Monetary Correction and Indexation: the Brazilian and Israel Experience

This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research

Volume Title: Explorations in Economic Research, Volume 4, number 1 (Indexation, The Brazilian Experience

Volume Author/Editor: M. Ishaq Nadiri and Affonso C. Pastore, editors

Volume Publisher: NBER

Volume URL: http://www.nber.org/books/conf77-1

Publication Date: 1977

Chapter Title: Monetary Correction and Indexation: The Brazilian and Israel Experience

Chapter Author: Ephraim Kleiman

Chapter URL: http://www.nber.org/chapters/c9237

Chapter pages in book: (p. 141 - 176) I

140 Roberto B M

Baer, Werner arid Beckerman, Paul. "Inflation without Distortiijnco An Fva(uatio5 Brazil's Indexing System.World Development 2 (Oc(ober.Decemher us 1974; 354' Carva(ho, Livio R. A/. Pnncipios e Appleaç,)o cia l'ii/iti(,i Saiarjal Pn5I 964 Dis( Paper No. 9, Universidade de Brasilia, Departamento rio tcon1 0550, l<73 Costa, Ramonaval A Size Distnhut,on ci Brazil in/ i)7: A ( ruc5_Si'it, Anaivs15 income Distribution by Occupations. Ph.D. Dissertation, Vanderbilt Unversity, 1975 DIEESE (Departamento Intersindical de EstatIstica e Estudos Sócio /\fl05 do P011/IC a Salarial. Estudos EconOmicos No. 3, Sao PauloEconomic05; Oez 1975 Doeringer, P. 8. and Piore, M. J. Internal Labor Markets and Manpower Lexington: D. C. Heath and Company, 1971. 'naf1,5 Fishlow, Albert. "Brazilian Size Distribution of Income," Amer,san f(OflUnj( Review (May 1972): 391-402. 62 . "Indexing BrazilianStyle:Inflation without Tears?" Brookings Papers on Economic Activity No. 1, I 974, 261 -280. Hoffman, Rodolfo and Duane, joo Carlos. "A Distribujco de Renda no Brasil "Rev5 de Administraçao de Empresas 12 (June 1972): 46-66. t.angoni, Carlos C. Distribuiçäo da Renda e Desenvolvi,nento EconOmjco d Bras;) de Janeiro: Editora Expressao e CuRura, 1973. Rio Macedo, Roberto B. M. Models of he Densanci Soc Labor and the Problemo Absorption in the Brazilian Manutacturing Sector. Ph.D. Labor Dissertation Harvard sity,1974. Unjvr.

.. . "Atgumas Dificutdades na lnterpretaco dos Dados do Salárjoe Sa(ánjo Mf'o da IndOstnia." Plane jarnenro e Conjuntura 79(August 1974)' 63-67. Rezende da Sitva, Fernando A. Avaliacâo do SetorPublic0 na Econornja Brasik'ira de Janeiro: I.P.E.A.-I.N.P.E.5,, 1972. Ri Supiicy, Eduardo M. "Alguns Aspectos da PoliticaSalarial." Revista de de Enupresas 14 (September 1974): 32-45. Administraçao lb. Tolipan, Ricardo and Tinelli, Arthur Carlos,eds. A Controvercja Sobre Dustribwçao d Renda e Desenvolv,mentoRio de Janeiro: Zahar, 1975. von Doellinger, Carlos and Cavalcantu, LeonardoC. E'npresas Muirinacjonajs tria Brasj/eua na indüs- Rio de Janeiro: I.P.E.A._l.N,P.E,S,,1975 Wells, John. "Distribution of Earnings, Growth, and Structure of Demandin Brazil During the Sixties." WorldDevelopment 2 (January 1974)' 9-24. [PHRAIM KLEIMAN The Hebrew University and the Falk Institute

MonetaryCorrection and Indexation: The Brazilianand Israeli Experience

0 Ill INTRODUCTION devel- The growing interest which indexationproposals have attracted in whether e oped economies in recent years hasinevitably raised the question jndexation has been a success in the countrieswhere it was adopted in the 5- repeated elsewhere. This past and whether the latter'sexperience could be the three countries paper compares the operationof indexation in two of Brazil arid lsrael.i Without pre- where it has been extensively practiced: above, I suming that such a comparison can answerthe questions raised and differences in theexperi- hope that, by pointing out the similarities insight into the rele- ences of these two countriesit may provide some vance of indexation to solvingproblems faced by others. tend to regard it as a panaceafor The advocates of indexation sometimes it for not beingthat. all inflationary ills, while its critics tend to deprecate therefore, To keep the limits of the present discussionclear, let me start, indexatiOn and whatthe with an attempt to define what is meant here by monetary ends areitis supposed to serve.Basically, indexationOr ad just- correction, as it is sometimes calledis aprocedure of automatic the social and ments of nominal values, used as a deviceto minimize

1PF.NBER Seminar on indexatiofl,São Paulo, This is an expanded verSion of a paper read at the NOTE: draft I owe a debt ofgratitude to lose professor Februan' 26-28 1975 for their most helpful comments on an earlierBeckerman, and DonPatirk Robrto Novacs de Airne idaEctmai Bacha, Werner Baer. Paul and patiently answeredmy Novaes de Alnida alyew kindly supplied mewith essential Brazilian data m3ny queries. 141 V

142 EphrainiKleinian

economic costs 01 ifltlatIOil. Consider tirsi the case where inilation devel. opc tinexpectedlv. after a period of price ctahi IitySince it was not taken into accou nt in the formulation of cx isti rig noni i na I contractstheir real outcomes will ex post differ from those envisaged by the cx ante on the basis of which they were signed; and the divergence bete0premises two sets of outcomes w;l be greater the longer the period of the the and the smaller the possibility of reopening it during its COntract Originallyagreed. upon lifetime.Itis these conditions which give rise tothe conclusion thatinflationresults in the redistribution of common income from creditors to debtors and, to a lesser extent (for wage contracts arcgenerai, of shorter duration), from labor income to profits. Unless inflation induced expressly for this purpose, the resultant redistribution was is one ofits major social costs.It will also result in a waste ofresources Caused attempts to force the revision of contracts through suchacts as strikes Furthermore, some resource misallocation may alsooccur, since the real price actually paid for goods and services supplied under existing Contracts is artificially lowered below their future replacementcost. Suppose now that inflation persists. The values at whichnew Contracts are now signed may be expected to take into account future declines in the purchasing power of money. And it is sometimes arguedthat if they do this correctlyi.e., if the expected rate of inflation incorporated intopresent contracts is the one that will, in fact, materialize__continued inflation will result in no further distributive or allocative costs beyond those incurredn the initial stages and, from the point of view of the individual, theinflation tax on the cash balances he voluntarily choosesto hold (which may turn out to be less distortive thanany other alternative tax considered). How. ever, this argument abstracts from both marketimperfections and the uncertainty factor inherent in inflationarysituations. Economic agents should be regarded as faced not by a point expectation of inflation,but rather by a spectrum of inflationaryvalues, with different probabilities attached to them. If,as we may assume, they are risk-averters, lenders will then demand a nominal interest rate which incorporatesnot only an element of compensation for the expected (mean) decreasein the value of money but also a premium tocompensate them for the extra risk element involved; and, for a similar reason, the nominalrate offered by borrowers, while augmented by the expected rate of inflation, will alsoincorporate a negative, clisagio elenient, reflecting their aversion froni thissame risk. The effect of uncertainty on the ex-ante real interest rate dependson the relative a strength of risk-aversion in the twogroups; but whatever its direction, it U will result in a decrease in the total volurniecleared in the marketi.e. ii n the total volume of saving and investment.1As uncertainty increases with the length of the time horizon, this lastresult will be accompanied bya (r change in the time structure of credittransactions, away from long-term tic 01 143 Correction aridIndexation st netary

With the collapse ofthe capital market, the silvings rio longer contrai_ts. channelled into it arediverted, partly to current consumption, and partly to particularto stockpiling and the l)lirChaSC of direct realinvestnlent-111 and durable consumergoods. Thus, evenvhc'n prices and real estate expectations (but With uncer- e interest rates canadjust in full to inflationary resource misallocationis unavoidable. And it, cx post, the tainty present) from those expected, a redistribution of rates of inflationturn out to differ n be added to it. income will market institutions In the absenceof institutional and legal restrictions, ly expected to adjust to this situation,albeit often with a costly time may be S he recoritractirig, allowing the lag. One suchform of adjustment may its of existing contracts and obligations.However, such frequent renegotiation problem is therefore one of adjustments are farfrom being costless. The -S. cheapest to operate, both choosing that adjustmentsystem which will be al it will be unable in terms of the amountof misallocation and redistribution ts of operation. Indexation can be to prevent andin terms of the actual costs by viewed as a device simulatingthe market adjustments made necessary cts developments in the inflation, but at a lower cost.To illustrate, consider he brought about in full labor market in ademand-pull inflation, such as is is of pure employment by governmentdeficit financing. Under conditions nt the value of marginal competition, as output pricesrise, and with them also II workers from their product of labor, individualfirms will try to attract in will finally he competitors by offers of highernominal wages. Equilibrium 011 before, but not before some re-establishedat the same real wage as rn Alternatively, with a reshuffling of labor among enterpriseshas taken place. ) W- will result in highly unionized labor market, theinitial fall in real wages the of existing wage demands for nominal wage risesbefore the expiration nts lost, either in the contracts. In both cases, someworking time will he but through industrial process of workers' transitionfrom one firm to another or ties change that disputes. Assuming the change in the pricelevel to be the only viii through wage has taken place, the same adjustmentcould be attained an raised proportionatelY contracts stipulating that thenominal wage will be e of man-days would whenever the price level rises. In this case,however, no ent be lost. ers, to constitute acost-Saving It follows from the aboveexample that. ea the automatic simulation device, indexation has to eilslirein advance Tle will be adjustment of nominal values to the pricelevel. Otherwise, it :tive costly, mecha- unable to prevent the operation of thealternative, more n, it indexations" nisms. In particular, this will happenwith so-called "ex-ante in from thatpostulated in them. whenever the inflation rate realized diverges with duced misalloca- (Nor can ex-ante indexation removethe expectation by a earlier.) Theassumptions made in tions due to the risk element mentioned tor term is not a substitute our illustration also bring out the factthat indexation 144 Ephrairn Klein)an

to changes other than tha' in the mechanisms providing adjustment pur. if the rise in the general price level chasing value of money. Thus, v"ere accompanied by changes in the structureof demand requiring, inturn a change in the real wage or in therelative wages of differentgroups oi workers, they would not be taken careof by indexation: as itsalternative name implies, indexationis designed to provide only monetary (nominal) corrections, not real ones. in the example, indexationneutralizes the effects of inflationon both real wages and realprofits, and therefore also on the distributionot income. Suppose, however, that the rise in the price level was due to, sa,,

a worsening of the country's termsof trade. This amounts to a decreaseii) the real value of national income which, under competitive condition5 would affect all income groups. Insofar as full indexation protects the real income of any one of them, say, labor vis--vis capital or lenders vis-a-vjs borrowers,it can no longer simultaneously neutralize the effects of the inflation on the distribution of income, its effects will then be similar to those o an attempt of one econcrnic group to increase its share of the national income at the expense of another. Finally, while indexation may slow down inflationary pressures if the actual inflation rate turns out to be lower than expected, in the opposite case it may enhance it (though, at the same time, doing away with some of the negative distributive and alloca. tive effects by means of which inflation would otherwise be slowed down). But basically, it is not an anti-inflationary device and should not be judged as such. It is with these reservations in mind that we can now turn to the way ndexation has actually been operating. As the Brazilian experience has been widely treated at this conference, Ifirst survey the way indexatiori evolved in Israel and then proceed to compare the experiences of the two countries. till INDEXATION IN ISRAEI

