Ed Dolan's Econ Blog

Is Greece Like Israel? Why the New Yorker is Wrong about the Shekel and the Euro

Bernard Avishai, who teaches business at the Hebrew University in Jerusalem, published an article in The New Yorker this week titled “Why Greece Needs the Euro.” A key part of his argument hinges on a comparison between Greece and Italy. In fact, Avishai has it backwards. A closer look at the Israeli experience shows that Greece does not need the euro. Here is why:

After considering the argument that Canada’s flexible exchange rate helped it recover rapidly from the global crisis of 2008, Avishai writes that “Israel is a more telling example than Canada, having suffered an economic crisis much like Greece’s, in the early eighties.” In response to the crisis, he explains, Prime Minister Simon Peres introduced a new shekel pegged to the dollar. “The Israeli government’s decision to keep the new shekel constant and to seek free access to American and European markets was the foundation of the entrepreneurial economy that emerged in Israel during the nineties,” he concludes.

A strange argument. What Avishai inexplicably fails to mention is that Israel quickly abandoned its fixed exchange rate as unsustainable. This paper from the Bank for International Settlements gives the details. By 1992, the policy of holding the shekel fixed against the dollar was already seriously undermining the competitiveness of Israel’s exports. In that year, the country shifted to a more flexible system that allowed the exchange rate to vary from day to day within an ever-widening trading band. Even the band turned out to be too restrictive. In 1996, Israeli monetary authorities moved to a freely floating exchange rate, which (aside from some sporadic intervention immediately after the 2008 global crisis) they have maintained to this day.

It turns out, then, that it was not the fixed exchange rate, but the decision to end the fixed exchange rate, that sparked an era of Israeli prosperity in the nineties.

It is also misleading to compare the 1985 crisis in Israel to that of Greece today. The Israeli crisis was one of hyperinflation. Although the Greek economy has a lot of problems, inflation is not one of them. What the Israeli experience really shows is that a fixed exchange rate can be a useful strategy for ending hyperinflation—a problem that Greece does not have.

Furthermore, even as a tool for ending hyperinflation, a fixed exchange rate works best if it includes a built-in exit strategy. A comparison of Israel and Argentina is instructive in that regard. In 1991, Argentina stopped its hyperinflation by introducing a currency board that fixed the exchange rate of the peso to the US dollar. Unfortunately, Argentina’s currency board had no workable escape hatch. At first the policy bought growth and stability, but, as in Israel, it did so at the cost of progressive overvaluation and gradual loss of competitiveness. By the end of the decade, the Argentine economy had slowed to a standstill and unemployment soared. As we all now know, the grand experiment of the currency board ended in chaos in 2001.

Unfortunately, the inflexible rules of the euro, which allow no orderly exit, make it impossible for Greece to follow the example of Israel. Instead, they put it in a position far more like that of Argentina. It is no wonder that many observers see a disorderly default and devaluation as the inevitable outcome.

10 Responses to “Is Greece Like Israel? Why the New Yorker is Wrong about the Shekel and the Euro”

ThomasGrennesJuly 15th, 2015 at 10:56 am

Agree. Floating has been beneficial for Israel. Floating against the Euro has also worked well for EU members, UK and Sweden. It has also worked well for non-EU members, such as Norway, that have free trade agreements with the EU. However, these countries have developed monetary and fiscal institutions that have produced low inflation rates and the absence of debt crises. The problem for Greece is that it has not produced similar institutions, and that is why the majority of Greeks do not want to abandon the Euro for a new "drachma". The Eurozone creditors are trying to impose discipline on Greek institutions, but these kinds of reforms are rarely successful unless they start at home.
From where in Greece does one find support for fundamental economic reform?

Ed Dolan dolaneconJuly 15th, 2015 at 11:05 am

Logically, one ought to find support for at least some kinds of reforms–stopping patronage and corruption, improving tax collection, breaking power of oligarchs–from an outsider leftist party like Syriza. Some how that doesn't seem to be where they have put their energy, though.

windrivenJuly 15th, 2015 at 5:14 pm

Syriza has only been in power for a short time and much of that time has been spent trying to negotiate with various members of the troika. I don't know that it is entirely fair to fault them for lack of cleanup this early in the game.

It seems likely that the 'deal' is going to collapse without IMF on board and with fractures between German and France (and some others). This might yet be a transformational moment for the Euro zone.

In any event fixing Greece's fiscal policy and cleaning up excesses won't right the ship. Either major new infusions of cash or Greece regaining control of its monetary policy or (perhaps best) both will be required. Still it will be a long road. Something along the lines of Schauble's 5 year Grexit with support from the EU might work *and* provide a fig leaf to keep EU jitters under control. But for all parties' benefit, everyone should ignore the 5 year klaxon when it sounds. Greece never belonged in the Euro zone. In 5 years it still won't.

Bryan WillmanJuly 15th, 2015 at 6:23 pm

Couldn't we also add that another part of the Greek problem is the combination of a fixed common currency but without currency union wide institutions?
If, for example, pensions were paid out of an EU wide equivalent of the social security administration, and banks regulated by an EU wide equivalent of the Fed, those would prevent at least some of Greece's pain.
Also, can we not expect ANY government which spends more than its economy can produce/support, to run into trouble eventually?
That is, a Greece run badly outside the EU is not necessarily any better off than a Greece run badly inside the EU?

RcoutmeJuly 15th, 2015 at 9:22 pm

Although to some extent true (that a "Greece run badly outside…" would have problems, if it were not part of the Eurozone (Eu is okay, it is the currency that is problematic), then its currency would devalue against other currencies. In a purely independent sense, this would not normally matter (you still get less for your drachmas), but from a sociological point of view it does, in fact, matter. If Greece were using the drachma, then they would not have to lower wages, prices, pensions, etc. The drachma would buy less (particularly in imports), but the people would be more willing to accept that.

