Central bank governor of the year 2010: Stanley Fischer’s bold moves show the value of experience
Israel’s resilience during the financial crisis and its aftermath proves that Stanley Fischer is worthy of the respect he commands at the top of the global financial community. Dominic O’Neill reports.
Sunday, October 10, 2010
JUST OVER A year ago, Bank of Israel became the first leading central bank to raise interest rates after the global financial crisis intensified in September 2008. It was a bold move by the central bank governor, Stanley Fischer, and it surprised some. But it has proved well guided and prescient. Countries such as Australia and India have been forced to follow suit.
The quarter-point rise succeeded in striking the right balance between moderating inflation and continuing to support the recovery. As the central bank pointed out at the time, the higher interest rate of just 0.75% still constituted an expansionary monetary policy.
After contracting in the fourth quarter of 2008 and the first quarter of 2009, Israel’s economy recovered to a point where it grew 4.8% in the fourth quarter of 2009. In 2010 Israel’s growth has continued to exceed expectations, growing 3.6% in the first quarter and 4.7% in the second.
By March this year Fischer had raised the benchmark interest rate to 1.5%. Inflation fell to 1.8% in July, well within the 1% to 3% target range. Inflation is down from 3.5% a year earlier, although Fischer raised rates again at the end of July, to 1.75%.
With all the political problems Israel has encountered during the global financial crisis, the economy might have been expected to suffer more. Yet as Fischer himself points out in an interview at the beginning of September, economies are more responsive to monetary stimulus when the financial system is still intact.
In Israel’s case, Hapoalim, previously the biggest bank, suffered a $235 million net loss in 2008 because of write-downs on US mortgage-backed securities. But the financial system was never brought to its knees and there were no bailouts. The biggest banks replenished capital in the markets.
Another factor supporting a recovery has been Bank of Israel’s policy of intervening in the currency market in the face of upward pressure on the shekel, after Israel began to be seen as a safe haven. Bank of Israel’s reserves more than doubled between March 2008 and September 2009, reaching more than $60 billion, a level around which they have hovered over the past year.
This has served a double purpose. First, at $30 billion, the reserves were too low, as Fischer acknowledges. Second, maintaining an exchange rate of just below four shekels to the dollar has supported Israel’s exports. Exports account for 40% to 45% of economic activity in Israel, with high-tech a particularly important constituent. Europe and the US are the country’s main export markets.
Bank of Israel’s move to an interventionist policy is another example of innovative leadership by Fischer. Israel had maintained a non-interventionist currency policy before. Fischer has given Bank of Israel confidence to do things differently. More examples of this can be seen in the new macro-prudential policies he has supported.
As a case in point: Israeli house prices have risen by more than 20% over the past year, but in June Fischer told banks to set aside higher reserves for housing loans with high loan-to-value ratios. Additionally, Bank of Israel made suggestions in a report in May for how the government could tackle the highly concentrated nature of corporate ownership in Israel.
The report suggested a tax on dividend transfers to deal with so-called pyramid-style structures of hierarchical interlocking ownership. Another suggestion was to force separation of control of financial institutions from non-financial institutions: to mitigate the risks in the financial sector.
Bank of Israel’s report stated that the level of ownership concentration in Israel was characteristic of a developing country. Nevertheless, the central bank’s efficiency in dealing with such economic vulnerabilities contributes to Israel increasingly being regarded as a developed country, despite the unremitting criticism its government faces over policies in Gaza and the West Bank. In May this year, Israel was admitted to the Organization for Economic Cooperation and Development, passing a series of developmental standards. In the same month, it was upgraded to developed-market status by index provider MSCI.
"It’s important to fix your financial system quickly, and not wait around to deal with the problem"
For its part, Bank of Israel has developed its own governance structure this year. Fischer accepted a second five-year term as governor in March only after Israel’s parliament passed a new Bank of Israel law, which reduces the governor’s power over monetary policy and the central bank’s management and budget. The law follows the resolution, to which Fischer contributed, of a public dispute dating from the early 2000s over pay at Bank of Israel. The bank had faced criticism before Fischer’s arrival, as its employees were some of Israel’s highest-paid officials.
