THE NEW BANK OF ISRAEL

Transcription

THE NEW BANK OF ISRAEL1
Proceedings from a Farewell Conference in Honor of
Stanley Fischer, Governor, Bank of Israel
The Israel Museum, Jerusalem
June 18, 2013
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CONTENTS
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FOREWORD
KARNIT FLUG, Governor, BOI
OPENING REMARKS
KARNIT FLUG, Deputy Governor, BOI
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SESSION I: RETHINKING THE LIMITATIONS OF MONETARY
POLICY
MARIO DRAGHI, President, ECB
Introduced by Stanley Fischer
MICHAEL WOODFORD, Columbia University
Introduced by Karnit Flug
ALEX CUKIERMAN, IDC Herzliya, Member, BOI MC
Introduced by Karnit Flug
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SESSION II: THE ROLE OF THE CENTRAL BANK IN
MACROPRUDENTIAL POLICY
Chair:
BARRY TOPF, Senior Advisor to the Governor, Member,
BOI MC
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CLAUDIO BORIO, Deputy Head, Monetary and Economic
Department and Director of Research and Statistics, BIS
PATRICK HONOHAN, Governor, Central Bank of Ireland
RODRIGO VERGARA, Governor, Central Bank of Chile
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JACOB A. FRENKEL, Chairman, JPMorgan Chase
International, Former Governor of the Bank of Israel
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ADDRESS
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SESSION III:
THE BANK OF ISRAEL'S CORPORATE
GOVERNANCE—INSIGHTS AND LESSONS FROM
THE FIRST YEAR
THE MONETARY COMMITTEE
Chair:
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NATHAN SUSSMAN, Director, Research Department, BOI
PANEL
KARNIT FLUG, Deputy Governor, BOI
REUBEN GRONAU, Member, BOI MC
RAFI MELNICK, Member, BOI MC
BARRY TOPF, Member, BOI MC
REUBEN GRONAU, Member, BOI MC
ALEX CUKIERMAN, Member, BOI MC
THE SUPERVISORY COUNCIL
DAN PROPPER, Chairman, BOI Supervisory Council
STANLEY FISCHER, Governor, BOI
KEYNOTE ADDRESS
LARRY SUMMERS, Harvard University
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REMARKS
HEZI (EZEKIEL) KALO, Director General, BOI
CONCLUDING ADDRESS
STANLEY FISCHER, Governor, BOI
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With thanks to Deputy Governor Dr. Nadine Baudot-Trajtenberg for editorial
support and guidance, and to Yehudit Golan, Meir Dubitsky, and Zipi Weiss for
their coordination, editorial assistance and typesetting efforts.
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FOREWORD
This volume puts into print the lectures, speeches and dialogues that were
presented and conducted at the Bank of Israel’s Farewell Conference honoring
Governor Stanley Fischer. The conference was held in Jerusalem on June 18, 2013.
The topics portray how the thinking about monetary policy and the central
bank’s role have evolved since the onset of the global financial crisis. The
conference also looked at the main pillars of the transformation of the Bank of
Israel into the "New Bank of Israel" under Stan's leadership, in light of lessons
from the global financial crisis and under the new Bank of Israel Law that came
into effect in 2010.
Stan made Aliyah in May of 2005, becoming an Israeli citizen and the eighth
Governor of the Bank of Israel. He brought to his Governorship the experience
earned during a distinguished career as a brilliant academic whose textbooks
served as the foundations of our understanding of macroeconomics, vast
experience in policy making at international organizations, and the perspective of
the private financial sector.
He navigated the Bank of Israel through turbulent times in the domestic and
global environments. During the years of his Governorship, Israel went through the
disengagement from the Gaza Strip in 2005, the passing of Prime Minister Sharon
and his replacement by Ehud Olmert in 2006 and the Second Lebanon War in
2006, and he served through all these while having to work alongside six different
Ministers of Finance over a term of eight years. On the global front, the period of
Stan's Governorship was, of course, marked by the global financial crisis and the
Great Recession.
Stan successfully steered Israel's economy through the rough waters of these
domestic and global developments. He brought about revolutionary changes in the
Bank’s structure and operations with the long-awaited passage of the new Bank of
Israel Law. He led the Bank into a new era—new in its structure, in its corporate
governance, in an activist approach to banking supervision, in the scope of its
policies, in the way we think about monetary policy and in its national and
international standing.
When the conference honoring Stan took place, we did not yet know that the
experience he gained in leading the Bank of Israel during the previous eight years
would turn out to be of great service to the global economy, with his subsequent
move to yet another peak in his career, as the Vice Chairman of the of US Federal
Reserve Board of Governors.
Israel, the Israeli economy and the Bank of Israel were lucky to have Stan's
knowledge, experience, and leadership at their disposal during what turned out to
be a critical time. In this volume, several of Stan's colleagues, from Israel and from
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around the world, have shared their insights on several topics which are all related,
one way or the other, to the work that Stan has done and will be doing in the
coming years. I wish to thank all those who took part in the conference, including
the speakers, panelists, audience, BOI staff who helped with the program, logistics,
arrangements and editorial support.
Karnit Flug
Governor, Bank of Israel
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OPENING REMARKS
KARNIT FLUG
Dear Stan, President Draghi, Governor Honohan, Governor Vergara, Professor
Summers, Professor Woodford, Jacob Frenkel, Claudio Borio, distinguished
guests, ladies and gentlemen.
I would like to open this farewell conference honoring our Governor, Prof.
Stanley Fischer.
During Governor Fischer’s tenure, the Bank of Israel has been profoundly
transformed. It has been transformed in the way decisions are made, its internal
organization and its corporate governance; it has been transformed in terms of its
goals and the targets of its policies; and it has been transformed in terms of the
policy tools that are being used. This transformation reflected the adoption and
implementation of the new Bank of Israel Law, as well as the evolution of central
banking following the experience of, and the lessons from, the "Great Recession".
In this conference we will deal with the various elements of this transformation.
In the first session, we will discuss the evolution of thinking about monetary policy
and its limitations in an environment where issues of systemic financial stability
play an important role and when interest rates approach the zero bound. In the
second session, we will discuss more specifically the role of central banks in
macroprudential policy. In the afternoon session, we will focus on corporate
governance, and we hope to draw some lessons and insights from the experience
we’ve gained in the first year and a half of operation of our Monetary Committee
and Supervisory Council.
The new Bank of Israel Law finally came into effect in June 2010 following a
very long—13 year—process. The initiative to update and modernize the Bank of
Israel Law began in 1995, when Governor Frenkel appointed Prof. Zvi Sussman to
head a committee to propose changes in the Bank’s decision-making process and
policy objectives, and to enhance the Bank's independence. This committee was
followed by the Klein Committee, which was appointed in 1997 to recommend
which alternative among those put forward by the Sussman Committee should be
advanced. By that time, it had become clear that in order to mobilize the support
for, and to overcome the controversies surrounding, the new Bank of Israel Law, an
independent public committee was needed. Prime Minister Netanyahu (then in his
first term) formed the Levin Committee and its recommendations were presented in
December 1998. Incidentally, among the experts who testified before the Levin
Committee was the then First Deputy Managing Director of the IMF, Prof. Stanley
Fischer.
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However, many disputes along the way prevented the completion of this
complex task of legislation until 2010. One benefit of having such a long process
was that the law that was eventually adopted was based on the accumulated
experience of many countries that had updated their laws much earlier. It also took
into account at least some of the initial lessons from the global financial crisis
regarding the role that central banks should play, and the tools they should have at
their disposal. (However, some work, regarding the coordination and cooperation
with other regulators, remains to be completed).
Since the adoption of the law, the Monetary Committee has been appointed and
has been making monetary policy decisions since October 2011. The Supervisory
Council has also been appointed, and has been overseeing the way the Bank is run,
including its annual budget and its work program.
Focusing on monetary policy:
Back in the old days (that is, before the global crisis) the lives of central bankers
were relatively simple: they would meet once a month, or every 6–8 weeks, to
decide about the interest rate, look at data on inflation and activity, they decided on
the rate, and they were done. Now they still meet at the same frequency to decide
about the rate, but they also look at the housing market, the growth of credit,
capital flows, the exchange rate—and they think about the interest rate, but they
may also think about purchasing assets in a quantitative easing program,
intervening in the foreign exchange market, and they may think of limiting loan to
value ratios or applying some other macroprudential tools to one market or another.
In the case of the Bank of Israel, the Governor didn't even have to consult with
anyone, he was (formally) the sole decision maker. Since the formation of the
Monetary Committee in accordance with the new Law, this is no longer the case.
Things have really become more complicated. This conference will deal with some
of the challenges faced these days by central bankers.
Here is a brief summary of what has changed at the Bank of Israel over the period
of the Governorship of Stanley Fischer:
We have a new law, which redefined the policy objectives; which expanded the
policy tools at our disposal; which expanded the flexibility in our foreign exchange
reserves management—we could invest in new assets that we couldn’t beforehand;
and a Monetary Committee and Supervisory Council were formed.
In terms of the use of various policy tools, we have been intervening once in a
while in the foreign exchange market; during the crisis we adopted measures of
quantitative easing in the form of purchases of government bonds on the secondary
market; we’ve used prudential and macroprudential tools such as, in the housing
market, limiting the loan to value ratios and limiting the share of variable interest
rate mortgages, among other measures; and we’ve introduced some limitations on
short-term capital flows.
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In its internal operations, the Bank of Israel has undergone a thorough
reorganization, has put in place business continuity plans and practices and has
reached a new wage agreement with its employees, following protracted
negotiations.
Before I call on Governor Fischer to present President Draghi, I would like to
take this opportunity to say just a few words on a personal level.
This conference is a farewell conference honoring Governor Stanley Fischer,
and it is about the transformation of the Bank of Israel, which he has led into a new
era—new in its structure, in its corporate governance, in the scope of its policies, in
the way we think about monetary policy and in its national and international
standing.
Although I have been at the Bank of Israel for almost a quarter of a century,
most of what I know about conducting monetary policy, especially during rough
times, I have learned from Stan. His leadership, which I have witnessed—his
recognition that it is worthwhile to listen to everyone in the room, encouraging
even the most junior person to speak, recognizing that listening to all helps in
making the most informed and best decisions, his steady hand on the steering
wheel during very rough times, his ability to make decisions early on, using
judgment, before the picture fully clears up (and it never does), and his ability to
communicate these decisions in plain language—Hebrew—in a way that can be
grasped by the general public, is an inspiration and a lesson for life.
Thank you, Stan.
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SESSION I: RETHINKING THE LIMITATIONS OF
MONETARY POLICY
Introduction of Mario Draghi
Stanley Fischer
Welcome and thanks to all of you, particularly those of you who have
come from abroad to discuss issues of central banking – notably those that
have arisen during the Great Recession – as well as Israelis, my colleagues
from the Bank of Israel and from the wider public.
We are fortunate to have as our opening speaker, one of the two leading
central bankers in the world, Mario Draghi. Mario earned his Ph.D. at MIT,
where he was one of the first of the Italian students who heralded a new
generation of Italian economists, those who are among the leaders of the
field, whether they work in Italy or elsewhere. I think the change had to do
with the growing capacity of Bocconi University, although Mario wasn’t
from Bocconi.
From MIT, Mario went back to Italy and taught at the Universities of
Trento, Padua, Venice and Florence. Not bad places to be if you were a
professor who probably sometimes had time to enjoy the scenery.
Mario entered the world of public policy in 1984 as Executive Director
for Italy at the World Bank and our professional paths crossed there,
because while he was there – and I suspect with his support – I became
Chief Economist of the World Bank.
He then left the World Bank and began a remarkable ten-year period as
Director General of the Italian Treasury, a job which he did from 1991 to
2001. The period was remarkable in many respects. Italian governments at
that time changed more frequently than the civil servants: it was the civil
service that provided the essential elements of stability and continuity in
economic policy. And during his period as Director General of the
Treasury, Mario was the anchor – a highly respected anchor – of economic
stability and continuity of policies.
Mario was well respected inside Italy, and well respected
internationally. Among his most impressive achievements was his
management of Italy’s large-scale privatization program during the 10
years he was Director General of the Treasury. There was not then, nor has
there subsequently been, one word in the press or anywhere else about the
possibility that there was any corruption in this process. Nothing—which is
almost unprecedented in any country, and probably particularly difficult in
the context in which Mario was working. That is symptomatic of the high
regard and high respect in which he was held.
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Ten years is a long time to serve in a position as responsible as Director
General of the Italian Treasury. Mario left in 2001, and moved to the
private sector, as Vice Chairman of Goldman Sachs, a position he held
from 2002 to 2005.
Then, in 2006, he became Governor of the Banca d'Italia. The Banca
d'Italia is probably the most highly respected institution in Italy, but its
reputation had suffered before he arrived. Very rapidly, he restored the
reputation of the Bank and began to operate in the international arena. As
Governor of the Banca d'Italia, he was obviously one of the people who
decided on monetary policy in the ECB.
In 2011 he became the president of the European Central Bank, at an
extremely difficult moment, when the European crisis was accelerating and
deepening. History may well credit him with the record for the most
effective open mouth policy in the history of central banking, and possibly
the most effective single sentence in the history of central banking, when
he said in a three and a half minute speech in London in July 2012 that the
ECB will do—I’ll allow you to quote it, Mario, since you do it better than
me—“will do everything that is necessary to save the euro”.
There were many—I among them—who were certain that he wouldn’t
have done that without coordinating with the political level. Now I
understand that almost certainly he didn’t coordinate with the political
level—and this, if you think about the politics, was an extremely
courageous step because he could have been repudiated and that would
have made his life as president of the ECB virtually impossible. That
sentence restored the credibility of the Euro and of the ECB. The situation
is not fully stabilized but it changed dramatically and immediately after
that single statement.
It is a great pleasure for me to present Mario Draghi as the first speaker
in this conference. Mario, we enormously appreciate and thank you for
your participation in this event.
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MARIO DRAGHI
Ladies and gentlemen,
The topic for this session – “the limitations of monetary policy” – is one that has
attracted a great deal of attention since the beginning of the financial crisis.
Circumstances have forced all major central banks to resort to instruments and
policies carefully tailored to the unusual situation. Alex Cukierman and Michael
Woodford, who will present their views on the issue in a few minutes, are among
the prominent academics that have written about it extensively.1
Before handing the floor to them, let me say a few words about the current
situation in the euro area, about our perspective at the European Central Bank
(ECB) on today’s topic and about longer-term issues for the euro area.
In terms of the current situation, the euro area economy is still in a phase of
adjustment. Real GDP fell by 0.6% in the fourth quarter of 2012 and by 0.2% in
the first quarter of 2013. Output has thus declined for six consecutive quarters,
labour market conditions remain weak and public and private sector balance sheet
adjustments continue to weigh on economic activity. Unacceptably high levels of
unemployment, particularly youth unemployment, are the prime concern of
economic policy-makers.
Recent survey data suggest some improvement, but from low levels. Export
growth should benefit from a recovery in global demand. Domestic demand should
be supported by accommodative monetary policy; by the recent real income gains
from lower oil prices and lower inflation; and by the confidence and wealth effects
stemming from the improvements in financial markets since last summer.
The ECB’s Governing Council has stressed that that monetary policy will
remain accommodative for as long as necessary. In the period ahead, we will
monitor very closely all incoming information on economic and monetary
developments and stand ready to act if necessary.
In the meantime, it is important to note that economic and financial
fragmentation in the euro area has declined significantly since last summer. This
has had beneficial effects for the real economies of all euro area countries.
Banks in stressed countries have been able to regain access to interbank and
capital markets – and they have raised funds as well as capital. Larger corporations
have benefited from lower borrowing costs in capital markets. And small and
medium-sized enterprises have seen borrowing costs from banks somewhat
reduced. All of this should support investment.
1
See, for example, Cukierman, A., 2013, Monetary policy and institutions before, during,
and after the global financial crisis, Journal of Financial Stability, in press, and Cúrdia, V.
and Woodford, M., 2011, The central-bank balance sheet as an instrument of monetary
policy, Journal of Monetary Economics, 58(1), 54-79.
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Target balances, which provide a powerful summary indicator of fragmentation,
have declined by almost 300 billion euros or 25% from their peak. The costs of
protection against risks of deflation have fallen from peaks twice their long-term
average last summer to slightly below average now.2
Overall, monetary policy has regained steering capacity, which had become lost
for large parts of the euro area in mid-2012. This is an important positive
development.
Let me turn now to the limitations of monetary policy. Here I see two possible
dimensions.
The first is positive and refers to the effectiveness of central bank actions at the
margin – for example, when interest rates are close to zero.
The second is normative and refers to the constraints imposed on us by our
mandate and to the fears that boundaries between central bank policies and other
policies might become blurred.
I will not dwell on the first dimension because I do not think that we are
materially challenged in our ability to deliver our objective of price stability by the
low level of interest rates.
Looking back, despite extraordinarily testing economic circumstances, inflation
in the euro area has remained on the whole consistent with the ECB’s objective of
below but close to 2%.
Looking forward, Eurosystem staff project annual HICP inflation at 1.4% in
2013 and 1.3% in 2014, but medium-term inflation expectations remain anchored
in line with our definition of price stability.
One reason why inflation expectations have remained broadly stable is that we –
and other major central banks around the world – have prevented the
materialisation of deflation risk by adopting both standard and non-standard
measures as and when necessary.
In the euro area, one such non-standard measure was the introduction of the
outright monetary transactions (OMT) programme last year, the stabilising effects
of which are widely recognised.
There are numerous other measures – standard interest rate policy and nonstandard measures – that we can deploy and that we will deploy if circumstances
warrant.
At the same time, I have also made clear that some of those measures may have
unintended consequences. This does not mean that they should not be used, but it
does mean that we need to be aware of those consequences and manage them
appropriately. We will look with an open mind at these measures that are especially
effective in our institutional setup and that fall within our mandate.
2
See P. Praet, Monetary policy in the context of balance sheet adjustments, Speech at
Peterson Institute for International Economics, 22 May 2013.
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This leads me to the second dimension of discussion of the limitations of
monetary policy, namely the risk of a blurring of the boundaries of central bank
policy.
To approach this question, it is useful to refer to the framework put forward by
another prominent scholar in central bank matters. Marvin Goodfriend classifies
central bank actions into three categories.3
The first category is what he calls “monetary policy” proper – changes in the
size of the monetary base via purchases and sales of government securities.
Second comes “credit policy” – changes in the composition of the central
bank’s assets between government securities and claims on the private sector of
various kinds.
Third is “interest on reserves policy” – changes in the opportunity cost for
banks to hold reserves or excess reserves.
Goodfriend argues that all three categories have fiscal implications. And he
states that credit policy and interest on reserve policy involve the use of public
funds in a way that may imply an allocative role – and which may therefore blur
the respective roles of the monetary and fiscal authorities.
In this context, it is worth recalling that the monetary constitution of the ECB is
firmly grounded in the principles of ‘ordoliberalism’, particularly two of its central
tenets:
 First, a clear separation of power and objectives between authorities;
 And second, adherence to the principles of an open market economy with free
competition, favouring an efficient allocation of resources.
More explicitly, and by reference to another famous framework – the three
basic policy functions that Richard Musgrave described as allocation, stabilisation,
and distribution, and which aim delivering what Tommaso Padoa-Schioppa later
described as efficiency, stability and equity – our policy is concerned only with
macroeconomic stabilisation through the pursuit of price stability. We do not and
should not play an active role in the functions of allocation and distribution.4
At the same time, our operational framework has always included elements of
what Goodfriend qualifies as credit policy.
The ECB manages liquidity and steers money market rates by lending to banks
in temporary credit operations against a broad range of collateral.
Furthermore, we have always remunerated reserves.
3
See Goodfriend, M., 2011, Central banking in the credit turmoil: an assessment of
Federal Reserve practice, Journal of Monetary Economics, 58(1), 1-12.
4
Having said that, the objective of monetary policy being stabilisation does not imply
that it cannot contribute to efficiency and equity, and indeed stable prices are a precondition
of both (see B. Coeuré, Monetary Policy in a fragmented world”, Speech at
Oesterreichische Nationalbank, Vienna, 10 June 2013.
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Does the fact that our operations entail some credit risk on the balance sheet of
the central bank imply a violation of our ordoliberal principles? Does it imply that
the ECB policy interferes with credit allocation? My answer is no.
The risks we take onto our balance sheet in the context of our operations are
controlled, and they are accepted only insofar as they are strictly necessary for the
pursuit of price stability. This is entirely consistent with the concept of monetary
dominance, which stipulates that fiscal considerations cannot stand in the way of
the achievement of price stability.
Indeed, ECB credit is backed by adequate collateral, which implies that the
amount of residual risk borne by the central bank is buffered. There are two layers
of protection.
The first is founded on the ECB’s recourse to the borrowing institutions and the
full credit and guarantee represented by their balance sheets.
The second – when the first is exhausted – is given by the appropriation of the
collateral posted as backing of the loan. If a counterparty defaults, the underlying
collateral assets allow for the recovery of the amount lent. The use of risk control
measures such as valuation haircuts and variable margins further mitigate the
exposure to credit risk.
The same risk control principle applies in the context of the OMT programme,
through limitations on the maturity of eligible securities (one to three years) and
through the strict conditionality for a country to be eligible for the programme.
Another aspect of our operations is that they are designed precisely with the
goal of achieving neutrality in credit allocation.
The ECB’s policy framework was designed with a view to allowing the
participation of a broad range of counterparties.
The framework rests on the fundamental principle of equal treatment of
counterparties.
Equal treatment is also reflected in the collateral framework, which features a
broad range of assets and a set of eligibility criteria that apply to all Eurosystem
credit operations without distinction.
A further observation is that lending to banks is consistent with an untargeted
monetary policy.
In the euro area, the majority of credit intermediation is processed via the
banking system, as opposed to financial markets. Banks lend to households and to
financial and non-financial firms of any size across the credit spectrum. Influencing
bank funding conditions amounts to influencing credit conditions across the whole
economy.
What I have said applies in normal times, but it also largely applies in the
specific circumstances of a fragmentation of the financial system – circumstances
that we have faced and continue to face, albeit to a diminishing extent.
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Financial fragmentation in itself creates a distortion of the allocation of
resources. It undermines the concept of a free market economy because it alters the
conditions of competition.
In this context, the measures that we have implemented through the crisis do not
have an allocative or distributive role. On the contrary, by supplementing financial
intermediation where it had become dysfunctional, they have contributed to reestablishing the allocative and distributive neutrality of markets.
The liquidity measures that we took early in the crisis can be interpreted in this
light. At that time, central banks had to substitute for the sudden disappearance of
interbank market activity by acting themselves as a money market intermediary
when necessary.
For the ECB, this task was facilitated by the wide range of counterparties
accepted in refinancing operations and by our broad collateral framework. Other
central banks had to innovate more through the use of various targeted facilities
outside their normal operating framework in order to reach out to the broad
economy.
The ECB could also mobilise its collateral framework to relieve the liquidity
constraints faced by banks. We expanded the list of eligible collateral, so that
banks could liquefy their balance sheets and mobilise assets that had become
difficult to trade.
In addition, the ECB could further contribute to alleviating the banks’ funding
uncertainty by providing banks with assurance that they could rely on our
refinancing operations for extended periods.
The maximum maturity of our operations increased from three months to three
years. Through these measures, the ECB decisively addressed the liquidity
pressures faced by euro area banks and avoided a genuine credit crunch.
What must be clear from what I have said so far is what constitutes the
limitations to our actions, consistent both with the letter of our mandate and with
the philosophy of the market economy that underpins it. We have been able to
regain better control of monetary conditions in the euro area economy, which is
very important for providing the appropriate monetary policy impulse to the
economy.
Part of this achievement is due to the announcement of the OMT programme.
But equally important has been the progress in economic reform and adjustment at
both the country level and the euro area level.
Such reforms need to continue. There is still a rich reform agenda, especially
structural, at the country level for many members of the euro area. There is also an
important reform agenda at the European level. One key aspect of that is the
banking union, which rests on single supervision and single resolution, the latter
with an effective backstop if necessary.
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Preparations for single supervision at the ECB are advancing, and naturally we
are working closely with the relevant national authorities. Five work streams are
underway: first, on mapping the euro area banking system to identify systemically
important banks; second, on the supervisory model to be adopted, which is most
likely to be centred around joint supervisory teams; third, on supervisory data
reporting; fourth on legal issues; and fifth, on the asset quality review that we will
undertake prior to taking any bank under supervision.
Formal adoption of the legal texts by the European Parliament will allow us to
formalise the preparations and launch them so that we can be operational one year
after adoption.
Effective supervision requires effective resolution, which in turn requires
establishment of a single resolution mechanism. We count on the European
Commission to make a proposal in due course.
Once these processes are launched, the banking union will be within operational
reach. It should provide an answer to many of the challenges currently facing the
euro area, including uneven credit conditions and the fragmentation of financial
markets.
When observers from outside look at our Economic and Monetary Union, they
often emphasise how unfinished it appears compared with fully established unions
such as the United States. In so doing, they highlight a number of unresolved
issues, for example that in a monetary union of 17 otherwise sovereign states, a
credit or transfer across Member States is viewed differently from a credit or
transfer within an individual Member State. The equivalent of Target balances, for
example, is a non-issue in the United States. However, such observers vastly
underestimate the political capital invested in the euro by our leaders, as well as the
political significance that such an investment has for the future of Europe.
Of course, much work remains to be done for economic policy-makers across
Europe. But I am confident that together we can build a stronger economic and
monetary union that ultimately delivers jobs, growth and a return to prosperity for
the citizens of the euro area.
Thank you for your attention.
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Intoduction of Michael Woodford
Karnit Flug
Professor Michael Woodford is the John Bates Clark Professor of Political
Economy at Columbia University. He received his undergraduate degree
from the University of Chicago, a law degree from Yale Law School, and a
PhD in Economics from MIT. Professor Woodford has been a MacArthur
and a Guggenheim Fellow, and in 2007 he was awarded the Deutsche Bank
Prize in Financial Economics.
Prof. Woodford’s primary research interests are macroeconomic theory
and monetary policy. He has written extensively on all aspects of monetary
theory and policy. His most important work is the award-winning book,
"Interest and Prices: Foundations of a Theory of Monetary Policy”. It is not
an accident that the title of his book is very close to Professor Patinkin’s
classic work, “Money, Interest and Prices”. We couldn't have asked for a
better qualified academic to speak about the challenges faced today by
monetary policy makers.
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MICHAEL WOODFORD
It’s a great pleasure to be asked to address you all, and particularly at a
conference in honor of the career of Stan Fischer. I owe Stan a very great
debt. When I came to graduate school at MIT, I knew virtually nothing
about monetary economics, indeed I didn’t know much about
macroeconomics in general. I had studied a little bit of macroeconomics
before, and I imagined that that was what I was going to specialize in, in
my graduate study. But in the first semester of the program at MIT, there
was room for one elective course in addition to the required courses that
we all had to take; and some of my fellow students who were more clued in
insisted, “we have to take Fischer’s course”. This was a course that we
weren’t supposed to be ready for, because it was a second-year course in
monetary economics, and there was a whole first-year sequence in
macroeconomics that we were supposed to take first. But it was already
known that Stan was going to be on leave during our second year, and
therefore my cohort wasn’t going to be able to have him teach this course
in our second year, and everyone said that this was a course not to be
missed. So I was one of the students who took the course in our first year,
and I have to say that it was an outstanding course. I didn’t even fully
appreciate how true this was until some years later, when I had to prepare
a course in monetary economics myself, and went back to the notes I had
from Stan’s course, and discovered how much more there had been in the
class than I was able to appreciate at the time. But it did convince me that
monetary economics was a deep subject, and of course, an important
subject, and that is what I have ended up trying to understand better. For
that I have Stan to thank.
We have been asked to speak about the role of monetary policy, and in
particular, about the limits to what monetary policy can achieve. I think that few
people today will argue that monetary policy is not important. Central banks have
played an especially prominent role in public policy over the past few years.
Indeed, in many countries, the central bank has been the indispensable policy
authority in dealing with the problems created by the global financial crisis.