History lndexatiori was first introduced in what isnow Israel in the early years 01 World War II. With the intention of avoiding the frequent industr disputes that could be expected to result from therise in the cost of living. the British government of Palestine encouragedan agreement between the trade union federation andgroups of industrial employers thatlinked wages to prices through a cost-of-living allowance. Over the years, the coverage of this agreement was extended to applyto almost all eniploY' ees. For a long time this remained the only form of indexa!ion in the country. 145 Correction andIndexation M0 netary the wake of the brief inkirig otfinancial instruments came in The followed the establishment of the stateof Israel in runawayinflation that primitive tax systeniinherited from the Britsh administra- j948. The very caused the Israeli well as a certainlack ot economic sophistication, tion, as finance the 1943 war and the government to resortto the printing press to immigration. An attempt to repressinflation through absorption of mass and rationing, at firstsuccessful, could not withstand the price controlS for long. By the beginningof 1952 the printing of money growing pressures in order to Wipe out the curtailed and priceswere allowed to rise was purchasing power. As aresult of the latter decision, the public's excess alone.3 official retail prices roseby nearly 60 percent in that year index of could not but destroy any moneyillusion people Such a development nourished until then. night have involving a time element, unwilling to refrainfrom all transactions S of value alternative to the households arid firmsbegan searching for units e had to find devices whithwould purely nominal one.In particulars they 0 making of actual payments make possible to contractand repay debts. The e prohibition exchange notes washeavily restricted by the in gold or foreign of the latter. As V the former and onboth trade in and possession e on trade in market prices contracting partiesresorted to the local black e an alternative, Israeli pound (IL) onthe Zurich of gold and dollarsand the rate of the a- of value. Thus, paymentswere made in IL, exchange as a constant measure good. in this case thatof but their size waslinked to the price of some d black market price arenot foreign exchange. Butcontracts based on a be expected to belooked easily enforceable in the courts,nor can they ay The use of this typeof linkage was upon favorablyby the authorities. as between small, lamily-owned therefore limited to transactions the or. the majority of theprivate sector of enterprisesof which, however, few big '10 could not be resortedto by the economy thenconsisted.It of them tried, raise capital onthe market. Sonic companies trying to linked to the priceof the instead, to issue bonds whosenominal value was the legality of eventhis outpUt5Pehic goods they produced. However, law dating hack to of an old anti-usury linkage was in sonic doubt because nominal which set an upperlimit on the the days of the Ottoman empire, interest ratescould not fulfil interest rate. (This explainsalso why nominal S of of inflationaryexpec- their expected function by adjustingto take account trial tations.) loans i rig financed itself bypractically unlimited As long as the government the from the issuedepartment). from the central bank (or, as wasthen the case, interest or to ked the legal rate ot it had, of course, no incentiveeither to raise effort, the time,it made no offer any but nominal repayment.At the same by- lent to privateenterprises either, to secure the linkage ofthe funds it of the objection tothe linkage through its development budget.The main e

146 Ephraini Kleirnan

government credits seemsto have been the lear thatthis wouldi interpreted as a sign that the goverrliii('ntexpe(te(I intlaton to persist,thus adding fuel to the inflationarybonfire.1 The situation changed when,tinder the preSsure 01 ha lance-ol-paynlentsconsiderations, the governni(fl cided to curtail its borrowingfrom the issue department and tried toraise money by loansIroni the general public. Nut wishing to discourage investment, and regarding interestprimarily as a cost COflul)oflentwhich could push up prices, it was unwilling totamper w!th the legal Ceilingon interest rates. But the lottery prizes itoilered instead were not sufficientto induce the public to buy governmentbonds. At the same time it became evident that the real value of the government's outstanding credit would be greatly reduced by the time of its repayment. Combined with the business sector's need of a stable value standard, the government's financial requirements led, by the mid-i 950s, to the adoption of widespread linkage The first government constant-value bonds, linked to the official foreign exchange (i.e., dollar) rate, came into hx?Ing almost unintentionally. They were issued in 1950 to compensate ownersof foreign securities for their forced purchase by the state at the overvalued officialate of the Israel poLind.' The successive devaluations of the IL in the early I 950s convinced the public of the validity of the linkage clause. ,\nd from 1954 onward the government had to offer either dollar or price level linkages for its bond issues to be acceptable to the pul)IiC. The introduction of linkage in government borrowing inevitably raised the question of its extension to government lending as well. lii 1955 the government accepted the recorn- riiendation of a Public commission set up for that purpose that linkage he required on all state credits extended for a period of two or more years. B the end of the decade linkage of niedium- and long-run financial contracts was almostuniversally accepted.Not onlyregularloans,butalso mortgages, life insurance, arid saving deposits acquired linkage clauses, which were even extended to some commercial bills. On the whole, the two value standards used were the official exchange rate of the U.S. dollar arid the Consumer Price Index (CPI). There were, however, some minor exceptions: for example, the value of down payments in certain housing schemes was linked to a construction cost index tor the purpose of final settlement. As a rule, both principal and interest were linked. The choice of standard, at least in credits emanating from the government, was optional, and some private credits had mixed linkage (by which changes in the U.S. dollar rate and the CPI each applied toone half of a loan's initial nominal value). After the massive (levaluatons of the earlyI 950s, the government preferred to cope with balance-of-paynient problems by varying the eec- tive rates of exchange rather than the formalrate, not least because a large and Indexation 147 MOfletYCOrreCtmohi

internal debt wasdollar-hnked. Its protessed revulsion from share of its 1hniigh caused many of itsdebtors to Opt tor dollar linkage. devaluation considerably slowed down bythen, the realvalue'of inflatioflhad been interest and repaymentburden was nevertheless reduced by their current quarter between19Sand 1961. This fool's paradise was more than one devaluation of the IL, from 1 .8 to 3.0 tothe rudely shatteredby the 1962 accompanied by some downwardscaling of tariffs and dollar. As this was financial assets its full impact wasin the main reserved for export subsidi, sud- The shock of havingtheir outstanding debt increase and liabilities. created considerable unrest amongthe governments denly by 67 Percent government had to bow topolitical pressrireit declared a debtors. The developmentbUdget loans to moratorium on someof the linkage in producersand allowedtherecipients of agricultural andindustrial the from state funds to optretroactively for linkage to mortgages financed however, default on its owndollar- Consumer PriceIndex. It could not, ii surprisingly, therefore, thegovernment discon- linkedobligations. Not dollar-linked obligations andcurtailed the granting of tinued issuing such borrowing being henceforthinked credits, most of itslending and all of its II government exchange rate linkagesurvived, however, in d to the CPI. Some individuals. industries and in transactionsbetween private e loans to export characterized the late 19605seeniS to The internal pricestability which d that it would carry overto the have misled thegovernment into thinking n offered to forgo thelinkage clauses in next decade aswell. In late 1967 it .0 "linkage insurance"premium of four most of its existinglinked credits for a -I- been introduced sometime percent per annum. Asimilar premium had in the borrowing abroad againstthe risk of changes Lfore to insure firms indexation risks as 3y Its extension to cover official exchange rate ofthe IL. public's :1 s for the prenhiLiilifell short of the well created a curious situation, medium- so Consequently, almost allof the internal expected rate of inflation. is linked, while alarge part ofthe and long-term public debtin Israel he the renewalof inflationarY government's outstandingcredit is not. With after the lar and particularly their verrapid acceleration tor pressures in 1971, asymmetry. As found itself badlypressed by this 1973 war, the government the contlict ng departments andagencies raised a result, various government the cii linkage on statecredits and taxing ing demands of reintroducing 'Of loans.' public's indexation profits on state abolition, should be mentionedhere is the The last development which rates. ,.s. which imposed aceiling on interest in 1970, of the old Turkish law in the more nal regarding pricedeveloPn1e0t In view Of the great uncertainty for indexation rate couldnot substitute ent distant future, the nominal interest spread of indexa- it probablychecked the fec- in long-term credit, bitt freeing irge tion to short-term transactions. *

148 Ephrairn Klejrnan

Indexation of Wages The wage indexation n hairisininisraelis tormally bed d riorlica I ly renewable agreementbetween the centrzr trade orion Organiia tion (H istadrut> and theManutaCturers Association ot Israel. But both H istadrut-owned enterprisesand the governmenttile two biggest single employers in the countryadhere toitautoniaticaII', and other flonsig- natories can be forced tocomply.8Its coverage has been gradijaI! broadened, so that by 1 963 it wasestimated to apply to about 85 percent of all employees.9 By now, theonly groups riot covered are such marginal ones as domestichelp, seasonal agricultural labor, etc. These agreements provide for the paymentof a proportionate cost-of- living allowance (COLA) wheneverthe rise in the consumer price index (CPI) exceeds a certain (cumulative)threshold. Initially, the allowance could be adjusted every three months. But overthe years its frequency has been reduced to twice a year, in Januaryand in July, except for periods of very rapid price increases.such as may follow a devaluation. The allowance is paid only on that part of an employee's earningswhich does not exceed a certain ceiling. Whik thisceiling has been periodically upgraded to keep pace with both inflation and the rise inreal incomes, its adjustment has been far from automatic. Consequently, the share of the total wage bill on which COLA was paid has varied between one adjustment of the ceiling and the next one)° Originally, the COLA was calculated on the basis of the change in the CPI rluring the period since the last adjustment was made. This, however, as well as the method used to calculate the CPI in the 1 950s, made it worth while for the government to manipulate the CPI for purposes of COLA. Because of the threshold condition, it also made the adjustment of the allowance highly sensitive to short-term price variations. The calculation was therefore changed to a comparison of the average price level in the period which elapsed since the last adjustment was made to the average for the preceding Period of the same length. Also, the most seasonally volatile component of the CPI, the price o1 fruits and vegetables, is included in the computation only once a year, and the price averages are annual ones, even when all other prices are compared on a six-month basis. Another, more sophisticated, correction has been the exclusion of changes in the imputed rent of owner-occupied housing, on the grounds that they constitute a self-balancing increaseri both income arid consunip- tion expenditure. Regarded at its inception as something of a social security measure, the allowance has been tax-free until now)It thus increased the government's wage-bill without providing a parallel source of tax revenue. In the earlie years this asymmetry caused the government to try manipulating the prices 149 Correction andIndexation netary so1

