David Klein: Israel's policy of integration in the global economy: the difficulties
Speech by Mr David Klein, Governor of the Bank of Israel, to The Directors' Forum, The Association of
Electronics and Information Industries, Tel Aviv, 29 April 2001.
* * *
1. The economic strategy
For the past decade the object of Israel's macroeconomic policy has been to achieve economic
integration within the global economy. The main aspects of this policy are well known:
• Reducing tariffs and abolishing non-tariff barriers, so that goods and services can move
freely;
• Removing foreign-currency control, enabling the free flow of capital;
•
Introducing structural changes to render the economy more competitive and reduce the
government's share in it;
• Adopting international standards of economic management, inter alia in the macroeconomic
sphere, the most prominent among them being to adhere to the fiscal discipline required in
order to reduce the government's debt burden, and to attain price stability via an
independent central bank.
The logic underlying this policy is two-fold:
• Contending with competition in world markets will require us to become more specialized
and more efficient. Utilizing the resources available to us, this will result in a higher growth
rate.
•
Abolishing foreign-currency control, introducing structural changes, and adopting
international standards of economic management will enable us to build another stratum on
this basis: improving the investment climate and attracting foreign capital to Israel. As a
result, Israel will be able to finance investment not only by domestic saving but also by
foreign saving, making an even faster growth rate possible.
We are evidently referring to a policy that focuses on sustainable growth accompanied by an ongoing
increase in productivity, and led by a rise in investments and exports; while the improvement of the
standard of living is not the leading factor, but the result of that structure, alongside adherence to
budgetary restraint and price stability. This policy differs substantially from that adopted in the first four
decades of Israel's existence, although it embodies elements-such as tariff-reduction-that have been
on the agenda in the past. On the other hand, the change in Israel was made possible because of the
significant shift towards globalization in the world at large.
Nonetheless, the adoption of the new approach, in all its aspects, has not gone smoothly. Many
interests and habits were based on the old framework, and although the number of advocates of the
old view is dwindling they are still able to drag out the process of change unduly, as they did in the last
decade. My aim here is to describe some of the difficulties that confronted us in the last decade in
attempting to implement the new approach.
2. The difficulties in adapting the policy instruments
a. The first difficulty: the exchange-rate regime
This difficulty kept cropping up, for two reasons:
• Foreign-currency liberalization cannot exist alongside a fixed exchange rate such as existed
in Israel, between depreciations, for about 40 years. The combination of the free flow of
capital and a government commitment to a given exchange rate is a prescription for
speculation and financial crises.
• On the other hand, Israel's exchange rate, especially since the Economic Stabilization
Program of 1985, served as a nominal anchor, i.e., the main instrument for stabilizing
inflation at a low level was supposed to be a fixed exchange rate.
This contradiction between the need to make the exchange-rate regime more flexible because of the
liberalization and the need to fix it in order to stabilize inflation had to be resolved. It is worth noting
here that in every transition process, whenever we encountered basic dilemmas that obliged us to
decide which path to take, we always asked ourselves what other countries did in similar
circumstances. In general, we aspired to re-invent as few wheels as possible, saving our creativity
- such as it was - for other matters. Thus, using the experience of others, we adopted the following
solution:
•
The exchange rate would be gradually made more flexible, parallel to the liberalization
process. This began early in 1989, when the exchange rate band was first introduced, and
continued when its determination was transferred to the market five years later, in 1994;
• Its place as a nominal anchor would be taken by the short-term interest rate, to be
determined by the Bank of Israel in view of the inflation target; this transition was also
implemented gradually.
• That shift turned out to be difficult for various elements:
- Those, mainly in the business community, who had become accustomed to a policy of a
fixed exchange rate (thus, for example, the transition from a horizontal to a crawling band at
the end of 1991 was still being justified by the need to give economic agents engaged in
international trade greater long-term certainty regarding the development of the exchange
rate-a commitment that could not be met, as has been proved innumerable times in the
history of exchange-rate bands).
- Those in the policy-making community who still believed in the exchange rate as a nominal
anchor: they continued to vigorously oppose each stage of the relaxation of exchange-rate
controls. These elements continue to this day to resist the abolition of the exchange-rate
band, even though their reasons have changed and it is perfectly clear that it will be
impossible to defend it should the need arise.
