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The Governor of the Bank of Israel delivered a lecture at the “Economics at IDC” conference at the Herzliya Interdisciplinary Center School of Economics. The lecture dealt with two issues: the Israeli economy and issues in central banking. The main points of his remarks are below:
I would like to begin by thanking Prof. Zvi Eckstein, Dean of the School of Economics at the IDC and former Deputy Governor of the Bank of Israel who, among other things, assisted us tremendously in the legislation of the Bank of Israel Law. The Bank of Israel has difficulty in legislative proceedings, since proposed bills must come through the government, meaning through the Ministry of Finance. Therefore, it is clear that there would be some difficulties in a legislative process that is supposed to strengthen the independence of the Bank vis-à-vis the Ministry of Finance, and Zvi had a very important role in this context, in conducting negotiations and in other aspects. I would also like to thank Prof. Rafi Melnick, Provost at the IDC and a member of the Bank of Israel Monetary Committee, for his warm greetings. If we are already mentioning lecturers at the IDC, I would also like to note Tal Regev, who was a member of the search committee to nominate members of the Monetary Committee and the Supervisory Council, who did excellent work in selecting two people from the IDC among others: Prof. Melnick and Prof. Cukierman. One of the most important things in being a member of such a committee is not just how to vote when making decisions, but also how to help build the institution for the future.
The Israeli economy
The Israeli economy is a small and open economy. To a large extent, this is what determines our approach to macroeconomic policy. When we formulate a forecast for the Israeli economy, we start with what is happening abroad, with the macroeconomic forecasts for global growth, and we mainly focus on forecasts for global trade, which is one of the most important growth engines for almost any small country in the world. Before the crisis, global trade grew by an average of 7 percent per year, and we have not managed to return to such rates after the crisis, other than the correction that took place in 2010.
The development of the Israeli economy after 2003 is a success story. Growth was significantly more rapid than the average for the world’s leading economies. The achievement was most impressive in 2005 and 2006, when political and geopolitical events took place that could each have had a significant negative effect on the economy on its own. I remember that I was very surprised by the fact that these events basically did not affect growth. Even during the global crisis, despite two quarters of negative growth, we got through the recession more easily than other countries, and returned to growth at a more rapid pace than most of the developed countries in the world.
If we look at the development of the main variables since I took the position, the debt to GDP ratio declined between 2005 and 2012 from 93.9 percent to 73.1 percent. At the same time, the deficit was higher in 2012, and is expected to be even higher in 2013. The unemployment rate in 2012 was at the lowest level in the last 30 years, and there was also an increase in the employment rate. This is a very important development for the Israeli economy. We still don’t know what part of the population is responsible for this growth—it is apparently not the ultra-Orthodox or the Arabs—but in any case, the employment rate is higher than the average in the OECD countries. The poverty rate has remained at the same high level as it was in 2005. Average growth was 4.3 percent during these years, and the last forecast that we published predicts growth of 3.8 percent in 2013, although without the effect of natural gas production, growth is expected to be just 2.8 percent. Average inflation between 2005 and 2012 was slightly above the center of the target range. No less important is the fact that long-term expectations are also at the center of the target range. The public believes that the value of money will not erode in the next few years, and this is a very important basis for economic activity.
These achievements are important, but they are not only based on the Bank of Israel’s policy during these years. They are based on stabilizing inflation that began in the mid-1980s, on the financial reforms that took place mainly in the 1990s, and no less important on the fiscal stabilization program that was implemented in 2003 which, had it not been implemented, would have made it very difficult for the government to raise credit in the financial markets. The reason that we got through the global crisis with relative success is that the economy was in very good shape before the crisis, as a result of these reforms. The Israeli economy today has a good foundation: the budget deficits are not very large, and the government has passed a program that I hope will succeed in stabilizing the budget situation.
The economy faces a number of challenges, and I will relate to some of them. The rate of poverty in the economy is high, and we must continue promoting growth in the labor force participation rate in the Arab and ultra-Orthodox sectors. Human capital is insufficient, despite the many achievements of Israeli academia. We have a demographic challenge, in that if we continue with the current growth rates, the secular population will become a minority within a few decades, and a process in which a population group with a low labor force participation rate becomes the majority cannot continue together with continued growth in the standard of living. I am pleased to see that there are already changes in this area.
Another challenge is the issue of bureaucracy. In the World Bank’s Doing Business Index, we fell from 25th place in 2005 to 38th place today, not because our situation grew worse, but because other countries are dealing with bureaucracy faster than we are. Not surprisingly, the area in which we place lowest is in bureaucracy in the real estate industry. Other challenges, which I have previously spoken about and will not delve into deeply this evening, are concentration in the economy (which is currently being dealt with), labor productivity, housing prices, competitiveness, defense expenditures, and the geopolitical situation. I am optimistic, because one trait that Israelis have is that they are always trying to come up with solutions to problems. We see a lot of activity in the Knesset, for instance, and it sometimes seems that they are trying to make changes too quickly, but I expect that we will find ourselves dealing with these challenges.