Fischer emigrated to Israel from the US in 2005 to take up the position of central bank governor at the age of 61. He became fluent in Hebrew, although he already had some familiarity with the language (he spent time as a kibbutz volunteer in his youth, for example).
Fischer’s first two degrees were at the London School of Economics. He did his PhD at the Massachusetts Institute of Technology, where he later supervised the PhD thesis of Ben Bernanke, now chairman of the US Federal Reserve.
During the 1990s he was first deputy managing director of the IMF, and a key figure in the Fund’s handling of the Asia financial crisis. In the early 2000s he coordinated Citigroup’s country-risk group and managed its relationships with government clients.
His discomfort with self-promotion might be a reflection of his upbringing in a British colony, Northern Rhodesia – now Zambia. But the past year has shown, more than ever, that he would be an asset to any country.
Some organizational changes that we made before the crisis certainly helped us in dealing with the global financial crisis. The most important of these changes was to put the foreign exchange and domestic currency markets departments together, into a markets department. That meant that foreign exchange operations and domestic monetary policy were totally integrated during the crisis, as they should be.
We also had a long-running labour dispute, which we managed to settle before the crisis.
Of all our changes in policy, the decision to intervene in the foreign exchange market was the most important. It went against a 10-year tradition in Israel, which had been very successful.
After my arrival, our foreign exchange department had told me our reserves were too small. But none of us wanted to break the non-intervention tradition and start buying reserves.
After the shekel appreciated strongly at the end of 2007 and during the first quarter of 2008, at a time we were virtually certain we were going to be hit by a serious recession, we decided in March 2008 to start buying foreign currency, slowly, and at a fixed daily rate. These purchases had some impact on the exchange rate.
But by July 2008, even before Lehman Brothers collapsed, the shekel had appreciated by 20% over the course of the previous eight months, and it was even clearer that a serious recession was on its way. So we stepped up our purchases to a rate of $100 million a day. At that stage the shekel began to depreciate against the dollar.
Israel’s economy depends on exports for about 40% to 45% of GDP. The relatively good performance of Israel’s exports during the crisis was a very important factor in limiting the impact of the recession. A reasonable exchange rate for exporters was critical in that regard.
We started the recession with our lowest unemployment level in 15 years, 5.9%. We thought the rate would rise to 9% but it peaked at 8%. The most recent unemployment rate, for the second quarter of this year, is 6.2%, barely above where we started. So the unemployment rate has already retraced its steps to a level close to that we think of as a natural level. Our labour market is very flexible, and we are very pleased with its recent behaviour.
The inflation rate at the moment is a little below the centre of the target range. But within a year it’s expected by most forecasters to rise to the top of the target range, just under 3%, and then to come down again.
The law specifies three goals of monetary policy: maintenance of price stability; support for growth and employment; and support for financial stability. So long as the inflation rate is expected to be within the target range, we can attend to the other goals.
In our monetary policy announcement each month we say that we are in a process of normalizing the interest rate, at a speed that is not fixed, but that depends on inflation and growth in Israel and abroad, and on the exchange rate. We do not think the economy is overheating now, and we have to watch what happens abroad, in our major export markets, in deciding when and how frequently to raise the interest rate. There is currently a great deal of uncertainty about growth prospects in both the US and Europe. If our export performance were to weaken significantly, Israeli growth and inflation would slow.
That is to say, so long as inflation is expected to be within the target range, we won’t jump ahead and raise the interest rate just because we have low unemployment. We’ve already raised the interest rate from 0.5% to 1.75%. To repeat our most important message: we see these increases as part of the process of normalization of the interest rate, the pace of which depends on developments in the domestic and global economies.
Israel’s house prices declined from the mid-1990s to 2007. There was a building boom based on the rapid immigration from the former Soviet Union during the 1990s. The relative price of houses peaked before the end of the last decade, and then continued to decline through about 2007. The Research Department’s housing model suggests housing prices are above but not far from long-term equilibrium now. They have more than made up for the long period of decline. If prices continue rising at the current rate for more than a year, we will find ourselves having to deal with a bubble, and we prefer to take precautionary measures now.