Yet this has not in all cases resulted in an increase in the prestige of central
banks and the deference shown to them. Instead, in many places, and certainly in
the US, public criticism of monetary policy has greatly increased in this period. In
some cases, this criticism raises legitimate issues about complex and debatable
judgments that have had to be made in conducting policy in a difficult
environment. But some of the criticism seems to reflect unreasonable expectations
about what monetary policy can be asked to achieve. In particular, the assumption
that central banks have god-like power over the economy neglects the importance
of real factors that monetary policy is powerless to undo.
24
For example, a criticism that is increasingly raised in the US argues that the
Federal Reserve’s policy that has kept the federal funds rate near zero for more
than 4 years, that promises to keep it there for considerably longer, and that has
also sought to lower longer term interest rates through asset purchases, is harmful
to savers. It’s argued in particular that retirees who worked hard and saved an
amount that was expected to be sufficient to finance their retirement now face
hardship if expected to live off the income from bonds in an environment of
unexpectedly low interest rates for years on end.
This is not, of course, an issue to dismiss lightly. But in asking whether the Fed
should raise interest rates, one has to recognize that a higher interest return on
savings will have to also mean a higher rate of interest charged to borrowers. And
it is unclear whether, on net, increased income for savers would do more to lower
hardship associated with unexpectedly tight budget constraints than the increase in
hardship on the part of indebted households, who would face unexpectedly
tightened budget constraints if interest rates are increased. Thus it is unclear in
which direction a consideration of the distributional impact of monetary policy
should cut.
But more importantly, the supposition that interest rates are simply determined
by the fiat of the central bank, and can equally well be higher or lower if the central
bank wishes them to be, neglects the role of real factors. In fact, the ultimate reason
for the current disappointment of savers in the US is a situation in which fewer
households and firms have been willing to spend, at a normal level of interest rates,
owing to increased concern to reduce their levels of indebtedness, and increased
uncertainty about future conditions. Under these circumstances, the equilibrium
real rate of interest is lower than its usual level, for reasons unrelated to Fed policy;
and in a world of perfectly flexible wages and prices, the real rate of return
received by savers would fall regardless of monetary policy. It would be
unfortunate to be a saver intending to live off the return of one’s past savings in
such a state of the world; but this would not be the fault of the central bank, nor a
problem that monetary policy could solve. It would have to be addressed by some
combination of better retirement planning, social insurance programs, and statecontingent fiscal policy.
In a world with sticky nominal wages and prices, instead, it’s no longer true that
monetary policy can’t affect real rates of return. Still, it is important to recognize
how it affects them. Monetary policy can achieve a temporary departure of the
market real rate from the natural rate only by causing the level of aggregate real
activity also to temporarily depart from the natural rate of output. Specifically, it is
possible for the central bank to keep the market real rate of return from falling,
when a shock of the kind that I’ve described occurs, only by pursuing a
contractionary policy that would keep output below potential for a time. This
means that preserving the incomes of savers would require not merely a
corresponding reduction in others’ incomes, but a reduction in aggregate income—
so that the incomes of others would fall by more than the amount by which the
25
incomes of savers would increase, if indeed a net increase in the incomes of savers
would even be achieved, given the likely effect on them of the sharper contraction
in economic activity.
This example illustrates one reason why people demand more from central
banks than they can possibly deliver—the simple fact that people have conflicting
interests. But this cannot, by itself, explain why the degree of controversy about
monetary policy has increased so much recently. I think part of the reason may
relate to the way that central banks have responded to the global financial crisis.
One source of outsized expectations about what monetary policy should
accomplish may be the degree which some central banks have emphasized their
power to stimulate the economy despite the unusually difficult circumstances
recently faced. Central bankers have sought to assure the public that monetary
policy is not impotent, that they have not “run out of ammunition,” even when their
traditional policy tools have reached their limits. The reason for this, doubtless, has
been a desire to avoid the possibility of self-fulfilling pessimistic expectations. It’s
feared that if the central bank were to admit that there were limits to its ability to
further stimulate aggregate demand, the result would be deepening gloom about
coming deflation, and continuing low incomes, which then would further reduce
what the central bank could achieve with its instruments.
But exaggerating the power of the available instruments of monetary policy has
potential costs as well. One of these is the creation of exaggerated hopes, that can
then lead to disillusionment with the central bank, which in turn results in political
pressure to limit the central bank’s autonomy.
Another cost, I believe, is that excessive confidence in what monetary policy
should be able to achieve tends too easily to relieve fiscal authorities of
responsibility for the macroeconomic consequences of their decisions. One of the
reasons for the slowness of the recovery in the US, and some other countries as
well, has been the fact that fiscal policy has lately been focused largely on the
problem of maintaining the long-run solvency of the government, with the
consequence that the government budgets and public sector employment have been
slashed precisely at the time when unemployment was already high and demand
already insufficient. Confidence that monetary policy should be able to manage the
level of aggregate demand has helped to excuse this emphasis. Indeed, one
wonders whether the UK Treasury’s enthusiasm this spring for requesting that the
Bank of England review the possible use of additional, more aggressive, easing
policies beyond the remarkable steps already taken there may not have been due to
this motivation—encouraging the view that monetary policy should be able to do
even more provides an excuse for continuing to focus fiscal policy purely on longrun solvency concerns.
I would agree that monetary policy can do more, when the zero lower bound for
short term interest rates has been reached, as it has been in the US, than to simply
point out that interest rates are as low as they can get. In particular, a commitment
26
to maintain a more accommodative stance of policy in the future, when conditions
would ordinarily justify a policy rate above zero, should be able to increase
aggregate demand now, through a variety of channels, and I believe that the
Federal Reserve was right to seek to increase current demand through “forward
guidance” of this kind. But there are limits to the power of this tool, particularly at
a time when many households and firms are reluctant to increase their spending
even if interest rates are low, owing to the state of their balance sheets and
uncertainty about the future. And it is not a tool without costs: even if promises
about future policy can increase demand now, they do so at the cost of constraining
the central bank’s ability to achieve its stabilization objectives later. In the case of
fiscal policy, it is well understood that spending more now has the cost of reducing
the government’s room to maneuver in the future; hence the emphasis at present in
the US and many other countries on reducing the amount of debt carried into the
future. But the available means of monetary stimulus when the zero lower bound is
reached constrain future policies, as well. Hence it seems a mistake to ask for no
help from fiscal stimulus, simply on the ground that future policy is thought to be
less constrained this way.
Another reason for increased pressure on central banks to satisfy an ever longer
list of demands is likely an increased perception that monetary policy is being
conducted in a discretionary fashion, with few constraints on what the central bank
might choose to do, and uncertainty about what is required to justify particular
policies. This represents an apparent change with respect to the most important
developments of the two decades prior to the crisis, which had instead emphasized
greater commitment on the part of central banks to specific but therefore limited
goals.
The guiding principles behind this new approach to monetary policy in the
period before the crisis were very well articulated in a paper by Stanley Fischer
called “Modern Central Banking,” written in 1994 for a volume celebrating the
tercentennial of the Bank of England. I realize that it is usually considered impolite
to remind a public official of things that he has said in the past, and even more so
when the lecture in question is from nearly two decades ago, and from a time long
before he was invested with his current responsibilities. But in this case, I think that
the essay stands up quite well to the passage of time, and I would still recommend
it to anyone interested in central banking.
Stan’s paper argued for the importance for granting central banks operational
independence in setting interest rates. But the case made for this independence was
not so that they could exercise the fullest possible degree of discretion. Rather, it
was so that the central bank could commit itself to clearly defined targets, pursue
them deliberately, and then be held accountable, both for achieving particular
outcomes and for explaining how its policies are guided by the pursuit of the
announced targets.
This required limiting what monetary policy can be expected to deliver, so that
it could be held accountable for delivering something. In particular, the paper
27
argued for the desirability of an explicit quantitative target, on the order of 1 to 3
percent per year, for the long-run rate of inflation. It also argued for the importance
of clarifying that the central bank was not to be responsible for “the financing of
the government deficit, or management of the public debt;” and it argued for the
desirability of allowing the exchange rate to float, and vesting responsibility for
both interest-rate policy and exchange-rate policy in the central bank, so as not to
require the central bank to conform to an exchange-rate target set by someone else.
Under this view—that was indeed the one adopted around the world in the
decade after Stan expounded it—the case for granting the central bank
independence from political interference was based on a commitment on its part to
pursue definite, pre-specified goals, for which it could be held accountable. A
reversion to a more discretionary approach to policy instead makes it more likely
that both the public and the political branches of government will ask why central
banks have so much apparently unchecked power.
But can the kind of framework for the conduct of monetary policy described in
Stan’s 1994 essay still be considered viable today, after all that happened since the
crisis in 2008? I believe that many of the principles enunciated there remain valid.
The analytical case for the desirability of a policy rule, as opposed to unfettered
discretion, turns on the importance of expectations of future outcomes as a
determinant of current conditions, and also on the idea that central bank
commitments can influence these expectations. But the importance of expectations,
and also of seeking to influence them through central-bank statements, has only
become more prominent in monetary policy since the crisis. Both the use of
forward guidance by the Federal Reserve and the Bank of Japan’s most recent
policy initiative represent examples of policies intended to affect the economy
primarily by influencing expectations. And to the extent that a central bank seeks to
change expectations about its future policy, it must be able to commit its future
policy in advance, rather than leaving itself full discretion.
I believe that the benefits of stabilizing medium-run inflation expectations have
also continued to be evident during the crisis. Inflation expectations have remained
relatively stable in many countries in the face of large disturbances and dramatic
changes in policy. I believe this has been an important stabilizing factor. In
countries like the US, a significant disruption of the financial sector didn’t lead to
the kind of deflationary spiral seen in the 1930’s; and elsewhere, large increase in
commodity prices didn’t lead to the kind of wage-price spiral seen in the 1970s. In
both cases, the stability of inflation expectations, relative to what had been true
under prior policy regimes, made it easier for current policy to contain the
disruptive consequences of these shocks.
Some aspects of the theory of inflation targeting as they were understood 20
years ago, however, do need to be modified in the light of more recent
developments. Most notably, I think there is a need for greater clarification of how
policy should be conducted in the short run so as to be consistent, and also to be
seen to be consistent, with the central bank’s medium-run inflation target. A
28
formulation proposed in Stan’s 1994 paper is that a central bank should always be
able to project that inflation will return to the target rate if things evolve as
currently expected, over a definite, fairly short horizon—say, within two years. I
don’t think this is a suitable general principle, if one allows for the kind of more
serious macroeconomic disturbances encountered recently. There is no reason to
think that the time that it should take for convergence back to a long-run steadystate position should be independent of the nature and the size of the economic
disturbance.
There is also a problem of intertemporal consistency with a criterion that only
requires a promise that the target will be reached two years in the future. If, a year
from now, one expects the central bank also to be content with an expectation of
reaching the target only two years further in the future, then one should not expect
now that the target will be actually reached within two years, if things develop as
can currently be anticipated.5
A solution, in my view, would be to define acceptable short-run departures from
the inflation target, not in terms of the time expected to be required to reach the
target, but in terms of the presence of other imbalances that justify not proceeding
more rapidly to the target rate of inflation. For example, the appropriate short-run
policy stance might be defined to be the one that keeps nominal GDP as close as
possible to a pre-announced target path. Such a criterion would allow for
temporary departures of the inflation rate from the long-run target rate if they
coincide with temporary departures of real GDP growth from the potential growth
rate. At the same time, the target path for nominal GDP could be 1.chosen so to
guarantee an average rate of inflation equal to the target rate over periods of several
years, as long as real GDP can be expected to equal potential on average over
sufficiently long periods of time.
Defining a desirable criterion for short-term policy decisions, which can clarify
the way in which alternative short-term objectives should be balanced, however, is
admittedly a more difficult task than simply designing a desirable medium-run
inflation target. The answer is more sensitive to specific assumptions about the
structure of the economy, and so judgments about it will therefore be more
controversial.
We will be fortunate indeed if someone with both the analytical capacity and
the practical wisdom of a Stanley Fischer will take on the task of synthesizing
what’s known about the principals of central banking in the light of more recent
experience. I don’t know what Stan’s own plans are after leaving the Bank of
Israel, though I was happy to see him say in a recent interview that he doesn’t
intend to retire. If he were to take on the challenge of writing an updated essay on
modern central banking, I for one would be very eager to read it.
5
This point is developed in further detail in Michael Woodford, “Forward Guidance by
Inflation-Targeting Central Banks,” paper presented at the conference “Two Decades of
Inflation Targeting,” Sveriges Riksbank, June 2013.
29
Introduction of Alex Cukierman
Karnit Flug
Professor Alex Cukierman is a member of the Bank of Israel Monetary
Committee and a Professor of Economics at the Interdisciplinary Center in
Herzliya. He earned his PhD at MIT, and his BA and MA at the Hebrew
University. He has served as visiting professor or research fellow at
Princeton, Stanford, the ECB, and the World Bank, among many other
institutions. He has served as associate editor of the European Journal of
Political Economy, and as an editor of other journals. He has written
several books and more than a hundred papers on macroeconomics,
monetary economics and monetary policy, monetary institutions and
political economy. His most well-known book is "Central Bank Strategy,
Credibility and Independence: Theory and Evidence".
Professor Cukierman was also a member of the Levin Committee,
which was appointed to recommend reform in the Bank of Israel Law.
Clearly, Professor Cukierman presents an ideal combination of research
on monetary policy and institutions and experience in policy making as a
member of our Monetary Committee, and is thus the perfect choice to be
the last speaker in this session.
30
31
US BANKS’ BEHAVIOR SINCE LEHMAN’S COLLAPSE,
BAILOUT UNCERTAINTY AND AMBIGUITY
ALEX CUKIERMAN
1. SOME EVIDENCE
There has been a dramatic shift in the behavior of the US banking system in terms
of both credit growth and demand for reserves since the collapse of Lehman
Brothers in September 2008. Between January 1947 and August 2008, total US
banking credit expanded at an average yearly rate of 7.15%. From Lehman’s
collapse until June 2011, this rate dropped to a mere 0.65% – about one-tenth of its
previous normal long-term rate of growth. Figure 1 illustrates this dramatic change
in the behavior of US banking credit prior to and after the downfall of Lehman
Brothers. Figure 2 shows that, although there was some resumption of credit
growth after the summer of 2011 this rate never came close to the rates observed in
the pre-Lehman’s collapse era.6
Figure 1: Total US commercial banks' credit (Billions of $):
January 1947 – May 2013
January 1947- May 2013
12000
10000
8000
6000
4000
2000
1 January 2013
1 January 2011
1 January 2009
1 January 2007
1 January 2005
1 January 2001
1 January 2003
1 January 1999
1 January 1997
1 January 1995
1 January 1993
1 January 1989
1 January 1991
1 January 1987
1 January 1985
1 January 1983
1 January 1981
1 January 1977
1 January 1979
1 January 1975
1 January 1973
1 January 1971
1 January 1969
1 January 1965
1 January 1967
1 January 1963
1 January 1961
1 January 1959
1 January 1957
1 January 1953
1 January 1955
1 January 1951
1 January 1949
1 January 1947
0
Source: Cukierman A., “Monetary policy and institution before, during and after the global
financial crisis, Journal of Financial Stability, 9(3), September 2013, 373-384.
6
Between June 2011 and May 2013 the average yearly rate of credit expansion rose to
4.58%.
32
Figure 2: Total US
commercial
January
2008 banks'
– Maycredit
2013 (Billions of $):
January 2008- May 2013
10200
10000
9800
9600
9400
9200
9000
8800
8600
8400
Source: Same as in figure 1.
1 April 2013
1 October 2012
1 January 2013
1 July 2012
1 April 2012
1 October 2011
1 January 2012
1 July 2011
1 April 2011
1 January 2011
1 July 2010
1 October 2010
1 April 2010
1 January 2010
1 July 2009
1 October 2009
1 April 2009
1 January 2009
1 July 2008
1 October 2008
1 April 2008
1 January 2008
8200
Source: Bloomberg - Ticker: ALCBBKCR Index
Table 1: Average growth of US commercial banks' credit by subperiods at
annual rates
Time period
Yearly growth of US
Commercial banks' credit
January 1947 – August 2008
7.15%
August 2008 – June 2011
0.65%
June 2011 – May 2013
4.58%
Source: Author’s calculations based on Bloomberg – Ticker: ALCBBKCR Index.
An even more dramatic break – before and after September 2008 – can be
observed in the behavior of total US bank reserves. Their annual long-term normal
rate of increase between January 1999 and August 2008 is about half a percent.
After the Lehman event and up to April 2011, this annual rate accelerated to 100%.
Figure 3 shows the rush to reserves of US banks after September 2008. At the end
of August 2008, total banking reserves stood at about $46 billion. A year later they
were eighteen times larger!!! They did decline moderately during the second half
of 2010, and then increased again by about sixty percent till the end of April 2012.
33
Figure 3: Total Reserves of US Depository Institutions
Figure 3: Total reserves of (Billions
US depository
institutions (Billions of $)
of $)
2500
2000
1500
1000
500
1
1
Ja
n
9
Ju 9
1 l9
Ja 9
n
1 00
Ju
1 l0
Ja 0
n
1 01
Ju
1 l0
Ja 1
n
1 02
Ju
1 l0
Ja 2
n
1 03
Ju
1 l0
Ja 3
n
1 04
Ju
1 l0
Ja 4
n
1 05
Ju
1 l0
Ja 5
n
1 06
Ju
1 l0
Ja 6
n
1 07
Ju
1 l0
Ja 7
n
1 08
Ju
1 l0
Ja 8
n
1 09
Ju
1 l0
Ja 9
n
1 10
Ju
1 l1
Ja 0
n
1 11
Ju
1 l1
Ja 1
n
1 12
Ju
1 l1
Ja 2
n
13
0
Source: Same as in figure 1.
Another way to appreciate the magnitude of the change in the behavior of US
banks prior to and after the Lehman event is to compare the ratio between their
total reserves and their total credit before and after this event. Just one month prior
to Lehman’s downfall, on August 31, 2008, this reserve ratio was slightly more
than half a percent. As can be seen from figure 4, it shot up dramatically
immediately after Lehman’s demise reaching 12.62 percent on November 30, 2009
(a twenty-four fold increase in the reserve ratio) and climbing further to almost 20
percent in May 2013.
Figure 4: Evolution of average reserve ratio of US banking system:
Figure 4: Evolution of average reserve ratio of US banking
January
2008 2008– MayMay
2013
system:
January
2013
25.00%
20.00%
15.00%
10.00%
5.00%
1 April 2013
1 January 2013
1 July 2012
1 October 2012
1 April 2012
1 October 2011
1 January 2012
1 July 2011
1 April 2011
1 January 2011
1 July 2010
1 October 2010
1 April 2010
1 October 2009
1 January 2010
1 July 2009
1 April 2009
1 January 2009
1 October 2008
1 July 2008
1 April 2008
1 January 2008
0.00%
Bloomberg - Ticker: ALCBBKCR Index, Federal Reserve Board Website
Source: Author’s Source:
calculations
based on raw data from Bloomberg – Ticker: ALCBBKCR
Index, and from Federal Reserve Board website.
34
2. HIGHER BAILOUT UNCERTAINTY AS AN EXPLANATION FOR THE
POST LEHMAN BEHAVIOR OF US BANKS
The previous evidence suggest that Lehman’s downfall marks a watershed in the
behavior of US banks, raising a fundamental conceptual question about the reasons
for this shift. I argue here that this change in behavior is due to a change in bailout
uncertainty induced by Lehman’s downfall.
In view of the Fed’s actions and the general political climate prior to the
collapse it is not hard to support the argument that the decision not to bailout
Lehman was a surprise that increased bailout uncertainty in the immediate
aftermath of the collapse. In conjunction with aversion to bailout uncertainty on the
part of banks, this argument can explain the rush of US banks into safe assets
during the initial post Lehman period.
In particular suppose that bailout risk is captured by a single binomial
distribution with a parameter, P, that designates the probability of bailout in the
minds of financial market participants. Bailout uncertainty in the Knightian sense
means that individuals are not certain about the parameter P. Following Gilboa and
Schmeidler this uncertainty can be modeled by postulating that individuals possess
multiple priors about P.7 To illustrate, suppose that, prior to Lehman’s collapse,
individuals in financial markets entertained the view that all the probabilities of
bailout in the range between 0.4 and 0.6 were possible. Following the decision not
to bailout Lehman, they became more uncertain about the likelihood of bailout,
implying that their set of multiple priors expanded to also include lower
probabilities of bailout. For concreteness suppose that their multiple priors set
expanded to include all binomial probability distributions with P between 0.1 and
0.6.
Using a set of axioms similar to the von Neuman-Morgenstern axioms on which
the expected utility criterion is based, Gilboa and Schmeidler (Op. Cit.) show that,
in the presence of ambiguity, individuals should behave as if they are maximizing
expected utility with respect to the worst probability distribution.8 In the context of
binomial multiple priors concerning the probability of bailout, the worst
distribution from the point of view of investors in financial markets is the one with
the lowest P. Continuing the numerical example above, this implies that, prior to
Lehman’s collapse, investors in bonds maximized expected utility under the
presumption that P=0.4 and after it under the assumption that it is lower (P = 0.1).
Cukierman and Izhakian trace out theoretically the general equilibrium
implications of this change in perceptions for banks and investors in the bond
7
See: (1) Knight F. M..Risk, Uncertainty and Profit. Houghton Mifflin, Boston, 1921.
(2) Gilboa I. and D. Schmeidler.“Maxmin Expected Utility with Non-unique Prior”.
Journal of Mathematical Economics, 18(2):141–153, April 1989.
8
Ambiguity is the term used in modern decision theory for Knightian uncertainty.
35
market.9 They find that such an increase in bailout uncertainty induces a flight to
safety by both banks and investors in the bond market, to a reduction in credit and,
depending on parameters, even to a total arrest of financial intermediation. The
upshot is that the decrease in the growth of banking credit, and the associated
dramatic increase in the demand for reserves following Lehman’s downfall, can be
understood in terms of an increase in bailout uncertainty in the aftermath of this
event.
9
Cukierman A. and Y. Izhakian, “Bailout Uncertainty in a Microfounded General
Equilibrium Model of the Financial System”, April 2013, Manuscript, Interdisciplinary
Center and Tel-Aviv University.
36
37
SESSION II: THE ROLE OF THE CENTRAL BANK
IN MACROPRUDENTIAL POLICY
BARRY TOPF
Good morning and welcome back. This morning’s first session, on the limitations
of monetary policy, leads us directly to the topic of the role of central banks in
macroprudential policy. As our first speaker, Claudio Borio, wrote in a recent
paper, “before the crisis there was a consensus that monetary policy will take care
of price stability while regulation and supervision will ensure financial stability.
Unfortunately we have seen that price stability does not ensure macroeconomic
stability. An additional objective has been added—financial stability, but that
requires additional tools to deal with specific tasks for the economy that can’t be
addressed easily or effectively by traditional monetary policy”. And so we have
seen increasing interest in the use of macroprudential tools. But what does
macroprudential policy actually mean? Macroprudential is very messy. Every
discussion of policy quickly runs into difficulties of definition: it does not fit nicely
into categories—theoretical, organizational or operational. It is hard to quantify,
lacks benchmarks, and cuts across numerous areas of responsibility. Models are
hard to come by and frequently unsatisfactory. It is extremely country specific;
success is frequently unobservable while failure is painfully obvious. It has few
tools which are exclusively its own but borrows them from other areas, and even its
name is a hybrid borrowed from more clearly defined aspects of economic policy.
The ambiguity is perhaps most succinctly summarized in the question posed in the
very beginning of one recent paper on macroprudential policy: “is the goal of
macroprudential policy to protect the banks from the economy or to protect the
economy from the banks?” We have with us today three speakers who are
eminently qualified to help us make sense of this complex field. Claudio Borio is
the Deputy Head of the Monetary and Economic Department and Director of
Research and Statistics at the Bank for International Settlements. He has written
extensively and more notably insightfully on macroprudential policy and central
banking. Patrick Honohan was appointed Governor of the Central Bank of Ireland
in 2009, and that is a position that certainly makes him well acquainted with the
risks and dangers of having a large banking system. Prior to that, he was a
professor of international financial economics and development at Trinity College,
Dublin. Rodrigo Vergara has been Governor of the Central Bank of Chile since
December 2011. Before that he had broad experience not only in that central bank
but in various think tanks and as a professor in the Economics Department of
Universidad Catolica. Claudio, please.
38
39
MACROPRUDENTIAL POLICY AND THE FINANCIAL CYCLE:
SOME STYLISED FACTS AND POLICY SUGGESTIONS
CLAUDIO BORIO
INTRODUCTION10
I would like to thank the organisers for their kind invitation; it is a pleasure and
great honour for me to be here in such distinguished company.
In the limited time available I would like to provide context. The objective is to
explore what I consider as the major source of systemic risk, namely the financial
cycle and its link with systemic financial (banking) crises and the far better known
business cycle. I would like to highlight a few stylised facts and then turn to the
implications for macroprudential policy.
By “financial cycle” I shall mean, somewhat loosely, the self-reinforcing
interaction between risk perceptions and risk tolerance, on the one hand, and
financing constraints, on the other, that, as experience indicates, can lead to serious
episodes of financial distress and macroeconomic dislocations. This is what has
also come to be known as the “procyclicality” of the financial system.
There are three takeaways from my presentation. First, the financial cycle
should be at the very core of our understanding of the macroeeconomy. To my
mind, macroeconomics without the financial cycle is very much like Hamlet
without the Prince. Second, the financial cycle has significant implications for the
design and limits of macroprudential policy. And, finally, it also has significant
implications for the design and limits of other policies, notably monetary and
fiscal.
I will address two questions in turn. What are the properties of the financial
cycle? I will highlight seven. What are the policy issues it raises? I will highlight
four.
Let me stress that what I will be presenting is based on research carried out at
the BIS over the years. But many of the findings are quite consistent with work
carried out elsewhere, including here at the IMF.11
10
This presentation was originally prepared for the IMF conference "Rethinking macro
policy" (April 2013) and appears in the corresponding conference volume. The views
expressed are my own and not necessarily those of the Bank for International Settlements.
11
Similarly, the references will be almost exclusively to BIS work, especially recent one,
although the institution’s support of macroprudential policy goes back a long way (eg,
Clement (2010)). That work contains extensive references to the literature.
40
1. THE FINANCIAL CYCLE: SEVEN PROPERTIES12
It is useful to think of the financial cycle as having seven properties.
First, its most parsimonious description is in terms of the joint behavior of
credit and property prices. In some respects, equity prices, while so prominent in
finance and macroeconomics, can be a distraction. This, in turn, is related to the
next property.
Second, the financial cycle has a much lower frequency than the traditional
business cycle.13 By traditional business cycle I mean how economists and
policymakers think of the business cycle and measure it. This business cycle has a
duration of up to eight years. By contrast, the financial cycle that is most relevant
for serious macroeconomic dislocations has a duration that, since the early 1980s,
has between 16 to 20 years. It is a medium-term process. This, at least, is what we
have found in a sample of seven advanced economies for which we had good data
(Drehmann et al (2012).
The point is illustrated for the United States in Graph 1. The graph plots the
traditional business cycle (red line) and the financial cycle (blue line) as measured
through band-pass filters as well as peaks and troughs (vertical lines). The financial
cycle is identified by combining the behaviour of credit, property prices and the
ratio of credit to GDP.14 The difference in duration is obvious.
Equities can be a distraction in the sense that their time-series properties are
closer to those of GDP in terms of the duration of swings. For example, the stock
market crashes of 1987 and 2000 were followed by slowdowns, or outright
recessions, in GDP. But the financial cycle as measured by credit and property
prices continued to expand, only to turn a few years later (early 1990s and 2007-8,
respectively), bringing the economy down with it and causing even greater
damage. Seen from this longer-term perspective, one can thus consider the early
contraction phases in economic activity “unfinished recessions” (Drehmann et al
(2012)).
Third, peaks in the financial cycle tend to coincide with systemic banking crises
or serious strains. Post-1985 all do in the sample of advanced countries we
examined (Drehmann et al (2012)). And those crises that occurred well away from
the peak were “imported”, ie they reflected losses on cross-border exposures to
financial cycles elsewhere. Think, for instance, of the losses that German and
Swiss banks incurred in the most recent financial crisis on their exposures to the
12
This section draws, in particular, on Borio (2012a).
The qualification “traditional” is important. The data also reveal longer swings in GDP,
which are closer to those for the financial cycle. See Drehmann et al (2012)).