should IN' StreSS('(I here basis of whichthe COLA was calculated. It on the he index itselfButii the 1 95 Os the ne\'eitoe-cl to tafllper with thatit the bundle of goods pur- weights of theindex, SUppOSedlY representing urban wage earner's household, were notadjusted chased by an average patterns; price often enough toallov for changes in actual COflSUI1)ptiOn collected on certain specificdates, and, as mentioned above, the data were itselt was calculatedaccording to the change in the index allowance All this made it easy tor the government to, in between twopoints in time. the index through short-termsubsidies on overrep- effect, manipulate updating of the index resented items.2 Since1959, however, the frequent basis, and the weights, the collectionof price information on a continuous six-month, or even longer,price-level averages in calculating COLA use of of the made such manipulation nolonger worthwhile.' The calculation inIsrael, is CPI, which is usedalso for most other indexation purposes agency the performed by theCentral Bureau of Statistics, a government law and partly by a integrity of whoseprocedure is guaranteed partly by index is published monthly, system of publicadvisory committees. The becoming available on the 15th of the month (or the with a fortnight's lag, to which it next day it this happens tofall on a Saturday) following the one

pertains. renegotia- For many years the governmenttook no part in the periodc voluntarily as an tions of the COLA agreenlent,though it adhered 10 it it has been taking anactive part in them, employer. Since 1970. however, policy. As this regarding the allowance as partof the general incomes between govern- policy tended to take the formof tripartite agreements regarding the simultaneousdetermination ol ment, employers, and unions recently, the COLA became lessautomatic; more wages, prices, and taxes, character, at however, all three parties haveagreed to restore its automatic of the price increasecompensated the same time restricting the proportion in far untested, arrangementsare described tom. Some of the new, so Israeli systems of Section III below, in the comparisonof the Brazilian and wage indexation.

Financial Assets Israeli capital market canbe ascribed The government's domination oi the funds required by partly to necessity and partly to ideology.The investment three years of massimmigration, the doubling of the population within the Private invest- 1949-1951, could not be mobilizedwithin the econonlY. fohcoming in sufficientvolume, so practi- ments from abroad were not aid in those earlyyears by the cally all of capital formation was financed obtaining fromabroad. While and loans the government succeeded in S

150 Ephrajrn Kleiniai,

most investment tunds were thus rei.:eived by the govemnlentitVas Iio unahle and, in VieW 01 its commitment to a miXed erunnmy unwilli8 to investnieiitprocess.In undertake the actual lending thesefurXjs to semipublic agencies and pris/ate enterprises, it performed the1tion of the then almost nonexistent capital riiarkel. In later Y(l1S private Capital imports and domestic savings came to play an increasingly iniportant role in investment financing. The government did not, however, curtail its role as the main financial intermediary in the country, partly owing to its wish to control the industrial arid regional distr!hution of economic activity

Originally, the funds obtained through aid or throughgovernme borrowing abroad were channelled through the development budget.With the increasing availability of doniestic financing, much of bothgovernn0 borrowing and lending operations have been shifted to banks andother financial institutions, some state-owned and some I)riVate. These issue long-terni bonds to the public and lend the proceeds according totreasury instructions. The government's power to allocate these fundsconies ultimately from its willingness to subsidize the cost of capital to theinvestor The government even subsidizes the capital cost ofsome enterprises, mainly state- or Histadrut-owned, which themselves issue bondsto linance their own investment projects. Fornially, the proceeds of suchissues are deposited with the treasury, who then lends them to the bondissuer, to used for the purposes and on the ternis specified byit.For all practical purposes they are indistinguishable from bonds issued directly bythe government.'4 With the exception of the Short-Term (up to eighteenmonths) Loan, government or government-sponsored bonds are issued for periodsof four to ten years, and their principal, and often also theirinterest, is index- inked. The index used is the CPI, theone which serves as the base for the COLA computation. However, unlike the lattercase, the monetary correction on index bonds is proportionateto the increase in the price level from the month preceding issue to the month preceding redemption (orpayment of interest), and not on longer period averages; also, the CPI isnot adjusted for either seasonal fluctuationsor changes in the prices of owner-occupied housing. While some of the bonds pay interest twice yearly, inothers it is cumulated up to maturity. Onei)ecu liar variant is a bond that allows its holder to opt retroactively for either index linkageor the alternative higher nominal interest rate. Theseare the results of a period in the 1 960s when expectations of price stability madethe regular linked bonds unattractive compared with the Short-Term Loan, which is unlinked butpays a higher nominal interest rate. The monetary correction, or,as it is called in Israel, the indexation differential,on the principal of these bonds is not taxable and they enjoy the privilege of a flat-rate taxon the interest, deducted at the source.'5 In addition, there exist also long-terninonnegotiable bonds Correction andIndexation 151 Monetary

lusively to provident ILinds and seventeen totWCiltV years) issued ext insurance C0111Pa11iC5. bonds amounted to 85 percentof the total market value of In 1974 registered at the Tel Aviv stockexchange. Of this, nearly nine- securities accounted for by in(IeXedl)OldS, and a further 8 percent by tenths was consisted those linked to ortraded in foreign currency The tiny remainder of bonds convertible into shares at somelater date. almost exclusively financial assets available to the public are savingsde- Other indexed funds posits, life insurancepolicies, and savings accumulated in provident loan certificates. and pension plans.Inclexation applies also to compulsory While sonic of these arenonnegotiable, they can substitute for other forms Demand and ordinary time of savings withinthe individual's portfolio. deposits, as well as theShort-Term Loan, are urrindexed. bank- indexed liabilities of thepublic, owed to the government and the categories of housing system, by nowconsist almost exclusively of sonic development loans, de- ing mortgages. Sincethe abolition of linkage on longer scribed earlier, most of thegovernment's outstanding credit is no also indexed. The short-term creditsupplied by the banking system is unindexed. prevalence of indexation in theprivate Itis difficult to ascertain the with the government sector of the economy,other than in its transactions linkage were or with the banking sector.Both exchange rate and index But since the abolition fairly common in the direct billbrokerage market. regarding the of the usury law in 1970 (and thetightening of regulations longer volume of brokerage a bank mayguarantee) this market is no significant. practiced In concluding this survey of the variousforms of debt linkage regarded in Israel in Israel, mention should be madeof another type of asset exceptions, exchange as linkedforeign exchangedeposits. With certain residents to hold loreign control regulations make itillegal for Israeli exchange currencies or securities. However, toprovide incentives for of foreign transfers despite the overvaluatiori ofthe IL, the recipients the GermanFederal currency (mainly private restitutionpayments from fraction of itin special time Republic) are allowed to hold a certain need's, such as deposits. These funds can be used fortheir owners' personal securities which canthen be travel abroad, or for the purchase of foreign be held in anothertype of time sold to other Israeli residents. The rest can only in deposit, nominally valued in foreign exchange,but redeemable effect exchaflgelied. In their local currency. Thus, these deposits ate in straightforward foreign cur- speculative function they are very similar to however, in the exchange controls; rency holdings in countries with no bank precedes its Israeli case the sale of foreign currency tothe central actual conversion into the local one. 152 EphratmKlejman

Taxes Though it accepted indexation in the labor market and iI)tru(i1J(ecl tinthe capital market, until 1 975 the Israeli governmentwas riot Prepared to see extended toits own revenues.Itsonly, reluctant, 1 COPCCSSi00 in th5 direction has been the exemption from personal incometax of the The position of self-employed taxpayers COLA was equalized with thatof employees by linking the minimum incomeexempt from taxation COLA. But income tax brackets were not adjusted to the auton1aticaIl, with inflation; revaluation of deprecial)le assetswas inhibjtd by the I gains tax and by the tax levied on real estate and business Capita! inventori and LIFO valuation of the latter was not allowed fortax Purposes. government relied on occasional and unsystematic Instead the tax revisionsas well as a whole series of specific devices that went a longway to Ufldrniining whole tax system. the Under the highly progressive personalinconl(' tax schedules infiatiop rapidly increased the tax burden imposedon a given real income lo a certain extent, the rapid growth of realincomes in Israel helped to alleviate this effect. Nevertheless, thetax base came to be more and more eroded h tax concessions on various types of inconle: overtime income andproduc- tivity bonuses, profits from "approved"investnients in industry, government bondsall became subject interest on to flat, nonprogressivetax rates. As moore and more taxpayers became liable to the highest marginaltax rate (which, together with thecompulsory loan, recently reached 87percent) an increasing share of profitscame to be taken in tax-deductible accounts and an increasing share expense ot wages came to be paidin the form of untaxed expense reimbursements. The valuation ofdepreciable assets at their historicalcost of purchase creates illusory but neverthelesstaxable profits. Rather than allowtheir continuous revaluation, the internalrevenue authorities allowed themto be depreciated for tax purposes at rates farin excess of those correspondingto the length of their case, that of long-held real economic life. In one estate, the land bettermenttax on the difference between sale andpurchase priceswhich tionary profitwas includes a considerable infla- reduced by a rebateproportionate to the number of years between thetransactions, While these nleasures helped to offsetsome of the negative allocation and distribution effects of inflation undera nominal tax systeni, they could not do away with allof theni, and they themselves introducedsome additional ones. Sincethey were not directly their impact also related to the rate of inflation, varied fromone year to another peculiar neglect, the Furthermore through a governnlent imposed only arrears, thus creating a nominal interest on lax an incentive, especially self-employed, for corporations and the not to pay theirtaxes on time. The 1975 taxreform introduced the iridexation ofincome tax brackets Correction andInclexation 153 eta1Y

system of taxcredits and allowances, in the future these are to and of the revised as often asquarterIyin line with the COLA. The reform also capital gains tax tothe index-deflated gain (but added a 10 limited the element) and imposed CPI linkage on tax percent tax onits inflationary This newlegislationhowever, has yet to be tested in practice. arrears. for continuous revaluation of deprecia- Furtherm0, itstill does not allow valuation of inventories. While there ble assets, nordoes it recognize LIFO of applying the indexation principle to some seems tobe some intention this has flot been done so far. other taxes aswell, such as the estate duty,

