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.