14
While the changes in amplitude over time in the business and financial cycles are
meaningful, because the financial cycle combines different series, it is not possible to draw
inferences about the relative amplitude of the two cycles from the graph. See Drehmann et
al (2012) for a discussion of the technical issues involved.
13
41
United States. Not surprisingly, business cycle contractions that coincide with the
bust of financial cycles are much deeper.
Fourth, thanks to the financial cycle, simple leading indicators can identify risks
of banking crises fairly well in real time (ex-ante)15 and with a good lead (between
2 to 4 years, depending on calibration). The indicators we have found most useful
at the BIS are based on the positive deviations of the (private sector) credit-to-GDP
ratio and of asset prices, especially property prices, jointly exceeding their
respective historical trends (eg, Borio and Drehmann (2009), Borio and Lowe
(2002)).16 One can think of these indicators as real-time proxies for the build-up of
financial imbalances: the deviations of asset prices provide a sense of the
likelihood and size of the subsequent reversal; those of the credit-to-GDP ratio, a
sense of the loss absorption capacity of the system. These indicators flashed red in
the United States in the mid-2000s (Graph 2). There is also growing evidence that
cross-border credit often outpaces purely domestic credit during such financial
booms (eg, Borio et al (2011), Avdjiev et al (2012)).17
Fifth, and for much the same reasons, the financial cycle also helps construct
estimates of sustainable output that, compared with traditional potential output
estimates, are much more reliable in real time, as well as statistically more precise
(Borio et al (2013)). None of the current methods, ranging from fully-fledged
production function approaches to simple statistical filters, spotted that output was
above its potential, sustainable level ahead of the Great Financial Crisis. In recent
work, we have found that incorporating information about the behaviour of credit
and property prices allows us to do just that.
Graph 3 illustrates this for the United States, by comparing our estimates of the
output gaps (the so-called “finance-neutral” gap) with those from the IMF and
OECD, based on more fully fledged model approaches, and with a popular
statistical filter (the Hodrick-Prescott filter). The traditional estimates made in real
time, during the economic expansion that preceded the crisis, indicated that the
economy was running below, or at most close to, potential (red lines in the
corresponding panels). Only after the crisis did they recognise, albeit to varying
degrees, that output had been above its potential, sustainable level (blue lines). By
contrast, the finance-neutral measure sees this all along (bottom right-hand panel,
red line). And it hardly gets revised as time unfolds (the red and blue lines are very
close to each other). One reason why production function and similar approaches
miss the unsustainable expansion is that they draw on the notion that inflation is the
only signal of unsustainability. But, as we know, ahead of the crisis it was the
15
Real-time or ex ante refers to an estimate which is based only on information that is
available at the time it is made.
16
Not surprisingly, these trends are consistent with the average length of the financial
cycle; see.Drehmann et al (2011)).
17
All this casts doubt on the view that current account imbalances were a cause of the
financial crisis; for an in-depth discussion of this issue, see Borio and Disyatat (2011).
42
behaviour of credit and property prices that signalled that output was on an
unsustainable path: inflation remained low and stable.
Sixth, and critically, the amplitude and length of the financial cycle are regimedependent: they are not, and cannot be, a kind of cosmological constant. Arguably,
three key factors support financial cycles: financial liberalisation, which weakens
financing constraints; monetary policy frameworks focused on near-term inflation
control, which provide less resistance to the build-up of financial imbalances as
long as inflation remains low and stable; and positive supply-side developments
(eg, the globalisation of real economy), which fuel the financial boom while at the
same time putting downward pressure on inflation. It is not a coincidence,
therefore, that financial cycles have doubled in length since financial liberalisation
in the early and mid-1980s and that they have become especially virulent since the
early 1990s (Graph 1).
Finally, busts of financial cycles go hand-in-hand with balance sheet
recessions.18 In this case, compared with other recessions, debts and capital stock
overhangs are much larger, the damage to the financial sector much greater, and
the policy room for manoeuvre much more limited, as policy buffers – prudential,
monetary and fiscal – get depleted. Evidence also indicates that balance sheet
recessions result in permanent output losses – growth may return to its long-run
pre-crisis rate but output does not regain its pre-crisis trajectory – and usher in slow
and long recoveries. Why so? I suspect it reflects the legacy of the previous boom
and the subsequent financial strains.
2. THE FINANCIAL CYCLE: FOUR OBSERVATIONS ABOUT
MACROPRUDENTIAL POLICY
How should prudential policy address the financial cycle? The financial cycle
requires that prudential policy has a systemic, or macrorpudential, orientation. This
means addressing the procyclicality of the financial system head-on – what has
come to be known as the time dimension of macroprudential policy: this is the
18
Koo (2003) seems to have been the first to use such a term. He employs it to describe a
recession driven by non-financial firms’ seeking to repay their excessive debt burdens, such
as those left by the bursting of the bubble in Japan in the early 1990s. Specifically, he
argues that the objective of financial firms shifts from maximising profits to minimising
debt. The term is used here more generally to denote a recession associated with the
financial bust that follows an unsustainable financial boom. But the general characteristics
are similar, in particular the debt overhang. That said, we draw different conclusions about
the appropriate policy responses, especially with respect to prudential and fiscal policy; see
Borio (2012a).
43
dimension that relates to how system-wide or systemic risk evolves over time (eg,
Crockett (2000), Borio (2011) and Caruana (2012a)).19
The general principle is quite simple to describe, but quite difficult to
implement: it is to build up buffers during financial booms so as to draw them
down during busts. This has two objectives. It would make the system more
resilient, better able to withstand the bust. And, ideally, it would constrain the
financial boom in the first place, thereby reducing at source the probability and
intensity of the bust. Note that these two objectives are very different; the second is
much more ambitious than the first. I will return to this point later.
Let me now highlight four observations about macroprudential policy. They are
all intended to manage expectations about its effectiveness and to set a realistic
benchmark about what it can and cannot do -- and this from someone who has been
a strong advocate of the approach for over a decade now and who continues to be
one! The reason is that the financial cycle is a hugely powerful force.
First observation: beware of macro stress tests as early warning devices in
tranquil times (Borio et al (2012)). In fact, to the best of my knowledge, none of
them flashed read ahead of the recent crisis.20 Their relentless message was “the
system is sound”.
There are two reasons for this.
The first has to do with our risk measurement technology. Our current models
are unable to capture convincingly the fundamental non-linearities and associated
feedback effects that are at the core of the dynamics of financial distress. In
essence, no matter how hard you shake the box, little falls out. This shifts the
burden to the required size of the shocks, which become unreasonably large and,
therefore, are discounted by policymakers. The deeper point here is that the essence
of financial instability is that normal-sized shocks cause the system to break down.
An unstable system is not one that would break down only if hit by a huge shock,
such as an outsize recession. An unstable system is fragile. As empirical evidence
indicates, crises break out close to the peak of the financial cycle, well before GDP
has plunged into a deep recession or asset prices have collapsed.
The second reason has to do with the context, or what might be called the
“paradox of financial instability” (Borio (2011)). Initial conditions are unusually
strong just before financial strains emerge. Credit and asset prices have been
surging ahead; leverage measured at market prices is artificially low; profits and
asset quality look especially healthy; and risk premia and short-term volatilities are
extraordinarily compressed. Taken at face value, these signals point to low risk
when, in fact, they are signs of high risk-taking. The system is most fragile when it
looks strongest. And this point is reached after years of solid and relentless
19
There is also a cross-sectional dimension, which relates to how risk is distributed in the
financial system at a point in time; see eg, Crockett (2000) and Borio (2011).
20
Even the FSAP for Iceland, released in August 2008, concluded that “….stress tests
suggest that the system is resilient“.
44
expansion, typically alongside widespread financial innovations. Under these
conditions, the temptation to believe that this time things are really different is
extraordinarily powerful (Reinhart and Rogoff (2009)).
Bottom line: at worst, macro stress tests can lull policymakers into a false sense
of security. That said, if properly designed, they can be an effective tool for crisis
management and resolution -- a tool to promote balance-sheet repair. After all, the
crisis has already broken out, non-linearities have revealed themselves and hubris
has given way to prudence. “Properly designed” means that the authorities need to
have the will to shake the system hard, need to start the tests from very realistic
asset valuations, and should put in place the necessary liquidity and solvency backups.
Second observation: beware of network analysis as a tool to detect vulnerabilities
(Borio et al (2012)). As a source of vulnerabilities, bilateral linkages (counterparty
exposures) matter far less than common exposures to the financial cycle.
Network analysis views the financial system as a web of connections linking
institutions. It then models systemic risk by tracing the knock-on effects of the
default of one institution on the rest along those interconnections. The larger the
portion of the system that fails, the larger is systemic risk.
The main problem is that, as empirical evidence confirms, given the size of the
interconnections it is too hard to get large effects. The reason is simple: mechanical
exercises abstract from behaviour. A financial crisis is more like a tsunami that
sweeps away all that gets in its way than a force knocking down one domino after
another. The main force driving it is indiscriminate behavioural responses. This
also explains why the failure of small and seemingly innocuous institutions can
trigger a major crisis. Small institutions do not matter because of what they are but
because of what they signal about the rest: they signal shared vulnerabilities – they
are the canary in the coalmine. When the financial cycle turns, the failure of the
first institution can shake previously seemingly unshakable convictions and trigger
a paradigm shift.
That said, this does not imply that information about bilateral exposures has
little value. Much like macro stress tests, it can be very valuable in crisis
management, as a tool to identify pressure points and understand where and how
best to intervene. But for this to be the case, the information has to be quite
granular and very up to date (Borio (2013)).
Third observation: beware of overestimating the effectiveness of macroprudential
policy (Borio (2011), Caruana (2012a)).
There are two sets of reasons here as well, which is some ways echo those that
explain the limitations of stress tests.
The first set is technical. The tools are more effective in strengthening the
resilience of the financial system – the first objective mentioned above – than in
constraining financial booms – the second, more ambitious objective. To be sure,
45
some instruments are more effective than others. For instance, it stands to reason,
and it seems to be confirmed by empirical evidence, that ceilings on loan-to-value
and debt-to-income ratios have more bite than capital requirements (eg, CGFS
(2012)). After all, capital is cheap and plentiful during booms. But for typical
calibration of the tools it would be imprudent to expect a strong impact. Moreover,
and critically, all such tools are vulnerable to regulatory arbitrage. And the longer
they stay in place, the easier arbitrage becomes.
The second set of reasons has to do with political economy. Compared with
monetary policy, it is even harder to take away the punchbowl when the party gets
going. The lags between the build-up of risk and its materialisation are very long,
certainly longer than those between excess demand and inflation – recall just how
long the financial cycle is compared with the business cycle. For some of the tools
the distributional effects are more prominent and concentrated. And while there is a
constituency against inflation, there is hardly any against the inebriating feeling of
getting richer. All this puts a premium on sound governance arrangements and on a
right balance between rules and discretion.
Fourth observation: beware of overburdening macroprudential policy (eg,
Caruana (2010, 2012b), Borio (2012a,b)). This follows naturally from the previous
observation. The financial cycle is simply too powerful to be tackled exclusively
through macroprudential policy, or indeed prudential policy more generally, be it
micro or macro. Macrorpudential policy needs the active support of other policies.
What does this mean in practice? For monetary policy, it means leaning against
the build-up of financial imbalances even if near-term inflation remains under
control (exercising the “lean option”).21 Monetary policy sets the universal price of
leverage in a given currency. In contrast to macroprudential tools, it is not
vulnerable to regulatory arbitrage: you can run, but you can’t hide. For fiscal
policy, it means being extra prudent, recognising the hugely flattering effect of
financial booms on the fiscal accounts. This is because the overestimation of
potential output and growth (Graph 3), the revenue-rich nature of financial booms,
owing to compositional effects, and the contingent liabilities needed to address the
subsequent bust.
As an important aside, a big open question is how macroprudential frameworks
should address sovereign risk. These frameworks were originally designed with
private sector vulnerabilities in mind, linked to the financial cycle. But such cycles
leave in their wake seriously damaged sovereigns, which can all too easily sap
banks’ strength. Moreover, as history indicates, sovereigns may cause banking
crises quite independently of private sector excesses. At a time when the
21
The existence of a “risk-taking” channel of monetary policy, whereby changes in
interest rates (and other monetary policy tools) influence risk perceptions and risk tolerance
strengthens the case for an active role of monetary policy. It is not, however, a necessary
condition for it. See Borio and Zhu (2011)).
46
sovereigns’ creditworthiness is increasingly in doubt, much more attention should
be devoted to this issue.
Against this broad backdrop, is there a risk that adjustments in policy
frameworks are falling short? Ostensibly, this was the case before the crisis, but
what about since then? My answer is that the risk should not be underestimated.
Progress has been uneven across policies (Borio (2012b)).
Prudential policy has adjusted most. A major shift from a micro to a
macroprudential orientation has taken place in regulation and supervision. Think,
for instance, of the adoption of a countercyclical capital buffer in Basel III (BCBS
(2010), Drehmann et al (2011)) and, more generally, of the efforts under way to
implement fully-fledged macroprudential frameworks around the world (CGFS
(2012)). That said, expectations about what these frameworks can deliver are
running too high and there is a question of whether enough has been done with
respect to instruments, their calibration and governance arrangements. Moreover,
more could and should have been done to repair banks’ balance sheets in some
jurisdictions.
Monetary policy has adjusted less. To be sure, there has been some shift
towards adopting the “lean option”. But the will to exercise it in practice has been
quite limited. The temptation to rely exclusively on the new macroprudential tools
has been very powerful, to avoid disturbing monetary policy. And it is worth
asking whether the limitations of monetary policy to tackle financial busts have
been fully appreciated.
Fiscal policy has adjusted least. There is as yet little recognition of the hugely
flattering effects of financial booms on the fiscal accounts and of the big risks that
busts pose for the sustainability and even effectiveness of fiscal policy.
Bottom line: there is a real risk that policies are not sufficiently mutually
supportive. And, critically, they are not sufficiently symmetric as between financial
booms and busts. They tighten too little during booms with the serious danger that
buffers get depleted during busts. This poses a huge constraint on the room for
manoeuvre – one that becomes tighter over successive cycles. Policy horizons are
simply too short, not commensurate with the duration of the financial cycle (Borio
(2012b)).
CONCLUSION
There is a need to bring the financial cycle back into macroeconomics.
Macroeconomics without the financial cycle is very much like Hamlet without the
Prince. This raises huge analytical challenges that the profession is just beginning
to tackle.
The financial cycle has major implications for macroprudential policy and
beyond. I highlighted four observations. Beware of macro stress tests as early
warning devices. Beware of network analysis as a tool to identify financial
47
vulnerabilities. Beware of the limitations of macroprudential policy. And beware of
overburdening it.
Has enough been done to adjust policy frarmeworks? Not quite. In the case of
macroprudential policy, more and better can be done with respect to the calibration
and activation of the instruments. In the case of monetary policy more can be done
with respect to the exercise of the “lean option”. And in the case of fiscal policy
there is a need to recognise the hugely flattering effect that financial booms have
on the fiscal accounts.
So much for prevention and how to address the financial boom; what about the
question of how to address the bust? If anything, here the questions are even bigger
and more controversial, while progress has been more limited (Borio (2012a,b)).
There is a serious risk, in particular, that the effectiveness of monetary and fiscal
policy is overestimated and of a new, more insidious form of time inconsistency.
But this is another story.
48
REFERENCES
Avdjiev, S, R McCauley and P McGuire (2012), “Rapid credit growth and
international credit: Challenges for Asia”, BIS Working Papers, no 377, April.
http://www.bis.org/publ/work377.pdf
Basel Committee for Banking Supervision (2010), Guidance for national
authorities operating the countercyclical capital buffer, December
http://www.bis.org/publ/bcbs187.htm
Borio, C (2011), “Implementing a macroprudential framework: blending boldness
and realism”, Capitalism and Society, vol 6(1), Article 1.
http://ssrn.com/abstract=2208643
______ (2012a), “The financial cycle and macroeconomics: what have we learnt?”,
BIS Working Papers, no 395, December http://www.bis.org/publ/work395.htm
forthcoming in the Journal of Banking & Finance.
______ (2012b), “On time, stocks and flows: understanding the global
macroeconomic challenges”, lecture at the Munich Seminar series, CESIfoGroup and Sueddeutsche Zeitung, 15 October, BIS Speeches,
www.bis.org/speeches/sp121109a.htm. Forthcoming in the NIESR Review.
——— (2013), “The Global Financial Crisis: setting priorities for new statistics”,
BIS Working Papers no 408, April. Forthcoming in the Journal of Banking
Regulation. http://www.bis.org/publ/work408.htm
Borio, C and P Disyatat (2011), ”Global imbalances and the financial crisis: link or
no link?”, BIS Working Papers, no 346, May.
http://www.bis.org/publ/work346.htm
Borio, C, P Disyatat and M Juselius (2013), “Rethinking potential output:
embedding information about the financial cycle”, BIS Working Papers, no
404, February http://www.bis.org/publ/work404.htm
Borio, C and M Drehmann (2009), “Assessing the risk of banking crises –
revisited”, BIS Quarterly Review, March, pp 29–46
http://www.bis.org/publ/qtrpdf/r_qt0903e.pdf
Borio, C, M Drehmann and K Tsatsaronis (2012), “Stress-testing macro stress
tests: does it live up to expectations?”, BIS Working Papers, no 369, January.
Forthcoming in the Journal of Financial Stability.
Borio, C and P Lowe (2002), “Assessing the risk of banking crises”, BIS Quarterly
Review, December, pp 43-54 http://www.bis.org/publ/qtrpdf/r_qt0212e.pdf
Borio, C, R McCauley and P McGuire (2011), “Global credit and domestic credit
booms” BIS Quarterly Review, September, pp 43-57
http://www.bis.org/publ/qtrpdf/r_qt1109f.pdf
Borio, C and H Zhu (2011), “Capital regulation, risk-taking and monetary policy: a
missing link in the transmission mechanism?”, Journal of Financial Stability,
December. Also available as BIS Working Papers, no 268, December 2008.
49
Caruana, J (2010), “Monetary policy in a world with macroprudential policy”,
speech delivered at the SAARCFINANCE Governors' Symposium 2011,
Kerala, 11 June http://www.bis.org/speeches/sp110610.htm
______ (2012a), “Dealing with financial systemic risk: the contribution of
macroprudential policies”, panel remarks at Central Bank of Turkey/G20
Conference on "Financial systemic risk", Istanbul, 27-28 September
http://www.bis.org/speeches/sp121002.htm
______ (2012b), ”International monetary policy interactions: challenges and
prospects”, Speech at the CEMLA-SEACEN conference on "The role of
central banks in macroeconomic and financial stability: the challenges in an
uncertain and volatile world", Punta del Este, Uruguay, 16 November.
http://www.bis.org/speeches/sp121116.htm?ql=1
Crockett, A (2000), “Marrying the micro- and macroprudential dimensions of
financial stability”, BIS Speeches, 21 September.
http://www.bis.org/review/r000922b.pdf
CGFS (2012), Operationalising the selection and application of macroprudential
instruments, no 48, December http://www.bis.org/publ/cgfs48.htm
Clement, P (2010), “The term "macroprudential": origins and evolution”, BIS
Quarterly Review, March, pp 59-67.
http://www.bis.org/publ/qtrpdf/r_qt1003h.htm
Drehmann, M, C Borio and K Tsatsaronis (2011), “Anchoring countercyclical
capital buffers: the role of credit aggregates”, International Journal of Central
Banking, vol 7(4), pp 189-239. Also available as BIS Working Papers, no 355,
November http://www.bis.org/publ/work355.htm
______ (2012), “Characterising the financial cycle: don’t lose sight of the medium
term!”, BIS Working Papers, no 380, November
Koo, R (2003), Balance sheet recession, Singapore: John Wiley & sons.
Reinhart, C and K Rogoff (2009), This time is different: Eight centuries of
financial folly, Princeton University Press: Princeton.
50
The financial and business cycles in the United States
Graph 1
Note: Brown and green bars indicate peaks and troughs of the combined cycle using the
turning-point method. The frequency-based cycle (blue line) is the average of the
medium-term cycle in credit, the credit to GDP ratio and house prices (frequency based
filters). The short term GDP cycle (red line) is the cycle identified by the traditional shortterm frequency filter used to measure the business cycle. NOTE: The amplitudes of the
blue and red lines are not directly comparable.
Source: Drehmann et al. (2012).
Leading indicators of banking crises: credit and property price gaps
for the United States
Credit-to-GDP gap
Real property price gap1
Percentage points
Graph 2
Percent
51
The shaded areas refer to the threshold values for the indicators: 2–6 percentage points for
credit-to-GDP gap; 15–25% for real property price gap. The estimates for 2008 are based
on partial data (up to the third quarter).
1
Weighted average of residential and commercial property prices with weights
corresponding to estimates of their share in overall property wealth. The legend refers to
the residential property price component.
Source: Borio and Drehmann (2009).
US output gaps: full-sample (ex post) and realtime (ex ante) estimates.
In percentage points of potential output
IMF
OECD
HP
Graph 3
Finance neutral
Linear estimates; the non-linear ones for the finance-neutral, which should better capture
the forces at work, show an output gap that is considerably larger in the boom and smaller
in the bust.
Source: Borio et al. (2013).
52
53
SMALL COUNTRY, BIG BANKING SYSTEM:
WHAT MACROPRUDENTIAL IMPLICATIONS FOR THE
CENTRAL BANK?
PATRICK HONOHAN
Knowing that Claudio would give a terrific overview of the whole area of
macroprudential policy, I had to decide what specific area to home in on in the
limited time I have here today, in particular reflecting on the fact that this is Stan’s
day.
I recall that my own first encounter with Stan was when he was Chief
Economist at the World Bank, at the start of that huge contribution he has made in
international public service at the World Bank and later at the IMF. Much of what
he did then falls into the category of “international economics”, but even more
would be better categorized as “comparative economics”, i.e., analysis of the
similarities and contrasts between the problems of different countries.
Thus, I decided to present a bit of comparative economics today, looking at a
few countries, whose recent experience is particularly relevant to the topic of
today’s conference. A few of the countries are close to you here in the Eastern
Mediterranean – thus, hot and dry (Cyprus, Lebanon and Malta); a few of them are
damp and cool and close to where I come from in North-Western Europe (Iceland
and Ireland). But the unifying factor is that they are all small countries with big
banking systems.
The problems of small countries with large banking systems have been quite
significant factors in the current financial crisis, and I would like to talk about the
macroprudential issues from the central bank perspective in these situations.
One of the things we were studying in the World Bank back in the 1980s and
later was the role of financial systems, and in particular the way in which the size
and development of financial systems could contribute to economic growth. I
suppose it’s still the conclusion of the academic literature today that having a small
and undeveloped financial system will constrain a country’s economic growth. But
what is increasingly clear is that, beyond a certain size, a large financial system
becomes a risk factor.
Nevertheless, industrial policy in governments in several countries encourages
international banking and international finance as an export sector. (That has
happened in all five of these countries to some extent.) What should the
macroprudential policy of central banks do about that?
The first thing to note is that this is not a question of doubting the absolute
importance of internationalization per se as a powerful positive force for
efficiency. What is questioned is the net effect of having a financial system that is
very large relative to the size of the economy.
54
It’s worth looking at this problem from three different perspectives: lending,
funding and the exchange rate. Thus, the first aspect relates to the contribution of
the international sector to lending and the well-known domestic bubble problem.
The second aspect relates to funding, and in particular to what I call the “domestic
financial shield”, sought by foreign providers of funds. This is less studied.
Sometimes the shield proves to be effective, sometimes not. The third aspect,
which I will not have time to develop, relates to the way that exchange rate policy
can become locked-in or constrained if the country has opted to have a large
financial system.
My main take away will be that it’s safer if domestic and international banking
in small economies are not too closely intertwined. Thus, if the government insists
on policies that result in a large banking system, then macroprudential policy
should try and keep the domestic and international components somewhat separate.
It was Mervyn King who said he found that banks were international in life and
national in death. That has been found to be true in many cases, but it’s not
necessarily true, and in the tradition of offshore centers it really wasn’t true.
In practice, governments have not been inclined to bail-out an international
bank in an international financial center that does little lending onshore and doesn’t
fund locally. Such banks come and go and they are part of something that is quite
offshore.
But in several of the countries that we are looking at, international banks got
involved in the local economy and created macroprudential risk.
The lending challenge is the most obvious one. Claudio has talked about this—
the funds that are drawn within from abroad pump up the property market. I guess
Chile was the first classic example that we also talked about in the early 1980s;
there was an example of this kind of boom and bust financed by funds coming in
through the banking system. And then we can talk as Claudio did about the
macroprudential policies to restrain such activity, and the fashion nowadays to talk
about exchange controls against inward flows, that seems to be a big fashion going
against the trend of earlier years.
The second dimension is funding. Nowadays banking systems are often not
readily partitioned on the funding side—between banks that are sourcing their
funds in the local economy and banks funded elsewhere. The local banks start to
fund internationally in this kind of environment, and the international banks start to
fund also locally. Now why would international banks want to do that? One reason
is to benefit from what I call the domestic financial shield. The fact that the
international bank has domestic funds providers creates a kind of protective shield,
inasmuch as they may benefit from the reluctance of the local government to
tolerate losses being imposed on domestic depositors, in the event that the bank
fails. National fiscal authorities often decide that domestic depositors should be
bailed out especially because transaction balances, and the payment system, are
involved. In the event of failure then, it is as if the local depositors are taken
55
hostage, because it is often not easy in law to discriminate against the foreign
funders. Either all or none must be paid.
By interlinking their funding sources, local and foreign, the banks are—
wittingly or not—tying themselves in eliciting a future potential bail out from the
national authorities. This can present a big risk to the fiscal authority and is
something that has caused major problems in this crisis.
I don’t have time to say much about the third element, exchange rate policy. In
many countries with large international banking systems, local borrowers from the
banks are tempted to denominate their borrowing in foreign currency because of
lower foreign exchange interest rates. Knowing this exchange risk overhang in turn
induces the central bank to be very cautious about exchange rate adjustments. After
all, a devaluation will then not just improve price and wage competitiveness; it will
impose large capital losses on some of the domestic borrowers.
Now let me turn to each of the five country cases. Chart 1 shows the size of the
total banking system as a percentage of GDP in 2008 and today. Cyprus around
800 percent, Iceland is the winner, with almost 1,000 percent, though now down
considerably lower. The other countries also appear very high—Lebanon not quite
as high, but included as an interesting and long-standing international banking
center which is in our immediate geographical locality today—as indeed is the very
topical case of Cyprus.
Chart 1
What can we take away from Iceland? Chart 2 shows bank deposits (measured
in Icelandic Krona) from 2003 right up to the present day. The chart distinguishes
56
between deposits of residents and the rest. The dramatic events of mid-decade are
clearly visible. Somewhere in 2005, 2006 the two lines become disengaged as the
Icelandic banks start to fund extensively from abroad. When the crash comes, look
what happened—the foreign creditors are wiped out but the domestic creditors are
not. Iceland managed to create a situation where the system was sufficiently
separable. Domestic funders were carved out and protected. The “domestic
financial shield” for foreign funders turned out to be weak. Accordingly, the
macroprudential risks were somewhat constrained. If Iceland had not had and
seized that possibility, the economy would have been in an even worse situation.
Chart 2
Turning to the case of Ireland, there’s a lot I could say, but I just want to
highlight one point, which is that the domestic financial shield did apply, albeit to
only part of the system, but this was sufficient to cripple the public finances. The
total banking system got to about 9 times GDP, but I would invite you to dig a little
deeper, because within this total are several distinct segments as seen in Chart 3,
which shows separately (i) Irish-controlled banks dealing mainly with the domestic
economy; (ii) Other domestic banks (they are foreign-owned but almost all of very
long standing, and mainly concerned with the domestic economy) (iii) and (iv) the
international financial services center – distinguishing between those firms, mostly
household names, that have been doing fine, and others that got into trouble in the
crisis. The important point here is that (iii) and (iv) represent segments that are not
implicitly guaranteed by the Irish Government as we have seen from the fact that
57
the banks in (iv) were bailed-out, but by external governments. So in Ireland the
domestic financial shield did protect the creditors of the banks in segment (i)
accounting for only 44 percent of the system. The Irish government did guaranty
all of those and bailed them all out so the domestic financial shield did work for the
foreign creditors. The government didn’t want to cause devastation to the domestic
holders of claims on Irish banks, so they bailed everybody out. And, by the way, in
segment (ii) the British government bailed out the creditors of the British owned
banks. Thus the domestic financial shield did work for creditors of banks in
Ireland, but only for part of the system.