EVALUATION [Ill]COMPARISON AND

Wages the papers submitted at this conference, As was pointedout in several of It may be argued that to there is no true"indexation of wages in Brazil)7 formula relating nominal wages to the price some extentthis is because the policy and not an automatic level constitutes aninstrument of government much contractual mechanism. But evenin Israel, where the COLA system approaches true indexation, theHistadrut has nevertheless more nearly when it considered its been known on occasionto forgo the allowance the national economy. payment to be againstthe interest of the workers or and arbitrariness of discretionaryaction, however, which It is the frequency operating in Brazil would be seem to justify theview that the mechanism guidelines. This was certainly more correctlydescribed as incomes-poliCY before 1 968, when the wageformula allowed only for true of the situation in the past. In expected inflation, but not forthat actually experienced of coverage, the addition to the discretionary elementand the narrowness from the Israeli also inthe present Brazilian wageindexation system differs following respects: correction is applied,and the The wage base to which monetary formula. inclusion of productivity changesin the wage with which the correctioni made. The length of the time lag of infla- The inclusion in the Brazilian systemof the expected rate tion. which wage earners are The proportion of price levelchanges for automatically compensated throughthe system. of illustrative of themain problem The first of these four differences is indexatiOn can Section Iof this paper, wage indexation. As stressed in which adjusts market mechanism substitute for only that part of the mechanisms arestill nominal wages to changes in the pricelevel. Other

S 1 154 j!L'° Kicimati

required to regulate the general level of the realwage nd the wages of different industries and ocCupational groups. In reJIti\e Israel, these mechanisms arc the same as those that wouldoperate in the absence of inflation: a centralized collective bargainingprOCess, which deternijnes percentage increase in the real wage (on which the the COLA will laterbe paid), and changes in individuals' wages through"wage drift." By contrast the Brazilian wage formula is burdened withthe two completely tasks performed inIsrael by the COLA system different on the one han(lan(i collective bargaining on the other,It may, of course, be questioned whether a complete separation of the variouslabor market mechanisnis is, in fact, possible. In particular, it has beenargued that inflationary expecta. tions are invariably taken intoaccount in collective bargaining indepen. dent of any COLAarrangements. Pure automatic indexation so runs this argument, must thus cause wageearners to be inflation. With resLiltant wage-push effects. overcompensated for The Israeli experience does not validate this argument.In a study of quarterly rates of change in the years 1955 to 1965, changesin the price level were found to affect nominal wages only indirectly,via the COLA. This should not, however, be I interpreted to mean that thereis no substitu- tion between the variousmechanisms: the nominal wage was found torise by the full COLA, despite thefact that the latter does wagehill.18 not cover the whole Whetherovercompensation will occur may depend the time lag involved in also on the lengthof the operation of theindexation mechanism. two commissions wich The were at different times askedto suggest improve ments in the CO'A system inIsrael both came out in favor of makingthe interval between COLAadjustments as short as technically feasible, forthis would reduce thepressure for immediate, and ultimately excessive,compensation through parallelimechanisms. The lag with is accounted for which past inflation in the nominalwage is much longer in Israel, because of both Brazil than in the lower frequencyof adjustment and lag in theavailability of the relevant the longer price indexes.19 In viewof the high rates of inflation in Brazil,the long lag with which indexationoperates through the wageformula might be expecti to providemore opportuni' forovercompensation Yet the question whether realwages have risen or fallen is the subjectof controversy in of GNP per capita Brazil despite thevery rapid growth in recentyears, suggesting that such (lid not, infact, occur.2° overconipencatjon Some of thepressures that the long adjustment interval of theBrazilian system might beexpected to call forth inclusion in the may have been Offset by the wage formula of theexpected rate of inflation, stressed in Section1 of this As was paper, ex-ante indexationdoes not, by itself, and Indexat ion Correction MoDet3rY of indexjtiori proper. But (Oml)iflpçwith of the Itinctions perform any it may improvethe working of the latter. As the .postindexation, the price level cannotbe instantaneous, a tempo- Of wages to 8dtuStment unwarranted by any realphenomena will decrease inreal wages, rary readjusiments of the nominal iage.The inclu successive occurbetween the nominal Wage may thus he element ofexpected inflation 10 on of an differentials due advance payment onaccount of indexation regarded as an inflation rates ratio ofpast-experienced to past-expected in thefuture. The Brazilian formula thus representsthe final incorporated inthe recent correction account.The need for suchadvance settlement ofthe monetary the inflation rate, the morerapid becomes moreacute the higher payments the intervals atwhich the indexationclause and the longer by the its acceleration, from the COLA Systemmay be explained operates.Their absence inflation rates on the adjustment periods areshorter and the fact that the for the last twodecades Israel than inBraziL Furthermore, whole lower in steady rate of 5 percent per Israel have beenrising at a fairly real wages in the Israeli workercould therefore expect annum. In mostof those years, in the preceding would not fallbelow that received that his real income lower delayed (thoughthen it would be year evenif COLA payments were had intended him toreceive in collective wage agreenients than what the occasions wheninflation inflation). Even so, on oneor two the absence of demanded, and received,an advance suddenly accelerated,the Histadrut for low wage earners. on the newCOLA, at least correction: only does not allowfor full monetary The Brazilian system enters the whether expected oractually experienced, half the inflation rate, mentioned underlying thisprocedure, as wage formula.2'The rationale reduction in thereal wage.27 inflation through a earlier, is that of restraining correc- demonstrates thatsuch imperfect However, the Israeliexperience with "true" circumstances bequite consistent lion may under certain when the risein the price speaking, thiswill happen sector. indexation. Generally income ofthe private fall in the real the Priceof level represents an exogenous through anincrease in A deterioration in the termsof trade nominal point. Theadjustment of imports, say, in oil prices,is a case in index is rise in thedomestic price wages to the full extentof the resulting shift thewhole behalf of theemployees to then equivalent to an attempt on employers. Thesame in real incomeonto the in of the unavoidable decrease in the rateof exchange, due to changes in general.These will be true of price increases indirect taxation import tariffs, and, to a lesserextent, in full indexation the introduction, and are all cases where, asmentioned in real incomes the status quoin both cannot simultaneously restore private sector, income distribution. outsi(le the originating from The treatment of price rises 156 Ephrn

particulady from outside the nationaleconomy, has bee,i the much discussion in subet israel, where imports ofgoods andsrvi( amounted to between one-third andone-half of GOP investment requirements, together While defensedfl( with inputs forexport prOj(j(t0fl count for most of total imports, the import d( - component direct unid in pnivate consumption indirer t, amounts to over 20percent exchange rate regime, the Under thefij infrequent massivedevakjatiors almost immediately transmittedinto the cost-of.iiving Used to be could, in principle, be solved index Theprol)Iem by computing theCOLA on th index of domestic prices only.'4 basis ofan But the constructiornof such especially one that could be an index calculated nionthlywithout much proved to be impracticable.Consequently, the (usually (lelay devaluation effects from COLA partial) exctusi of computations used to he ad-hoc negotiations, the sub;etof as when, on one of theoccasions referred the l-listadrut agreedto forgo the allowance to earlier, due to theimposition general import levy in thesummer of 1970. of a The transition toa system of nhinidevaluatjons in1 975 made it ble to resort to ad-hocnegotiations any longer. impossi Consequently the agreement has been revisedso that in the future COLA compensate for only 70 the allowancewill percent of the increase inthe CPI. Such compensation cannot he easily a l)artia justified in thecase of Brazil where imports amount to total no more than between7 and 10 would, however, berequired in the high-trades percent of GDP. It tries, though not West Europeancoon. in the UnitedStates.25 Another argument,raised both in Brazil than full and in Israel,in favor of less wage indexation refersto the inability of which lag behind industries the the rest,particularly export prices of wages in proportion to the industriesto raise nominal price level.26 The such divergent structural changesreflected in development ofindividual prices average real wage to may actually requirethe failfor example,when the demand labor-intensive for theoutput of industries hasgrown relatively downward stickiness less than therest. The of wages couldthen with determining prevent the rnechanisn the realwage from downward entrusted for the adjustment to operation of a fullindexation system, compensate the Histadrut It is worth notingthat in 1966 inIsrael forwer)ta COLA Prevailing payment in view of the employment situation, then the wage a contrjbuto cause of which had been increases obtainedthrough collective except in sucha case, price divergences wage agreements. But industries would simply mean thatsome plants or expand and others a contractUnder full indexation process will start withlayoffs in the this indexation with contracting industries;under partial individual workersbeing As for the attracted to the expandingones. export industri argument, it is the equivalent simplyto asking for subsidization ofexports by the labor n producingit. Besides being b 157 and Indexa iOt CorfeCtio Moneta ich,uhsidi iitiot1 rant tot he ('ft('(t('d on equiP.' grounds indefent c hihiv specilic. with noalternat V1 n exporti ndustn es unless labor the econOtllY. emp10Yfht inthe rest of

Financial Assets issued by the treasury and the total ofindexed instruments The sum ORT, housing bonds,and indexed saving financial systemin Brazi 973. This was Cr$ 41,583 millionby the end of deSiSam0uted to and somewhat sorfleVt'1t less thanhail the money supply, equivalent to for lsrael_onsistingof one-tenth of GDP.The comparable figure less than bondswas IL and the valueof all indexed governmeflt saving deposits the money supply and the equivalentof nearly five times 35,695 million, strictly comparable, nine-tenths of GDP.27These ratios are not as much as and other differencesbetween the two of course becauseof institutional direction. Thus, for however, do notall operate in one countries. These, cornpulsor commercial banks canhold part of their example, Brazilian while Israeli banks can- adjustable treasurybonds (ORTNs), reserves in system is a malorholder of hand, the social security not.2 On the other Nevertheless, it seems tohe a bonds in Israel. but notin Brazil. index instrumentS play,quantitatiY a safe conclusion thatindexed financial Israel's economy thanin BraLil'SJ" much greater role in of inrlexedinstru- The figures quoted aboveoverstate the importance ot aconsiderable portion ments to the generalpublic. In both countries the treasury used to effecttransfers between indexed government bonds is authorities and between themonetary and various government agencies, or of that of the Cr$21,000 million the banking system. Itis worth noting percent couldbe end of 1973,only about 18 ORTNs outstanding by the the holdingsof public. Andin Israel regarded as held by the general nearly a quarterof all National Insurance Institute aloneaccounted for indexed bonds outstanding.3° general liquid assetsheld by the Table 1 provides data on theportfolio of conclusions as tothe possible to draw public in both countries. To make it comparab despitedifficulties of relative importance of indexed asses each of the twocountries. In we present two alternative seof data for of indexedI estimate otthe share both cases alternative B gives a higher A: inBraLil, byexclud assets in the public portfolio thandoes alternative including categoly; inIsrael, by ing acceptances from the nonindexed are also Furthermo.the estinlates compulsory loans in the indexed one. proporti0flof indexed to biased so as to reduce the differencesri the deposits and exchangerateIinkl nonindexed assets held. In particular indexed, ' exciLided bonds, which in the long run can beregarded as 0 TABLE 1 Liquid Assets Held by the (million Cr$) Brazil (A) cent)(per- Public, Brazil andBrazil Israel:(million (B)Cr$) (per- 1973 (million (per- (million (per- NonTotal indexed 162,231187,281 100 87 125,657150,707 cent) 100 83 Total Israel23,320 (A) IL) cent) 100 Israel30,660 (B) IL) cent) 100 TimeMeans deposits of paymenta 25,87993,835 1450 93,835 62 MeansNonindexed of pavment 11,620 7392 3250 11,620 7,392 2438 AcceptanceseTreasury bills (LTNS)b 36,574 5943 20 3 31 822 , 21 Short-termTime deposits Loan 3,838 390 1 18 3838] 390 14 ORTNsbIndexed 25,050 4,411 13 2 25,050 17 Indexedindexed bondse 11,700 50 19.040 62 SavingsNational deposits housing bonds 14,122 6,517 83) 10,928 Compulsory loans 8,100 35 7,3408,100 2426 SOURCE:Currency 44Israel: Brazil:(May Bank 1976). Banco of Israel, State Central Annual Comptroller, do ReportBrasl, RelatOr,o1974, Annual Table XVI-2; Anual(the figures Report1974, for Table No, holdings 25 111.2, for of 1974 indexedVl3, (Hebrew),and 14,122 10 Vl.6. p. 88.Savings deposits bonds according to revised figures in Bank 3,600 - 15 of israel Fconiim,c Review No 3,600 12 diotal'Letras amount de Câmb.o.Incudung outstandingHeld by those the public held through ("non identified") unit ri circulation plus demand depotits. trust funds and provident funds of theand by insurance companies, seI('emplcsy.J - 0- p

