Saudi Arabia, Israel’s Improbable Ally? Part II

Inflation. That word triggers negative thoughts, especially for Israelis who recall the hyperinflation of the early 1980s. It is also a dilemma for the Bank of Israel’s monetary policy: balancing inflation through currency control while providing liquidity to the economy through the increased circulation and availability of cash.

Concurrently, geopolitical events can spark demand-pull inflation, making the currency’s purchasing power, at least for that product, weaker. If demand-pull inflation extends across numerous products, especially those deemed essential, then inflation becomes a serious economic problem.

The rise of the so-called Islamic State or ISIS poses such a potential threat to the Israeli economy, wherein consumers may panic and stockpile “essentials” along with other survival provisions. Such a panic would generate demand-pull inflation and damage the economy.

All this would occur without ISIS firing a shot. Surprisingly, Israel may have an improbable ally who is inadvertently protecting the economy.

Demand-pull inflation arises because the aggregate demand of a product increases faster than the corresponding increase in aggregate supply as consumer appetite outpaces production. Moreover, the increased demand pushes prices higher, even if manufacturers increase production capacity.

Economists theorize that this occurs because companies would need to pay workers more (e.g. overtime) or invest in additional equipment or infrastructure to keep up with demand, thereby increasing production cost. In turn, to maintain profit levels, manufacturers pass on the higher cost of production to consumers.

Prior to establishing the Bank of Israel in 1953, Israeli monetary policy was to print money as needed. At the time, the Israeli government was concerned with the absorption of refugees from post-Holocaust Europe and Arab lands, not with sound monetary policy. This resulted in significant inflation. With the establishment of the Bank of Israel, the policy changed.

Faced with high inflation, the newly established Bank of Israel sought to corral inflation and institute sound economic policy. Its solution was inflation indexing, which is linking inflation to the consumer price index (CPI). As the CPI rose, the “value” of money correspondingly adjusted. For instance, banks would contractually assure depositors that at withdrawal their deposits will modify to an amount commensurate with the movement of the CPI, so a 100 shekel deposit could become a 103 shekel withdrawal, not including interest. Similarly, agreed-upon real estate prices today adjusts to the proportionate closing price linked to the CPI. In fact, indexing became prevalent in all sectors of the economy.

The early 1980s changed the indexing policy. To index requires constant updating and balancing of the shekel against the CPI. Indexing became too cumbersome and time consuming with rapid inflation in the Israeli economy during the 1980s, when inflation climbed from over one 100 percent per year to over 400 percent per year. The economy needed a new plan to offset inflation.

To counter hyperinflation, the Bank of Israel reconstituted the shekel and employed an alternate anti-inflation measure. To stem inflation, the Bank of Israel sought to control liquidity by raising taxes to punitive levels. The idea was higher taxes, less shekels in the economy, stronger currency, more purchasing power and therefore less inflation. While the strategy succeeded in suppressing inflation, it also stymied economic growth and plunged Israel into recession.

At this point, an unlikely savior emerged for the economy. Beginning with the fall of the Soviet Union, Soviet expats swelled the Israeli landscape. Significant portions of those immigrants were skilled laborers, creating new markets. Coupled with new opportunities afforded by the so-called peace process, Israel broke free of the recession, despite its punishing tax scheme.

The same may be applicable today.

Just as increased liquidity in the Israeli economy raises basic inflationary concerns, the ISIS threat also raises inflationary concerns, specifically for demand-pull inflation. ISIS’s rapid growth concerns Israel, who may have to contend with ISIS on its northern border. ISIS has also attacked oil-rich Saudi Arabia, who has joined the coalition against ISIS. The chaotic circumstances in Syria and Iraq provided ISIS with fertile ground to grow and challenge the regime for control.

In contrast, Saudi Arabia’s stability challenges ISIS. Due to Saudi stability and the desire for Saudi oil, a clash between ISIS and Saudi Arabia would be much more taxing on ISIS and would likely draw the bulk of its fighters east, thereby decreasing its threat to Israel. In turn, Israeli consumers would not have ISIS jitters, thereby not triggering demand-pull inflation. Thus, Saudi Arabia would be Israel’s economic ally in controlling inflation.