US military equipment that did nothing in the Israeli view to increase the
productive capacity of the Israeli economy or increase its ability to earn
foreign exchange to repay the debt. The Begin government has already
made a number of proposals to the United States aimed at reducing debt
servicing costs and increasing defense exports. These include:
? Restoring the share of Foreign Military Sales (FMS) credits that is
forgiven to 50 percent-the proportion prior to FY 1981.
? Provide military loans at concessional interest rates as an alternative to
increasing the forgiven share.
? Allow third countries to use a portion of their FMS funds to buy military
equipment from Israel.
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