COrreCt10f..!id Indexation Monetary 159

israel, although theirrelative volume probablyOutstrips the similarly excluded holdings offoreign currencies in Brazil)' The data in Table 1demonstrate that though thedifferences j- the role which indexed assetsplayed in the financial asset potlfolioof the public in the two countries weresmaller than suggested by theconsideration of their total, gross volume,they were nevertheless significant.Indexedassets amounted to between 50and 60 percent of the portfolio heldby the public in Israel but toonly between 10 and 20 percent of the Brazilian portfolio. The most strikingdifference is in the relative importance of indexedbonds. These amounted to no morethan 7 percent of the portfolio in Brazilbut to more thanone-third in Israel, and to as much as one-half if compulsory loans are included.32 Associated with the difference in the Structure of the public's portfolio of liquid assets are thoseiiiitssize.In Tab!e 2,the main magnitudes presented above are expressed as ratios to GDP. itis evident that the relative size of the public's total holdings of the assets considered here was smallerriBrazil than inIsrael.Part of the difference can probably be ascribed to the higher per capita income of the latter.Operating in the opposite direction, however, should be the greater absolute economic size of Brazil and the presumably greater inequality of incomes there, Indeed, Table 2 shows that the ratio of money balances to income was roughly the same in both countries, and, if anything, slightly higher in Brazil. Practi- calithe whole difference in the overall ratio of liquid assets to income is due to differences in holdings of indexed assets, primarily of indexed bonds. With the latter excluded, the ratio of the remaining assets to GDP is on the same order of magnitude in the two countries: 0.39 in Israel as against 0.30-0.37, depending on the definition used, in Brazil.34 The size, relative to GDP, of the public's portfolio of liquid assets may be

TABLE 2 Ratio of Selected Liquid Assets Held by the Public Relative to GDP, Brazil and Israel: 1973 Brazil Israel A B A B

Total 0.39 0.32 0.60 0.79

Nonrndexed 0.34 0.27 0.30 0.30 0.19 Monetary 0.20 0.20 0.19 0.49 indexed 0.05 0.05 0.30 0.40 Bonds 0.02 0.02 0.21 0.39 Total excluding indexed bonds 0.37 0.30 0.39

SOURCE: Table1 and the sources quoted there (for GOP). Ephrairn Kleirrian

regarded as an indicator of the financial system's capability to intermediate in the capital market,Inn p led with the genera iy miic h chorter term structure of the unindexed financial instruments, the figures of Table 2 suggest that indexed assets, and indexed bOndS Ifl particular, played an important role in capital accumulation in Israel, bit almost none in Brazil, The remarkable difference between the proportion of indexed assets in the liquid portfolios held by the public in the two countries israther surprising, for Brazil has a long history of sustained inflation atrates considerably exceeding those experienced by Israel before 1973)6 Admit-

tedly, in that year the 20 percent rate of inflation in Israel exceeded the16 percent reported for Brazil.3 And with inflation rising to 40 percent in 1974, the public reacted by raising the share of indexed assets from 50to 60 percent of its liquid holdings. But already in 1972, with an inflation rate

of only 13 percent, this share amounted to 38 percentmore than twiceas much as in Brazil. In contrast to the experience in Israel, the Brazilian share does not seem to be correlated with inflation, rising by two discrete steps from about 6 percent in 1966-1967 to 17 percent in 1970-i 9733s Part of the difference in the propensity to hold indexed assets may be due to the difference in expectations. In Israel, the last Iew years referredto here were a time of rapidly accelerating inflation. In Brazil,on the other hand, inflation has been decelerating since the mid-i 960s. But I would ri also venture the opinion that at least some of the difference must be due to ill imperfections in indexation practices in Brazil, on the one hand, and the n greater adjustability of nominal interest rates there, on the other. As a tt result, tile attractiveness of indexed bonds (and deposits) relativeto unindexed financial assets is smaller in Brazil than inIsrael. 01 Broadly speaking, the Brazilian and Israeli bond indexationpractices In differ with respect to the price index used, the method of calculatingthe DL monetary correction, and the frequency of its payment. No single index U, can be claimed to be the'correct" one for allndexation purposes, re especially if we consider linkage within the private sector as well, and the to linkageof transactions referring to the future purchase of a specific cx commodity (e.g., housing) in particular. Insofaras the public debt is bo concerned, however, equity and policy considerations haveto be taken into account. That the CPI (the index used alsoin wage linkage) was adopted for this purpose inIsrael can be ascribed to the equity consid- (11 eration, as well as to the fact thatit was readily available when the indexation of debt instrumentswas first introduced. However, unlike the Pr COLA calculation, bond linkage is one-hundredpercent mechanical, being I,' subject to neither seasonalor other adjustments nor ln'' ad-hoc interven- tions. With the acceleration of inflation in thelast ICW years, and particularly since the partial exclusion of devaluation effects on the CPI from the be COLA calculations, it has been arguedthat this favors rentier capital over PC pu UOIW)PUI MMJ0W iO) 191

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which preceded the actua time oliirchae. Flie divergence Ex'twe('ilthe two cannot he of much importance when the relevant periodsare very short.ButinBrazil the price levels used to calculate themonetary correction are three-month averages, aridare available with a delay of two montlls.41 in Israel, these are monthly averages and the delay is onlytwo weeks. Nevertheless, even there, theoccurrence of sudden, considerable price rises makes it possI)le for the lender to link his capital toa lower index base than actually prevailed at tile time.42 Adjustable treasury bonds (ORTNs)are issued in Brazil for periods of two to five years, and there was evenan attempt to issue One-year bonds. In Israel, indexed bonds areissued only for periods of fouryears and upwards. Basically, the difference isthat of the frequency withwhich monetary correction is pad out. At one extreme, one coulrl thinkof monetary correction being paid currently, together with,say, a twice- annual interest payment; at tile other, of it beingcumulated up to maturity.43 The first corresponds to the view which regardsnlonetary correction as a way of calculating the correct nonuinal rate of interest;tile second, to that which regards it as a way of preserving the real value of theprincipal. \A'ith perfect capital markets, thetwo systems affect tile individual's wealth in the same way.44 Buteven then, their monetary effects are different. Unless the public is ready to reinvest periodically thesame real amount in government bonds, reliance on short-term indexed loanswill result in price increases being, at least in part, accommodatedwithin a short time by the monetary expansion required topay the monetary correction. A highly concentrated term structjre o a long-run indexed debt contracted inan inflationary period, on the other hand,may result in long cyclical swings of nlOnetary expansion. But the effect of suchcycles will probably be offset by the growth of real income. The difference between the term structures of the indexed debtin the two countries could possibly he attributedto the rate of inflation being in the long run much higher in Brazil than in Israel.Itis, therefore, worth mentioning that with the recent acceleration of inflation in Israel thepublic came to regard bonds with short maturityas a close substitute for monetary assets. Consequently, considerablesupport has been gained for the view that indexation should beconfined to long-term bonds,or if possible, granted only to their long-termholders. A peculiar problem which shouldbe mentioned here is that of tionin one country." Under "indexa- a constant-exchange rateregimeit Ii' become extremely profitable can for foreigners topurchase the bonds of an indexed country__provided theymanage to repatriate their capital the exchange rate before iseventually adjusted in thewake of inflationary pressures. The indexing country can thus find itself borrowing fromabroad at effective interest rates considerably exceeding thoseprevailing there. In

a 1PX3PUI UOI UO!1J3JJ0J pue I 9

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tion is the borrowers fear that the price of hisown reven uc-prodticirig goods will rise more slowly than the general price level(,ind that the lag will increase with inflation). This argument implies that the Iiigher th0 rate of inflation, the more relative prices are expected tO vary. I3ut when, ina preliminary exaniination, the relative annual dispersionin the prices often nIain CII groups was regressed on the annual rate of inflation,th0 result for Brazil, for 1962 -1970,was prI

= 0.09 + 4.60x R2= 0.573 to 1)21 I.M) fl0 and that for Israel, for l956-172,was

1h 0.37 + i .25x -' = 0.653 lii where .x denotes the general aut price increase and the small numeralsare the standard errors of the coefficients.1 Further investigation ofmore highly disaggregated data may reverse this ftY finding that relativeprice dispersion decreases with inflation; furthermore the fear of direct government interference in the pricingprocess rilay have played a greater role in individualprice expectations than past experience tt. of broad price aggregates. In bothBrazil arid Israel, inflationwas accompanied by attempts to ''Suppress" inflation ece either by direct price Controlsor by Lu pressure-backedpersuasion. And eveninmore market-oriented econlonlies, itis precisely the big, multiproduct corporation able to com- e'p mand a market for its indexedbonds which will also be the object of enc government price-freezing 'guidelines."But in any event, in both Brazil and Israel, the abstention of firms not from issuing indexed obligations(other than against holdings of pro indexed government bonds) isprobably due primarily to the government alte domination of the capital markets. Theavail- ability of cheap unlinked rub development loans, on tileone hand, and tax ascr concessions on government bonds,on the other, made private long-term borrowing bothunnecessary and excessively expensive. in 8cc.

recu Taxes appi In the first part of this (On. paper indexation was definedas the more or less Ofl \ automatic adjustment of nominal values to changes in theprice level. In the case of taxes this means preventing inflation fromchanging tile tax burden imposed and on a given real value. In practicalterms,itrequires deflating by the price index all revenues andproperty values subject to a flat tax rate and the income brackets to whichgiven rates of a progressive tax apply. The former has, infact, been done inBrazil, by allowing continuous revaluation of both fact depreciable assets and workingcapital. In 1='