And so, we have a prospering economy, with long-term challenges, and with a budget problem that the government has started to deal with. This week, we published an analysis stating that the government will need to continue reducing expenditures in 2015 and 2016 as well, but by much smaller amounts than what we dealt with for 2014. We are therefore not talking about prohibitive amounts.
Central banking issues
The first issue is how to operate at the zero lower bound. We learned during the crisis that even when interest rates reach close to zero, the central bank can still take expansionary measures. In the US, it’s called quantitative easing, and each country has a different name for it. These are measures whereby the central bank injects cash into the system in exchange for assets whose value has declined. We also learned that we can use monetary policy to revive markets that have crashed, where the central bank serves as a “market maker of last resort”, as the Federal Reserve did in the commercial paper markets, in the mortgage-backed assets markets, and more. The Japanese dealt with a near-zero interest rate environment for many years, but they did it carefully and without too much courage. Japan recently began a policy of “Abenomics”—significantly increasing the monetary base. For us as economists, this will be an interesting test case of a change in the economy that is solely the result of a change in policy approach. In any case, I have no doubt regarding the ability of the central banks to continue having an effect even with interest rates at the zero lower bound.
The second issue is the issue of macroprudential policy. Today, we understand that we must take into account the interaction between the various financial institutions. The authorities in the US say that they had no choice and that they had to allow the bankruptcy of the Lehman Brothers investment bank. But Lehman was very active in the derivatives market, which had ramifications for many financial institutions around the world. In any case, two days after a bank that was not particularly large went bankrupt, a global recession the likes of which we have not seen for decades began. In Taiwan, for instance, export volume declined by 50 percent within 6 months. What we understand today is that the central banks must also think in terms of financial stability. Our policies must be based on the fact that we cannot allow a situation in which one match leads to a huge blaze, as happened in the US and then in the entire world.
The third issue is how we deal with financial crises. In Europe, they now understand the connection between a banking system crisis and a fiscal crisis, since the solution to distress in the banking system was the injection of cash by the government. ECB President Mario Draghi and his colleagues looked for a way to prevent the governments from dragging themselves into the banking crises, and such crises will continue happening even if we conduct a perfect supervisory policy. They realized that they needed to establish a body that would inject the cash directly into the banks, and not to the governments, in order to prevent the phenomenon that I have outlined. The final model has not yet been formulated, but this is an important development in the way we must deal with financial crises in the future, although it is certainly possible that in the future as well, governments will need to get involved in order to deal with financial crises.
The fourth issue deals with the future of inflation targeting. Today, we have a flexible inflation target, which is also reflected in the Bank of Israel Law. The Bank of Israel Law defines other targets for the Bank in addition to achieving the inflation target, which is the main objective. My colleagues in Europe, for instance, argue that their only role is to maintain the inflation target. In my opinion, this is not logical, and I believe that there is no central bank that has not taken into account considerations of economic growth in its policy. The Federal Reserve recently surprised us when it set a quantitative target for the unemployment rate. Central banks do not tend to do this because we are not all that sure about our abilities to affect the unemployment rate, while in contrast, we do believe that it is within our ability to relatively easily influence inflation. If central banks follow the dual mandate policy of the Federal Reserve, which gives equal weight to unemployment and inflation, this will be a significant change. I believe that we will encounter this policy later on.
In response to questions:
I don’t want to say what we must do with the revenues from natural gas receipts. Every government ministry is interested in receiving a part of the receipts, but I don’t think that it is correct from our point of view to base the budget on natural gas revenues. We must plan our total expenditures according to priorities, and budget them out of total government revenue, including natural gas revenues.
There are models whereby a fiscal tightening policy can be expansionary, although it is very difficult to do this in practice. However, we must recognize the fact that had we not dealt with the budgetary problem, we would have experienced much bigger problems. We must fix the result of the fiscal expansion of 2011–12.
There was a certain level of optimism when they formulated the two-year budget for 2011–12. We came out of the crisis with growth of almost 5 percent, and there was a sense that the good times would continue. The Finance Ministry based the budget on lower growth, and even so the forecast was, in retrospect, too optimistic. Until mid-2012, the government took on commitments to increase the budget by almost 10 percent in 2013, while budget growth was supposed to be 5 percent according to the expenditure rule. The cutbacks that are now taking place are not cuts compared to the previous year’s budget, but compared to what people hoped and expected to receive.
We believe that investment in education and in higher education has a high rate of return, and we feel confident in making recommendations to the government in this context. When we must choose, for instance, between expenditures on health and benefits to the poor, it is harder for us to create a firm economic basis for such decisions, so we prefer to leave those to the politicians.