- Those who did not like the by-product of the change under which the Bank of Israel acquired
greater independence in managing monetary policy: the tradition in Israel is that changes in
the exchange rate can be made only with the agreement of the Ministry of Finance, while
changes in the interest rate can be made solely on the basis of the Bank of Israel's decision.
The person who immediately grasped that aspect of the change-although that was not the
reason it was introduced-was the Minister of Finance, Yitzhak Modai, when the shift was
made from a horizontal to a crawling exchange-rate band, in December 1991.
- One question still remains open: can the Bank of Israel's intervention in the foreign-currency
market serve, in certain circumstances, objectives that are also important for the central
bank? This question can be placed on the agenda once the exchange-rate band has been
abolished. In the last three years the Bank of Israel has refrained from intervening in the
foreign-currency market in any way. As long as that policy continues, changes in the Bank of
Israel's foreign-exchange reserves can result primarily from the government's
foreign-currency cash flow, because only the government has direct access to the Bank of
Israel for selling and buying foreign currency, and from profits made from investing the
reserves. There are small changes from time to time because of shifts in the banks'
voluntary deposits with the Bank of Israel. The level of the reserves is not affected, as some
still think, by private capital flows and interest-rate differentials. Only a few days ago an
analyst explained in an interview why "Israel's foreign-currency market is not a classic target
for assault by foreign speculators." One of the reasons for this, he claimed, was that "the
foreign-currency reserves are very high" (Ma'ariv, 17.4.2001). Since we are not active in the
market, there is no relevance in this context to the question of how large our foreign-currency
reserves are.
b. The second difficulty: managing monetary policy so as to attain price stability in a
regime of inflation targets
Israel's economic integration within the global economy requires inter alia accepting the standard of
price stability prevailing in the developed countries, obtained via an independent central bank. This
transition also created several difficulties:
• At one time the slogan 'inflation isn't everything,' meaning that other objectives such as
growth and employment also need to be considered, was very popular. The debate was
conducted between those who believed that expansionary monetary policy (i.e., reducing the
interest rate) could stimulate employment and those who thought that the end-result would
only be inflation which, if it persisted, would eventually increase unemployment. The
discussion of this subject was concluded in the world, and the general consensus comes
down to the following two points:
- Monetary policy has to be geared first of all towards maintaining price stability;
- To the extent that it does not contradict that primary aim, interest-rate policy can also be
administered so as to aid the government in attaining other policy objectives.
• As long as we were endeavoring to reduce the inflation rate-until two years ago-the
argument as to whether price stability was at all possible in Israel continued. It was claimed
that it was not feasible because of structural reasons, defined as 'nominal rigidities' or a
'monopolistic structure.' In any case, a low inflation rate was said to be achievable in Israel
only if it was 'latent,' in which case it would be bound to re-emerge at the first opportunity.
For example, a low inflation rate would be possible only with a large balance-of-payments
deficit and 'cheap imports flooding the economy'-an unsustainable situation. Thus, according
to this scenario, there would eventually be massive devaluation, followed by accelerated
inflation. The inevitable conclusion was that it would be better not to try to eliminate inflation,
as it would not last. We appear by now to have acquired sufficient experience to be able to
see that this argument was baseless.
On the basis of these considerations, until 2000 the government continued to display reluctance to set
annual inflation targets (it deferred determining a target for as long as possible, leaving it to the end of
the year, ignoring the logic regarding the lags with which monetary policy takes effect; from time to
time it considered accepting the inevitability of rising inflation; it refused to set a long-term or final
target). In August 2000 conditions were created in which the government decided to adopt a target of
'price stability' for 2003 and subsequently. This brought to an end a period in which it was necessary
each year to take a stand with regard to the inflation target. The target from now on is to maintain price
stability, defined as an annual inflation rate in the range of 1 percent to 3 percent.
• In the Bank of Israel, too, the shift to managing a policy based on inflation targets created
difficulties. In the first half of the 1990s we were still wavering between reducing
unemployment and lowering the inflation rate; between defending the exchange rate so that
it did not deviate far from the mid-point of the band and aiming for price stability. In 1994 the
inflation rate was 14.5 percent, compared with a target of 8 percent-the most outstanding
failure of monetary policy in the last decade-and in mid-1996 inflation expectations were still
14 percent. Altogether, 1995-96 was a period of impending crisis. Fiscal policy was at
breaking-point because of growing deficits, and monetary policy was contending with a new
problem: defending the lower limit of the exchange-rate band against the massive capital
inflow of billions of dollars while persevering with the effort to attain the inflation target. Only
in the last third of the 1990s did inflation start declining, albeit not continuously, towards price
stability. The lack of focus in the first half of the decade obliged us to display greater
decisiveness in conducting monetary policy in the second half, so that we could indeed
advance towards the target.