Chart 3
Chart 4 does not do full justice to the complexity of the situation in our third
country, Cyprus. It distinguishes between depositors from Cyprus itself; depositors
from other parts of the euro area; and depositors from the rest of the world. The
declines in the past few weeks and months as the Cyprus crisis evolved are evident.
In Cyprus they had an entangled system (as far as domestic and foreign funding is
concerned). The two big banks had a lot of foreign funding and a lot of foreign
lending. They were very much entangled; macroprudential risks were large in that
case. The financial shield did not protect the foreign depositors of those banks
because the problem was too big for the fiscal authority to solve. There was a very
costly disruption to the domestic economy when the failure occurred, because the
domestic shield wasn’t there so the domestic depositors lost as well. This may the
clearest example teaching the lesson: “try to disentangle”.
58
Chart 4
What I’m about to say about the Lebanese banking system could have been said
in 1988 or 2012. Chart 5 is in trillions of Lebanese pounds. Lebanon has had a
fixed exchange rate against the dollar throughout this long period. Indeed, they
have skillfully maintained an equilibrium and contained several interesting
complicating features. There is an exchange rate peg throughout; there is large
government borrowing from the banking system throughout; there is a domestic
financial shield which has enabled the banking system to attract those large
external deposits because it’s credible and it has held. So this is really an
interesting case.
59
Chart 5
Finally, two charts on Malta. If I understand in properly, it seems that Malta has
achieved the desired separation. Depositors from Malta represent only a quarter of
the system as shown in Chart 6. Malta’s “core domestic banks”—they are the ones
in the top left hand side of Chart 7—are almost 100 percent domestically funded,
and they deal almost 100 percent with the local economy. In contrast, you have the
international banks (on the bottom right hand side of the chart), which have very
little domestic funding and almost zero systemic relevance in the sense that they
don’t do substantial lending in the local economy.
The policy conclusion: international banking can be a valuable export sector for
a small economy, but beware of it becoming entangled in the local financial
system.
60
Chart 6
Chart 7
61
BEING PRUDENT ABOUT MACROPRUDENTIAL
RODRIGO VERGARA
Good morning. I would like to thank the Bank of Israel and the organizers for
inviting me to participate in this farewell conference in honor of Governor Stanley
Fischer.
I have been asked to talk about macroprudential policy. I would like to take this
opportunity to share with you some of the questions I have on this topic, my views
on some of them, and the way in which we, at the Central Bank of Chile, have gone
ahead in balancing the need for more answers with the need for policy action on
this front.
1. THE RISE OF MACROPRUDENTIAL
Since the financial crisis of 2008, the term “macroprudential” has become the new
darling of academic and policy circles. After surviving at the fringes of policy
discussion and being outside mainstream academia for decades, hundreds of
research papers, policy notes and press reports have been written around this
concept since 2008.22
The rise of macroprudential is closely related to the criticisms to the prevailing
framework of macro stabilization before the crisis. They have crystallized in an
emerging consensus that achieving financial stability requires having it as an
explicit goal and adding macroprudential policies to the traditional monetary policy
and regulatory framework. This view also reflects the shift in the lean versus clean
debate produced by the financial crisis, whose depth and persistence convinced
many that the cleaning approach is unable to fully dampen the consequences of a
crisis. 23
2. WHAT ACTUALLY IS MACROPRUDENTIAL?
Regrettably, while becoming increasingly accepted, this “new consensus” has not
fully crystallized in a broadly shared view about what constitutes macroprudential
policy. There is currently more consensus on the broad goals of macroprudential
policy than on its tools and institutional arrangements.24 This is not surprising
22
See Hanson, et al. (2011), Hahm, et al. (2012), and Galati and Moessner (2011) among
others. See also Clement (2010) for historical review of the term “macroprudential”.
23
See Hahm et al. (2012) for a summary of the lean-versus-clean debate and the changes
in the monetary policy paradigm after the crisis.
24
For a recent discussion on the meaning, scope, and implementation of macroprudential
policies see Bank of England (2009), Borio (2011), Galati and Moessner (2011), and Group
of Thirty (2010).
62
considering the fluid discussion around a relatively new approach to economic
policy, but it could lead to a situation where an extremely broad range of policy
actions is justified on “macroprudential” grounds. This concern is not academic.
The real risk is that it becomes confusing for the public and costly for
policymakers.25
At a broad level, there is consensus that the goal of macroprudential policy is to
ensure financial stability. But there is less agreement on whether the pursuance of
financial stability should focus on avoiding crises or on smoothing the financial
cycle.26 These two views have many similarities but also subtle differences. A
financial system without crises would be more stable than one with, and a less
volatile financial system should experience no crises. But in contrast to crisis
avoidance, smoothing the financial cycle explicitly includes the dampening of
booms regardless of whether this reduces the probability of crises. For instance,
one may worry about financial booms if they lead to resource misallocation – even
if no crisis is looming at the end of this misallocation. Of course, from a practical
perspective the distinction becomes blurred if booms are typically followed by
crises.
Another small difference between these two views is that, while neither
provides an immediate operational target for gauging success, the financial cycle
view comes a bit closer. The success of crisis avoidance is based on a discrete
counterfactual—the occurrence of a crisis, which cannot constitute an immediate or
operational target. In turn, smoothing the financial cycle could more easily be cast
as an operational target as long as there is agreement on how to measure the state
of such cycle. Regrettably, this is not easy task.
Since avoiding crises is too discrete a goal to be a useful measure of success, it
typically translates into an operational goal focused on limiting risk taking by
financial institutions. This requires the definition of risk-taking indicators, and
immediately begs the question of what risks should be monitored and what
indicators should be used. There are many forms of risk taking and various types of
financial sector agents, each with several potentially related indicators. The
combination of all of these aspects usually ends up in multidimensional targets.
Smoothing the financial cycle, in turn, requires a measurement of the state of
such cycle. Some recently proposed measures include the growth rate of credit or
some interest rate spreads. However, these indicators typically focus on bank
behavior. Since other forms of credit extension are harder to monitor, they have not
been considered in the existing analyses of leading indicators of financial stress.
Additionally, the available evidence on this front comes from a period where the
candidates for leading indicators were not being actively monitored by regulators.
25
See Born et al. (2012) on the challenges involved in communicating macroprudential
policies for Central Banks.
26
The Bank for International Settlements (2011) lists five operational definitions of
financial stability, but they can be grouped along these two dimensions.
63
Tracking these indicators with regulatory purposes may simply result in risk
shifting behavior that renders the indicators useless.
The issues I just highlighted have resulted in an abundance of macroprudential
policy tools. Most regulatory tools currently used for banking supervision can be
given a macroprudential twist by relating them to an aggregate indicator of risk or
of state of the cycle. Other tools that have not been heavily used in the past, such as
minimum levels of core funding, have also been proposed as macroprudential.
Even tools typically used for liquidity management, such as the reserve
requirement rate, have been considered as macroprudential because they can tame
domestic credit growth.
The toolkit has also been extended to include capital controls and exchange rate
interventions. The case for using these tools with macroprudential purposes is that
they may help deal with episodes of excessive growth of external borrowing and
misalignment of some key relative prices. Finally, some also propose using the
policy interest rate with macroprudential purposes.
This leads me to the discussion about the institution or institutional setting that
should be in charge of implementing macroprudential policies, and how should
these policies coordinate with other aspects of economic policymaking, such as
monetary and fiscal policy.
There is broad debate around these issues. The role of a country’s central bank
in the implementation of macroprudential policy has been widely discussed. While
there is consensus that central banks should care about financial stability, there is
less agreement on whether they should be exclusively in charge of macroprudential
policy. The main tradeoff is that while they have a systemic view of the financial
system and its interactions with the real economy, the interactions between
macroprudential and monetary policy tools and goals may send confusing signals
to the public. At the end of the day, the existing institutional frameworks have
evolved in a pragmatic manner partly determined by the institutional designs
existing before crisis, and therefore varying from one country to the next.
3. BEING PRUDENT ABOUT MACROPRUDENTIAL
The difficulties in identifying what actually constitute macroprudential policy
means that there is still an important degree of discretion in their setting and
pursuance. Many targets and policy combinations may fall under the
macroprudential umbrella. There is, therefore, the risk that, for the time being, this
situation may become a license to kill for policymakers, justifying the discretionary
implementation of a large number of policy measures with little transparency or
64
accountability. This is especially dangerous for independent central banks, whose
reputation and credibility rely heavily on both.27
In addition to these risks, we cannot forget that macroprudential measures have
costs. The crisis has taught us that mopping after a bust is difficult and costly, but
we still know little about the costs of preventing the bubble from building. The
debate seems to assume that such costs are small. But if these policies constitute
insurance against a ”once in a century credit tsunami”, it is crucial to know if the
insurance is actuarially fairly priced. 28
These considerations are behind our current approach to macroprudential
policies, which I would like to define as being prudent about macroprudential. This
prudence does not mean that we believe the macroprudential approach to financial
regulation is not useful. On the contrary, we think that close monitoring and
understanding of systemic risk is crucial, and that if the need arises we have to act
decisively in order to face those risks. We also think that it is crucial to advance in
reaching a consensus on best practices in the implementation of macroprudential
policies that incorporate the need for transparency and accountability, as well as
advance in establishing the costs of different macroprudential policy combinations.
We are indeed working on several of these fronts. But while we are busy at
work on them, we need to set a high bar for engaging in policies whose impact we
still do not fully understand and whose overly enthusiastic pursuance may send
confusing signals to the public and markets.
4. MACROPRUDENTIAL POLICIES IN CHILE
As I just mentioned, being prudent about macroprudential does not mean that we
do not engage in policies that have an either explicit or implicit macroprudential
nature. Indeed, our central bank has a mandate to preserve the integrity of the
payment system, both domestic and international, and a regulatory role over some
financial operations. We are also part of the Chilean Financial Stability Committee
(CEF) that brings us together with the other financial regulators: the
Superintendency of Banks (SBIF), the Superintendency of Securities and Insurance
(SVS), the Superintendency of Pensions (SP), and the Ministry of Finance. As I
will explain next, many of the actions we have implemented following this
mandate, even before the onset of the crisis, can be seen as falling under the
macroprudential umbrella previously described.
Since 2004 the Central Bank of Chile publishes a semi-annual financial stability
report that tracks and informs the markets of the state of our financial system, and
of the main risks that have developed since the previous report. Given our special
27
For a thorough discussion of the challenges involved in the implementation of financial
stability goals in central banks see Bank of International Settlements (2011)
28
Former Chairman of the Federal Reserve Board, Alan Greenspan coined this term to
refer to the financial crisis in testimony given to the US Congress in October 23, 2008.
65
interest in the payment system, the report focuses naturally, but not exclusively, on
the banking sector. As the banks are at the core of our financial system, they
interact with many other financial agents, such as pension and mutual funds. Thus,
we also monitor and report the main developments and risks faced by these market
players. We also track the behavior of key prices, including not only various
liquidity and lending spreads, but also equity and, recently, real estate prices. As
our financial system has become increasingly complex, we have placed our efforts
on keeping track of this increasing complexity and bringing new market segments,
agents and prices into our analysis. We complement this analysis of the supply side
of financial services with a household financial survey that tracks the financial
position and leverage of Chilean households.
Giving information to market participants about the state of the Chilean
financial system and our perception of the potential buildup of risks in some of its
segments has a macroprudential role. The credibility we have been able to build
over the years in the conduct of monetary policy means that market participants
pay special attention to our reading of the economic conditions, especially in times
of uncertainty. Through our close interaction with regulators, our warnings have
teeth, even though we do not have a direct regulatory role over many financial
institutions. For instance, in our financial stability report of December 2012, we
raised our concern with the evolution of housing prices in Chile and clearly let
market participants know that the trends that had been recently observed should not
be extrapolated into the future. Following this warning we have observed some
tightening of credit conditions in the mortgage market.
In recent years, we have also sporadically intervened in exchange-rate markets
through pre-announced interventions with a fixed amount and a daily schedule of
purchases. We have done so when we have judged our real exchange rate to be
significantly misaligned from its fundamental level and with the goal of
accumulating reserves and dampening exchange rate volatility. Such reserves can
later be used to provide foreign exchange liquidity in times of financial stress.
Thus, the main goal of our interventions in foreign exchange markets may be
interpreted as macroprudential in nature.
In the more distant past we have also intervened using capital controls aimed to
put some “sand in the wheels” of capital inflows, especially on short-term ones.29
Under some of the definitions previously discussed, this measure also has a
macroprudential interpretation. It aims to reduce our exposure to volatile forms of
capital inflows that may end up in a sudden stop, with costly consequences for the
financial and real sectors of our economy. We have not engaged in this type of
controls since 1999, but we are not closed to the option of using them if we
consider that the situation requires it. However, what we learned from our previous
experience is that this type of measure needs to be temporary. The incentives to
29
For a review of Chile’s experience with capital controls see Cowan and De Gregorio
(2005).
66
outmaneuver them are large and eventually the creativity of financial engineers
finds a way around them.
The implementation of policies of macroprudential nature in our country is not
exclusive to the central bank. In the past, the banking regulator has expressed
concern about systemic issues on several occasions. For instance, in the 1990s, the
Chilean banking regulator (SBIF) issued a directive instructing banks to build
provisions for consumer loans based on the payment behavior of the whole banking
system instead of that of each single institution. In the 2000s, the same agency
issued a directive instructing banks to carefully consider the foreign exchange
mismatch of their borrowers in their risk assessments and provisions.30
5. CONCLUSION
We are living in exciting times where a new paradigm for economic policymaking
is rising. In this new paradigm, there are areas of broad consensus, such as the
importance of financial stability and the need for a systemic approach to financial
regulation. But these broad consensuses have yet to translate into shared views
about the goals, operational targets, and preferred tools of macroprudential policy
that may eventually turn into best practices. The scope spanned by all possible
combinations of these elements risks turning macroprudential policy into a catchall
that may be used to justify almost any kind of policy, with the consequent risks to
the reputation and accountability of policymakers. Independent central banks
should be especially wary of these risks.
This does not mean that we should maintain business as usual and not derive
any lesson from the painful experiences of the recent crisis. We should clearly
strengthen our understanding of the linkage among financial system players and
properly assess the importance of systemic risk. Neither should we hesitate to
undertake measures to tackle the buildup of risks based on our best judgment and
the knowledge derived from our improved analysis.
Nonetheless, despite the current diversity of views about macroprudential
policy, I have no doubt that eventually a consensus on best practices in the conduct
of macroprudential policy will emerge. I also believe that we should work hard and
push for discovering and reaching such consensus. But in the meantime we should
be prudent. As much as waiting for certainty in undertaking policies usually leads
to acting too late, acting too early and too broadly has its costs, some of which we
do not fully understand yet. While the evidence is still being collected, it is very
likely that among the diverse views on the concept and implementation of
macroprudential policies, some are likely to be found mistaken and to carry costs
that may outweigh their likely benefits.
30
See Marshall (2012).
67
REFERENCES
Bank for International Settlements (2011), “Central Bank Governance and
Financial Stability”. Available at http://www.bis.org/publ/othp14.htm
Bank of England (2009), “The Role of Macroprudential Policy”. Bank of England
Discussion Paper. Available at
http://www.bankofengland.co.uk/publications/Documents/other/financialstabili
ty/roleofmacroprudentialpolicy091121.pdf
Borio, C. (2011), “Implementing a Macroprudential Framework: Blending
Boldness and Realism”. Capitalism and Society, 6 (1).
Born, B., Ehrmann, M., and M. Fratzscher (2012), “Communicating About MacroPrudential Supervision- A New Challenge for Central Banks”. International
Finance, 15(2), 179-203.
Cowan K., and De Gregorio, J. (2007), “International Borrowing, Capital Controls,
and the Exchange Rate: Lessons from Chile.” In “Capital Controls and Capital
Flows in Emerging Economies: Policies, Practices and Consequences”, 241296. National Bureau of Economic Research.
Galati, G. and R. Moessner. (2011), “Macroprudential Policy – A Literature
Review”. Bank for International Settlements, Working Paper 337.
Group of Thirty. (2010), Enhancing Financial Stability and Resilience:
Macroprudential Policy, Tools, and Systems for the Future. Available online at
http://www.group30.org/images/PDF/Macroprudential_Report_Final.pdf
Hahm, J., Mishkin, F., Shin, H-S., and K. Shin (2012), “Macroprudential Policies
in Open Emerging Economies”. National Bureau of Economic Research,
Working Paper 17780.
Hanson, S., Kashyap, A., and J. Stein (2011), “A Macroprudential Approach to
Financial Regulation.” Journal of Economic Perspectives, 25(1): 3-28.
Marshall, E. (2012), “Implementación de Políticas Macroprudenciales en Chile”.
Documentos de Política Económica 44. Banco Central de Chile.
68
69
BARRY TOPF
I sometimes wonder if conferences of this sort actually contribute anything to
concrete policy making, and I can certainly state that in this case they have,
because I intend to take these cards with me to the next Monetary Committee
meeting—especially this one, and use them liberally (referring to a large card
informing speakers that "time is up" –ed.) The late Andrew Crockett was superb in
summing up sessions, even the ones that were very difficult. Once he was asked
how he did it. He said it was very easy—he didn’t say what they said; he said what
they should have said. Well, our speakers saved me from that task. All I have to do
is review what they said so well, and put some of it together and add a few remarks
of my own very briefly. Claudio Borio presented important evidence on the role of
the financial cycle in macroprudential policy. Governor Honohan focused on the
risks of banking systems which are large in relation to their home country, and also
mentioned that beyond a certain point, financial system growth becomes a risk
factor in and of itself. And Governor Vergara used the Chilean framework to
explain to us some of the risks involved in macroprudential policy. As we have
seen, macroprudential policy is important but also complex—but it’s this very
complexity and crucial importance which make macroprudential policy so
challenging. Success requires integrating areas and operations within the central
bank and outside of it in order to meet common goals effectively. In short: putting
it all together. I would suggest that in a sense it is one of the toughest tests policy
makers would face, a sort of comprehensive exam for central bankers. To succeed,
the central bank must meet multiple goals, using multiple tools, in a dynamic and
risky environment. Now since the precedent has been established to say a few
words personally, I’ll use that. We are talking about success in the central bank;
Karnit spoke about the role of the governor, and we have an expression in Hebrew,
“anyone who tries to add only subtracts”, so I will leave that where it is, but there
are two other points I would like to make when we are talking about success in the
central bank. One is so obvious that it’s often overlooked but I think it deserves a
mention here, and that is having a staff which is up for the tasks. Be it
macroprudential policy, be it monetary policy, supervision, research or anything
else, we here in the Bank of Israel were extremely lucky in having a staff which
was up for the challenges and was great in helping us go through the previous
period so successfully. The other thing that I would recommend, as we have seen in
the first session, we spoke about the limitations of monetary policy and we heard it
again in this session, is that a good degree of modesty is highly recommended. Not
necessarily rewarded but certainly highly recommended in central banking as in
other areas of our lives, and I think we should take this lesson away from
everything we’ve heard today. One thing is certain: we will be tested. Let us hope
we succeed. I would like to thank our speakers and wish everybody an enjoyable
continuation of today’s conference. Thank you very much.
70
71
Introduction of Jacob Frenkel
Stanley Fischer
Jacob has had a remarkable career. I am sure that most of you know a lot
about his role as Governor of the Bank of Israel, but he had significant
achievements well before that.
Jacob and I first met in 1969, at the University of Chicago, when I was a
post-doctoral fellow freshly arrived from MIT, and he was already well
advanced on his thesis. There was a remarkably good class at Chicago
when I arrived, with students primarily in international economics, under
the leadership of Robert Mundell and Harry Johnson. The three students
who later became best-known were Jacob, Rudi Dornbusch and Michael
Mussa, who was Jacob’s successor as Economic Counselor and Head of
Research at the IMF. Jacob and I wrote a few papers together during that
period.
Jacob earned his PhD from Chicago, and then returned to Tel Aviv
University to join the faculty there. Nineteen seventy-three was a point of
some difficulty between Jacob and me: he was invited back to the
University of Chicago as a member of the faculty, and precisely after he
was invited back, I received an offer from MIT and I left Chicago. There
was no causal connection between his arriving and my leaving, but he
keeps asserting that he was what forced me to go to MIT. I deny that, but
confess that later there were two similar coincidences in other institutions,
so my record in his book is not as good as it should be.
Jacob was on the faculty at the University of Chicago for 14 years. He
ended up as the David Rockefeller Professor of International Economics, a
very prestigious chair, and as one of the editors of the Journal of Political
Economy, a very prestigious journal of the University of Chicago, and the
editorship is a great honor for anyone to have held.
In 1987 he was invited to join the IMF to serve as Economic
Counselor—which means chief economist but it sounds much better—and
Head of Research at the IMF, and we overlapped there during the time I
was chief economist at the World Bank. Jacob, I apologize, but I can’t
avoid telling this story. We used to fly together to Paris for meetings of the
OECD. It’s about a six hour flight, and we would start talking. On one
flight, somewhere around three hours into the six hour flight, Jacob says,
“We’ve got a great new sleeping tablet at the IMF. You should take one of
them, and you’ll be able to go to sleep and wake up not feeling tired at all.”
I said, “Jacob, you take the sleeping tablet, and I’ll be able to go to sleep.”
Jacob served at the IMF with distinction, and then after nearly five years
there he was invited back to Israel as Governor of the Bank of Israel,
following Michael Bruno who had had such a critical role first in the
72
stabilization program and then later, as Governor of the Bank of Israel.
Michael was the person who was most responsible for stabilizing the
stabilization.
Jacob inherited the economy as it was then, and served as Governor for
eight and a half years, from 1991 to 2000. Many important things happened
in the economy during that period. Larry Summers has a word which he
uses frequently, which is “consequential”. Jacob was a consequential
Governor, which is to say that there were major consequences of his being
Governor. By the end of his governorship, the inflation rate, which had
been somewhere just below 20 percent when he took office, had declined to
the low single digit range. The crawling-band exchange rate that had been
in place when he took office had been opened in a way that is still worthy
of study. As a result of the crawling band, the Bank had lost control of the
money supply because the exchange rate was pushing on the lower –
appreciated – limit of the band, and the Bank kept having to intervene to
maintain the band. They had no way at that time of sterilizing, and in any
case, did not want to intervene. They opened the band more at its top – the
depreciated level – than at the bottom, the appreciated level. But from that
day on they hardly ever had to intervene again during Jacob’s
governorship: the Israeli exchange rate became flexible, and the Bank after
one intervention in 1998 didn’t have to intervene again until 2008. Further,
capital controls were significantly liberalized, the inflation targeting
approach to monetary policy was set up, and the Israeli capital markets
became much more like the capital markets, particularly the exchange
markets, of more advanced countries.
This was a much more modern economy in its institutional structure and
in other respects as a result of Jacob’s service as Governor of the Bank of
Israel – and I know for sure that much of what we have been able to do in
the Bank of Israel in the last few years has been a result of our ability to
work within a framework behind which, while many contributed to it,
Jacob was the driving force.
Then he left to work in a series of private sector financial institutions,
first Merrill Lynch as chairman of Merrill Lynch International, then AIG,
currently JP Morgan Chase, and in each one he has been a highly valued
member of those private sector organizations.
In addition, he has played a leading role in this mysterious group, the
G30, which sounds like a compromise between the G77 and the G20, but it
isn’t. It’s a private sector group, while all the other G’s are public sector
groups, but it has almost the same prestige as those public sector groups.
It’s a group of formers, and some currents—former Governors, former
finance ministers, and so forth—which meets to discuss the situation in the
global economy 2 or 3 times a year. Its meetings are among the most
interesting and important I have the privilege of attending each year.
Jacob became Chairman and CEO of the G30 in 2001. Previous
Chairmen and CEOs of the G30 were Gordon Richardson, the former
Governor of the Bank of England, Paul Volcker, and then Jacob. Jacob
filled that role for 10 years, made sure that the G30 remained a vibrant and
interesting institution, and has now graduated to become Chairman of the
Board of Trustees of the G30. Jean-Claude Trichet has taken the job that
Jacob had as Chairman and CEO, which is a measure of the prestige Jacob
has in the international economy.
Throughout all these activities abroad, he has been in Israel a significant
part of the time, he has never cut his ties with Israel, never lost his interest
in, and willingness to help, the State of Israel in a variety of ways, and he
has done that also in an exemplary way. Most recently he has accepted to
become Chair of the Board of Governors of Tel Aviv University, an
important position in an important university in Israel, which has had a
difficult time during the difficult financial times everybody’s gone through.
Jacob will have a big role which I am sure he will fulfill extremely well in
helping maintain and strengthen that important Israeli institution of higher
learning.
Jacob, for everything you’ve done, and for a very long friendship, I
thank you, and I’m very happy to present you as one of our three keynote
speakers of the day.
73
74
75
INFLATION TARGETING, DISINFLATION AND EXCHANGE RATE
POLICY: THE ISRAELI EXPERIENCE
JACOB A. FRENKEL
INTRODUCTION
This is a very special event commemorating the New Bank of Israel. During the
past eight years, under the skillful leadership of Professor Stanley Fischer, the
Bank of Israel has played a central role in navigating the Israeli economy and in
contributing to its outstanding performance. Now, as we get close to the end of
Professor Fischer’s term as Governor of the Bank of Israel, it is very appropriate to
celebrate the great achievements of the Bank and take stock of its contributions. It
is difficult to exaggerate the extraordinary contribution that was made by Professor
Fischer. The new Law of the Bank of Israel, the modern internal governance of the
Bank, its domestic and international prestige, the intellectual leadership of the
Bank, and of course, the outstanding performance of the Israeli economy, all reflect
Professor Fischer’s dedicated stewardship, and for that we all owe him an immense
debt. As a former Governor of the Bank of Israel and as a very close friend and
colleague of Professor Fischer for forty-four years, I feel especially privileged to
take part in this special conference. Over the years, the Bank of Israel has
established a great tradition anchored in high professionalism and commitment. It
was able to continuously modernize and rejuvenate itself so as to keep up with the
frontiers of the “art of central banking”. For maintaining this great tradition and for
lifting the Bank to new heights, Professor Fischer deserves great credit and deep
gratitude and appreciation.
The organizers of this Conference have suggested that I provide an overview of
the experience of the first ten years of inflation targeting in Israel, and draw some
of the general lessons. I am delighted to do so, and to share with the audience some
of my own experience with the introduction and implementation of inflation
targeting in Israel during the decade 1991-2000. My presentation of the Israeli
experience aims at drawing some general analytical and practical principles that
can be applicable to other experiences and that are relevant for the subject of
inflation targeting, disinflation, and exchange rate policy. By doing so I would also
like to pay tribute to the Bank of Israel and its Governor, Professor Stanley Fischer.
STABILIZATION AND THE ROAD TO DISINFLATION
As background, it would be worthwhile to discuss the situation prevailing in the
Israeli economy almost 30 years ago. At that time, in the mid-1980s, Israel suffered
from very high inflation, which reached about 450 percent per year. During that

Chairman, JPMorgan Chase International, Former Governor of the Bank of Israel.
76
period, Brazil and Argentina also suffered from hyperinflation, and these three
countries launched a very similar stabilization program that was based initially on
the nominal exchange rate as a key nominal anchor. The success of the Israeli
stabilization program reflected the fact that, in addition to relying on the nominal
exchange-rate anchor, Israel adopted fundamental macroeconomic adjustments,
which included, in particular, a drastic cut in the budget. The lack of such drastic
budget correction in other stabilization programs resulted in their demise.
As a result, the rate of inflation declined very rapidly from about 450 percent in
1984 to 20 percent in 1986. Following this initial success, the annual rate of
inflation remained (or was “stuck”) at around 18 percent until 1991 (Figure 1).