Bernard AvishaiJuly 16th, 2015 at 12:32 pm

Ed, what you seem not to have picked up from my piece is the sequence. A rock-hard currency is necessary when a country is at the stage of inviting in direct foreign investment. Call it the learning stage. Once Israel had begun to enjoy a variegated and entrepreneurial economy, which was increasingly export-driven, had free-trade- agreements in hand, and the Oslo process, then floating the shekel became an option. The floating shekel was the product of take-off, not its cause. As for the Greek crisis being unlike Israel, I fear you need to take a step back. Both had similar problems, no-growth, unemployment, and, crucially, the widespread real impoverishment of the middle class; both derived from government profligacy and wild consumer buying which was paid for by money that was not earned, and could not be, printed in Israel, borrowed in Greece. The question is, what does a country need when it is the first stage, when it is trying to lure investment and intellectual capital?

Ed Dolan dolaneconJuly 16th, 2015 at 8:06 pm

Thank you for your response. I appreciate the chance for a dialog.

You say, "A rock-hard currency is necessary when a country is at the stage of inviting in direct foreign investment. "

I'm really not sure I agree that a fixed nominal exchange rate is such a critical factor for attracting foreign investment.

First, there are abundant examples of massive foreign investment between countries with floating exchange rates–back and forth between the US and Japan, between the US and China, between the euro and dollar areas are all examples. Or if you want to bring in peripheral European countries, there has been heavy investment from Germany into the Czech Republic (e.g. Volkswagen purchase and restructuring of Skoda), and other examples of investment into Poland, despite the floating koruna and zloty.

Although it seems like a fixed nominal exchange rate is one less thing to worry about when you are making a foreign investment, what really matters for the success of a project in the long run is what happens to the real exchange rate. A country that has inflation plus a fixed exchange rate suffers overvaluation of its currency just as much as a country with an appreciating floating rate and no inflation. That was exactly the problem of Argentina in the 1990s. It was also a factor in the failure of some early Western attempts to invest in Russia in the 1990s, when the nominal exchange rate of the ruble was held constant (before the 1997 crisis) but inflation continued at a pace much faster than in the US. I was living in Russia at the time and saw that happen first hand.

On the whole, I just disagree with your idea that a fixed exchange rate is a particular advantage for countries with weak export sectors–countries that "don't make what the world wants," as you put it. On the contrary, the euro has been the biggest benefit to Germany, the export powerhouse. After all, without having the weaker countries in the euro area, the DM would be like the Swiss franc–it would appreciate until it threatened the competitiveness of the whole export sector. When you mix strong exporters and weak exporters like Germany and Greece within a currency area, what you get is an average real valuation for the currency as a whole–a little undervalued for the Germans and a little (or even a lot) overvalued for the Greeks.

In short, the weaker members of the euro that suffer most from its flaws, rather than gaining the most.

Bernard AvishaiJuly 17th, 2015 at 12:51 pm

I agree VW invested in Bohemia in spite of the Crown. (I knew VW's Carl Hahn well–he made the deal–and I wrote about him in HBR.) But my point, clearly, pertains to countries that are in a crisis like Greece today, or Israeli in 1984, which means either deflation of hard currency and unemployment or inflation of a soft currency and unemployment–in either case, pressure on the government to grow quickly.

So the question is how? And the main point is about learning to make things the world actually wants. Hahn bought the entire Skoda works for virtually nothing because he persuaded the workforce that VW would be a better teacher, and treat workers better, than Renault, which was the only other major bidder. All important prices, from stock to salaries, were denominated in hard currency, by the way. Hahn also did not imagine that the Czech government would be looking at years of serial devaluations. On the contrary, former communist countries like Czechoslovakia, China, etc., had tightly controlled banking and controls on foreign currency, so devaluation was the last thing on the mind of foreign investors.

And we have to distinguish between countries that are so big (like Argentina, Turkey, and Iran), and so have a domestic market attractive to investors in any case, and small countries, like Greece, Israel, Jordan, etc., who are of interest only as a part of supply-chains.

This is not the place to argue all of these things out. What I'm appealing for is an economics profession willing to see things from the point of view of global business strategy, not stay comfortable with old algorithms. "If devaluation then growth" has become silly. It works for big, variegated, entrepreneurial economies–and, in a way, is working (as you say, and as I wrote in the NYer) for Germany, which complains about Greece, but would suffer if the crisis did not weaken the euro. But it assuredly does not work for emerging states that have spent their way into penury, make little of what the world needs, and desperately need global corporations to absorb them into their supply networks.

Ed Dolan dolaneconJuly 17th, 2015 at 7:46 pm

I don't agree with all your points. I still see strong advantages in having a sovereign currency. It is no coincidence that Poland (not usually considered an export powerhouse) was the only EU country to make it through the 2008 crisis without a recession, and no coincidence that the 2008 recession was milder in CZ than in, say, the fixed-rate Baltics (although the CZ recovery fizzled out later, I acknowledge.)

However, there is one thing I strongly agree with you about. I do agree that the economics profession should be willing to look at things from the point of view of global business strategy, not just from the standard economic models. I see from your bio that you teach in a business school, and I have found that experience very insightful myself. In fact, my career is divided more or less in half, the first half teaching econ students in econ departments and the second half teaching economics to MBA students (mostly in emerging Europe). I learned a lot of economics from my MBA students and colleagues that I never learned in grad school.