• The list of difficulties would be incomplete without mentioning the need to uproot all the
habits and institutionalized arrangements acquired and established in the long years of
inflation in order to enable us to live 'in peace' with it. Most prominent among them are the
arrangements with regard to public-sector wages, the various kinds of indexation in the
goods and services markets, and inflation-adjusted taxation and reporting regulations. The
government needs to address all these issues in order to get rid of them once and for all.
c. The third difficulty: managing fiscal policy in order to reduce government debt
In this sphere, too, several problems have arisen:
• First, there was a longstanding tradition in Israel and the world according to which the budget
can serve as a counter-cyclical instrument, with a surplus during a period of prosperity and a
deficit during a slump. Experience shows that it is easier to create a deficit in a slump than to
maintain a surplus in a period of prosperity. The result is rising government debt, an increase
in the share of debt-servicing costs in the budget, and a heavier tax burden.
The conclusion throughout the developed world was that priority has to be given to reducing
government debt to a reasonable level by limiting the budget deficit, and to easing the tax
burden by cutting government expenditure as a share of GDP. This conclusion has not yet
been accepted by everybody in Israel, even though the basic approach has been adopted by
all governments in the last decade.
• Second, the way the budget deficit was defined in Israel differed from that in the rest of the
world, so that our measured deficit was significantly lower than it would have been had the
generally-accepted definition been used. This misled many people, including prime ministers
and members of the government, made it very difficult to compare the situation in Israel with
the rest of the world, and also hampered efforts to explain the need to reduce the deficit. The
advocates of our own special method of defining the deficit, which is still used, claimed that it
is more correct and refused to change it. For years the Bank of Israel has avoided arguing
about which definition is more correct, suggesting that both figures be presented to the
government and the public, but so far without any success.
The reduction of inflation has served to greatly narrow the gap between the two definitions,
but has not eliminated it completely. Naturally, it is not difficult, statistically or otherwise, to
measure and present the deficit in the same way as is done elsewhere, and it is time we did
so.
• Third, the need to adhere to fiscal discipline over the long run requires a change of approach
in setting the order of priorities in allocating government resources. Whereas in the past it
was possible to solve any problem, whether genuine or imaginary, by increasing expenditure
and the government debt, the need to maintain the declining path of government
expenditure-albeit not absolutely but as a share of GDP-raises new issues all over the world,
for example:
-
Should the social services that the government provides be extended universally or depend
on a means test? Should the government's plans to reduce poverty make a distinction
between people of working age and others?
- Is there a place for private services alongside the public services in the spheres of
education, health, and welfare?
- Should the government be the sole agent involved in developing and operating the economic
infrastructure, or is there room for the activity of private for-profit elements in part of it, in
accordance with a framework determined by the government?
In Israel, too, we have begun dealing with these and other questions, but we are still a long way away
from their implementation as an integral, routine aspect of the long-term effort that features
prominently-as it rightly should-in the government's discussions of the budget. In the world in general
considerable progress has been made on these subjects, extensive experience has been acquired by
other governments, and we can and should benefit from it; there is no need to invent everything
ourselves.
3. Coping with problems of adaptation
A decade of administering a macroeconomic policy designed to open up the economy and reduce the
government's share in economic activity, against the backdrop of the changing geopolitical situation,
has served to create closer economic integration between Israel and the rest of the world. There no
longer seems to be anyone who disagrees with the view that this is the way to fulfill Israel's potential
for sustainable economic growth. An organic part of this approach is to adhere to accepted standards
of economic management, including fiscal discipline, price stability, and an exchange rate that is
determined by market forces. This framework obliges us to cope with several additional problems,
some of them as yet unresolved, as we have just seen. Because of the extensive economic
involvement of foreign elements in Israel that is a result of that policy, we are subject to constant
review by foreign analysts, who rank our economic performance. In addition, many of Israel's foreign
liabilities and assets are traded on international stock markets, which also continually indicate their
confidence in us. We are not isolated from the rest of the world, and we must grow accustomed to that
idea in order to continue developing the economy, creating jobs, and raising the standard of living.