While this achievement was hailed at the time as a great success, it still left Israel
with an inflation rate that exceeded significantly the rates of inflation prevailing in
much of the industrialized world. As a result, given the fixity of the exchange rate,
this inflation differential between Israel and the rest of the world resulted in a
continuous loss of Israel’s international competitiveness. Obviously, that reality
created a non-sustainable situation. It became clear that in order to arrest the
continuous erosion of competitiveness and restore a more sustainable situation,
Israel’s rate of inflation had to be reduced to international levels, or alternatively
the exchange rate would have had to be adjusted continuously in order to reflect
inflationary differentials. Thus, a policy adjustment had to take place.
Figure 1: The rate of inflation
(percent)
445
450
400
350
300
250
191
200
150
133
185
132
102
9
11
15
8
11
7
9
1.3
0
1.4
1999
2000
2001
18
1998
18
1997
21
1996
17
1995
16
1994
20
1993
50
1992
100
Note: Data for 2001 refers to November.
Source: Bank of Israel.
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
0
77
The reference made earlier to the role that was played by the dramatic cut in the
budget during the stabilization program highlights the fact that a successful
stabilization and disinflation program must be framed within the broad context of
macroeconomic policy. A narrower framework that focuses only on the role of
monetary policy without paying due regards to other policy instruments is bound to
yield unsatisfactory results. Indeed, the non-sustainability that resulted from
attempting to maintain a fixed exchange rate in the presence of a significant gap
between domestic and foreign inflation, manifested itself in other parts of the
macroeconomic system. For example, by the mid-1990s the deficit in the current
account of the balance of payments (as a percent of Gross Domestic Product, GDP)
rose to non-sustainable levels, reaching 5.9 percent in 1995 (Figure 2). Normally, a
country suffering from the inconsistencies associated with the combination of high
inflation, fixed exchange rate, and large current account deficit, in penalized by the
international capital markets that make the continuation of such inconsistencies
nonfeasible. During that period, however, Israel was able to maintain these
inconsistencies since it kept the capital account of the balance of payments
practically closed. At the time, Israel had strict foreign exchange controls, the
foreign exchange market was underdeveloped and, as a result, the discipline, which
is normally exerted through world capital markets, was absent. Thus, during the
first half of the 1990s, Israel’s “success” in escaping the discipline exerted by the
international capital markets was achieved at the cost of not having the full benefits
Figure 2: Current account deficit
(as a percent of GDP)
7
5.9
6
5.6
5
4.5
4
3.6
3.6
3
2.1
1.9
2
1.3
1.3
1.0
1
0
-0.3
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
-1
78
that could have been obtained through a deeper and a more complete integration
into the ever growing world capital markets. This situation changed in the second
half of the 1990s.
Figure 3 shows the composition of Israel’s international transactions. As may be
seen, until the middle of the decade, practically all of the international transactions
took place in the current account of the balance of payments. In contrast, during the
second half of the 1990s, Israel implemented a more comprehensive program of
liberalization of its international capital transactions: the capital account of the
balance of payments was opened up and liberalized, and foreign exchange controls
were removed. As a result, along with the increased international convertibility of
the Israeli currency, the composition of the international transactions changed
dramatically and most of the transactions shifted to the capital account of the
balance of payments. In other words, the capital account has become more and
more active and, thereby, the judgment of the markets has become much more
prominent and immediate. The dictum that “capital markets carry a continuous
referendum on the conduct of policies” has become a reality. With this new reality,
the tolerance of the markets for excessively large current account deficits and for
excessively high inflation has diminished. As a result, markets have regained their
usefulness in exerting a more effective disciplinary role. This development has
served as a potent catalyst for directing attention to, and increasing urgency of,
exerting a more vigorous disinflation effort aimed at reducing inflation to world
levels. The strategy that was chosen to bring about the disinflation process has been
the inflation targeting strategy.
Figure 3: Foreign exchange transactions: capital versus trade flows*
(percent of total)
120
$4 billion dollars
$9 billion dollars
100
38
80
60
104
40
62
20
0
-4
Capital transaction
Trade transaction
-20
January/1989-March/1995
March/1995-March/2000
* The sum above the columns indicates average cumulative change in transactions p.a.
including unilateral transfers.
79
EXCHANGE RATE POLICY
The fixed exchange rate
This section addresses the role played by the exchange rate in the early stages of
the stabilization program. Figure 4 illustrates the role of the nominal exchange rate.
Initially, for about the first 18 months, the U.S. dollar served as the nominal
anchor. During that period, the U.S. dollar depreciated with respect to other major
currencies while the Israeli currency was pegged to the U.S. dollar. As a result,
Israel’s “trade weighted basket” has gained competitiveness in spite of the fact that
Israel’s inflation rate exceeded the corresponding inflation rate of Israel’s trading
partners. As illustrated in Figure 4, in 1987 Israel shifted from pegging its currency
to the U.S. dollar towards pegging it to the trade–weighted basket of currencies.
That situation held for a while but, before long, it became evident that the fixity of
the exchange rate coupled with the significant differentials that prevailed between
domestic and international rates of inflation continued to erode competitiveness.
Thus, the non-sustainability of the situation re-emerged and the search for a new
exchange-rate regime got underway.
Figure 4: Shekel exchange rate versus basket & USD
(July 1985 - May 1989, NIS per unit of basket & USD)
2.1
Band
2.0
3%
Adjustment of
8% in the basket
1.9
3%
1.8
1.7
10%
1.6
1.5
1.4
Shekels vs U.S. dollar
Shekels vs basket
1.3
1.2
III
IV
I
II
1985
III
1986
IV
I
II
1987
III
IV
I
II
1988
III
IV
I
II
1989
80
The horizontal exchange-rate band
The search for the new exchange-rate system led to the adoption of a new exchange
rate regime that was based on a band. Within the band, the exchange rate was
allowed to fluctuate, though the boundaries of the band set a strict limit to the
permissible degree of flexibility. These efforts of introducing some degree of
flexibility into the determination of the exchange rate reflected the belief that the
very introduction of potential exchange-rate flexibility would mitigate the intrinsic
inconsistency associated with the maintenance of a fixed exchange rate under
circumstances in which the domestic rate of inflation exceeds the foreign rate.
However, the new exchange-rate band has not solved the problem and the
challenge of non-sustainability prevailed. For, as long as the domestic rate of
inflation exceeds the corresponding foreign rate, the mere existence of an
exchange-rate band does not remove the basic difficulty. Within the band, the
exchange rate is subject to continuous market pressures for depreciation and, as a
result, it tends to move towards the top of the permissible band. In order to prevent
depreciation to levels beyond the permissible band, the authorities need to
intervene in the market for foreign exchange, and non-sustainability of the fixed
exchange-rate system reemerges.
This phenomenon is illustrated in Figures 5 and 6, which describe the actual
experience. The figures reveal how, due to market pressures, the exchange rate
band had to be shifted upwards repeatedly reflecting the ongoing mounting
pressure for a depreciation of the currency. The pressure for depreciation was the
natural and the inevitable consequence of the continuous gap between domestic
and foreign inflation. As long as the magnitudes of the two boundaries (and
especially of the upper boundary) of the exchange-rate band remain fixed, and as
long as domestic inflation exceeds the foreign one, the mere existence of the band
does not alleviate the basic difficulty characterizing the fixed exchange-rate
regime. The policy of allowing an occasional upward displacement of the
exchange-rate band, which was aimed at restoring sustainability, did not achieve its
objective. In fact, the repeated upward displacement of the exchange-rate band
induced speculation and uncertainty as to the timing and magnitude of the next
adjustment of the band. Everyone realized that as long as there was a gap between
domestic and foreign inflation, the exchange-rate band could not last for too long,
and the nominal exchange rate was expected to depreciate continuously and move
towards the upper boundary of the band. Towards the end of 1991 the nonsustainability became more and more evident. With it started the renewed search
for an alternative exchange-rate system that would be more sustainable while at the
same time would accompany and support the disinflation process.
81
Figure 5: Shekel exchange rate versus basket
(January 1989 - December 1990, NIS per unit of basket)
Shift in band
10%
mid-point:
2.4
Band
2.3
Shift in band
mid-point:
6%
2.2
Shift in band
mid-point:
Band
-5%
+3%
6%
2.1
+5%
Band
-3%
2.0
+3%
-3%
1.9
1.8
I
II
III
IV
I
II
1989
III
IV
1990
(March 1990 - June 1992, NIS per unit of basket)
2.8
2.7
Band
2.6
Shift in band
mid-point:
10%
2.5
2.4
Band
Shift in band
mid-point:
5%
+5%
-5%
+5%
-5%
2.3
+5%
2.2
-5%
2.1
2.0
1.9
1.8
II
III
1990
IV
I
II
III
1991
IV
I
II
1992
82
The sloped exchange-rate band
At the end of 1991, Israel adapted a new exchange-rate regime: the sloped
exchange-rate band, also referred to as the “diagonal exchange-rate regime”.
Accordingly, the exchange rate band, which up to that point in time was horizontal,
became upward slopping. The idea behind the design of the sloped exchange-rate
band was to allow for a continuous rise in the boundaries within which the actual
exchange rate can vary. The slope of the band embodied the newly adopted
inflation targets. The slope was designed to reflect the expected inflation
differential between Israel and the rest of the world that is implied by the inflation
target. For example, during 1991 the rate of inflation was 18 percent; the targeted
inflation for 1992 was 14 percent while foreign inflation was projected to be 5
percent. With these data the slope of the exchange-rate band was set to equal 9
percent. The logic of this determination was that an exchange-rate band that
exhibits an upwards slope of 9 percent, reflects the gap between the target rate of
domestic inflation (14 percent) and the projected foreign rate of inflation (5
percent). This construction removed the non-sustainability that was associated with
the horizontal exchange-rate band as the latter ignored the projected gap between
domestic and foreign inflation. Thus, a slope of 9 percent corresponds to the
difference between projected domestic inflation (14 percent) and the projected
foreign rate (5 percent).
The idea in the design of the sloped exchange-rate band was that after each
period of time (say one year), a new and a more ambitious inflation target would be
set and, with it, the projected gap between domestic and foreign inflation would
diminish. Associated with such a narrowing of the projected inflation gap would be
a less slopped exchange-rate band. The important point to note is that in the Israeli
context the slope of the exchange rate band was set with a forward-looking
perspective. This unique perspective contrasts with the design of the Chilean
exchange rate band whose slope was set with a backward looking perspective (so
as to compensate for a past differential between the rate of inflation in Chile and
the corresponding rate abroad). The forward-looking perspective governing the
slope of the exchange-rate band in Israel, contributed significantly to the formation
of the inflation-targets strategy. It transformed the policy debate from focusing on
the exchange rate towards focusing on reducing inflation. Thus, the subject of
exchange-rate policy left the center stage and gave way to the subject of inflationtarget policy. At that stage of the evolution of the policy debate the exchange-rate
band still played a prominent role, but the slope of the band was set to be consistent
with the inflation target. From that point onward, the focus of monetary policy
shifted from being guided by exchange-rate objectives towards being guided by
inflation objectives.
Figures 7 and 8 describe the evolution of the sloped exchange-rate band
throughout the decade of the 1990s. As may be seen, over time, the slope of the
band got flatter and flatter, reflecting the progress that was made in the disinflation
process. Throughout that period the actual exchange rate moved within the
83
widened band. From time to time when a new slope was announced the band itself
was allowed to be adjusted upwards. Such upward displacements of the entire band
typically accompanied once-and-for-all policy measures which removed
distortions, or reduced protectionist measures, or advanced one more step in the
direction of opening up the capital account.
Figure 7: Shekel exchange rate versus the basket
(Early 1992 - June 1994, NIS per unit of basket)
3.6
3.5
6% slope
3.4
+5%
3.3
-5%
3.2
8% slope
3.1
+5%
Band with
9% slope
3.0
-5%
2.9
+5%
2.8
-5%
2.7
2.6
2.5
2.4
I
II
III
IV
I
1992
II
III
IV
I
1993
II
1994
(July 1994 - January 2001, NIS per unit of basket)
5.4
6% slope
4.9
4.4
6% slope
3.9
2% slope
+7%
4% slope
3.4
+5%
-7%
-5%
2.9
III IV
1994
I II III IV I II III IV I II III IV I II III IV
1995
1996
1997
1998
I II III IV
1999
I II III IV
2000
I
84
The natural consequence of adopting the policy which allowed for an everwidening exchange-rate band was the reduced relevance of the formal exchangerate band. As the band got wider, its relevance for the daily determination of the
rate of exchange diminished while, at the same time, the degree of exchange-rate
flexibility increased. In fact, from 1998 onwards, foreign exchange controls have
been eliminated, foreign exchange intervention vanished, and the exchange-rate
system has played practically no role in the operation of the inflation-targets
strategy. The events in 1998 have stimulated this outcome.
As is well known, no country can adopt an exchange-rate policy and a monetary
policy that are independent of each other. This constraint on the degrees of freedom
that policy makers have, becomes more and pronounced, the more open the capital
account of the balance of payment is. Accordingly, by the mid-1990s, with the
gradual opening of the capital account and with the gradual removal of foreign
exchange control, the conflict between exchange-rate target (as imbedded in the
exchange-rate band) and the inflation target has become more and more
pronounced. It became clear that at some point in time the choice would need to be
made between having an exchange rate objective and having an inflation target.
The moment of truth occurred in the summer of 1998. At that time, emerging
markets all over the world faced unprecedented challenges. Russia declared a
unilateral default on its debt, the large hedge fund LTCM (Long Term Capital)
went under, and world capital markets exhibited a high degree of stress. Investors
attempted to unload their holdings of emerging market assets and return to their
“safe haven”.
As a result, the currencies of practically all emerging markets underwent a very
sharp and rapid depreciation. Monetary authorities all over the world faced a
critical choice: should they attempt to intervene in the foreign exchange market in
order to prevent the sharp depreciation of their currency or should they allow the
depreciation of the currency to take place and risk the danger of accelerated
inflation. The choice was not simple. On the one hand, history is littered with
examples of failed foreign exchange interventions which resulted in the monetary
authorities suffering huge losses of foreign exchange reserves and with lost
credibility. On the other hand, if the monetary authority decides not to intervene in
the foreign-exchange market, the challenge that it faces in combating the
inflationary consequences of a large depreciation of the currency is also not simple
as it may require a very significant rise in rate of interest.
In the wake of the emerging markets crisis of the summer of 1998, the Bank of
Israel faced a very similar dilemma. In that context the Bank’s decision was clear
cut. We reached the conclusion that foreign exchange intervention would be futile
and ineffective. As a result we decided to allow the exchange rate to find its own
equilibrium in the market place. At the same time, we decided to raise interest rates
very dramatically in order to offset the inflationary consequences of the currency
depreciation. It is important to emphasize that the rise in the rate of interest was not
designed to prevent the depreciation of the currency; rather, it was designed to
85
prevent the inflationary consequences of the currency depreciation. This episode is
shown in figure 9.
(January 1997 - January 2002, NIS per unit of basket)
5.5
44.0%
Slope 6%
5.0
4.5
Slope 6%
+7%
4.0
Slope 2%
-7%
Slope 0%
Slope 4%
Slope 6%
3.5
I
II
III
IV I
1997
II
III
1998
IV
I
II
III
1999
IV
I
II III
2000
IV
I
II
III
2001
IV
I
2002
The decision not to intervene in the foreign exchange market laid the foundation
for the rapid development of that market. Up to that point in time, the Bank of
Israel was expected to be one of the key players in the foreign exchange market. As
a result, one of the most important roles of that market—the pricing of foreign
exchange-rate risk—was distorted. The continuous presence of the Bank of Israel
in the foreign-exchange market reduced the incentives of market participants to
develop sophisticated financial instruments designed to deal with foreign exchange
risk. As a result, the volume of transactions in the forward and futures market as
well as in the market for foreign exchange options was very low. Market
participants assumed, at least implicitly, that when the need arises the Central Bank
would step in and mitigate sharp changes in the exchange rate; thus, the exchangerate risk, as perceived by the private sector, was deemed to be relatively low. All
this was changed dramatically following the Bank of Israel’s decision on
intervention in the foreign exchange market during the emerging markets crisis of
1998. Once it became clear that the Bank of Israel was not going to step in and
assume the exchange-rate risk, the incentives for developing the appropriate
financial instruments required to help the private sector deal with foreign exchange
risk were in place. The developments of such instruments improved the efficient
functioning of the market and, thereby, facilitated the functioning of the flexible
exchange-rate regime. Figure 10 shows the resulting growth in trade in options and
86
futures as a share of total foreign exchange transactions. With the passage of time
this share has increased further, and by now a very significant proportion of foreign
exchange transactions is conducted in the options and futures market.
Figure 10: Trade in options and futures as a share of total foreign
exchange transactions
25%
20%
Exponential trend
15%
10%
5%
Moving average
0%
Jul - 94
Jan - 95
Jul - 95
Jan - 96
Jul - 96
Jan - 97
Jul - 97
Jan - 98
Jul - 98
Jan - 99
Jul - 99
Note: Incl. TA Stock Exchange.
We conclude this section by recalling the evolving role that exchange rates have
played in the disinflation process. Initially, the nominal exchange rate has served as
the nominal anchor for stabilization. The pegged exchange rate was first set in
terms of the U.S. dollar and later in terms of a basket of currencies. Subsequently,
the exchange rate was allowed to vary within a horizontal band. In the next phase,
with the adoption of inflation targeting, the exchange rate was allowed to vary
within an upward sloping band, the slope of which reflected the inflation target.
The gradual opening up of the capital account of the balance of payments
necessitated an ever widening of the exchange-rate band, while the continuous
progress in reducing inflation resulted in a diminished slope of the band. Finally, as
the capital account was opened, foreign exchange intervention ceased, the
exchange-rate band was abolished and the exchange-rate system was transformed
into a flexible exchange rate régime.
This process was accompanied by a systematic development of a wellfunctioning foreign exchange market which, over time, became wider and deeper.
The determination of the exchange rate was left entirely to the market place, and
the maturity and depth of the foreign exchange market enabled the private sector to
87
deal appropriately with the foreign exchange risk while efficiently employing the
appropriate financial instruments.
These developments enabled monetary policy to sharpen its focus on reducing
inflation and, subsequently, on achieving and maintaining price stability.
MONETARY POLICY AND INFLATION TARGETING
This section presents some of the conceptual and technical issues associated with
the conduct of monetary policy under inflation targeting during the process of
disinflation. As background, it is relevant to note the special role that inflationary
expectations play in the conduct of monetary policy.
Inflationary expectations
Prior to adopting the disinflation policy, Israel suffered for many years from high
inflation. As a result, both the government and the private sector developed
numerous indexation schemes, and many indexed financial instruments got
developed. A large proportion of government borrowing was conducted by using
indexed bonds, and a large proportion of wage contracts were also indexed.
Typically, this indexation used the consumer price index (CPI) as the benchmark.
With the passage of time, especially as the disinflation process progressed, two
types of government bonds were traded side by side: indexed and non-indexed
bonds. Market participants as well as the Bank of Israel have viewed the yield
differential between indexed and non-indexed bonds as a proxy for inflationary
expectations. This market measure of inflationary expectations is determined every
day, and is widely accessible and widely known to market participants. The Bank
of Israel has employed this market measure (and a few variations thereof) as a
gauge for assessing market expectations about the future course of inflation and
about the future course of policy.
To gain insight into the characteristics of this inflation expectations indicator,
Figure 11 describes its evolution in the later part of the 1990s; also shown is
another measure of expectations constructed as an average of various forecasts. It
is instructive to focus on the later part of 1998, the period around the emerging
markets crisis. Recall that during that period the currency depreciated significantly
(Figure 9). Associated with this sharp currency depreciation there was a record rise
in inflationary expectations. As seen in Figure 11, inflationary expectations rose by
more than 4 percentage points (from 4.3 percent to 8.6 percent in one measure of
expectations and from 3.3 percent to 7.7 percent in another measure of
expectations). This sharp rise in inflationary expectations posed a real danger to
stability, as it threatened to derail and damage the credibility of the entire
disinflation strategy.
88
Figure 11: Inflation expectations indicators
(percent)
10
8.6
8.4
8
7.7
6
4.3
3.7
4
3.5
3.3
2.5
2.7
2
Capital markets
1.6
1.5
Average forecasters
Oct-01
Jun-01
Feb-01
Oct-00
Jun-00
Feb-00
Oct-99
Jun-99
Feb-99
Oct-98
Jun-98
Feb-98
Oct-97
Jun-97
0
The sharp rise in inflationary expectations reflected the fact that the legacy of
the past high inflation was still deeply rooted in the psychology of market
participants. Against this background, the Bank of Israel reached the conclusion
that a dramatic move was necessary in order to arrest this deterioration.
Accordingly, the Bank raised its interest rate by 400 basis points—an
unprecedented magnitude. We explained to the public that the purpose of the sharp
rise in interest rate was to prevent the adverse inflationary consequences of the
sharp depreciation of the currency. We also indicated that this rise in interest rates
could be gradually reversed once inflation returns to the target range, and once the
rise in inflationary expectations is reversed so as to indicate that future inflation is
likely to return to its target range. The results of this policy measure were dramatic.
Immediately, as seen in Figure 11, inflationary expectations reversed their course
and started to decline. At the same time, as seen in Figure 9, the sharp depreciation
of the currency also reversed its course and the currency started to appreciate. The
crisis was averted, the creditability of the inflation targeting strategy was
reestablished and the stage was set for a further decline in inflation.
Monetary policy, inflation targets and the rate of inflation
The extraordinarily rapid transmission mechanism of monetary policy is exhibited
in Figure 12 which shows the monthly inflation rates prevailing during that
episode. As may be seen, during the period of July 1997 through August of 1998,
the average monthly rate of inflation was 0.3 percent, reflecting a very significant
89
progress of the disinflation process. The sharp depreciation of the currency during
the emerging markets crisis translated itself into a very sharp rise in the monthly
price index. The price index rose in one month by 1.4 percent and rose by a further
3.0 percent in the subsequent month. There was a real danger that these steep rises
in the price index, which in principle should be once-and-for-all rises, would feed
themselves into rising inflationary expectations, which, in turn, would be
transformed into a more permanent rise in the rate of inflation.
Figure 12: Change in the monthly CPI
(percent)
3.5
3.0
3.0
Ave. 7/97 to 8/98:
0.3%
2.5
Ave. 12/98 to 11/01:
0.1%
2.0
1.4
1.5
1.4
1.2
1.3
1.0
0.9
1.0
0.5
0.4
0.4
0.3
0.7
0.5 0.5
0.3 0.3
0.5
0.9
0.6
0.5
0.40.4
0.3
0.1
0.3
0.1
0.0
0.0
-0.1
-0.3
-0.4
-0.5
-0.1
-0.2
-0.2
-0.2
-0.1
-0.2
-0.5
-0.5
-0.6
-0.6
-0.6
Jan-01
Oct-00
Jul-00
Apr-00
Jan-00
Oct-99
Jul-99
Apr-99
Oct-98
Jul-98
Apr-98
Jan-98
Oct-97
Jul-97
Jan-99
-0.8
-1.0
The sharp policy response of raising interest rates by 400 basis points paid off
very rapidly. As seen in Figure 12, the monthly price index responded
immediately. During the first few months following the rise in interest rates, the
monthly rates of inflation were negative and, thereafter, from December 1998
onwards, the average monthly rate of inflation converged to 0.1 percent. In
retrospect, it seems that this episode was the turning point. The decisive monetary
policy response broke the back of inflation and paved the way to achieving price
stability. In fact, from 1999 onwards, the rate of inflation in Israel has not exceeded
3 percent per year. Accordingly, in 1999, the disinflation process reached its
successful conclusion and the economy started to enjoy the benefits of price
stability. From that point onwards, the objective of reducing inflation with the aid
of inflation targets was replaced by the objective of maintaining stability.
90
Figure 13 presents the summary evolution of the rate of inflation for the entire
disinflation period. As may be seen, during the five years (1986–1991) following
the stabilization program of 1985, the average annual rate of inflation was 18.1
percent. At that stage, the inflation targeting strategy was adopted. During the
1990s, with the inflation targeting strategy in place, the average rate of inflation
declined and, by the end of the decade, price stability was achieved.
Figure 13: Change in the annual CPI
(percent)
20
18.1
18
16
14
12
10.8
10
7.8
8
6
4
1.4
1.3
2
0.0
0
1986-1991
1992- 1996
1997- 1998
1999
2000
2001
* Note: Data for 2001 refers to November 2001.
The evolution of the rate of inflation is shown in Figure 14. Also included in the
figure are the ranges of the inflation targets corresponding to the various years. As
seen, the path of the rate of inflation exhibits a downward trend which is generally
consistent with the downward trend of the inflation targets. It is noteworthy,
however, that the close association between these two trends did not always hold
on a year by year basis. In some years actual inflation missed the target range, but
this deviation was then corrected during the subsequent year.
The lessons to be drawn from this experience are that it is better to set the
inflation target as a range, rather than setting it as a precise numerical value. This
reflects the reality that, generally, monetary policy cannot determine with absolute
certainty the exact numerical value of future inflation, and it makes little sense to
pretend otherwise by setting targets that are likely to be missed. Furthermore, it is
preferable to set the inflation target within a multi-year framework, rather than
setting it separately for each year. The multi-year setting enables policy makers to
correct deviations over time and thereby smooth the relevant adjustments. In
contrast, having a single year target may require correcting deviations within a very
91
short period of time and thereby may necessitate too sharp and too costly
adjustments. In addition, the multi-year setting reflects the lags that are known to
exist between the timing of policy actions and the timing of their results. Multiyear frameworks also provide incentives to market participants to view and
consider monetary policy within a medium-term perspective, which is the more
appropriate time frame.
Figure 14: Inflation rate* and the inflation target
(percent)
25
20
Inflation rate
Upper target
Lower target
14.5
15
11.0
10.0
10
10.0
10.0
8.0
7.0
5
4.0
4.0
3.5
3.0
3.0
3.0
2.5
0
1991
2.0
1.0
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
* Previous 12 months.
Monetary policy and inflationary expectations
Earlier, we highlighted the role that inflationary expectations play in the conduct of
monetary policy. This link between monetary policy and expectations is a two-way
link. On the one hand, changes in expectations influence the conduct of policies
and, on the other hand, changes in policies influence expectations. Figure 15
demonstrates the interaction between expectations and monetary policy. As may be
seen, until 1998 inflationary expectations followed a downward trend, reaching the
level of 4.2 percent in mid-1998. At the same time, the path of the nominal rate of
interest also followed a downward trend. In comparing these two paths, it is
important to emphasize that the path of the rate of interest lagged behind the path
of expectations rather than led it. The sharp jump in inflationary expectations that
occurred in the later part of 1998 (from 4.2 percent to 8.6 percent) induced the
Bank of Israel to respond by a sharp rise in the nominal rate of interest from (9.5
percent to 13 percent). As is seen in Figure 15, this sharp policy response brought
about a reversal in the path of inflationary expectations which have now resumed
their downward trend. That reduction in inflationary expectations enabled the Bank
of Israel to lower gradually the nominal rate of interest.
92
Figure 15: The Bank of Israel monthly interest rate and inflation expectations
(percent)
18
17.0
Bank of Israel interest rate
Inflation expectatitions
16
13.5
13.4
14
12.6
11.5
12
9.9
10
9.3
9.5
8.7
7.7
8
6.3
6.0
6
3.8
4.2
4
3.5
2.9
2
1.6
0.8
0
1996
1997
1998
1999
2000
2001
2002
In considering the reduction in the nominal rate of interest, it is important to
emphasize that the pace and magnitude of this reduction were slower and smaller
than the pace and magnitude of the reduction in inflationary expectations. As a
result, the level of real interest rates remained relatively high. The Bank of Israel
allowed for a gradual reduction in the real rate of interest only after a significant
period of time, when it became clear that the fight against inflation succeeds and
that the levels of inflationary expectations reflect the belief that the reduction in
inflation is likely to stay.
The interaction between the rate of interest and inflationary expectations is
illustrated in Figure 16. It shows that following the emerging markets crisis of
1998, the real rates of interest were kept at levels which were relatively stable and
relatively high. At the same time, throughout that period, the Bank of Israel
lowered the levels of the nominal rates of interest in view of the progress achieved
in the disinflation process.
