Yaron Amir: Are we again taking financial stability for granted? (Or:
Do we need central banks?)
Speech by Mr Yaron Amir, Governor of the Bank of Israel, at the Israel Economic Association
Conference at the Hebrew University of Jerusalem, Jerusalem, 6 June 2019.
* * *
"In recent weeks that has been an increase in uncertainty in Israel. While the financial
markets have so far not been tremendously agitated by it, we cannot assume that there
is no damage, and it is clear that we must deal with it and that this is a challenging
period. In order to prevent harm to the economy, all policy makers and public officials
must act responsibly and do all that they can in order to reinstill certainty and fiscal
responsibility soon after the elections."
Summary:
The volatility in consumption and income may, under certain circumstances, have a
significant negative impact on well-being, such that the central banks' stabilizing policies
may be very valuable. The volatility may have an impact on the path of growth, such that the
stabilizing policies also have an impact on growth.
There is "bad" uncertainty, because of which we must guard stability, but there is also
"good" uncertainty. We must maintain stability while enabling that good uncertainty, which is
reflected in innovation and technological improvements, research and development, and
competition.
The stabilizing policy is particularly important to prevent financial crises, since the damage
from such crises is significant. Therefore, the financial stability committee becomes all the
more important as a vital layer in the early identification of risks. The establishment of the
committee is a very important step in view of the reforms in the financial system that are
being formulated.
The Bank of Israel advises the government on how to increase the long-term growth rate,
and indicates main policy measures that can increase the long-term growth path: in the
areas of education, infrastructure, and bureaucracy. The Bank is currently working diligently
on a formal report containing the Bank's recommendations to the government regarding the
advancement of productivity in the economy and an analysis of their expected costs and
benefits in the long term, which we will publish soon.
***
I chose to deal today with this question, because I think that this conference is the proper
platform for such a discussion, which combines economic theory, policy measures, and the
current public discourse in Israel, a decade after the Global Financial Crisis.
There is a model by a very famous economist behind this question, and his insights can lead us
to the conclusion that the value of stabilizing policy, mainly by the central banks, is not great. But
there is also widespread economic literature that proves otherwise, as well as insights that are
specific to Israel. These insights have become clearer to me in recent months, since I took on
the position of Bank of Israel Governor and saw how the Bank of Israel's measures, in their
various forms, have contributed to the economy's growth and its resilience to shocks.
First, let us mention the Objectives of the Bank of Israel, according to the Law:
To maintain price stability, as its central goal;
To support economic policy, especially growth, employment and reducing social gaps;
To support the stability and orderly activity of the financial system.
It is common in the economic literature to assume that one of the central bank's roles is to
moderate the volatility of the business cycle, since the widespread assumption is that this
volatility is undesirable among consumers and firms. And in fact, since the mid-1980s, there has
been a decline in the volatility of business cycles in the advanced economies, which has been
reflected in GDP, production, employment, and more. The success in reducing the volatility is
mostly attributed to the policies of the central banks, which, thanks their independence, can act in
the interest of macroeconomic stability.
If so, it is worth examining whether the effort to stabilize economic activity, which has in fact
borne fruit in recent decades, is actually important and worthwhile.
The economist Robert Lucas examined this question in 1987 by estimating the negative impact
to well-being that results from volatility in consumption, assuming that potential consumption
increases at a fixed rate while actual consumption is volatile. Lucas's model shows that the
consumption value that individuals will agree to pay for completely cancelling volatility-for
convenience, let's call it the "insurance premium for nonvolatile consumption"-is near zero.
This means that the value to the consumer of smoothing consumption is negligible, and we can
theoretically conclude that there is no tremendous value to a stabilizing policy. This leads to a
similar potential interpretation regarding the importance of the central banks. Is this really true?
Where does the gap between the intuitive notion that volatility should be moderated and Lucas's
conclusion come from? The answer has to do with three components that are not reflected in
Lucas's paper:
1.The single individual is exposed to greater risks than the average individual.
2.The path of growth on its own is subject to volatility and is not certain.
3.The significant impact of financial cycles on the business cycles.