We started in June with a fairly small measure, requiring banks to hold larger reserves against loans with high loan-to-value ratios. We are reviewing the effects of this measure, and of the recent increase in the interest rate. We may have to take further steps. We are undertaking macro-prudential supervision. Future measures would be focused on the housing market, because, while housing prices are rising very fast, overall, the economy is growing nicely and it doesn’t seem to be overheating.
"I am generally cautious when asked for advice by other countries. I don’t want to start giving advice based on inadequate knowledge of their situations"
You’ve got a lot of experience of financial crises. Has anyone from Europe or the US – Greece or California, for example – asked for your advice?
The governors of the 55 leading central banks meet in Basle every two months, and between BIS [Bank for International Settlements] meetings we talk on the phone and sometimes meet at international conferences. And of course we follow news reports about the situation and policy measures in other countries.
I am generally cautious when asked for advice by other countries. I know less about their economies than I do about the Israeli economy, and I don’t want to start giving advice based on inadequate knowledge of their situations. What I try to do is to share experiences: to say, for example, that this approach worked here or in country X, it looks like it could work in your case, and if you were to try it this is what you would need to do.
I meet him from time to time and at the BIS. Whenever I go to Washington I try to see him. But these are not serious discussions of what he should do. He knows the situation that he faces much better than I do. He has shown himself capable of making excellent decisions in very tough circumstances, and he has an impressive staff of his own.
The IMF projections of where US Federal debt may be heading are very high – way above any number that I’ve ever seen in my career. And the current and projected Federal budget deficits are also remarkably high. There’s a further problem when you see states like California issuing IOUs to finance themselves. The US is in a difficult situation fiscally. It needs to persuade the markets and its citizens that the budget and debt situations will be brought under control in the foreseeable future. But at the same time, given the high level of unemployment, the US can’t undertake a full-bore contractionary fiscal policy at present. It’s difficult to persuade people that you will be reining in deficits and debt in the future while not doing anything to that end in the short run. On paper, you can describe how the US will come back to a situation of fiscal normalcy, four, five or six years down the road, without endangering growth in the meantime. But making such a path credible is difficult.
In countries with big deficits, which do not have a programme to bring the deficit down, there is uncertainty in the markets as to how the deficit will shrink. The UK approach has been to face the problem head-on, to start cutting now, and this is likely to resolve some of the deficit problems over the medium term. More tightly defined expectations of how the fiscal situation will be stabilized in a couple of years will moderate the contractionary effects of the fiscal tightening that the UK government plans to implement. But we will have to see how far those expectations moderate the effects of the tightening in practice.
If one begins to see signs that the UK’s programme is successful, then I imagine other countries will move in that direction. But at the moment, there are uncertainties surrounding every approach.
It also depends on the country’s political system. The UK has a strong, centralized and newly elected government, with a fairly long time horizon. There are countries where you just couldn’t make those kinds of announcements with any credibility.
Our debt-to-GDP ratio was 100% in 2003. It got down to about 77% in 2008. During the crisis, it rose only slightly, to 80%.
Up to 2008 we thought of ourselves as having a very high debt ratio, and we were able to persuade the Israeli public and politicians that it was essential to continue bringing it down. Now it’s probably going to look moderate relative to debt ratios in some of the leading countries. Nonetheless, there is a widespread understanding in Israel that we have to keep on bringing the debt down.
The budget deficit this year will probably be under 4% of GDP, well below the finance ministry’s 5.5% ceiling. The target in 2011 is 3%, and it is expected to decline to 2% in 2012.
The government is well aware of the necessity to keep the fiscal situation under control, and that’s a real benefit to anyone who runs monetary policy. The treasury keeps a very firm hand on the fiscal tiller. The minister and senior civil servants are tough, and they have been successful in maintaining fiscal discipline.
There are always arguments over whether we are cutting spending too much, and that’s partly a political issue. It’s also an economic issue. I worry about us possibly not spending enough on strengthening our education system.