93
Figure 16: Bank of Israel interest rate - in nominal and expected real terms
(percent)
18
17.0
Bank of Israel nominal interest rate
16
Expected real interest rate *
14.0
13.4
14
13.5
11.5
12
9.3
10
9.5
8.5
8
7.0
6.3
6.0
6
6.0
3.8
4
2
3.2
2.5
2.9
2.2
1.3
0
1996
1997
1998
1999
2000
2001
2002
* Expected real interest rate = effective Bank of Israel interest rate adjusted for inflation
expectations.
One of the benefits obtained by the successful disinflation process has been the
enhanced credibility of monetary policy. Market participants have taken the
inflation targets seriously because they knew that the monetary authority takes
these targets seriously. As a result, the announced inflation targets which gained
credibility started to be incorporated by the business sector into their pricing
strategies and wage contracts. The enhanced credibility of the inflation targets
impacted on the relationship between changes in the nominal exchange rate and the
associated changes in domestic prices, and resulted in a significant departure from
the past. In the past, during the high inflation period, every nominal depreciation of
the currency was immediately transformed into a corresponding rise in the price
level and, as a result, nominal depreciations have not been translated into real
depreciations. Consequently, the exchange rate could not be relied upon to
influence international competitiveness. With the reduction of the rate of inflation
and with the enhanced credibility of the inflation target, a nominal depreciation of
the currency was no longer expected to result automatically in higher prices and
cost. For market participants knew that if they attempted to mark up prices
according to changes of the exchange rate, the monetary authority would respond
by altering interest rates so as to insure that inflation stays within the inflation
target range. As a result, the path of the nominal exchange rate and the path of
inflation got disconnected. In other words, the pass-through from exchange rate
94
changes to domestic inflation has been broken. This phenomenon is illustrated in
Figure 17 which shows the disconnect between the path of the exchange rate
changes and the path of the differential between domestic and foreign inflation.
Thus, during that period the nominal depreciation of the currency transformed itself
into a real depreciation and was not eroded by an accelerated inflation.
Figure 17: NIS depreciation & CPI differential with US
(cumulative since January 1997)
135
129.7
129.2
130
130.1
127.8
125
122.0
120
Depreciation
Inflation differential
115
112.1
110
108.5
107.1
109.7
108.0
105.7
105
100
1997
105.4
1998
1999
2000
2001
The success of the inflation targeting strategy in reducing inflation and in
bringing about price stability has also paid off in terms of the rating of the Israeli
economy by the international rating agencies. The improved rating that was
associated with the successful disinflation process improved the positioning of
Israel in the international capital markets. Figure 18 shows the continuous
improvement in the rating of the Israeli economy that occurred during the relevant
period. In general, the level of international rating has been inversely related to the
rate of inflation. Namely, a lower rate of inflation was typically associated with an
improved rating. This phenomenon is shown in Figure 19.
95
Figure 18: Israel’s international credit ratings
Figure 19: International credit rating and inflation
(1986 to 1999)
1.6
Israel's rating / sample average
1.5
1.4
1999
1997
1.3
1998
1996
1994
1995
1.2
1993
1.1
1992
1
1991
1990
1989
1988
0.9
1987
0.8
1986
0.7
1
6
11
Inflation
Increase = improvement relative to sample (about 100 countries).
Source: Institutional Investor, semi-annual survey.
16
21
96
The output cost of disinflation
The Israeli disinflation process under the inflation targeting regime spanned the
entire decade of the 1990’s. Questions concerning the feasibility and desirability of
a vigorous application of the disinflation effort were the subject of heated debate.
This debate involved politicians, business leaders, academics, journalists and
ordinary citizens. One of the important questions was whether the effort to reduce
inflation would exert a significant cost on the Israeli economy and, in particular,
whether it would entail a significant recession that is associated with a rise in
unemployment. In retrospect, it seems that the cost in terms of economic growth
has been limited and confined to a relatively brief period. Figure 20 describes the
rate of growth of GDP during the decade. As can be seen, the slowdown was
mostly pronounced during the years 1998-1999 but it was short-lived. Once price
stability was achieved by the end of the decade, economic growth resumed and
reached 6 percent during the year 2000.
Figure 20: Growth rate of GDP
(percent)
8
7.1
7
6.4
6.5
6
2.6
2.7
5
4
4.3
5.0
6.0
3.7
2.5
3
2.4
2.7
2
1
2.4
3.3
4.5
3.8
2.5
2.1
2.3
2.5
1.0
2.4
2.4
0.0
-0.1
2.6
0.8
0
GDP per capita
Population
-1
1990-1992
1993
1994
1995
1996
1997
1998
1999
2000
In retrospect, it seems that the output cost of the disinflation policy was smaller
than feared. In fact, even the slowdown of the years 1998-99 should not be
attributed only to the anti-inflation policy since this was also the period of the
emerging markets crisis and its aftermath.
97
CHECKLIST OF PRACTICAL ISSUES
This section discusses some practical and technical issues that need to be addressed
in the context of a disinflation process that employs the inflation targets strategy.
Characteristics of the exchange rate band
As should be obvious from the analysis from previous sections, the exchange rate
system that facilitates the most effective application of the inflation target is the
flexible exchange rate regime. However, in some cases (like the Israeli case), the
economic system is not ripe for the adoption of flexible exchange rate during the
early phases of the disinflation process. Frequently, disinflation starts when the
foreign exchange market is still undeveloped and the capital account of the balance
of payments is relatively closed. During this transitional phase, the authorities may
wish to adopt an exchange rate system that corresponds to the sloped exchange rate
band. The practical issues that need to be specifically addressed are:
1. What should the widths of the exchange rate band be?
The key principle in answering this question is that the width of the band should
increase over time, in parallel with the degree of development of the foreign
exchange market.
2. What should the slope of the band be?
The main determinant of the slope should be the gap between the level of the
inflation target and the corresponding level of projected inflation abroad. Foreign
inflation can be measured in terms of the level prevailing in the economy’s trading
partners. Over time, with the progress that is being made in reducing inflation, the
inflation targets should be more ambitious, and the slope of the band should
correspondingly diminish.
3. Who sets the band?
It would highly desirable that the band be set by government in close consultation
with the central bank. The participation of the central bank is justified on the
grounds that it will need to implement the monetary policy in accordance with the
exchange rate policy implied by the band.
4. What should the frequency of changes in the band be?
It is highly desirable that the band is set at the same time along with the setting of
other key macroeconomic targets, like the budget.
98
The relevance of these issues diminishes over time as the degree of exchange
rate flexibility increases. By the end of the process the system converges towards a
flexible exchange rate regime, and the exchange rate band is abolished.
Operational issues for inflation targets
In implementing the inflation target strategy several operational questions must be
addressed.
1. What price index should be targeted?
The choice of the relevant price index is critical. For example, should the target be
the wholesale price index, the consumer price index or any other index? Likewise,
should the target be stated in terms of headline inflation or core inflation? The
answers to these questions depend on the specific circumstances, such as the
historical relationship between the indices and the role that each index plays in the
economic and financial systems. In the Israeli context, the inflation target was set
in terms of the consumer price index; furthermore, it was decided to focus on the
measure of headline inflation. One of the main reasons for these policy choices has
been the fact that many financial instruments and contracts in the economy,
including government indexed bonds and wage contracts, employ the consumer
price index as their benchmark.
2. Should the inflation target be set as a numerical point or as a range?
It seems that a range would be preferable since it is very unlikely that the monetary
authorities can aim with absolute precision to achieve a specific numerical target at
a specific period of time. In fact, if such a numerical target was set, the likelihood
that the target would be missed would be very high. Missing the target would hurt
the creditability of the monetary authority and is likely to damage the inflation
target strategy. It would, therefore, be preferable to set the target in terms of a
range. The monetary authority would be expected to aim to achieve an inflation
rate in the middle of the range but would tolerate the deviations within the range.
3. Should the target be a single year or a multi-year target?
There are great advantages in adopting a multi-year inflation target. A multi-year
framework would enable the authorities to correct deviations over time so that the
adjustment would be smooth. In the absence of a multi-year framework, all
deviations would have to be corrected within the year, thereby necessitating sharp
and costly adjustments. Furthermore, since monetary policy impacts on the
economic system with lags, a multi-year approach recognizes the presence of such
lags. In addition, a multi-year focus is consistent with the general principle that
monetary policy should be conducted within a medium-term framework.
99
4. Who should set the target?
It would be advantageous for the inflation targets be set jointly by the government
and the central bank. The objective of achieving price stability and the
responsibility for implementing the disinflation strategy should not be viewed as an
esoteric objective of the central bank. Rather, this objective should be “owned”
jointly by the government and the central bank. Thus, a joint determination of the
inflation targets would be appropriate.
5. When should the inflation target be set?
The disinflation policy should be cast within the general framework of the overall
macroeconomic policy. Since one of the important components of macroeconomic
policy is the budget, it would be highly desirable that the inflation targets are set at
the same time and together with the budget decisions. This would also ensure that
the various objectives of the government are consistent with each other.
IMPORTANT “BACKGROUND MUSIC”
A successful implementation of the inflation target strategy does not depend only
on monetary policy. The rest of the macroeconomic system must be supportive.
This section lists some of the essential key institutional requirements that would
contribute to the success of the inflation target strategy.
1. A solid fiscal system
An important ingredient of a stable macroeconomic system is a sound fiscal
system. Among the key characteristics of such a system are relatively small budget
deficits and relatively small public debt.
2. A flexible exchange-rate regime
The flexibility of the exchange rate frees the monetary authority to focus on its
main objective—the attainment of price stability. Furthermore, during some phases
of the disinflation process an appreciation of the currency contributes to reducing
the inflation rate. In the absence of exchange rate flexibility, such an appreciation
would not be possible. Since exchange rates (like other financial variables) tend to
respond rapidly to new information, their flexibility speeds up the transmission
mechanism and, thereby, shortens the adjustment process.
3. A functioning foreign-exchange market
The well-functioning market for foreign exchange reduces the cost of exchange
rate flexibility, and contributes to the appropriate pricing of foreign exchange risk.
100
Furthermore, an efficient market provides market participants with the appropriate
financial instruments that can provide protection from excess exchange rate
variability.
4. Availability of instruments of monetary policy
In order to conduct effective monetary policy, the monetary authorities must be
provided with the range of monetary and financial instruments which enable them
to carry out the policy tasks. For example, in order to conduct open market
operations, the central bank must have access to a sufficiently large stock of
government bonds.
5. Central bank independence
The requirement of central bank independence is critical. The central bank must be
granted the full legal and practical authority and ability to implement monetary
policy according to its best and independent judgment.
6. Strong banking system
It is important that when the central bank decides on a course of monetary policy, it
is not burdened by considerations of the strength of the banking sector. For
example, the central bank might decide that it is appropriate to raise interest rates
by a significant amount; such a rise in rates might adversely influence banks that
have weak balance sheets. In some circumstances the central bank might delay the
rise in interest rates in order to prevent damaging the weak banks. This would have
negative inflationary consequences. In order to assure that the central bank does
not compromise its monetary policy by such considerations, it is imperative that
the banking system be strong and sound.
7. A functioning capital market
The success of the disinflation strategy would be enhanced if the economy has
capital markets that are deep and wide. It is through the well-functioning capital
markets that the effects of monetary policy are transmitted throughout the
economic system. In order to insure that this transmission is effective, the capital
market must be functioning well. Furthermore, when the capital account of the
balance of payments is opened, the efficient absorption of international capital
flows requires a well-functioning domestic capital market.
8. A flexible economic system
The disinflation process may induce short-term cost. Such cost typically arises
from rigidities of wages, contracts, and the like. In the presence of such rigidities,
101
nominal changes (like a contraction in the quantity of money), induce real changes,
which in turn may adversely affect output and employment. In the absence of such
rigidities, the cost of disinflation would be reduced. The typical policy instruments
that contribute to enhanced flexibility of the economic system are structural
policies that remove distortions and enhance competition.
CONCLUSIONS
This paper dealt with inflation targeting and exchange rate policy. The analysis
drew on the experience from the Israeli disinflation process. The lessons, however,
are more general and should be applicable to other experiences of disinflation
especially for countries that have had a history of high inflation. In recent years,
several countries have used the inflation targeting strategy in order to bring down
inflation and achieve price stability. It is noteworthy that every country that has
implemented the inflation targeting strategy has not regretted that choice. This
observation by itself serves as the best testimony to the usefulness of the inflation
target strategy.
102
103
SESSION III: THE BANK OF ISRAEL'S CORPORATE GOVERNANCE—
INSIGHTS AND LESSONS FROM THE FIRST YEAR
THE MONETARY COMMITTEE PANEL
NATHAN SUSSMAN:
Good afternoon. This morning, Karnit told us about the new Bank of Israel Law,
and one of the major changes in the Law was the institution of the Monetary
Committee that replaced the sole decision making of the Governor. What we would
like to do in this short panel is to look a little bit into the inside of the operation of
the Monetary Committee—we are not going to reveal what our interest rate
decision on Sunday will be. Some of you probably would have liked to be flies on
the wall when these committees are sitting, and we will give you a little bit of a
glimpse into the operation of the Monetary Committee. We have four members of
the Committee here, two internals and two externals, so I’ll start with Barry Topf,
who is the Senior Advisor to the Governor, formerly Director of the Market
Operations Department at the Bank; Professor Rafi Melnick who is an external
member of the Committee and the Vice President for Academic Affairs in the IDC;
we have Professor Reuben Gronau, who is also an external in the Committee and is
a Professor Emeritus at the Hebrew University, and we have Dr. Karnit Flug, who
is the Deputy Governor and my predecessor as Director of the Research
Department until recently. Actually, my experience in the Bank starts with the
Committee so I will learn here a bit as well about the things that happened before.
So the way we will do this will be a short question and answer session, and I’d like
each one of the participants to be brief so we can cover more ground. I guess this is
one occasion—usually in the Committee, Andrew, who is the Director of the
Market Operations, and I are on the hot seat—now we get the rare chance to put
these guys on the hot seat. So we’ll start with the veterans of monetary policy
decision making, and I’ll ask you a question: what has changed, before and after?
BARRY TOPF:
First of all, despite what Nathan said, for those of you who regret not being a fly on
the wall, you might not be missing all that much, so you don’t have to regret it all
that much. We have three external members, so of course we’d be hard put to add
three external members, let alone members of the quality we have, without
improving the quality of the discussion, without adding additional points of view,
without adding additional factors, especially the fact that they are outside the Bank
of Israel and they can bring new viewpoints—I must say, in some cases certainly,
new viewpoints which we might not have been able to generate within the Bank, so
that has been a great advantage. The very fact that there is a discussion I think is
very positive, and I must say one of the motivations of having a Committee instead
104
of a sole decision maker is primarily, or to a great extent, to limit the downside
risk—in other words, the risk of having a very bad decision being made. We have
seen that in the Bank of Israel in the past, we have seen that in other places, so that
risk, I think, was greatly reduced because the members, both the three internal
members and the three external members of the type that we have, will make it
very unlikely for us to stumble very badly.
KARNIT FLUG:
Just to add to what Barry said, I think that one of the things that have changed since
we’ve had a Committee is that there are many more questions asked about the
analysis. So the downside is that meetings are much longer, but I think it really
improves the quality of the analysis. The staff is being put on its toes, and a lot of
the underlying assumptions of the models and the analyses are being questioned
and reviewed and discussed, and it really improves the quality of the analysis.
There is also more diversity in the preferences regarding the different weights that
people put on different considerations, there are different views about the
likelihood of certain risks materializing and it certainly enriches the discussion.
NATHAN SUSSMAN:
Thank you. So that leads me directly to the second question, and I’ll start on this
side now. Do you think there is any fundamental difference between the
considerations made by the internals of the Bank verses the externals? So you can
continue on that line.
KARNIT FLUG:
There was an expectation that there might be a division between external and
internal members. That is certainly not the case, and that is not how it played out.
In terms of voting, as an indication, we have seen diverse votes, and many times
there was one external member, one internal member voting on one side, and four
others on the other—this is the clearest indication that there is really no division
according to that line. Obviously there are different members on the Committee
who put different weights on the different considerations, but it is certainly not
divided by the division between externals and internals.
REUBEN GRONAU:
I can only add that whenever the minority vote consisted of two votes, they came
from different "camps". Somebody has thought of the seating arrangement around
the table so that each "insider" is flanked by two "outsiders", (and vice versa), and
105
judging from the discussion you cannot tell whether the speaker is an "insider" or
an "outsider".
NATHAN SUSSMAN:
Rafi, before you answer, can you clarify a little bit not only about the voting
preferences but also on the considerations, how people weight things. Do you see a
difference?
RAFI MELNICK:
It’s very hard to make a judgment about how people on the Committee weight
things, because it’s been a very short period of time since we started making
decisions. However, from a long term perspective, if we look at the Taylor rule to
reveal preferences of decision making on interest rates, we can clearly identify,
historically speaking, a change in the Taylor rule when Stanley Fischer started to
be the Governor of the Bank. The Bank moved from a very strict Taylor-type
policy rule to a flexible inflation-targeting regime, considering output and
employment as well.
One thing that I can say about the Committee and the way it operates is that it is
a very active Committee. Out of 21 decisions we have made since the Committee
was formed, on seven occasions we changed the interest rate, which is a ratio of a
very active type of committee. Each time we changed the interest rate we had the
impression that this is something that will stick for a longer period of time. But
then new information arrived, the evaluation changed, and we took new decisions.
So it’s a very active Committee. We get a lot of very interesting and very
comprehensive information from the different divisions of the Bank and the
decisions are taken not according to who is inside the Bank and who is outside.
BARRY TOPF:
I’ll just add one point which should be fairly obvious, but nevertheless should be
remarked. As an internal member, one difference I do see is that in addition to
monetary policy there also have to be considerations of monetary operations—it is
an operating central bank, and naturally I believe the inside members of the Bank
will have a bit more weight on operational considerations as opposed to pure policy
concerns, but that might be also a part of a learning curve for the external
members.
106
NATHAN SUSSMAN:
Thank you. So moving on to the publication of the minutes of the meetings—those
minutes reveal the considerations and also reveal the pattern of the vote. In the
recent Annual Report of the Bank of Israel we had a little box on the pattern of
voting, and it seems that one can infer something from these votes, based on the
outcomes of the votes and on the decision. What we have shown there, and again
it’s not 100 percent and we didn’t test for any statistical significance, but we could
show that if there is a dissenting vote during a vote, then in the following meeting
the likelihood that that vote will prevail is higher than otherwise. I’m asking you as
members, when you’re thinking about casting your votes and speaking to the
minutes, the protocols we call them, do you take into account these considerations
about the impact of the vote, the impacts of the minutes?
BARRY TOPF:
OK, I know that puts me with odds with major trends in the profession, but I
happen to be much of a skeptic when it comes to transparency. I think it’s a much
overplayed attribute, and that will color what I’m about to say, which is that I think
consciously or unconsciously everybody takes into consideration the minutes and
what will be revealed, and I think we are very bad in anticipating how to actually
be understood by the public. I’ve heard also from other central banks that efforts
for transparency often are counterproductive and backfire. This might be one of the
occasions where less is more. I think there is still value to the old fashioned
tradition of, I won’t say secretive central banking, but let’s say very discrete central
banking.
RAFI MELNICK:
OK, here we start with the first difference between one inside and one outside
member. I certainly believe that transparency is a very important element in our
decision making. The minutes play an important role of interacting with the public,
with the financial sector, with industry and with households. In my opinion, their
understanding of what we are doing plays an enormous role in achieving the policy
goals. And in fact, when I recall all the decisions we made, except for one, in most
cases the financial markets actually expected our policy in advance. When you
follow over time different interest rates and different indicators of market
expectations, it becomes evident that policy is clear and therefore much more
effective.
107
REUBEN GRONAU:
The market and the Committee receive the same signals concerning the state of the
economy, but the signals are often murky. As a result, the interpretation of these
signals may differ between different members of the Committee, and between the
Committee and outside analysts. The strength of the signal determines the timing
of the vote for change. In the last 20 months, since the Committee was established,
we have been living in a period of weakening growth. The disagreement in the
Committee never concerned the direction of change, but focused on the timing.
Given the side effects of the lower interest rates on the capital and housing
markets, it is not surprising that some members advocated a more active interest
rate policy and others preferred a more conservative one. But with the exception of
one vote, I never had the feeling that the members voted with the minutes in their
mind.
KARNIT FLUG:
Here I happen to disagree with the other internal member on the Committee, and I
agree with Rafi. I think that actually transparency and the minutes have been
extremely useful in conveying what we really meant in our policy, what the
reasoning behind it was, and it helped shape the expectations for the near future.
We put a lot of effort into trying to be very clear about what we mean, maybe we
are not always successful, but we do put quite a lot of effort into the precise
wording of the minutes in an attempt to be really clear about what the arguments
behind our decision are. One thing we learned from our experience is not to try and
give hints as to our next move, because in our experience, when we did that in the
past, by the time the information came and another month passed, we ended up not
doing what we thought or hinted that we will do. So we are more careful about that,
and it’s not because we don’t want to shape expectations in a certain direction, but
just because, as it turns out, things are too dynamic to predict what our next move
will be.
NATHAN SUSSMAN:
Thank you. In one of our recent decisions, in May, we actually had a draw and for
the first time, the double vote of the Governor was used. I’d like to ask you, does
the special role that the Governor has on the Committee, chairing the Committee
and having the double vote, does that impact the decision, does that impact your
considerations in voting?
108
KARNIT FLUG:
Generally I would say that the discussion has a strong effect on the voting. Many
times we come to the meeting where presentations are being made with a certain
view as to where the decision should go. Then we get into what we call the
“narrow discussion”, the discussion of the Committee, and the arguments can
really affect our views. When the votes are split, actually, in many cases in some
way the vote is split within each of us. The arguments are convincing on each side,
and the vote reflects the weights each of us puts on the different arguments, and the
probability we assign to different scenarios. Naturally, when our Governor, who is
extremely experienced in monetary policy making, expresses his views, Committee
members listen very carefully. So to sum up, in many cases it’s the discussion that
shapes Committee members’ views as to the policy decision that should be taken.
REUBEN GRONAU:
I don’t have much to add. It is only natural that the Governor's views, given his
past experience, carry more weight than other members of the Committee. Every
member of the Committee comes to the meeting with his priors on how to act given
his beliefs concerning the state of the economy. These beliefs may change through
the discussion. This is true for me, and I believe it is true also for the Governor.
Trying to outguess him is therefore a futile exercise.
RAFI MELNICK:
I second Karnit. I think that the process of analyzing the information, which we get
in a very professional way from the people of the Bank, and the discussion that
takes place at the Monetary Committee, play an important role, at least in my
decisions. I don’t come with a prefixed idea although I certainly have a strategy.
The decision is made based on the information we get and the discussion that
follows.
There is an important lesson I have learned in this process of decision making.
As you know, at the end of the day there is a decision to take and it’s not like an
academic paper you can end with a question or doubts—you have to decide: the
interest rate is going up, down or is not changed. And there is a phenomenon
connected to what Reuben said before, related to the question of timing. You
always think that when you get the next piece of information the picture will
become clear. I have news for you—the picture is never clear. Even when the new
piece of information arrives, the horizon is not clear, so it’s always a decision made
under uncertainty with things that are not known for sure. Given that, we have
adopted Stan's approach—that the Committee or monetary policy should be
proactive, in the sense that we should always try to be ahead of the curve and not
follow events. It is a real challenge. It seems that making a policy mistake is
109
probably less harmful than not making a decision when necessary. A decision can
always be corrected; I have learned that from Stan in the last year and a half that
we have been working together. Combining the necessity of making a decision,
with the picture unclear, in a model that doesn’t exist, at this point, is very
challenging. Therefore the discussion and the ideas that we hear from the
professionals of the Bank, from the members of the Committee is an important way
of taking the decision.
BARRY TOPF:
I’ll extend something that Reuben said. I would like to think that the influence and
weight of any particular position is determined by the arguments marshalled in its
favor, and the facts that can be presented in the force of the argument, regardless of
whether it’s an external member, an internal member, the Governor or not the
Governor. I would even venture to say that staff members can be allowed to
influence the decision should their arguments be persuasive enough, and I think
that is as it should be. That being said, I think one has to take into consideration
that there are also considerations, and should be considerations, of the credibility of
the Bank’s policy, continuity of the Bank’s policy, and so on, which can influence
people’s decision to vote, but those kind of considerations should be granted the
weight they deserve and not more than that.
NATHAN SUSSMAN:
OK, thank you. I would like to end this short panel by, I guess, addressing the new
members, and I will start with Rafi. Summing up the year and a half or so you’ve
been on the Committee, what have you learned?
RAFI MELNICK:
I have learned quite a lot. It’s been quite an experience and a privilege to be among
the founders of the Monetary Committee of the Bank of Israel. Obviously the big
challenge has been to make the right decisions—but not only that. This is a new era
for Israel, it’s a new era for monetary policy making in Israel, and we had to
confront the challenge of translating the new Law into an operational way of
working within the Bank. This is a tremendous change. In the past, the governor
was a sole decision maker, so he could assign any weights he wanted, but now it’s
different and there are many things within the law that we have had to consider, on
how to implement and how to translate what the legislature wants for us. The goals
are very clear and we take them very seriously in the process of decision making. I
think that in translating the law into an operational thing we encounter many wise
things that the legislature put there in the process. It took a long gestation period to
finally produce a law but I think the law is a good law. There are some minor
110
things that should be probably corrected in the future but these are not fundamental
things. One aspect that the legislature didn’t pay a lot of attention to is the big
difference between the process of nominating the members of the Monetary
Committee—there are a lot of specifications, there is a procedure and everything is
taken care of—but the law doesn’t say anything on how the Governor should be
nominated. I think that this is a problem, we are living with that problem these days
because less than two weeks before Stan ends his term we still don’t know who is
going to enter into his shoes, which are very big shoes. I think that a process of
overlap before transferring command should be an important aspect in the
nomination of the Governor.
NATHAN SUSSMAN:
Thank you. I’d like to invite Reuben now to make a short presentation.
111
MONETARY POLICY 2009-2013 –AN OUTSIDER'S VIEW
REUBEN GRONAU
Philipp Maier, in his analysis of the performance of monetary committees, points
out the importance of the diversity of backgrounds of the committee members. Stan
must have read this paper carefully when he chose me to serve as the oddball on
the Committee. My specialization is in Labor Economics, and my monetary
economics background is confined to two courses on the subject: one by Don
Patinkin in the early 60's, and one by Stanley Fischer in the early 80's.
Given my empirical background, I thought it is only fitting that in this
conference I present an analysis of the impact of the new Monetary Committee on
monetary policy, employing a "before and after" comparison based on the change
in regime in September 2011—the date when the new Committee first convened.
Unfortunately, with only 17 observations on the new era, I realized there is not
enough variability in the data to reach any substantive conclusions at this date. I
decided, therefore, to expand the period of study to the period beginning in January
2009, one quarter after the beginning of the Crisis.
In his lecture to the Israel Economic Association, Stan Fischer lamented, "I long
for the days before the crisis when we used to meet once a month to set the interest
rate, and thus finishing our work for that month. These days we find ourselves
running around throughout the month looking for the holes we have to plug to
prevent the floodwater from entering.” Stan is known as an enthusiastic runner.
How hard did he run?
Figure 1 describes the interest rates at the beginning and the end of the period,
and the number of interest changes in between, in a selected sample of OECD and
emerging market economies. Judging by the point of departure and the point of
arrival very little has been "achieved": Early in 2009, the Bank of Israel rate was
1.75%, and the current rate is 1.50%. But the small differential disguises the
amount of effort that was required to stabilize the boat. Given the stormy winds,
keeping the boat on track required constant tacking. In the 53 months between
January 2009 and May 2013, the Bank of Israel changed its interest rates 21
times—nearly a world record, if we are to judge from the sample of Figure 1.