For now, I will expand a little on each of them.
A more correct assumption for the model, which is closer to the economic reality, is that the
single individual is exposed to greater risks than the average individual. Therefore, when
the distribution of risk among the individuals is not uniform, aggregate data do not necessarily
provide the complete picture. A more simplistic description of this assumption is used a lot in
describing the statistical average, ignoring variance and volatility: "You can also drown in a pool
with an average depth of 20 cm." So when examining the change in the effect of volatility on
different population groups in different situations, the "consumption insurance premium" that
Lucas thought was negligible becomes positive in the model and significant in "real life". For
instance, during a recession, most of the public that continues to work and receive wages feels
the recession only on the margins, while workers who have been laid off take a serious hit. From
the point of view, a reduction in volatility would have led to a very large advantage.
Another parameter that needs to be taken into account is that, as opposed to Lucas's
assumption, the path of growth actually is subject to volatility and is not
certain. Economists who took this into account in their models, such as Obestfeld (194), and
Dolmes (1998) actually found that the effect of shocks is prolonged. As such, if the shocks
affect consumption over time, and are not limited to short-term volatility of consumption, then the
value of stability-the "consumption insurance premium"-is high. Those shocks that we
mentioned have an effect that is not uniform. Positive business cycles accelerate the economy,
while negative business cycles moderate it asymmetrically, so that the volatility itself has a
negative impact on the path of growth. A study by Yellin and Eckerloff (2004) shows that
unemployment responds asymmetrically to changes in inflation, such that a stabilizing policy
may increase GDP by 0.5-0.8 percent per year on average. One of the studies that helps to
explain this positive outcome was done by DeLong and Summers (1988), in which they show
that a stabilizing policy can have a medium-term impact because it is not necessarily
symmetrical, and hence its importance. The troughs can be smoothed without "shaving" the
peak periods in the business cycles.
Another way of examining the cost of volatility, or alternatively the value of stability, is to examine
investment in the economy, which has a large effect on GDP and on consumption. Uncertainty
affects production decisions, when firms must made decisions in advance regarding the
technology that they will use and the means of production they will employ. Firms may therefore
inefficiently allocate their resources. Ramay and Ramay (1991) also found a statistically
significant value to the "consumption insurance premium". In addition, Bar-Levy (2004) found
that an increase in investment during peak periods contributes less to growth than the negative
impact to growth from a reduction in investment during a recession. Therefore, a stabilizing
policy is not limited to smoothing consumption volatility, but contributes to the growth rate and to
improving per capita consumption. It is important to note that there is "bad" uncertainty,
regarding which we must guard stability, but there is also "good" uncertainty, as shown by a
study I conducted with Segal and Shaliastovich (2015). We must maintain stability while
enabling that good uncertainty that is reflected in innovation and technological improvements,
research and development, and competition.
Until now, the discussion has been regarding volatile business cycles. But what about the
significant effect of financial cycles on that volatility?
"Financial cycle" is a term that is described and analyzed in the Bank of Israel's upcoming
Financial Stability Report. It is a method of identifying cyclical behavior of financial activity. The
financial cycle is defined as "deviations from the long-term trend of a group of variables that are
important to financial stability". The definition first requires us to choose the relevant variables,
and then to choose the method of identifying deviations in the trend. In accordance with the
literature, the Bank of Israel examined a number of estimations for identifying the financial cycle,
including private credit, home prices, share prices, and the slope of the real yield curve. It was
found that, except for private credit and home prices, the rest of the estimations that were
examined vary at a different (high) rate, and therefore do not contribute to identifying the financial
cycle.