The Knesset passed a law [on May 25 2010, to be adopted initially in 2011/12] that specifies a formula – developed jointly by the treasury, the Bank of Israel, and the National Economic Council (which operates out of the prime minister’s office) – that fixes the rate of increase of government spending. Until the debt-to-GDP ratio reaches 60%, government spending will be limited to a fraction of the potential rate of economic growth, defined as the average growth rate of the past 10 years. The fraction of potential growth is set at 60% divided by the current debt-to-GDP ratio. So at present, with a debt-to-GDP ratio of 80%, government spending can grow at three-quarters of the potential growth rate (60%/80%), and as the debt-to-GDP ratio gets closer to 60%, the rate of increase of government spending will be permitted to expand.
This is the core of the stability of the fiscal system.
It’s a matter of probability: the probability that growth will slow in the current quarter has risen. But the odds on a double dip are generally quoted as being well below 50%, and somewhere around 25%.
It could be accelerating right now for all we know. The Fed is talking about growth accelerating in 2011, possibly towards the end of this year. The Fed has the best record on macro US predictions and I rely on that.
Nobody is immune. Even China has announced measures to produce a certain slowdown – although a slowdown in China would be regarded as an ultra-boom in much of the rest of the world.
It’s not just Asia and China – other countries whose financial systems stayed more or less intact during the crisis are growing more rapidly too. Israel is one of them – but also Australia, Canada, Hong Kong, Norway and Poland, among others. Having reduced interest rates, these countries have, typically, seen a rapid recovery in the housing sector and more generally.
When you put your foot on the accelerator, and there’s still a financial system there, so that people can borrow at very low interest rates, the economy typically reacts reasonably quickly. When the financial system is broken, you can cut interest rates sharply without getting much feedback into growth. That’s why it’s important to fix your financial system quickly, and not wait around to deal with the problem.
Natural gas fields recently discovered off the coast could be as large as 22 trillion cubic feet. If Israel becomes a net gas exporter, how would you protect the competitiveness of Israel’s other exports?
Israelis are generally optimistic, sometimes impressively so. But this time the discoveries do seem substantial. Nonetheless, there’s still considerable uncertainty as to what is out there. The estimates now suggest the deposits are significant, and might turn Israel into a gas exporter, but they are not of a size that would make a big macroeconomic difference.
If gas production were to reach levels that would make a macroeconomic difference, given the understanding in Israel of the need for fiscal discipline, I believe we would find a way of dealing with the issue, probably with a stabilization fund like Norway’s, with some local variations.
Studies show that on average committee decisions on monetary policy tend to be better than individual decisions, although there might be instances when this is not the case. One might argue that when there’s a crisis, for example, an individual might be better placed to make the right decisions. But the individual is also better placed to make the wrong decisions.
At the moment, the governor of the Bank of Israel decides the interest rate and all budgetary and management issues within the bank. In the new set-up there will be a board of directors, which deals with internal management matters, and the management budget of the bank. There will also be a monetary policy committee, with three outside members and three inside members, and a casting vote for the governor, if the vote splits three-all. The process for choosing the members of these two committees is fairly lengthy, and they haven’t yet been chosen. We hope they will be chosen soon.
The idea to have a monetary policy committee has been around since the mid-1990s. There was less focus at that time on the need for a board of directors, or management committee. Our approach in having two committees is based on the Bank of England model.
The issue of wages in the Bank of Israel had been on the front burner for some time. There’s an institution in Israel called the government wage supervisor, which has to approve every labour contract in the public sector. It was asserted by the supervisor [starting in 2003] that wages in the Bank of Israel were too high and that some of them had been paid without his certification, and were therefore illegal.
Settling the issue required negotiations among the Bank of Israel labour union, the government wage supervisor, the management of the Bank of Israel, and the Histadrut, the national labour union. Getting a wage agreement among so many different parties was difficult. But we got one after a couple of years [in 2007]. We resolved the dispute as has been done in many other similar situations: the existing workers’ salaries stayed on their pre-existing wage schedule (with some adjustments) and workers hired after the date of the agreement (called Generation B) were put on a different and lower wage schedule, one which was agreed with the wage supervisor, and the unions. This seems to be working reasonably well now.