112
6.00
25
5.00
20
%
4.00
15
3.00
10
2.00
5
0.00
0
Eu
ro
De UK
nm
No a r
rw k
Sw Sw e ay
it z d en
er
C h la n d
e
P o ko s
la
Ru nd
ss
ia
C a US
n
M a da
ex
ic
Ch o
B r i le
a
Ja z il
pa
Ko n
Ta rea
Th iw a
a n
Au i lan
Ne s t d
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Si Zel a
ng a n
ap d
o
I re
S. n di a
Af
r
Isr ic a
ae
l
1.00
No. o f cha ng es
Figure 1:Central Bank Interest Rates
and the Number of Interest Changes During the Period
Jan. 2009 - May 2013
I.2009
V.2013
# changes
Figure 2 provides a schematic view of the path taken by interest rates in a
selected sample of economies during the period. It seems that only very few central
bankers enjoyed the “tranquility” described by Stan in his speech. Two central
banks (the US and Japan) did not change their interest rates throughout the period,
one bank (the UK31) adjusted interest downward and stayed there, and one central
bank (Canada) adjusted its rates downward only to return to its original position.
For the rest of the economies, the interest rate policy, reacting to the dual crises,
resembled a rollercoaster—down, up and down again.
31
Switzerland, not in the graph, followed a similar course.
113
Figure2: The Path of Central Bank Rates, Selected Economies,
January 2009 - May 2013
6.00
5.00
4.00
3.00
2.00
1.00
I.2009
Is
ra
el
K
or
ea
Ta
iw
an
Th
ai
la
nd
A
us
tra
lia
C
hi
le
D
en
m
ar
k
N
or
w
ay
Sw
ed
en
Eu
ro
C
an
ad
a
U
K
Ja
pa
n
U
S
0.00
V.2013
Chile championed in this race, cutting its rate from 7.25% to 0.50% in a sixmonth period, climbing back to 5.25% and settling on 5.00%. Israel was not far
behind. With a small open economy, the Bank of Israel reacted immediately to the
sign of crisis. It started its travel in September 2008 when the rate was 4.25%, by
January 2009 it was already down to 1.75%, continuing downwards to 0.50%; in
September of that year it changed course and by June 2011 it reached the level of
3.25%, only to start four months later its way down to the current level of 1.50%.
Were these just symptoms of hyperactivity—"Much Ado about Nothing", or
were they the traces of fine-tuning as the scenario of the dual crises evolved? The
answer is contained in Figure 3, which describes the quarterly rate of growth of the
economies that appear in Figure 1. The figure presents both the mean rate and its
standard deviation. Israel ranks among the fastest growing economies in this
period, surpassed only by Chile and Korea. However, what is unique about Israel’s
growth path, though perhaps less known, is the steadiness of this path. Israel’s
average growth rate was 3.56%, and the quarterly standard deviation was 2.15%.
Chile, which enjoyed an average rate that was one-third higher, went through
fluctuations in growth (as measured by the quarterly standard deviation) that were
2.7 times as large. The US economy in that period went through similar
fluctuations, but its average growth was only less than one-half the Israeli growth
rate.
114
Figure 3: GDP Quarterly Growth Rates, Mean and
Fluctuation, 2009 - 2013
5.0%
4.0%
3.0%
2.0%
1.0%
O
OE ECD
CD T
- E o ta
Un Eu u ro l
i te r o a p e
Sw d St r ea
itz at e
e s
Swr lan
d
Ne N ed e
w o rw n
Ne Zea ay
th l a
er nd
la
n
Ko d s
Ge re
r a
De m an
nm y
a
C rk
C a hile
n
Au ada
Au str
st r i a
al
Isr i a
ae
l
0.0%
GMEAN
% (in annual terms)
6.0%
-1.0%
STDEV
Has there been a unique consistent pattern describing Israeli monetary policy
throughout the period? Bank of Israel researchers set out to detect this rule (Bank
of Israel 2012 Annual Report, Ch. 3). They applied the Taylor rule to the data,
adding a variable measuring the state of the foreign currency market. The equation
they estimated related the rate change to the difference between the current rate it
and the long run rate, the deviation of the inflation rate πt from its target, the output
gap and the depreciation of the Israeli shekel ∆St,
(1)
it- it-1=ρ
ρ *[(iLR - it-1)+α
α*( πt-π
πT)+ β * GAPt + δ* ∆St].
The parameters estimated were ρ=0.2, α= 2.5, β= 0.8, and δ=0.1. Figure 4
describes the fit of the estimated equation. The estimated rule gives an almost
perfect fit to the interest rate path prior to 2007, but, systematically, overestimates
the path thereafter.
115
Figure 4: Applying the Taylor Rule to the Bank of Israel Interest Rates,
1999–2012
Source: The Bank of Israel 2012 Annual Report, Ch. 3, p. 102.
The report concludes that “it appears therefore that during the period of the
global economic crisis, monetary policy was conducted differently, affected by
factors that are not included in the interest rate equation—in particular, risk factors
originating in the global economy and expectations of their future moderating
effect on the Israeli economy led to a lower rate of interest than that dictated by the
equation”. Thus, for example, foreseeing the crisis looming on the horizon, the
Bank’s leaders preferred to keep the rate stable in 2007–2008, though the rule
called for raising it, and then lowered the rate when the crisis hit.32
The report hypothesizes that it seems that the Bank adopted a forward looking
pre-emptive strategy (Stan would call it “being in front of the curve”). A crude test
of this hypothesis calls for the replacement of the current values of inflation rates,
the output gap and the foreign currency depreciation by future ones (the values of
two quarters removed)33
(2)
32
it- it-1=ρ
ρ *[(iLR - it-1)+α
α*( πt+2-π
πT)+ β * GAPt+2 + δ* ∆St+2]
In the period December 2006–August 2008 the rate fluctuated in the range of 5.00% to
3.25%.
33
Assuming perfect foresight and that future variables are not affected by current policy.
116
the parameters being identical to those in Equation 1. Figure 5 describes the new
equation, and it is hard to see where the new “forward looking" equation improves
the fit.
Figure 5: The BOI Interest Rates, The Taylor Rule And a Forward
Looking Monetary Policy
14
12
10
%
8
6
4
2
0
BOI Interest Rates
The Taylor Rule
A Forward Looking Policy
It seems that the Bank of Israel interest rate policy in this period is a classic case
of a “two-regime” equation. I tried to disentangle the secret of the second period
equation but it evaded me. In despair I concluded that in the second period, as of
2008 onwards, the rule can be summarized by the naïve model it = it-1, or
alternatively ρ = 0. The results of this two-regime equation are presented in Figure
6. The new equation outperforms by far the previous ones, leaving us to wonder
whether interest rate setting is a science or just art.
117
Table 6: One or Two Regime Taylor Rule
1999- 2007 vs. 2008-2012
14
12
10
%
8
6
4
2
0
BOI rates
One regime
Two regime
REFERENCES
The Bank of Israel Annual Report 2012.
Maier, P. (2010), “How Central Banks Take Decisions: An Analysis of Monetary
Policy Meetings”, in Siklos, P.L., M.T. Bohl, and M.E. Wohar (eds), Challenges in
Central Banking: The Current Institutional Environment and Forces Affecting
Monetary Policy, Cambridge University Press, 320-356.
118
119
THE TRADEOFF BETWEEN BEING AHEAD OF THE CURVE
AND ACCURATE FORECASTING
ALEX CUKIERMAN
I would like to better highlight a basic tradeoff of monetary policy decision making
that is partially implicit in remarks made by some of the previous speakers. On one
hand, due to lags in the impact of monetary policy, efficient policy has to be geared
to the state of the economy in the future. As a consequence, inflation targeting is
really inflation forecast targeting.34 During committee meetings, Stan occasionally
referred to this as “making decisions ahead of the curve”.
On the other hand, since the future state of the economy is uncertain and even
data about the current state of the economy arrives with a lag, monetary policy
committees have to make decisions on the basis of current forecasts about the
future. Inevitably those forecasts rely on data availability at decision time. Broadly
speaking this data consists of the past history and of recent indicators. To minimize
future forecast errors policymakers need to determine how much weight to give to
recent indicators in comparison to past history. This is an important inference
problem in which they have to decide (paraphrasing an old Hebrew proverb)
whether one swallow signals the arrival of spring or not. More generally they have
to decide how much of recent changes will persist into the future. But learning
about the persistence of economic variables is more accurate the more one waits in
order to observe how long a given change persists into the future.35
The upshot is that policymakers face a tradeoff between making decisions
“ahead of the curve” and waiting in order to obtain a better evaluation of changing
economic conditions. The more a monetary policy committee waits before making
a decision the better are its forecasts of the economy for a given time period in the
future. But waiting also raises the likelihood that policy will be “behind the curve”.
Thus, monetary policy committees face the difficult task of finding the optimal
balance between those two factors.
34
See Svensson, L.E.O., 1997, “Inflation Forecast Targeting: Implementing and
Monitoring Inflation Targets”. European Economic Review 41, 1111–1146.
35
See Muth J.F., 1960, “Optimal Properties of Exponentially Weighted Forecasts”,
Journal of the American Statistical Association, 55, June, 299-306, and Brunner K.,
Cukierman A. and Meltzer A., 1980, “Stagflation, Persistent Unemployment and the
Permanence of Economic Shocks”, Journal of Monetary Economics, 6: 467-492.
120
121
THE SUPERVISORY COUNCIL
STANLEY FISCHER:
Before I introduce Dan Propper, the Chairman of the Bank of Israel’s Supervisory
Council, I would like to say a word on the issue of academic economists on the
Monetary Committee. It would have been useful to have on the Committee an
economist who had practical experience in business or in the government, and we
suggested that to the Winograd Committee – the Committee appointed to propose
people for the Monetary Committee and Supervisory Council. They tried very
hard, but found no-one suitable for the Monetary Committee who did not have a
conflict of interest between service on the Committee and some aspect of their
current activities. The Monetary Committee does not pay its members enough to
persuade a potential member to give up on his or her particular conflict of interest
in favor of joining the Committee, so it is a real problem. However, we do have a
significant range of opinions among the academic members of the Monetary
Committee, and that to some extent compensates for the absence of members from
different backgrounds.
I would like also to mention that we are fortunate to have with us today the
Governor of the Palestinian Monetary Authority, Jihad Al-Wazir. The Palestinians
use the shekel as one of their currencies, and that requires interaction and
cooperation between the two monetary authorities. I believe that cooperation is
good, and thank Jihad and the PMA for that.
We turn now to a discussion with Dan Propper, the Chairman of our
Supervisory Council, which acts essentially as a Board of Directors. As you know,
a new Bank of Israel law was passed in April 2010. There had been a lot of work
on formulating a new law already in the 1990s, when Jacob Frenkel was Governor.
The main difference between the 1990s proposals and the current law is that we
added a Supervisory Council to the structure that had been proposed earlier.
Under the 1954 law, the Bank of Israel had an Advisory Committee and
Advisory Council, with the Advisory Committee’s membership being a subset of
the membership of the Advisory Council. Private sector bankers played a major
role in each. Dr. Arie Krampf from Ben-Gurion University of the Negev, wrote a
thesis on the governance of the Bank of Israel in its early years. A major
conclusion of his, based on the protocols of the meetings of the two committees,
was that the Bank of Israel in its early years was in practice managed by two
people: one was the Governor, David Horowitz, and the other was Ernst Yefet, a
prominent private sector banker. That sort of model of central bank management,
including private sector bankers who are interested parties in what the central bank
does, has dropped out of favor.
Why did we add a Supervisory Council to the structure of the governance of the
Bank of Israel? When I arrived, I discovered that I was responsible for every
decision of the Bank, both the monetary policy decisions and all the managerial
122
decisions, including the budget, which was not approved by anybody but me. I
thought that was not an appropriate way of running an important public sector
organization with a big budget. In addition, I felt uneasy with the responsibility
this implied. So we suggested the Supervisory Council largely on the model – as is
much of this law – of the Bank of England, which has had a management body, the
Court, since 1694. The Court sits in a wonderful room. It has on the wall an
instrument that tells the times of the tides of the Thames, because in the early days
of the Bank of England, the times when the ships came in was part of what drove
the level of activity in the city.
The Bank of Israel does not have a tide measurer in the room where the
Supervisory Council meets. The Council has seven members, five external and
two internal, the internals being the Governor and the Deputy Governor. Neither
the Governor nor the Deputy Governor is Chairman of the Supervisory Council;
the Chairman is from outside the Bank – and clearly he or she was bound to be a
key figure in the running of the Bank.
Everyone who was following the process of implementation of the new law
asked who we were going to get to be Chairman of the Supervisory Council. We
had a general description: someone who is independent – totally independent of the
government, independent of the Bank, with his own reputation and the authority
that would bring to the Supervisory Council from the start, somebody who has
demonstrated powers of management and persuasion, and more.
Then Justice Winograd was named as Chairman of the Selection Committee for
members of both committees—the Monetary Committee and the Supervisory
Council. I was told immediately that I could relax – that there would not be any
politics in the choice of members of the committees, that we would get the best
people possible.
I relaxed and in due course the Winograd Committee found the perfect
candidate to be Chairman of the Supervisory Council, Dan Propper. I wasn’t
extremely surprised by their choice, because in the meantime I had been asking lots
of people who it was that we needed to chair the Council. Dan, we didn’t have an
official list, but you were atop the unofficial list, and everything that has happened
in the Supervisory Council since has justified that opinion and the choice of the
Winograd Commitee.
Dan knows how to run a meeting. He doesn’t like to meet too often, so we meet
once a month for 5 hours, which, believe me, is a long time to discuss managerial
problems, even though we are permitted one coffee break. He listens patiently as
the members of the Council speak, occasionally asking a question. At the
appropriate moment, he suggests a decision. Occasionally the members of the
Council disagree, and discussion then focuses on what the decision should be – and
in the end, Dan knows how to formulate the right decision, and how to take the
group with him.
123
But he is much more than the perfect Chairman, because he also acts as a
trusted adviser to the Bank on other issues. From time to time he raises concerns
with the management of the Bank, issues which are not directly the responsibility
of the Supervisory Council, but are essential to the way the Bank is viewed in the
community and in society. He plays a far more active and important role as a wise
advisor to the management than I would have imagined beforehand. The Council
would not have been anywhere near as effective as it is without him – so, Dan, we
are extremely grateful to you.
DAN PROPPER:
Let me interject here on two counts: First, I want to stress that all this praise goes to
all the members of the Supervisory Council. Second, after hearing these flattering
words from you and from Yankele Frenkel, perhaps I should make a quick exit
before anyone has time to get in a critical word.
STANLEY FISCHER:
I’d like to introduce Dan. He is of Czech origin, that is to say, his parents are
Czech, and were born in Czechoslovakia. He was born in Israel, educated in the
Technion, with a degree in chemistry and food technology, and after his army
service joined a company which eventually became a key component of the wellknown Israeli company, Osem — a food processing company, which is the
industry in which his father owned a factory in Czechoslovakia before coming to
what was then Palestine.
It was Dan who understood that the quality of the firm’s products would be
improved significantly if it could form a partnership with a high-quality foreign
firm in the same industry. Osem formed such a partnership with Nestle. Osem is
now 58 percent owned by Nestle, and was run by Dan as CEO between 1981 and
2006; now he is Chairman of Osem. From 1993 to 1999, he was the president of
the Manufacturers Association, and in this context, as Jacob Frenkel mentioned
earlier, there were some serious conflicts between Dan and the Governor of the
Bank of Israel, possibly over the refusal by the Bank of Israel to intervene in the
foreign exchange market.
Dan was named Chairman of the Supervisory Council in September 2011, and
as I have said, we couldn’t have had a better choice and a better chairman. So Dan,
if I can start by asking you a question about your experience as Chairman: what has
impressed you most in the Bank – either positively or negatively?
124
DAN PROPPER:
I came into an entity—the Bank of Israel—with which I had no prior managerial
experience. In addition, my acquaintance with public or quasi-public sector entities
came from my experience as a chair of NGOs, which of course are much simpler in
nature—there is basically no operation to run, the focus is on attracting funds from
outside and redistributing them. For most of my life I was heavily involved in
private sector businesses, where the emphasis is on profits, for which you establish
specific targets, and which are run very differently.
Here, I came to a huge entity which is neither a business nor an NGO. It has to
generate results like a business, but its goal is not to maximize profits; and it’s not
an NGO, which gets donations from the outside—so it’s a very different creature. I
admit pondering the question of how such an entity can be run, because all my life
I believed that you need simple targets, such as a bottom line and a top line,
translating them into many operational targets for managers and employees to
focus on, and motivating them accordingly, to ensure that your ultimate goal is
reached.
So I was surprised to find that there are other ways to motivate. In fact, I found
a wonderful team headed by you, of course, Stan, and I saw talented and dedicated
people at the top—but I also found people at lower echelons in the Bank to be
outstanding. It is not just their qualifications that are impressive, but how they
operate even in the small details, such as the way they prepare and present their
presentations—there is no doubt in my mind that their overall performance is first
class. A second point I would like to mention is that I must say that this experience
is a fascinating one for me. It is exciting, because this newly established
Supervisory Council must develop and design the managerial framework in which
the Bank will operate in the future. So though we are not busy designing policies as
the Monetary Committee does, we are putting procedures in place and monitoring
their effectiveness. We have also needed to create methodologies for reviewing the
financial situation of the Bank, and yes, we’ve had to shake up some mindsets in
order to introduce useful elements from the business sector.
If I were to take a snapshot of the Bank when I first came, and compare it to
what there is today, I think one would find that the Bank has improved
considerably in the way it operates, in its corporate governance. It now functions
according to quite precise lines and boundaries. There is still a lot of work to do,
we still have a long way to go, but I think that the Bank of Israel Law which took
effect in 2011—and here again you were one of the people, if not the man, who
pushed it forward—is starting to bear fruit.
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STANLEY FISCHER:
Thanks very much. I think that the improvement of the management of the Bank is
a very large contribution and that it comes from the outside members of the
Supervisory Council, of which three other members are here—Prof. Nina
Zaltzman, a law professor from Tel Aviv University, Yitzhak Edelman, an
accountant, and next to him Uri Galili, a former banker — each from a different
profession. Nina had helped us before we changed the law. Tzvika Eckstein had
suggested that we form an Audit Committee with external members, which we did,
and Nina was a member of that Committee. We are lucky that Nina is also a
member of the current Audit Committee. The one person on the Supervisory
Council who isn’t here at the moment is Maxine Fassberg, who was here this
morning. Maxine is the CEO of Intel Israel, and brings her intelligence and
business experience to our work in a highly constructive way.
There is no question that more discipline is being asserted in the way the Bank
is run. There is great value in having a majority of outsiders on the Supervisory
Council. A fundamental problem in managing the Bank is that almost everyone
has tenure. That means that the management is far more constrained in managing
personnel than is private sector management in companies without strong unions.
The tendency of most – but not all – departmental heads when asked to take on an
additional task (X) is to ask for more workers. It has very rarely been – “if I do X,
I will have to reallocate workers and stop doing Y.” In reply to the demand for
more workers, one says “No – tell me how to reallocate workers at minimum cost
to the work program.” But, you need to keep your managers and workers
enthusiastic and motivated, so to keep saying no is not pleasant. Having the
backing of the Supervisory Council for standing by the budget is extremely
valuable.
One of the things that surprised me, and I think also my colleagues in the
management of the Bank, is that the Audit Committee has been more active, more
important than I thought it would be. The Audit Committee consists of the four
outside members of the Supervisory Council; neither the Chairman of the Council,
nor the two Bank members of the Council, are members. It is acting somewhat in
parallel to and complementary to the internal auditor. Its very active role
sometimes creates difficulties with the people who are being audited, but I think its
activities contribute to improving the management of the Bank.
DAN PROPPER:
Although I’m not a member of the Audit Committee—by law I cannot be—I can
tell you that I am most impressed by the work of the Committee, comprised of the
other representatives of the public on the Supervisory Council, I think it is truly
outstanding. First and foremost, the Audit Committee members are bolstering the
internal audit process of the Bank, which is very important. An additional point is
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that when they look at issues, they bring with them the much needed perspective of
outsiders, with a wealth of experience coming from various corners of the
economy, from the private sector as well as from academia. We on the Supervisory
Council benefit from the fruits of their labor, fruits born of this combination of
well-grounded theoretical knowledge and practical experience that fuse together
with the very good work done by the Internal Audit. The truth is, this Committee is
one of key tools of the Council, and I am sure it will remain so.
STANLEY FISCHER:
Would any of the members of the Audit Committee like to say something? No.
Like Dan Propper, I am struck by the important role your committee plays. And as
he said, you look at our work with very different eyes than we would look at
things, and those different eyes are extremely important. The amount of work you
put in is also impressive. Sometimes, when Maxine Fassberg wants to tease me,
she reminds me that I said the Council would have about six meetings a year of two
hours each. In practice, we have several Council meetings, and together with the
meetings of the Audit Committee, you must hold two or three meetings a month,
and not of two hours each.
Dan, last question: We have a lot of changes, none of them large, that we
probably would like to make in the Bank of Israel law, when circumstances are
ripe. That will be after my time, because we need enough changes to make it worth
the effort of going to the Knesset. Further, you know the problem with going to the
Knesset is, as the Chairman of the Knesset’s Finance Committee said when we
brought the current law to him, “You have to know that no law leaves here as it
enters”. That means that if you want to make ten changes, you will probably have
12, at least two of which you don’t want – and you have to weigh that balance all
the time. But Dan, if we were to change the system, and certainly if we ever go to
the government and Knesset Finance Committee, that is, to the Treasury and the
Knesset Finance Committee, would there be changes that should be made in the
structure of the Supervisory Council?
DAN PROPPER:
Given that we haven’t discussed the issue in the Supervisory Council, I can’t speak
in the other members’ names. I want to emphasize that the Councils’ decisions are
reached through a true democratic process. So when I summarize as Chairman of
the Supervisory Council, I review the points made by each one of our members in
order to make clear that the decision taken is not mine, but truly the Council’s. I
cannot recall having a vote in the Council, and I don’t think we ever should,
because so far we have always succeeded in reaching a consensus through open
and frank discussions.
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However, your question was about a theoretical change of the law, and here I
have to admit that in my view there is one thing that is missing—I am not sure
whether it should be a separate law or part of the Bank of Israel Law—and that is
that the law does not touch on the issue of labor relations. It doesn’t refer to the
status of employees of the Bank, in fact, it doesn’t refer to anything having to do
with the employees. I feel that there is a need to address that and to do it in a
serious way. Government employees are regulated by certain laws and regulations,
while employees in private enterprises are regulated by different agreements
between the employers and the employees, unions, etc. I think that the Bank needs
better defined and appropriate rules regulating the roles and contribution of each
and every employee—the best way to design such a set of rules would of course be
by way of agreement with the employees, but if that proves too difficult to do, we
should still lead for a change, and I am all for it.
Finally, I would like to say a few things about you personally. First, Stan, don’t
worry I’m not going to praise you here after all the things you heard. My prose is
not as good as the prose of many of the other speakers. However, I join everyone
who said that you are, first of all, what we call in Hebrew a “mensch”, which
translated—it comes from German—says you are a human being, a human being
with a heart. Second, you are also a gentleman, a quality that is related to the first
one, but it adds some manners. And third, you are also a very wise person who
knows when to talk and what to say, and when to listen. Most Israelis think they
know it all and thus they rarely listen, so this characteristic of yours, the ability to
truly listen, is something very special, and I really appreciate and value it. Last but
not least, Stan, I think that the many achievements of Israel’s economy of these last
years are in large part your contribution—and I should say your personal
contribution—to us. Looking ahead, I want to wish for you that in the future, in all
other positions you’ll have, and I’m sure there will be many more, that you will
succeed in creating the same environment that you crafted here, and with the same
rate of success.
One final note: I must say that I would have expected that with such a fine
audience as this one, we could also have welcomed the new Governor.
Unfortunately, this did not happen, and as a citizen of this country, and as a person
involved in the economy of this country, I feel that damage is done to the economy
by not announcing who the next Governor will be. This uncertainty creates
instability, and instability is enemy number one of success.
With these words, I will thank you again, and since we don’t say goodbye, and I
know you will come to Israel many times, we’ll just say farewell. Thank you.
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129
Introduction of Larry Summers
Stanley Fischer
We’re now going to have the pleasure of listening to Larry Summers.
Larry almost needs no introduction, but he has had such an impressive and
varied career that it is worth reminding ourselves of his many jobs and
achievements.
Larry was an undergraduate at MIT and then moved to Harvard for his
PhD. He came back to MIT as an assistant professor, and then returned to
Harvard. Harvard and MIT are only about three miles apart, so these moves
were logistically very easy. But MIT was extremely sorry to lose Larry,
because he is one of the most creative, and one of the most fertile, thinkers
in economics – and not only that, he also throws off more interesting ideas
per hour than anyone else I have met.
Larry, the wunderkind, became the youngest tenured professor at
Harvard, and later the recipient of the John Bates Clark Medal for the best
American economist under the age of 40. It was clear early on that Larry
was interested in economics primarily as a way of understanding and
influencing the real world. He is a great conversationalist, and having a
conversation with Larry is one of the pleasures of life, particularly if it
starts at around 11 pm and continues for a couple of hours. It’s always fun,
and always interesting – and usually you not only enjoy the conversation,
you also learn a lot from it.
In 1991, he went to the World Bank as Chief Economist, replacing me
in that job. In 1993, at the beginning of the first Clinton administration, he
was named Undersecretary of the US Treasury. The Undersecretary of the
Treasury for International Affairs is probably the most important official in
the Treasury with respect to the international economy – and Larry was a
very active and very important Undersecretary of the Treasury.
Larry believed, and I also believe, that if the US doesn’t lead, nothing
much good happens in the international economy. By 1994, I was in the
Fund, which meant that he and I spoke often. Sometimes we disagreed –
and when that would happen and I was recalcitrant, Larry would unleash
the final arrow in his quiver and say to me, “You’re also disagreeing with
Bob Rubin and Alan Greenspan.” At that point I was supposed to
surrender, and sometimes I did.
Larry was remarkably persuasive and remarkably active, including in
leading the G7 deputies, and he duly rose through the ranks. He became
Deputy Secretary of the Treasury when Bob Rubin became Secretary of the
Treasury—that was in 1995. In 1999, Larry was named Secretary of the
Treasury. I remember asking him at the time if he was the youngest
Secretary of the Treasury since Alexander Hamilton, and he said possibly,
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and I never remembered to follow up so perhaps, Larry, you’ll clarify on
this point when you speak.
Following the end of the Clinton administration, Larry became president
of Harvard University. He was a controversial and courageous president of
the university. People in this audience should know that inter alia he was
courageous in making his support for Israel quite clear, and that he rejected
the almost reflexive hostility to Israel of some student groups. More than
once, he took on the students on issues which most presidents would have
ducked.
After he left the presidency of Harvard, he became a university
professor at Harvard, and then in 2009, at the beginning of the Obama
administration, he become head of the National Economic Council, which
is the group within the White House that coordinates economic policy
within the administration. This is a difficult but necessary job because
views on economic policies come from the Treasury, from the Council of
Economic Advisors, the State Department, the Department of Commerce,
and others. The director of the National Economic Council, the first of
whom was Bob Rubin, has a very important role to play. Larry left that job
at the end of 2010 and President Obama said, “I will always be grateful that
at a time of great peril for our country”—remember he took this job after
Lehman Brothers and during the worst times of the Great Recession—“a
man of Larry’s brilliance, experience and judgment was willing to answer
the call and lead our economic team”.
He went back to Harvard in 2011, and he is now at the Kennedy School,
writes columns for the Financial Times, Washington Post and others, and is
frequently seen on television and conferences all over the world – and he is
listened to intently.
Larry used to be a wunderkind, but we cannot any longer call him a
“kind”. However, we certainly should continue to call him a “wunder” – as
you are about to discover.
Larry, please come and talk to the audience.
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LARRY SUMMERS
Stan, thank you very much for those generous words. You have it right in
essentially every respect save one. The students were easy at Harvard. It was the
faculty that was the problem.
I have known Stan for thirty-five years. The first serious course, first any
course, really, in monetary economics I took was Econ 462 from Stan Fischer, in
the fall of 1978. There were several things that struck me in that course: the
crystalline clarity of everything that Stan Fischer said; the complete lucidity with
which he explained and commented on the latest works in the literature; his
dedication to his students; and his habit, which I am going to reciprocate in a few
minutes, of posing important questions which would be very valuable for students
to figure out how to answer. It was a remarkable experience that had a great deal to
do with my decision to focus my efforts as an economist on macroeconomics.
