Remarks by the Governor to the Israel Economic Association Conference
Bank of Israel Governor Prof. Stanley Fischer spoke today before the Israel Economic Association Conference. The main points of his remarks are below:
In my work as a central banker, I have made much use of my knowledge of central banking history around the world. Many of the events that are taking place today remind me of events from the past, and knowing the lessons from the past helps us develop policy in the present. A prominent example of this is that of Ben Bernanke, who learned the lessons and the mistakes in handling the Great Depression of the 1930s during his research, and knew how to deal with the most recent financial crisis differently and more efficiently than how they tried to handle the situation in the 1930s. We, the central bankers, thought at the outset of the crisis that we were about to experience another great depression like in the 1930s, when the unemployment rate in the US reached 25 percent. I am not here to claim that the current situation is good, but during the current crisis, US unemployment rate hit 10 percent and then began to decline, and I am sure that the situation would have been very different had Bernanke not acted according to the knowledge that he acquired in the course of his research.
An important contribution to our understanding of the connection between the various financial crises in history has come from the two researchers Reinhart and Rogoff. These are two extraordinary researchers, and the attack recently launched against them is completely improper and unfair. When I was a student, I read almost every word written by Paul Samuelson. In his writings, Samuelson talked about the difficult confrontation between economists in Sweden, and about his insistence on helping to make sure that such a confrontation would not take place in the US economic community, even if there are strong disagreements between the various camps. Such a confrontation in fact did not take place in the US during his time, and it would not be correct to hold such a confrontation now.
During the recent global crisis, we saw two main changes in the global economy: The first was the change in roles between the G-7 and the G-20 - the transfer of control of the global economy from the smaller group of industrialized countries to a larger group of large economies, some of which are emerging. It is clear that it is harder to coordinate positions between 20 finance ministers than it is between seven finance ministers. The second change is the establishment of the Financial Stability Board, which became the central body supervising the global financial system. This body sends a large quantity of directives and guidelines each day to the various financial supervisors. In my role, I sign these directives, which are sent to the banks in Israel, and I have so far gained the impression that the results of this process appear successful. At the same time, we cannot know if the process is actually achieving its objectives until we witness another crisis, which will serve as a true stress test of the financial system.
During the current crisis, I believed that the most important lesson we learned was how to conduct monetary policy in a zero-interest environment. There is research that shows that the quantitative easing in the US succeeded in affecting the markets in the same way that continued lowering of the interest rate would have affected them had it been possible to continue lowering it. Later on, we learned of the importance of macroprudential supervision—the supervision of the entire financial system as a whole. We understood that it is not enough to supervise each financial institution individually, and that we need to ask ourselves what the interaction between the various institutions is. We got an example of this right after the collapse of the Lehman Brothers investment bank, when a financial institution that was not very large caused a very sharp negative effect on the financial and real systems in the entire world. We then saw that more and more economists understand that a central bank can have more than one objective, and that Tinbergen’s algebraic conclusion, that if a bank has only one tool it can achieve only one objective, is not correct because if a bank has a utility function with a number of objectives, it can maximize this utility among these objectives. In the same way, I don’t believe that each institution needs to have only one objective.
Another important insight from the crisis is that it is very important to break the close connection that has so far existed between financial crisis and the development of government debt. We are witness to a dynamic where a banking crisis leads to government intervention, which leads to growth of debt and a fiscal crisis. The European Monetary Union is currently trying to deal with this by establishing a consolidated banking entity that can make direct loans to banks and not to governments. If they succeed, it is possible that we will know how to better deal with financial crises without having them turn into a real recession. What did we see in Cyprus? Among those who designed the assistance package to Cyprus, there was a will to have the investors in the banks pay for the damage to the system, rather than the government of Cyprus. Therefore, they tried to apply the costs of the defaults to those holding an interest in the banks. This is acceptable among shareholders, less so among bondholders, and even less so among depositors. In Cyprus, they dealt with the shareholders, but the banks did not have bonds, so they tried placing the cost on depositors as well. In the end, the parliament did not agree, and the final agreement was that those who had insured deposits would not bear the damage, while those with uninsured deposits would bear the damage up to 40 percent of the value of their deposits. The fact that most of these depositors were foreigners certainly made things easier. In any case, we saw a precedent here, where depositors were asked to bear the costs of a banking crisis.