Correction and Indexation 165 MonetarY

revaluatiOn has beenallowed on oniy a lew Israel, such occasions, usually wake of big, discreteexchange rtt devaluations Asa Substitute tor in the the government, as we have seen iii the preceding 0ntnuoijsadjustinei1t relied on various oflsetting measures, such as tax COnceSSions ind c,ectiofl, quick depreciatbotlwrite-offs. While indexatiofl 01income brackets tor income tax purposes was not practiced in Israeluntil recently, itis thought to have been applied by the BraLilan tax authorities.This impression, however, seenis to be clue in part to the term asinterpreted in Brazil, which differs from the one underlying the presentdiscussion. There, indexation has come to mean any adjustment whichtakes into account changes in the general price level. Thus, the developmentof the price index is considered for the purpose of income bracketrevaluations. But they do not seem to he carried out automatically according to agenerally available set of rules.1 The Israeli government'slong-standing refusal to index taxes may be explained in part by the lowerinflation rates experienced in Israel. For a long time, the rapid growthof real incomes, on the one hand, and the various partial remedies applied, onthe other, mitigated the erosion of the tax system by inflation. But overand above the conditions which facilitated t, the government's behavior wasalso determined by considerations of economic management and equity. 'Fiscaldrag" has long been believed to be an important automaticstabilizer.Itis generally conceded that inflationary pressures in Israel were, in mostperiods, generated by the expansion of the public sector. Coupled with easy moneypolicies aimed at encouraging growth, this left the revenue side of thebudget as the main, if not the only, instrument of combating inflation.The 'naturaI" elasticity of progressive taxation with respect to inflation wasthus regarded as an alternative to raising the tax rates themselves. That the two werenot perfect substitutes is evident from the other beneficial rolewhich tax authorities ascribed to inflation: that of reducing income inequality. In fact, neither object was ac:omplishc-d to anysatisfactory degree. Because the marginal inconie tax rate is subject to an upperlimit, inflation resulted in narrowing the real income range towhich tax progression the range of the applied, moving an increasing number of taxpayers into constant marginal rate. Thus, inflation had the effectof reducing inequality with very only within the low- and medium-income groups. Furthermore, tax loopholing high tax rates applying to successively lower real incomes, section) canie to and avoidance (of the types mentioned in the preceding anti- assume ever-growing proportions. This alsogrossly reduced any have had. inflationary effects the fiscal drag might in principle as well asthe The Israeli experience in the absence of tax indexation, did Israel, eventu- fact that Brazil had to introduce some nieaSUre oI it (as stabilizers, at least ally), point out the limitations of reliance on automatic 166 Ephraim Kleiman

on the revenue side.It seems that neither income equalization noran increase in the real tax burdencan be achieved by default to cant degree, Inflation-induced any cignifj movements in these diretiuiismay be possible as long as they are small and therefore of little importanceBut under rapid inflation, the magnitudes they assume in themselves prevejitthem from being fulfilled. The Israeligovernment was able to enjoy the ing effects of an unindexed stabiliz- tax system only because (and onlyas tong as) inflation was rather mild. InBrazil, where the high inflation such stabilizers much rates made more desirable, they had to beabandonedby allowing some degree of tax indexationfor precisely thesame reason for which they were required. If one of the arguments against indexatioriis the reduction of automatic fiscalstabilization, it seems to be by the present evidence. much weakened In one rather important respect, especially in developingcountries tax linkage can provide thestabilizing effect supposedly lost tion. The reference is through indexa to tax arrears. The niore rapidthe decline in the purchasing power ofmoney, the greater the incentive to delay taxpay- ments, even if arrearsare subject to some nominal interest. fiscal destabilizing effect, Besides its the accumulation of unlinkedtax debt also affects Income distribution,for employeescan exploit it to a much lesser degree than can the self-employed andcorporations, Both the Israeli perience and that of Brazil ex- before the indexation oftax arrears was introduced underline theiniportance of this phenomenon. Finally, there is thequestion of how indexation affects inflation itself. By reducing the tax aspect of the real value of thegovernment's and the monetary authority's internaldebt, inflation transfers from the private to the purchasing power public sector.53 lithe publicdebt were exclusively in the financing contracted of publicconsumption, the inflation tax be identical with the would reduction in the real valueof the outstanding unindexed outside-money stock of and government bonds.However, the heavy government involvement in the capitalmarket in both Brazil pr!\ means that the public sector and Israel is a creditor, andnot only a debtor, of the private sector. It is thereforethe net internal cou position of the publicsector which determines themagnitude, and even the t1 sign, of the inflationtax. The evaluation ofthe government's IhLi position as creditorposes some difficulty, for in bothcountries much of its lending and des and financial is done throughagen. institutions enjoying the varying degrees ofindependence In particular,itis practically lip impossible to ascertain theextent to which government carries the lossescaused to banks and Br the nonindexatjon financial institutions by of loans grantedat its recommendation tax the inflation tax base The estimates of presented in Table 3are therefore only rough indi- sect cators. Nevertheless, theysuggest that, in both gra longer be regarded countries inflationcan no as an instrument for ban transferring resources from the and

L The Net Inflation Tax Rase, Brazil and Israel: iBLE3 1973

Brazil Israel (Cr$ million) (IL million)

CutrencY heldby public 16,427 2,700 liquid assets 01 Noniflde private con1merc bcitiks' 11,161 3,600 Nonindexed government ijonds 3 held by public' 6,356 400

Subtotal (1 through 3) 33,944 3a. 6,700

tess Net nonindexed public sector loans to the private sectoC 26,922 '-8,300 Net (3a less 4) 6,952 '-1,600 Net as percent of GDP 1.5 -4.1

SOURCE: Brazil: Boletiin do Bancc' Cenir,iI rki Brasi(. Vol Xl (No. 12). Table2 (line 2); Bunco Central do Brasil, Relarório Aiival t974, Tah!e 111.2line 1); Table 5/1.6 (line 3), arid Tables 11.6 and 111.7 (line 4). Israel: Bank of israel, Aflriu3l Report 7q74, Table XV1-2 (line 1), Table XVII-4 (lInes 2 and 3), and Tables XX-9 and XX-l0 (line 4); Stale Comptroller, Annual Report No. 25 (Hebrew), p. B8 I (line 4). 'Brazil: Cash, noninde,ed deposits with the Bank of Brazil, special deposils with monetary authorities. compulsory reserves other than ORTNs, and treasury bills )LTNs) held by private commercial banks.

Israel:liquid assets of commercial banks. rBra23: LTNs held by the general public and by insurariccompanies and nsestment banks. Israel' Outstanding government Short-Term Foan. 'Stazil: The balance of the Bank of Brazil's loans to lIe privale suitor, CiS 37,970 million, netof the private oector's demand deposits with the Bank of Brazil (err )usive of banking institutions). isuel: Long-term outstanding credit of the Ministry of Finance (II. 7.500 million) >055 loans to government ogencies estimated at IL 1000 million), pius balance 01 ''directed'' credit in local currency granted outof the esp'jrt credt fund, etc., and lhrough Bank of Israel recliscounts and liquidity exemptions.

private to the public sector. Because of institutional differences,the definitions used to estimate net government credit are not the samefor the two countries. For Brazil, this was defined as the differencebetween the Bank of Brazil's loans to, and the deposits held with it by, the privatesector. between 1 Thus estimated, the inflation tax l)JSP ariioufltS to no more than loans granted by and 2 percent of GDP. As this assumes all developrilent the National Bank for Economic Development (BNDE) to befully indexed, detailed study of it probably overstates the size of the tax base. Indeed, in a Brazil's inflation it was estimated that over 90 percentof the gross inflation rebated to the private tax revenue in the period 1969-1972 was ultimately development loans Sector.54 For Israel, we took the balance of long-term granted by the treasury and of the short-term creditlent by commercial the government banks out of deposits held with them with this purpose by tax base inIsrael is and the Bank of lsrael.Thus estimated, the inflation

fl,a.car I 168 Ephraini Kleimnan

seen to have been ne'at,ve. In otherwords, inflation resulted in of resources away from the a transfer government to the private Se(tOr! !in This outcome is, ofcourse, the obverse of the phenomenon commented upon earlier, that the existence ofindexed governnient bonds results ina e55e1 return to the public ofa great part of the receipts from price-raising taxes tion via indexatjon. But, whileindexatiori would, in any case, cause the base of P the inflation tax to shrink, itcould not by itself eliminate it completely and porn certainly not turn it negative.Indeed, indexation did not reduce of the unindexed the volume part of the money base in Brazil,which remained or less constant at 5-6 percent of GDP more eC between 1966 and 1973.'It was, thus, the rapidexpansion of unindexecj loans granted post by the publicsector that almost wipedout the inflation tax. ar g(

he g

(IVJ CONCLUSIONS either The two countries where ind' indexation has been widelypracticed in recent years, Brazil and Israel, differconsiderably in their economic tioft " and their social and development ivef political structure. Despitethis (and perhaps of it), because more the similarities anddifferences in the way in worked in the two which indexation countries may allow us to drawsonic conclusions regarding its operation ingeneral. indea The first, most strikingsimilarity is in the effects of same inflation on thecapital markets. Some of these, likethe charging of high banking do, o' tying of loans to collateral commissions the moga deposits, and the outflow offunds from hank deposits into the billbrokerage (or, in Brazil, the pohtis Ietras de camb,o)market, can to a great extent beattributed to the existence index, in both Countriesof usury laws restricting the In nominal rate of interest. But,given the uncertainty involved, tis most doubtful whether cofl1p the virtual disappearanceof long-term lending and much borrowing could have beenavoided even in their absence. nret c The other similar characteristic less oftennoted, is that in both all the indexation, of financial countries instruments at least, didnot spread until after (Ountri inflation began todecelerate. Indexed bonds not be were first issued in Brazilin 1964, the year pricesrose by 92 percent. But, Size ot were hardly in evidence before quantitatiteIy speaking, they 1966 or 1967, when to rei down to 40 and 24 inflation was already percent per annum, Ehn of indexed bonds respectively In Israel, the firstissue appeared on the marketin 1955, when inflation again 6 percent, far below was only its 58 percentI)eak of 1952. Casual suggest that indexation does empiricism would not affect the rate ofinflation: in the first preierj fifteen years afterits introduction in Israel, annual inflation averagedonly S PUPIIU percent, while in Brazilit decreased from 01 mu 25 Percentper annum in the years 1967-1968 to 16percent in 1972-1973 taken Yet in neithercountry did it equie Monetary CorrectiO1an(I Indexation 169

