The Bank of Israel - Vol. 1

By Haim Barkai; Nissan Liviatan | Go to book overview

5
Financial Repression

ISRAEL’S “TRADITIONAL” MONETARY REGIME

It is important to realize that Israel entered its inflationary period after two decades of highly regulated financial markets. Government control of the capital market was almost total. Pension and mutual funds had to invest 95% of their total annual net inflow of sources in government bonds, mostly nonnegotiable, that provided government with a cheap source of finance for its current expenditure. Thus, the government had no problem financing the fiscal deficits that it ran up in the late 1960s and early 1970s. Furthermore, the interest on negotiable government bonds was tax-exempt as against a 25% tax rate on interest paid by corporate bonds. This effectively channeled all available nondirected private-sector funds to government paper.


FINANCIAL REPRESSION: A UNIVERSAL ECONOMIC POLICY

This kind of regime was not specific to Israel. In one form or other, it was common practice in most developing countries at that time. Its label, financial repression (FR), was coined rather late in the season.1 The literature offers two main explanations for the emergence and persistence of this regime. First, the restrictions imposed on the capital market increased the demand for domestic money and, thereby, enlarged the base of the inflation tax (Nichols, 1974; Sussman, 1991). The restrictions on investment in alternative liquid assets also tended to reduce the elasticity of demand for money with respect to inflation and thus facilitated the extraction of more inflation tax. Thus, FR could enable lower inflation for a given fiscal deficit. The imposition of low interest rates

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