In the past 20 years, an approach to monetary policy has developed in which the central bank must strive for a flexible inflation target. Over time, this belief has become an almost religious imperative. However, in the US, the law defines a dual mandate for the central bank, according to which it must give equal weight to real activity and inflation. The Federal Reserve recently surprised observers when it announced that it would continue its quantitative easing until the unemployment rate reaches 6.5 percent, on condition that inflation does not reach 2.5 percent. They did this despite the natural tendency of every central banker to try not to give quantitative targets to his policy. I was surprised by the fact that the Fed was ready to give a forecast to monetary policy with a range of more than 2 years, since in general, it is very hard for us to forecast developments at such ranges. However, Keynes wrote that "Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again" The world with which we must deal is the world of the next quarter, not just the world of after the storm is past. The central banks tend to focus on the inflation target since it is easier to forecast that in the long term, we will stand at the target inflation rate, and it is harder to forecast developments in GDP or unemployment. I believe that the fact that the most respected central bank in the world set itself a quantitative target for real activity without being asked to do so by the government will lead other central banks to set such goals. This will confuse the life of the central bankers, but that is what they pay us for.
The Fed frequently uses the term ‘forward guidance’. I have gained the impression that there are two different meanings for this term in the literature. The first is transparency regarding the central bank’s expectations regarding the future, both from the models and from the gut instincts of the central bank. However, it seems to me that the Fed believed that this forward guidance is another tool to affect the market. In other words, the Fed announces that it believes that in another two years, the unemployment rate will decline or the interest rate will rise, in an attempt to affect actual events. However, in my opinion, the central bank must tell the truth that comes out of its models and estimations. We at the Bank of Israel also try not to limit ourselves. In the past, I thought that it was worthwhile sending hints to the markets that we believe we will change the interest rate soon. However, too often, I discovered that when the time of the decision arrives, I have changed my mind, and that it would have been preferable not to send out such signals. The reason we make interest rate decisions each month is that circumstances change frequently. In any case, the Fed adopted a forward guidance policy, and until now, it has succeeded with it.
There are those who support setting a nominal GDP target. I think that this is very impractical. The data that we receive on nominal GDP are very unstable. There are changes of whole percentage points between the various estimates of GDP. For this reason, I think that there is no reason to use nominal GDP as a target.
Many people ask themselves how the major central banks will get out of the quantitative easing policy they are currently conducting. We remember that in 1994, the Fed started raising the interest rate after a long period of reductions, and on the day this occurred there were large shocks in the financial markets around the world. The Fed also remembers this, and they know that if they start selling large quantities of bonds, it will cause sharp shocks in market prices. Therefore, the Fed has another tool that gives the banks the right to make deposits at the central bank. The Fed can use the interest on those deposits for long terms without needing to sell bonds. This will have ramifications on the size of the Fed’s balance sheet, and this is also a very interesting issue.
In Japan, they are planning on increasing the growth rate of the monetary base over two years, taking fiscal expansion steps despite the fact that the national debt is very high, and making structural changes in the economy. If the Japanese succeed in doing all of this without it having serious ramifications on inflation, financial stability, and more, the global macro-economist community will have an interesting case study that we will need to learn.
We expect changes in global monetary policy. I long for the days before the crisis when we would meet once a month to set the interest rate, and that would be the sum total of our job for the month. However, these days, we find ourselves running during the month to find the holes that we must plug in order to prevent the floodwaters from entering. I believe that in another few years, and I refuse to use a precise number, we will return to a more normal environment. But I think that our life, and our study books, will be more complex and less clear. However, if we recognize the fact that there is tremendous uncertainty and many things that we don’t understand, our work will be easier.