prevent prices asmeasured b the (MSt.oi.living index, fromrising by more than 40 percent in1974. A closer scrutinyreveals that indexatjon proper waspracticed to a much lesser extentthan is sometimes suggested. The impression oftotal jcJex tion in Brazilis partly due to the very broad sense in which theterm monetary correctionis used there, to Cover practically all changesin nominal values in which some official index is usedas a guideline.. particularly the use of the term to describe payments compensating for expected, as well as experienced, price developments Furthermore, post indexation is sometimes restricted by ceiling clauses, and discretionary governmentintervention seems to be Irequent. The moreautomatic type of indexation practiced in Israel, on the other hand, turned out to be politically difficult to maintain, and was in fact abandoned as far as most of the government's debtors are concerned. Thus, it cannot beargued that either of the systems (Oflipared here provides a real-lifeexample of a fully indexed economy. Their experience may even ind:cate thattotal indexation, whatever its drawbacks or merits, is politically unattainableit may well be that further research, both theoretical and empirical,should pay more attention to the problems of partial than to those of total indexation. With respect to the indexed sector itself, there is the questionwhether indexation should be homogeneousi.e., with identical conditionsand the same index. Differences in the availability of supplementary mechanisms do, on the face ofit,justify differential indexation. But thestory of mortgage indexation in both countriesisillustrative of the social and political considerations that may make uniform procedures, anda single index, preferable to economically more sophisticated methods. In both countries, the inflation tax base was found to have been almost completely eliminated. However, especially in Israel, thiswas due not so much to indexation of the public debt as to abstention from itin government credits. It was the result of the belief in state intervention which, for alltheir political dissimilarity, characterized the governments of both countries. In niore market-oriented economies indexation would probably not be accompanied by so much discretionary action. But the potential size of the subsidy that can be granted inthis manner may make it (liffiCUlt to resist even for less intervention-prone governments. Elimination of the inflation tax has been one of the main arguments against indexationfor thisis really what the inflationary feedback ascribed to it amounts to.It has been suggested that inflation tax may he preferable to the alternative taxes considered. But the resulting transfer of purchasing power from the private to the public sector is only a by-product of much greater redistributionvithiin the private sector itself. When this is taken into account the inflationtax has little to recommend it, atleast on equity grounds, Although thetax is the way in whichinflation may play S

170 Ephrairn Kleiman

itself out "naturally," the accompanying redistribution effectsare IJiecisely the reason why inflationis generally regarded as undesirable, Finally, it Is worthwhile to compare the direction in whichindexation has spread in the two countriesconsidered here. In Brazil, inrlexation originally restricted to capital. was Wages were for a long timecompletely tinindexed, and even the formula employed in recent years doesnot allow for their monetary correction to the extent allowed for capital. InIsrael, on the other hand, wageswere indexed many years before financial ments. Thus, instru inIsrael indexatjon was introducedprimarily for equity considerations, the protection of laborincome; in Brazil, it was primarily for allocative introduced considerations enhancement of capitalaccumula tion and improvement of its allocation Political attitudes in bothcountries probably had much to do with the order in which indexationwas adopted (It is perhaps indicative of the Israeli attitude that savingsaccounts were the last to be indexed.) Yet, under the pressure of economic andsocial forces, sooner or later both had to move away from their originalPositions: Israeltoward the inclexation offinancial assets, Braziltoward measure of true, ex-post indexation some of wages.It has sometimes been suggested that if more highlydeveloped countries are to tion, they should do introduce indexa- so on equity grounds only, and limitit protection of the weaker and to the more vulnerable members of society;or else that they should restrictit to very long-term debts, of which are difficult extreme misallocation5 to remedy by othermeans. The Brazilian and Israeli experiences indicate that suchselective indexation practice. may be impossible in

NOTES

The thirdis Finland. Until the recent worldwideupsurge in inflationary trends, the ii experience of these countries hardly merited a mentioniiithe general economic literature and even now littlematerial on it is accessible to the English-speaking reader. [A description of the Finnishexper:ence has recently become available lndexajjon in an Inflationary Economy, in S. Mukherjee A Case Study of Finland (London: is perhaps a sign of the culture-bound PEP, 1975)1It nature of our profession that exposition of the subject, the late a pioneering Amotz Morag's "For anlnflation.proof Economy" lAmer,can Econom, Review,LII (March 1962(, 177-185j time. received little attention at the The assumption underlying 13 this resultis that individuals consider the possible changes in purchasing dispersion of power to be greater under inflation than stability under price It may be noted thatit is the effects of inflationary seen to have a real cost attached expectations which are thus to them, irrespective of whether materialize. See Dwight Jalfee or not they ultimately 14 and Ephraim Kleiman"The Welfare Implications of Uneven Inflation," Institutefor International Economic Studies SeminarPaper No. 50, Stockholm, University ofStockholm, 1975. For a general survey of price developments in thisperiod, see Don Patinkin, "Monetary and Price Developntentsin Israel: 1949-53," Script,i Hieroso/ynijtan,Vol. III (1956), Correction and Indexation Monetaty 171

reprinted in that author's Stidiein Monetary Economics (New York Harperand Row, 1972). Thusin answering demands br linkage, the chairman of what w the country s largest bankwhich forrnaiiy ran the mc- tix- issue department)retorted that whose name appears on the banknotes lose trust 'if we, r thCurrency how can the public to sustain it:' we expect A precedent may be said tohave beeii set by the National Eoan raisedby the lewish Agency in the spring of 1948. But this linkage reflected the monetary accompanied the termination of the British Mandate for interregnuns which Palestine and the fact that loan was guaranteed by the Agencys future dollar receipts the Nevertheless, some agricultural develotsment loans continued tobe granted unlinked. For a description of the early origins of the linkage of financial assets in Israel see Alex Rubner, "The Abdication of the lsraeh Pound as a Standard of Measurement for Medium- and Long-Term Contracts," Review of Economic Studies, XXVttt (October 1960), 69-75; and Marshall Sarnat, The Development of the Securities Market h'j Israel )Basel and Tiibingen: Kvklos-Verlag and J. C. B. Mohr, 1966). From the government's point of view, the situation was further complicated by the intoduct:on of a pol!cy of minidevaluatioris in lune 1975. The Collective Agreements Law of 1957 empowered the Minister of Laborto issue regulations extending the force of the wage indexation agreements to nonsignatories, and this has become regular practice since 1959. See, for example, Bank of Israel, Annual Report, 1%3, p. 186. It was not possible to estimate directly the number ol employees whose wages exceed the ceiling or the share of the unindexed svage component. One estimate put the share of the wage bill not covered by COLA at 35 percent in 1962, of which about half represented employees outside the COLA agreement and half represented theexcess of actual wages over the ceiling. (See Bank of Israel, Annual Report, 1962, pp. 164-165.) It should, however, be pointed out thatin 1962 adjustment of the ceiling was long overdue, so that this figure should be regarded as the upper boundary of the estimate of uncompensated ss'ages. Another Slu(ly revealed that betsveen 1957 and 1969 the average wage actually paid amounted to only between 40 and 60 percent of that calculated on the basis of the ceiling PlUs the maximum COLA. See Y. 1-indling, "The History of the Cost-of-Living Allowance" (unpublished seminar paper, The Hebrew University, 175: Hebrew).) H. The tax reform of July 1975, which provided for the readjustment of tax brackets with changes in the price level, also recommended putting the allowance on a par with all other income for personal tax purposes. During the period of repressed inflation in 1949-1951 the government even succeeded in obtaining a reduction in COLA in this way. This manipulation of the index seems to be very similar to the Finnish practice of "buying-off index points." See Bruno Suviranta, 'A Unique Experiment in Escalated Wages," B,inca Nazionale del Las'oro Quarterly Review, No. 54 (September 1960), PP 265-282. When the weights of the index accurately represent the bundle actually purchased by consumers, and the index and the COLA are calculated from a comparison of average price levels rather than from point estimates, such buying-off lowers the "true" cost of wing, and shoulrl not be regarded as a manipulation. For a concise description of the mechanism through which the funds mobiiied by financial institutions are directed by the government, see Bank of Israel, Annual Report, 1973, Chapter XIV. This concession applies to all government bonds in Israel, whether indexed or not. Because of the ceiling on the interest rate imposed by the usury lasv (then still inforce) and because of government restrictions on the volume nf credit granted by the banks, 172 Ephrairp Kleirnan

tie latter otiiid it more protitable at the noviii ierate as 1)111 hrokirthan to attract loiig-t'rni (f('pi'isItsOr th0 iiirpr. itkr'idr iig thvnr uriC 2' "ale, br ecample, \-\1rner Bier and Paul Fttu k,'iriia,r'infl,i turn wi thotit >it u,.,,s'Sri EEvaluatiim ot Brazil's Indeiiiit System'' and Pedro I iiioll,in owl "'Or 0'.1.\t lndexat,on 01 Wages: Some Asptv Is ot the Brazil,an F \perrl'nce(apers pn'srn-it tireIl'I - N B FR Scm oar On at iu lox a lion So I'a i; lo, h hoi,irv 26 -28,I 97'St I 8. Ephra mi K lei man and I cvi ()ph i r,The I )e tvrm nat ion of Money Wages'Thy iii 'ho0 Llmversity, 1970; minicograph) Baer and Beckerman, op. cit.; M. H. Sirnonsenand R. do Oliveira ('anipoc f/i1.ieis Brazilian fconi en y (Rio de Janein), nd,) I)I), 85-87. Had this hen due Ii)purely economic forces,it could have h)POfl evicteri( e that the onech,ioisiç deterniinirig real inberfireteti as wages operated in the Opt')5te direction to that of the monetary corre('tiori. I lowover, as the redir(-tion 01 realwages 'vas regarded by the Bra zili an ai ilhori ties as a main instrument Of anti - i ntlat inriary poliiv, it cannot lx ascribed to the tree operatron of market forces.(Finance Minister Sinionsen in Simonsen and de OIivira Campos, op. cit..p. 87( refers to the Wage torniula as 'one of the main props of Brazilian policy for fighting inflation.') 2 1. Neglec I irg the tiroihtit ii fs' ,'ros th sdemen I 00(1 1 lie tWo-year hOst' 1)1 thei cola Brat Ii an torniu)a reduces to in, th