We can see that recessions accompanied by a downturn in the financial cycle (movement from
a high point to a low point) are the deepest and most serious. This finding significantly increases
the "consumption insurance premium", as shown in a study I conducted with Bansal and Kiku
(2010). An examination in the forthcoming Financial Stability Report tested the effect of the
intensity of the financial cycle on periods of slowdown in Israel. It shows that during downturns in
the financial cycle, there was a significant negative impact to the real cycle (-3.3 percent at the
beginning of the 2000s, compared with 0.2 percent in the mid-1990s and -2.0 percent during the
Global Financial Crisis, when the financial cycle in Israel was in an upward path). One of the
issues raised by such an analysis is the question of the need for setting anti-cyclical capital
buffers: a demand that the banks hold higher levels of capital during boom periods, which can be
decreased during economic downturns, thereby releasing the credit supply constraint during
such periods. The use of anti-cyclical capital buffers obviously requires precise identification of
the financial cycle. A number of countries, such as the UK, the Czech Republic, Hong Kong, and
the Scandinavian countries, are already implementing anti-cyclical policy in setting capital
buffers, in accordance with the Basel 3 guidelines.
As such, we can say that volatility in consumption and in income may, in some circumstances,
have a significant negative impact on well-being, such that a stabilizing policy on the part of the
central banks can have tremendous value. The path of growth on its own may be affected by
volatility, such that a stabilizing policy also affects growth. The stabilizing policy is particularly
important for preventing financial crises since financial crises have a very strong impact.
How does the Bank of Israel, in practical terms, implement the insights from these analyses and
studies in order to contribute to the stability, prosperity and growth of the Israeli economy?
First we examine long-term price stability, which influences many of the decisions previously
discussed. We can see that the long-term inflation expectations are anchored around the
midpoint of the target range, meaning that the Bank's policy is credible and the market
participants benefit from certainty regarding long-term inflation. The monetary policy that enabled
this outcome was accompanied by macroprudential measures taken by the Bank, which
succeeded in preventing overleverage despite the low interest rates, thereby protecting financial
stability with a long-term systemic view, and enabling monetary policy to focus on achieving its
main objectives. At the same time, the Bank of Israel worked to strengthen the capital buffers in
the banking system in order to increase its resilience to crises, and increased the foreign
exchange reserves to around 30 percent of GDP in order to strengthen the economy's financial
safety buffer.
Notwithstanding these actions, there is room for advancing further measures, partly because the
credit market is becoming more varied and requires a more integrated regulatory view. The
volume of credit issued by nonbank entities has been expanding in recent years, partly due to the
reforms in this market. Regulation of nonbank financial entities, particularly over the granting of
consumer credit, is not the same as regulation over the banks. While the difference in the type
of activity between the entities justifies certain differences in regulation, it is important to make
sure that these differences don't develop into regulatory arbitrage that could under certain
circumstances create a systemic risk. Therefore, the Financial Stability Committee that
convened for the first time in April 2019 is increasingly important, and provides an important
element in reducing regulatory arbitrage and in the early identification of risks. The establishment
of the committee is a very important step in view of the reforms taking place in the financial
system. The multiplicity of participants in the credit market, and the division of responsibility
between the various regulators require a view of the entire system and close coordination
between the regulators.
If we have so far discussed the Bank of Israel's contribution to reducing volatility, I would like to
mention that volatility and growth are connected to each other in certain ranges. This brings up
another area under the Bank of Israel's responsibility, where, as opposed to most other central
banks, the Governor of the Bank of Israel also serves as economic advisor to the government.
As such, the Bank advises the government on how it can increase the long-term growth rate.
The Research Department indicates main policy measures that can increase the long-term
growth path: in the areas of education, infrastructure, and bureaucracy. The Bank is currently
working diligently on a formal report containing the Bank's recommendations to the government
regarding the advancement of productivity in the economy and an analysis of their expected
costs and benefits in the long term, which we will publish soon.
In conclusion, it is, of course, important to enable and promote innovation and
competition, but as I have emphasized throughout this discussion, it is no less important
to avoid taking stability for granted. There is tremendous value to overall well-being
from a policy that stabilizes volatility and uncertainty in the short term, the medium term
and the long term, and certainly when volatility increases to the point of a financial crisis.
In recent weeks that has been an increase in uncertainty in Israel. While the financial
markets have so far not been tremendously agitated by it, we cannot assume that there
is no damage, and it is clear that we must deal with it and that this is a challenging
period. In order to prevent harm to the economy, all policy makers and public officials
must act responsibly and do all that they can in order to reinstill certainty and fiscal
responsibility soon after the elections.