National Agenda : Israel’s New Inflation Imperils More than Pocketbooks : Economic problems are dragging down the government’s peace options. Early elections to win a popular mandate could be too risky now.

When zucchini shot up 28% in price in late summer, and tomatoes and cucumbers by 23%, Bank of Israel Gov. Jacob A. Frenkel knew that inflation was again out of hand and that he had to act.

Frenkel, who bitterly recalls how hyper-inflation nearly destroyed the Israeli economy a decade ago, hiked interest rates twice in the last month in an effort to curb the ascending prices. The inflation rate was running at nearly 15% a year.

The result of tighter money would be slower economic growth, probably less than 5% this year rather than the current 7.5%, but it would be healthier growth, Frenkel contended.

“You can’t buy growth with inflation,” said Frenkel, a stalwart “Chicago school” monetarist and former official of the International Monetary Fund. “It’s an extraordinary mistake to go for growth by accepting inflation. You will have less growth at the end, not more.”

But in Israel, the political implications of such economic decisions are immense. The higher interest rates--the prime rate is now 17%, compared to 11% at the end of last year--will mean slower business growth, fewer new jobs and perhaps even a recession after several boom years here.

And all this poses serious problems for a government that was elected in 1992 as much for its pledges of more jobs, lower inflation and improved living standards as for its promises to make peace with Israel’s Arab neighbors.

Prime Minister Yitzhak Rabin, as a result, finds his options far narrower as he pursues talks with Syria, Jordan, Lebanon and the Palestine Liberation Organization.

With an economic downturn, Rabin will hesitate to call early elections to secure popular approval for the difficult compromises involved in negotiations with the Arabs, political insiders say, because Israelis could vote their pocketbooks, ousting Rabin’s Labor Party.

“If you add together those who oppose peace with the Palestinians and withdrawal from the Golan Heights to those who are angry over their economic situation, then we are in trouble,” a key Rabin adviser said. “The polls already show it. . . . We have to pull together a peace package in the next year, but we also have to get the economy rightened in that time.”

Instead of elections, Rabin might choose to hold the referendum he has promised on any agreement with Syria that involves a substantial Israeli withdrawal from the Golan Heights, according to these calculations. But that would leave him without the broadened mandate he wants for a final Palestinian settlement.

And if he waits until June, 1996, when parliamentary elections are required, he runs a variety of risks: loss of momentum in negotiations with Syria and the Palestinians, a deeper economic downturn and resurgence of the fragmented rightist opposition.

In the complex politics of Israel, the search for peace thus is tied to the price of vegetables, the shortage of housing and the creation of jobs as closely as it is to political agreements.

“This government seems so busy with the intricacies of separate peace negotiations with the PLO, Jordan and Syria that it is falling badly behind in the basics of economic management,” said Michael Eilan, editor of the Israeli business magazine Link.

Although hesitant to criticize Rabin, banker Frenkel warned last month that “the Israeli economy is again at a crossroads” where fateful decisions will have to be made. “Inflation is the key challenge,” he said, announcing the seventh increase in interest rates in 10 months.

In its first year and a half, the Rabin government had not done badly. Unemployment dropped from a record 11.2% to 7.7%, inflation was almost halved and, at the end of 1993, the economy appeared set for long-term growth of 6% or more per year.

But the government had also pushed the Bank of Israel last year for lower interest rates and easier credit to stimulate economic growth and job creation in order to meet its campaign promises--and bolster support for its still-controversial agreement on Palestinian self-government.

“We wanted people to feel that peace paid,” a former Rabin adviser said. “The political logic was very powerful. With business growth and especially new jobs, people would see that peace paid in their own lives. . . .”

Problems, however, piled up quickly. A sharp 35% decline in stock prices left investors badly shaken, and that slowed plans for a selloff of more state-owned companies. The country’s major health insurance fund nearly went bankrupt and required a large infusion of government cash. Strikes by various state employees were settled with big raises, and wages grew faster than productivity.

The result was that interest rates lagged well behind inflation, savings declined and the inflationary surge pushed consumers into a buying spree. Imports began growing at twice the pace of exports, widening Israel’s trade deficit and adding to pressure for devaluation of the shekel, its currency.

The key component in the inflationary spiral has been the cost of housing, which has soared 28% in the last year. The problem results primarily from the massive investment by previous governments in building settlements on the occupied West Bank and from the failure of the present government to release much state-held land for new construction within Israel.

In agriculture, where imports of meat, fruit and vegetables could bring down market prices, the agriculture ministry has resisted strongly in an effort to protect Israeli farmers.

But the government recently authorized increases in a number of services it provides or controls--telecommunications, bus fares, school fees, among others--that have wide impact.

The fact is, however, that neither the government nor the Bank of Israel wanted to trigger a recession. They tried modest interest-rate hikes, reforms of the money markets, curbs on government spending, a modest devaluation and other steps viewed by most economists as good but not enough.

There are warnings now that the Bank of Israel alone cannot bring down inflation with higher interest rates--and that the latest increases put the economy at risk.

Frenkel expressed confidence, however, that “within a few months” the higher interest rates combined with limits on government spending will begin to cut inflation.

But the new 17% prime rate worries Israeli businesses, which warn that they will have to postpone plans for expansion and, with that, the creation of the new jobs needed by Russian immigrants still arriving by the tens of thousands.

Losing Control in Israel

Yitzhak Rabin’s government has tamed unemployment but not inflation.

1991

Unemployment (Percent of labor force): 10.6%

Inflation (Percent increase at annual rate): 18%

*

1992

Unemployment (Percent of labor force): 11.2%

Inflation (Percent increase at annual rate): 9.4%

*

1993

Unemployment (Percent of labor force): 10.0%

Inflation (Percent increase at annual rate): 11.2%

*

Aug. 1994

Unemployment (Percent of labor force): 7.7%

Inflation (Percent increase at annual rate): 14.5%

Sources: Israel Central Bureau of Statistics; Bank of Israel