------o,gi)5,,r

ivhere i, is the nf)ation rate which was expected for perincl ri and i'is the (InC actual ly experienced. The ratio term is a correction for past under- oroverestimation of i Simonen in Simonsen arid (IC (')liveiraCanipos, op. cit Bank ot Israel, 4rinof Reports1969 and 1973, Table lV-2. Th sta tenent CIra sw OnI lie 01010(iIa) led iiit tics 'ciiiProvided in Rt'pi yr o ('isnrnirorr (IfI 5p'rt it 0)11/ring !'ltr)tin' ('oct-it-Hi tic''\lloii .ini i'Id I lebrety), .'\s iv,I 906 The commission which suggested his recent revision in the COLA didnot claim external effects necessarily th,it account for 30 percent of total price changes,only that this was their share actually excluded from COLA con'iputafioris in the last Vearthrough discretionary action and act-hocnegotiations. They did, however, stress financial tl'iat,un)rk inkage, the indexation ofcx ages an always he supplemented by theother mechanisms of the labor market,At the same time, the commission also 31) that the adJustment interval should rccommencJ be shortened to three months: thattheeiling should be gradually abolished; that thefull COt should be taken in that its payment should computing the COt A arid not be subject to ad-hoc negotiationsor discretionary action See Report of the (Ooiflh(Ssioflto frtirne the ('I )L .4 Ilon'rm- I 975; Hebrew) Provisions 'k'rucalmni See, for example. Cipollari andMa edo op. Cit. For the volume of indexed instruments in Brazil. see t3arir'oentral rio Brasi I, Ri'l,itdrr 40 dnoal 1074, It should he pointed not that Ii rite di'posi ts in Brazil aronot indexed in the sense in which the term is us.cl here. For Israel see Bank of Israel, Annual 4t for the volume of savings deposits, Report, 1974, and Israel, State Comptroller,Annual Report, No 25 for (974 (Hebrew), tor indexed gocernment debt at end of March 1974. Thelatter figure was deflated for the pricerise since December 1973. '(he GOP figures are Cr$ 93,835 Correstxmding money supply and and 477,163 million,respectively in Brazil, and It. 7,392 and 42. 38,695 million in Israel. [xcept against indexed savings deposits held with them bythe public 29 Thirs, even if we cxere to include deposits of the socialset urity s stern in the indexed total br Brazil, the ratio01 the Iota I to, say, the mi iney upplv woo Id still be a hni it Sex en times as high in Israelas in Brazil.

43- Monetary Correchoriand Iridexalion 1 73

Banco Central do Brasil, Os). t, arid Israel o, State Comptroller Also, it has been assumed that all housing I)Oflds Woir h 0p tire indexed by the public, while in Israel, the Sii1fl ,iO ri Brait held d5'iii)ption "as madeihot the government Shui l-Teiiii i.i)dii.1 li)W('Vertliligure for inchxi?d uriiilexrxi Israeli public Includes those held by unit trust fur) bond holdingsof the and by the Voluntary of the self-employed; these Were treated as a proxy for direct Pension funds The Israel compulsory loans should not he compared holdings.> to the Brazilian through FGTS, P15, and PASEP, which are sociOl forced savings Security funds, whose parts are the National Insurance Institute and the provident Israeli count funds of be Moreover, some of the compulsory loan Certificates trade unions were already tradableat the time. 33, About five times as high as in Brazil. If liquid balances are related to total resources as a proxy for the volume oi rather than to ir,conie, the difference belween the tWO transactions) countries IS reversj Relative total resources for domestic uses (GDP plus the import to surplus) liquidassets exclusive of indexed bonds amounted to 29 percent in Israel,as against 29 to 37 on the definition used, in Brazit. percent depending See Ronald j. McKinnon, Money ,ind Lipaal in Economic Deve!oprnen) (\Vashington The Brookings Institution, 1973). 8y recent world standards, and certainly by those of Brazil in the early 1960s, theperiod in which debt indexation was practiced in Israel svas one of rather mild inflationIt was only in t971 that, for the first time since 1954, the risein the CPI exceeded 10 This is the order of magnitude of the increases in percent. the general and svholesaleprice indexes and their main components. Estimates of tire increase in the cost-of-livingindex lwhich is the index cited here for IsraelI were for the roost part considerably higher, though they varied from as little as 13-14 percent in Rio de laneiro and BeloHorizonte to as much as 21 percent in Porto A!egre, 28 percent in Brasilia, and 33 percent in Curitiba. Total exciusive of acceptance (i.e., alternative B of Tal)lec 1 and 2L This increase occurred despite the considerable decline, whichpersisted until 1973, in the share of ORTNs held by the general public. It is noteworthy thatthe acceleration of the inflation ratio to about 35 percent in 1974 coincided witha sudden tump in this proportion, which resulted in a 5 to 6 percentincrease in the share of indexed assets in the public's liquid holdings. See below for a comparison of indexationpractices in the two countries. According to at least one author, it was only in 1974 that ''indexedbonds for the first time became more attractive to the private saver than nonjndexc-d paper" lack D.Guenther, " 'Indexing' versus Discretionary Action Brazil's Fight Against Inflation," Finance andDevelopment. XII (No. 3, September 1975),25-291, That the improved adjustability of nominal rates did, most probably, providea substitute for inclexation is also evident from the near doubling between 1966 and 1973of the ratio of total unindexed assets to GDP. Albert Fishlow, "Indexing BrazilianStyle: Inflation without Tears?" Brookings Papers on Economic Activity (No. 1,1974), p. 263. 4L See, for example, José RobertoNijvaesIc' Alnseida, 'liidexalion of O.R.T.N.'s: Manners of Calculation' Con,rjnturafcon(rnjca XX\'lli (December 1974), 92-95. iEnglish translation presentedas background material for the IPE-NB[R Seminar on tndexation, Sn Paulo, February 26-28,1975.) To offset the delayin the availability of price statistics, the Brazilian government has resorted in recent years to theimputation of the forecast rate of inflation for the two months preceding the monthof pur hase and the month of redemptionBut as no correctionis made ex post for faulty forecasts, this does not constitute a proper indexalion procedure(compare the discussion above of the use of the forecast rate in the wage formula>. Correction on Brazilian housing bonds is paid quarterly. In Israel, one eight- 0

174 Ephraim Kleiman

year bond paid eti mu ated I nu'rr'st andi rid (sat m d ffi'ri'riti ii', i'vi'rtourpars, rather tlia n at nlatu ri ty. We should ri ote herr- the are& i nient that monetary ( on ci tiin diii'siit rca Iviri' owe th i ndividij a swea I th, for it5 u tim atel y p il out of extra axes. See tot esa Flit) Ic Robert I. B arro, ''Are Government Bonds Net Wea liii' Ji n,rn,i I of Pc litF( a! I 000m t xxx (Noveni her/DecemberI 974;I 09 - III 7, for the appl ( atoii of Iii argil merit to the

public debt iii general- But this view 5I'('FI ist( Frest (Iii a tal atY Ofooipositontile personal distribution of taxes is not known with (ert,i I nty in adva ix', a id an i nitividu al decision to purchase a government bond does net necessarily ,itfevthis Iiituir' tax liability. For a change in the public's attitude toward indexed bonds see, e.g.. Bank of Israel, Annual Report. 1974. I am grateful tc, Paul Beckernian for pointing out that the development described here may be cited with equal success in support of the opposite view that money balances should be indexed as well, since there is no jtistific,itinn, except that of implementation costs, for levying the inflation tax on cash holdings but noton other financial assets. IIis assumed here that interest rates abroad fail to adjust to the nh Ider inflation rates

prevailing therewhich seems indeed to have been the case in recent years. As itis usually the government which 'borrows linked,'' the influx ot foreign funds need not result in a dec-line in domestic interest rates which ivould cancel the indexation gains. Baer and Beckerman, op. cit. The foreign purchaser (if Brazilian OR1 Ns enjoys in addition a hedge against devaluation through tile exchange rate linkage option these bonds offer. For a short period in the mid-l96Os new mortgages were in fact linked to the COLA. See A. Cukierman, Index-Linked Mortgages in israel (Foerder Institute Working Paper No. 60; Tel Aviv: Tel-Aviv tiniversit',', 1974). Compare Ingemar Sthl, ''The Rise and Fall of Index Loans in Sweden,'' .Skaothriayjska Enskilcla Bankeri Quarterly Review (No.I, 1975), 14-20. Baer and Beckerman, op. cit. For the legal maximum interest rates on certaintypes of "indexed" credits, see Banco Central do Brasil, Re!atOrio Anual 1974,pp. 56-59. St.See laffee and Kleiman, op. cit. Similar results were obtained for the other eleven countries examined there. Note, incidentally, that unless it increases with inflation, the lag of the producer's own price behind the general price level should reducethe attractiveness of borrowing in general, but not the relative attractiveness of ''borrowing linked." In the early1 960s, income tax brackets were defined in Brazil as multiples of the nhininlum wage. Later, either the minimum wage or the pnce level were used in adlusting income lax brackets. But these served as guidelines rather thanas automatic rules. See Guenther, op. cit. Thts is accompanied by a considerable transfer of purchasingpower within the private sector as well. Here, however, we are interested in the net inflationtax and therefore deduct that part of ;t internalized by the private bankingsystem. See Affonso C. Pastore et al.,'Reflections about the Brazilian Experience(In Indexation" (preliniinry version, n.d. 1975)). Excluded were credits in foreignurrency and those linked to the exchange rate. Estimated as in Table 3, exctusive of unindexedtreasury obligations held by the public. The GDP figure for 1966 is inflated by 20percent, to allow for different definitions in the 1973 estimate. Rut F

Correctiol) and lnde\atior'l Monet3'5' 175

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Mukherjee, S. !ndesation in an Jntlatmriars . "S ('ct'1 Study of Finland. London: PEP, 1975. Novaes de Almeida, José Roberto, ''Inde\atsonor' (YR.T.N.'s: Manners of Calculation,' Conjuntura EconOnisca. XXVIII iDec'emher 1974, 92-95. lEnglish translation presented as background material for iPE-NBER Seminar on Indexation,S,'So Paulo, February 26-28, 1975.1 Pastore, Aifonso C,, Airnonacid, Ruben D. and (IC Barros, José Roberto M. 'Reflections About the Brazilian Experience with lndexation' Preliminary version (19751. Patinkin,Don,''Monetarymd PriceDevelopmentin Israel: 1949-! 953."Scripta Hseroso!p,nitana. Vol. III'. Stisdiso in U ononie and Soc a! Sciences. Ed. Roberto Bachi. Jerusalem: The .Magnes Pre. 1956, pp. 20-52. Reprinted in Don Patinkmn. Storm's in

Monetary Econornic Nr'xx York:I t,irper ano Rc,ix , 1972. I 5 Report of the Coniniicsjriri Evarnirn n On'C')L 'S(IOIS ,i,ic'e Pont ciom .lerusalem, (Hebrew), Report of the Conirnission cd Esçirts 105101 r;fi' inti) the' Cost-nt-Lining ."Slloixance (Subnntted to Histadrut and the Xtaritjtacturers''\s',O(i,itiOflotIsrael.) Tel Aviv: No, ember 1966 (Hebrea. I. Rubrier, Alex''The Abdication of the Israeli Pound as a Standard of Measurementfor Medium- and Long-Terni Contracts." Res sew of Econc,rnStudies, XXVIII (October 1960), 69-75. Sarnat, Marshall, The Oee(opnient ofthe Securities Market in Israel.Base! and Tubungen. Kvklos'Verlag in"'' \lihr 1966