I was privileged to be Stan’s colleague, but then years later, after Stan had done
a remarkable job as Chief Economist of the World Bank and decided to return to
MIT, he was bold enough, perhaps kind enough, perhaps wise enough, to push the
idea that I should be his successor. Stan prevailed upon the then-President of the
Bank, and I had the honor of succeeding him as Chief Economist. It was not easy
to be his successor, as I suspect it will not be easy for whoever succeeds him at the
Bank of Israel. He was universally liked, universally admired, universally trusted,
and universally revered—and I was the new guy on the street. And when I say all
these things I’m not only talking about his colleagues at the Bank, I’m talking
about finance ministers around the world who had come to depend on his advice
and his wisdom.
As Stan mentioned, I moved from the Bank to the US Treasury in 1993. At the
end of 1993, the position of Deputy Managing Director of the IMF, a position
traditionally filled by an American, came open, and our advice was sought as to
who should fill it. My first strategy was very bureaucratically clever. I said the
United States is prepared to renounce, temporarily, American leadership in this
position, if we could have a Rhodesian Israeli—and if we had a Rhodesian Israeli
maybe he could give us some other positions as well. That stratagem was rejected,
but my higher purpose was enthusiastically accepted. Michel Camdessus and the
IMF Board appointed Stan as the Deputy Managing Director, and I shudder to
think what would have happened in Mexico, what would have happened in
Thailand, Indonesia, Korea, much of Asia, what would have happened in Brazil
and Russia, if Stan Fischer had not been there. He brought the combination he
brings to everything – of total analytic skill, unimpeachable integrity, and the
ability to connect – and that made him the most influential Deputy Managing
Director that the IMF has ever had and I suspect ever will have.
I remember a few years later sitting at a dinner in Philadelphia at the American
Economic Association meetings and learning that Stan had been approached and
was likely to accept the position of Governor of the Bank of Israel. I remember
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having the view that that was fantastic for Israel, that I thought it was very good for
Stan, and that I was a little less certain how good it was for my friend Rhoda, but
that it would come in time to be wonderful for my friend Rhoda (which I think is
the view my friend Rhoda has come to), and that it would be a very good thing for
the international financial system, and so it has been. I’m not going to presume to
tell this audience the difference that Stan Fischer has made for Israel in this period.
What I can say is that in international and economic and financial dialogue on the
global response to the financial crisis, if you weighed every country by the ratio of
its influence on those discussions to the scale of its GDP, there is no country that
had more weight than Israel, and that is not a tribute to Israel’s superb geopolitical
positioning. That is instead a tribute to one man, Stan Fischer, and the difference
that he has made. So, we are celebrating a remarkable man here today.
You know, there has been a tremendous change in the role of economists in the
economic system in the forty years since I entered graduate school. When I entered
graduate school, it was well known that economists were influential. They wrote
books that had a profound impact on economic thinking, some of them whispered
in the ears of Presidents or Prime Ministers, some of them advised in other ways,
some of them wrote newspaper columns that changed the public debate, but it
would be fair to say to that point that, as Churchill put it, “brains were on tap rather
than on top.” Few, if any, economists were in a position of ultimate authority over
key areas of economic policy to that point. That has changed over the last forty
years, and Stan is an exemplar of that change. Stan is an exemplar of that change,
as is his student Ben Bernanke, as is his student Mario Draghi, as is our mutual
friend Mervyn King, and as is my student Rodrigo Vergara. Of course, Israel was
one of the very first in this trend when it appointed Jacob Frenkel to be the
Governor of the Bank of Israel in the early 1990s. And so now Ph.D. students in
economics can look to model themselves after others like them, others that started
in academic careers and now hold positions of high authority with respect to the
economy, and no one is more an embodiment of that through the life he has led,
and the creator of that through the students he has taught, than Stan Fischer.
This trend has created a dynamic in which a professional life cycle is a kind of
arc, an arc that begins in reflection as one writes a Ph.D. thesis, as one writes a
variety of articles; then, moves into a phase of action when one holds responsibility
for actions that affect the lives of millions and millions of people; and then, since
no one holds one of these positions forever, cycles back, providing more
opportunities for reflection and for instruction.
When I was a student, Stan was kind enough to tell me what the most important
question would be for me to figure out the answer to—and what comes around
goes around, and as Stan prepares to leave the Bank of Israel, but very
emphatically not to retire, it occurs to me that I might pose questions that a man of
his extraordinary wisdom and experience can usefully answer for all of us. Let me
suggest five that go in various ways to the practice of central banking.
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First, can one meaningfully operate with two instruments, or is central banking
ultimately a brake and accelerator operation? Classic central banking, forget
classic, central banking as it came to be understood in the 80s and 90s is basically a
brake and accelerator operation. You judged the strength of your economy, you
judged the risks of inflation (whether it was an inflation targeting framework or
some other framework), and sometimes it was time to put your foot on the gas and
sometimes was time to put your foot on the brake. Basically, if the vehicle moved
as smoothly as possible that meant that you had succeeded, and enormous
intellectual energy has gone in to doing that as well as was possible. Now, we find
ourselves living in a more complex world. No one really supposes that inflation
was breaking out in a massive way in the mid-2000s; yet, one does somehow
suppose that if financial excess had been more effectively curbed less bad things
would have happened after 2007. Today there are discussions and concerns around
financial excess running substantially ahead of the degree of concerns about
demand outstripping capacity or product price inflation accelerating. We can use
the word macro-prudential, but can we meaningfully operate with multiple
different instruments that allow acceleration on some dimensions with restraint on
others, or is that a chimera, an unrealistic aspiration in a world of increasingly open
and competitive financial markets? Much about the practice of central banking
over the next twenty years will depend on how this question is answered and the
world is today without a well-resolved answer to this question.
The second question, rather a different type of question—in a sense, Stan has
provided his answer to in its Israeli context, but it seems to me it exists more
broadly: how should a central bank be structured and how should it communicate?
Monetary policy is truly important, so is war and peace; yet, almost every country
manages with one Secretary of Defense and not a committee of Secretaries of
Defense, and almost every country turns to a committee to make monetary policy.
In some cases it is a committee that is very symmetric; in other cases it is a
committee that is very asymmetric. A committee provides for the pooling of
wisdom; but, a leader seeking advice also provides for the pooling of wisdom. Ken
Arrow taught us that an individual can reliably be expected to have consistent
preferences, and that a committee can less reliably be expected to have consistent
preferences. An individual can perhaps communicate with more clarity than a
committee; yet, a committee has the huge advantage of providing broader
representation, providing for greater input, providing for greater dissemination of
knowledge. What is the optimal way to structure decision-making in this sphere?
Perhaps the question is too abstract, but when you think about it, even a small
probability of reducing the risk of some of the more unfortunate monetary events
we’ve seen over the last fifty years has enormous stakes for human betterment. So,
second question: with all the experience, with all one has seen, what is the right
structure of central banks – how should they communicate and how frequently?
Third question: what is the appropriate role of public liquidity? It is surely right
to say that too big to fail is a besetting problem of financial regulation. It is surely
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the case that moral hazard is central to any set of reflections on financial crisis and
its prevention, and it is surely the case that transparency and clarity are great
virtues. And yet I will also suggest to you that no government, not even the
government of Israel, lays down with complete clarity its policy as to how it will
response to kidnappings in advance. It provides for a certain ambiguity in how it
will respond, perhaps in the interest of preserving credibility, perhaps in the interest
of maximizing incentives. And I would ask another question that bears on this very
much. It is surely a fact that because there are guardrails on highways people drive
a little bit faster than they otherwise would. Is that a good feature of guardrails on
highways, or is that a bad feature of guardrails on highways? I would argue it is a
good feature of guardrails on highways, it permits people to drive in reasonable
safety to where they want to go more quickly than they otherwise would. So then
what is the right policy, what is the right way to ultimately understand the role of
the discount window, the role of lending in times of crisis? It is easy to say that one
should lend only against absolutely good collateral, but of course if collateral is
absolute, categorically, certainly good and universally perceived to be good, there
is not likely to be any need for the public sector to lend against it, and if it is not
those things, then there is a measure of risk involved. These questions go back to
Bagehot at least, but they have not been decisively answered. A younger Stan
Fischer pushed for the frontier of the notions that I am raising by suggesting a
world lender of last resort. Nowadays people wonder whether central banks should
or should not be in a position to be able to provide support to institutions that are in
extremes. What is the right doctrine that should carry us forward?
Fourth question: what about extraordinarily low real interest rates? We say, so it
must be right, that interest rates need to find their level, need to be set by the
market, need to be responsive to economic conditions. And yet, if one thinks about
it, it is a remarkable thing that the safe interest rate as measured by indexed bonds
in most of the industrial world and as projected by the market out for periods close
to a generation is essentially zero. On at least a simple kind of economic reasoning,
that would indicate that the certain equivalent marginal product of capital was zero,
which suggests very little impatience on the part of consumers. I first learned this
in Stan Fischer’s monetary theory course, and at the time I regarded as a complete
theoretical curiosity, finding it interesting how wrong my preconceptions were. But
Stan’s course developed to some detail the idea that all kinds of funny things
happen when the interest of a country was less than its growth rate: that, for
example, it was possible to pay for things without ever really paying for them
because one could roll over the debt and still have a declining ratio of debt to GDP.
One learned that such an environment was an environment that would create and
make possible in every sense a variety of kinds of financial bubbles, and in such
cases various government actions that would normally be seen as quite inefficient
became quite efficient. And yet, the normal state over the last several decades has
been of interest rates less than growth rates in many parts of the world. Should we
draw the implications for economic theory from that reality? That would seem a
bold and probably rash course. Should we revise economic theory to understand
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these low real interest rates in a way different than we do? Should we be seeking to
pursue macroeconomic policies in a way that will create a world in which the
interest rate is higher than the interest rates that we have observed? I do not know
the answer, but I think it is a question that requires more reflection than it receives,
because I think if you describe every feature of modern industrialized economics to
most people that are well-trained in economics who have never observed anything
in the world, and then ask them what do they think the real interest rates will be,
their answer will be nothing like zero. This is a question that I think receives less
attention than it should.
My final question is what is the broad political compact that will surround 21st
century central banking? The world in the wake of the 1970s came to a quite clear
doctrine. It was a combination of empirical evidence, theory and argument. It went
something like this: inflation always tempts, and it always tempts because in the
short run it brings good things with it, and in the long run it brings nothing good
with it, and some substantial cost; thus, democracy in its most pure forms lends
itself to yielding to short term temptation. Therefore, independent central banks
who preserve their independence and are led by figures of extraordinary rectitude
can be society’s bulwark against the inflation temptations, leading to lower
inflation, the same or better output performance, and a better world. And so,
around the world, central banks have become much more independent, in a way
that would have been inconceivable to me as a student. When I studied with Stan,
and particularly a few years after I studied with Stan, if you took a course in
monetary economics, hyperinflation was a big topic, not because it was a really
interesting theoretical curiosity where things were taken to their extremes, but
because there were hyperinflations on most continents, and a big task of
economists was to give advice on how to stop hyperinflation. Today, hyperinflation
is like measles: a really bad thing that used to happen often and happens now in
very few places. And that is because of the independence of central banks. The
independence of central banks now means that there is much more acceptance,
though this acceptance is always fragile, of the idea that inflation needs to be
contained and controlled, so inflation tempts much less than it once did. To be sure,
there needs to be vigilance, there needs to be continued determination, there needs
to be continued strong figures of rectitude, but the threat of inflation seems much
less pressing than it did in 1979. There are new major concerns for more and more
countries: the exchange rate is of central importance for economic performance,
questions about the functioning of the banking system are pivotal to every
economic objective that a society has, questions of the ways in which monetary
policy is carried out matter fundamentally for issues of fairness and equity,
deflation has emerged as a major issue in many places. What will be the formula in
democratic society for preserving the virtues of independent central banks while at
the same time allowing for the cooperation of these central banks with elected
officials on matters of fundamental import to democracy? That, too, is a question
that will have to be answered in this generation.
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And so, Stan, it is my fervent hope and it is my great conviction that your
contributions to monetary economics and monetary practice are no more than half
over as you leave the Bank of Israel, and it is my hope that freed from the daily
preoccupation, among the many things that you would do, along with the great rest,
relaxation and time with your family that you deserve, that you will provide us
answers to these questions and the even better questions that you could pose. On
behalf of all of us, thank you for a job extraordinarily well done.
137
HEZI (EZEKIEL) KALO
Distinguished guests,
Good afternoon.
I am very moved, and I consider myself fortunate to chair the final part of this
Farewell Conference honoring Governor Fischer.
However, before I invite Governor Fischer to present the concluding address, I
would like—with your permission, Stan—to say a few personal words of farewell
at this prestigious forum.
I first met Stanley when I was a candidate for the post of Director General of the
Bank of Israel. This was five years ago, the first days of the global financial crisis
and the collapse of Lehman Brothers. What struck me then, and still does, was that
Stanley found time during the crisis to discuss my role, and internal problems faced
by the Bank of Israel.
Over the course of my career, I have worked with many managers in different
sectors of the country. You, Stan, are the first, and the only, one that I can call a
powerhouse. Stan, you are a rare and special blend of unique professional abilities
and charming personality—a real "mensch". We have developed a special
relationship, based on immense mutual trust.
We heard earlier about the reform at the Bank of Israel, with the establishment
of the Supervisory Council and the Monetary Committee. There is no doubt that
this historic process, led by Governor Fischer, could not have taken place if not for
his vision and his willingness to sacrifice parts of his authority in order to allow us
to set corporate governance at the Bank of Israel.
Stan, you have transformed the Bank of Israel into a leading central bank in the
world. In accordance with the vision of the Riksbank, the Swedish central bank, we
are really now “among the best”.
It is not for me to comment now on Stanley’s economic leadership, but I can
definitely say that during Stan’s terms of service, our technological infrastructure
was improved very impressively. Governor Fischer has promoted and made a
priority of business continuity and disaster recovery planning, including countering
cyber threats.
And now a special word for you, Rhoda. I will conclude with expressing my
warmest appreciation and gratitude to Rhoda, who took part so remarkably in life
in Israel, and contributed significantly, through her volunteer work and devoted
efforts, to promoting numerous social causes. Thank you, Rhoda.
Rhoda and Stan, I wish you much success in the future and all the best.
It is now my honor and pleasure to call upon Stanley Fischer for the concluding
address.
Thank you, Stan.
138
139
CONCLUDING ADDRESS
STANLEY FISCHER36
It is a pleasure and an honor for me to deliver this concluding speech. It is also
difficult, for three reasons. First, I am about to leave the Bank of Israel, after eight
wonderful years – wonderful not in the sense that every minute was a pleasure, but
rather that we in the Bank had the opportunity over these past eight years to
contribute to the economy and to the wellbeing of the people of Israel – and I
believe we did that successfully and in a positive spirit that made our work
fulfilling and rewarding. That means that I will leave the Bank with the most mixed
of feelings. Second, I have been sitting here for a whole day listening to visitors
and Bank members speaking well of the Bank and of me. I am grateful to all of you
for agreeing to take part in this conference, for your excellent papers and speeches,
and for your kind words. But – now I have to return to the real world. And third,
there are so many people that I want to thank, that if I thanked them all, I would not
have time enough to talk about the main focus of this speech – which is the topic of
the conference, “The New Bank of Israel”. So I shall not mention by name almost
all the people to whom I am extremely grateful for their advice, assistance, and
support.
Let me start by saying that whatever successes the Bank of Israel has achieved
in the period I have had the honor of being Governor, were built on the foundation
of a strong professional staff. That staff was seen at its best during the global crisis.
During the crisis we had to do a lot of things we hadn’t done before. We had
thought about some of them, we had prepared for crises, as is essential, but still you
never fully anticipate what will happen in practice. The management and top
professionals of the Bank worked in an exemplary way in dealing with the very
difficult issues we had to confront. I would like to thank them and all the workers
of the Bank for their work during the crisis and in more normal times.
No institution is an island unto itself, especially in Israel, and we owe thanks
also to colleagues in other institutions – starting with the Prime Minister’s office
under Ariel Sharon, Ehud Olmert, and Benjamin Netanyahu respectively. In
addition we generally cooperated closely with the Treasury and the six or seven
Ministers of Finance with whom we worked over the past eight years.37 In working
on the new Bank of Israel law and on other laws we interacted closely with the
Ministry of Justice. We appeared frequently in the Knesset, and met often with
members of the Knesset. And we were in continual contact with the private sector,
36
This is an edited version of the concluding speech that I presented at the Bank of Israel
Conference “The New Bank of Israel” held on June 18, 2013. In editing the speech, I have
tried to retain the tone of the original, while making the text more linear and less discursive.
37
I say “six or seven” because one Finance Minister (Ehud Olmert) served as Finance
Minister twice.
140
with the hi-tech and the traditional sectors, with the Arab and ultra-Orthodox
sectors, with charities and schools and universities, and with members of the armed
forces. From them we learned the depth of the talent and dedication of so many
people in this amazing country. I am grateful to them for showing me aspects of
Israel that I had never seen before – and Rhoda and I are grateful to the public for
the warmth with which we were treated from the very beginning to today, from
May 2005 through June 2013.
I turn now to the new Bank of Israel law.
1. Getting the new law passed
The Bank of Israel was set up in 1954, and operated for over fifty years under the
law of 1954, in which the Governor made all the policy and administrative
decisions, with the advice – but not necessarily the consent – of an advisory
council in each area. In 1997, after the then-Governor, Jacob Frenkel, had strongly
made the case for modernizing the Bank of Israel law, the then Prime Minister,
Benjamin Netanyahu, set up a committee headed by a retired judge, Judge Levin,
to recommend a new law. This was the period during which the inflation targeting
approach to monetary policy was being developed and implemented in a number of
advanced economies. The Levin Committee consulted widely, in Israel and abroad,
and presented its report in 1998. The report proposed setting up a Monetary
Council, with stable prices as its main goal, and with the subsidiary goal of
supporting the other goals of government policy. The report was well received, but
despite continuing pressure from Governor Frenkel, the old law remained in place.
Before accepting the job of Governor in January 2005, I received assurances
from the then Prime Minister (Ariel Sharon) and the then Finance Minister
(Benjamin Netanyahu) that they would support the passage of a new Bank of Israel
law, broadly along the lines set out in the Levin Report. I took office in May 2005,
expecting that it would take two to three years to pass the new law. The
negotiations turned out to be far more arduous and perilous than I had anticipated –
especially in light of the assurances I had received – and the new law was passed
only in March 2010, a month before the end of my first term.
Many people – some of them present today – helped to pass the Bank of Israel
Law. The Chairman of the Knesset Finance Committee, Rabbi Moshe Gafni,
playing a key role in passing the law through the Knesset. The law would not have
been passed without the support of the legal team in the Bank of Israel; it would
not have passed without the Bank staff who spent countless hours negotiating with
Treasury officials and others; it would not have passed without the support of at
least two Prime Ministers, Prime Minister Olmert and Prime Minister Netanyahu,
and one critical contribution by Prime Minister Sharon in the short period that I had
the privilege of working with him.
There was an inherent problem in persuading the Treasury to support a law
designed among other things to make the Bank of Israel more independent. The
141
problem was that the Treasury officials naturally found it difficult to agree to a
variety of changes that would take power away from the Treasury. So I would
particularly like to recognize the contribution to the new Bank of Israel law made
by the then-Director General of the Treasury, Yossi Bachar, who is here today. I
had come to Israel with a naïve notion that I could manage a monetary policy
committee on which there would be a minority of central bank members. Several
people told me: “Listen, you are not in New Zealand, you are in Israel: forget about
having a majority of outside members, it’s not going to work.” But that proposal
was in the first draft, which included a proposed monetary policy committee with
five members, two insiders and three outsiders. One day Yossi took me aside –
Yossi, the Director General of the Treasury, supposed to be leading the charge
against us – and said, “Stan, you can’t let that happen. You won’t be able to run the
central bank that way”, and we, together with colleagues in the Bank, came up with
the current structure of three members from within the Bank and three external
members, with a double vote for the Chairman. Yossi, the new law wouldn’t have
worked without your violating the code of the mafia or the Treasury as you did –
and for that, the Bank of Israel and the economy of Israel are very grateful to you.
In addition, it took the cooperation of Ministers of Finance, and Directors General
of the Treasury, and the Ministry of Justice and many others to pass the new law.
2. Features of the Law
The new Bank of Israel Law is not so new anymore; it was passed in 2010 and
came into operation at the end of 2011. As mentioned earlier, the law drew heavily
on the report of the Levin Committee, which was formed in 1997 and reported in
1998. That report recommended setting up a Monetary Committee with a structure
and goals close to that adopted in 2010.
The 2010 version added a Supervisory Council, to supervise the non-policy
aspects of the work of the Bank, particularly the budget of the Bank of Israel. The
Supervisory Council has seven members, five – including the chairman – from
outside the Bank plus the Governor and Deputy Governor. Its audit committee
consists of the four outside members who are not the Chairman – the key feature
being that there is no member of Bank management on the audit committee. As
must be clear from the discussion earlier today with the first Chairman of the
Supervisory Council, Dan Propper, I believe that the Supervisory Council is an
important addition. It has improved the overall governance of the Bank, and in
particular has significantly strengthened budgetary discipline in the central bank.
I believe further that the structure of the law is basically sound. We have
operated in its framework for 17 months, and while there are aspects we would like
to change, there are no major problems with the structure. Consider first the way
the members of the Monetary Committee and the Supervisory Council are chosen.
The mechanism is by now traditional in Israel: if something non-political has to be
done, you set up a committee with a retired judge at its head, either to do it or to
142
propose how to do it. This is also the method the new law prescribes for choosing
members of the Monetary Committee and the Supervisory Council. The
appointments committee has only three members. In addition to the retired (and
highly respected) judge at its head, the current committee includes a person from
the business sector and an economist. The law sets out criteria the members of the
Monetary Committee and the Supervisory Council respectively are required to
meet. The committee is expected to consult widely in searching for candidates; in
addition people can apply for membership. The committee is required to consult
with the Governor, but the Governor does not have a veto on its recommendations.
The cabinet either approves or disapproves the slates proposed by the
committee; it approved the committee’s recommendations made in 2011 for both
the new bodies. The delay of nearly a year and a half between the passing of the
law and its provisions going into effect in the Bank of Israel was a result of the
length of time it took for the appointments committee to identify and choose
candidates for the two committees.
In his comments earlier today, Dan Propper, the chair of the Supervisory
Council, commended the law for setting out clear criteria for membership of the
two new committees, but pointed out that it does not specify criteria for an
individual to be qualified to become governor, nor does it specify the process by
which the governor is to be chosen. That is a lacuna that needs to be filled.
3. The Monetary Committee
The Monetary Committee is the change in the new law that is most visible to
markets and to the public. I think it works very well. As everybody in the Bank
who took part in the previous interest rate discussions said earlier today, the
Monetary Committee works better than the informal consultative committee we
used to have.
In his presentation, Larry Summers asked some questions about committees. I
don’t think the issue is whether someone consults. I consulted in my first five years
on the job as governor, when I was in effect an absolute monarch. The issue is
whether there is a formal committee, including some outside members who do not
report to the governor and are thus likely to be more independent of his views,
whose procedures are set out, and whose decisions and the reasons for taking them
are presented and explained to the markets and the public.
Much of the discussion in the negotiations over the new law focussed on the
mandate of the Monetary Committee. The policy mandate is lexicographic on the
inflation issue. The law says that the central goal of monetary policy is to maintain
the stability of prices, as defined by the government. In writing the law, we had
lengthy discussions of whether price stability should be the main or the central or
the primary goal of monetary policy. Since my Hebrew wasn’t good enough to
detect the critical difference in meaning between these adjectives, I would have
been content with any of them. The goal is defined as a range, which for all the
143
time I was governor, and also before that, was set by the government at between
one and three percent per annum.
The second goal, provided the inflation goal is being met, is to support the other
goals of government policy, particularly growth and employment. In addition, the
Bank of Israel is charged with reducing social gaps, a goal which I think is
desirable in Israel, but for which the central bank does not have policy tools. Let
me explain how it nonetheless made it into the Bank’s mandate. The procedure in
the Knesset Finance Committee was that there was a full discussion of all the
clauses of the law, and then after the extensive discussion was done, the Committee
was set to vote on each clause of the law. The day of the vote the Chairman of the
Finance Committee called me into his office and said “You need to know that no
law leaves this committee exactly in the form it arrived”. We discussed the various
suggestions that had been made by Committee members, and he concluded by
telling me I could choose – either we would be given the goal of reducing social
gaps, or the Knesset Finance Committee would insert a clause requiring their
approval of the central bank budget.
I chose to reduce social gaps, and that was acceptable especially because the
Member of the Knesset who pushed for it was talking mainly about the Research
Department and its research on poverty, labor markets, education, and other topics
relevant to social gaps.
The lexicographic ordering could be a problem, if the committee interpreted the
inflation target as being one that has to be met at every moment of time. In the
profession, that problem was solved by the introduction of flexible inflation
targeting, the approach under which if, for whatever reason, the inflation rate is
outside the target range, the committee has the flexibility to return inflation
gradually to within the range. The law specifies that “gradually” means that the
policy chosen by the committee should be expected to return inflation to within the
target inflation range within two years.
The third part of the mandate is to support the stability of the financial system, a
topic to which I will return later.
Larry Summers discussed the transparency issue, which is both important and
complicated. The problem relates to the publication of minutes. From time to time,
particularly in a crisis, the committee may want to discuss ideas which might be
very novel or unorthodox. However, if you say something novel or unorthodox in
discussion within the Monetary Committee, it will be reflected in the minutes and
you are going to start creating problems in the markets – so full transparency in
practice constrains discussion and may limit the range of decisions that can be
considered. A friend who is on the board of the Fed said that when they discovered
they would have to make transcripts of their discussions public within five years,
the quality of the discussion changed. He said people showed up with written
speeches which they read to their colleagues, and the quality of discussion was
reduced because people were worried about what they are going to see in print
thereafter. I don’t know what to do about this. One wishes there was a way of
144
saying “OK, this is all off the record”, but that is against the principle of
transparency. I’m not persuaded that it is optimal to require us to publish
everything that we talk about, but that is what was said to us in the Knesset Finance
Committee when we raised the issue – “We publish transcripts of everything that
we say here, you can publish transcripts of everything you say”.
I’d like to mention two incidents in which Meir Sokoler, former Deputy
Governor, who is among those present today, was involved. The first is a story
from over seven years ago. In those days, even before we had a Monetary
Committee, we used to publish an announcement which explained the interest rate
decision. I usually worked on that explanation with the then-spokesman of the
Bank, Gabi Fiszman, who is also present today. That month I made a decision, and
Gabi and I started working on the announcement. The more we thought about it
and tried to explain it to each other, the less sense the decision made. I was in
charge in those days, so we changed the decision. But we were up against the wire,
to get the decision written in time to be announced at the regular time of 6:30 p.m.
at which we then announced the monetary policy decision. We did not have enough
time to inform the informal advisory committee with which I then worked of the
change in the decision. The rumor I heard, Meir, was that you were less than
pleased to be surprised at the interest rate decision while you were driving home
after helping make the opposite decision. I apologize. The point is not primarily
that I’m apologizing, but that having to write down your decision and the reasons
for it is a very valuable discipline on decision making.
We are subject to that discipline now that we have a Monetary Committee. We
discuss the decision on the first day of the meeting, and usually reach a preliminary
decision by the end of that day. On the second day the Bank spokesman brings a
draft of the decision, or sometimes drafts of two possible decisions, and the
committee sits down and gets to work on rethinking the decision, on its
explanation, and on the wording of the explanation. A lot of work goes into getting
the wording right. That is appropriate, for we have to explain ourselves to market
participants and the public, and in so doing we try to make sure that what we are
doing makes sense, and that it will make sense to those who read or listen to it.
Now for the second story. I frequently think of what we are doing in our lengthy
discussions of the state of the economy before making an interest rate decision as
being like looking at a pointillist painting, and trying to figure out what is going on
in it. At one of my first meetings, I said this is an unusually uncertain situation, and
a very hard decision, let’s wait a month for the situation to clarify, and then decide.
Meir responded with this Anna Karenina-like statement: “there will not be less
uncertainty next time; it will just be uncertainty about something else, so make the
decision”. That was absolutely right, not only because there would be some other
uncertainties a month later, but also because there are lags between making a
policy decision and the effects of the decision on the economy. This was a topic on
which I wrote some of my earliest papers, under titles like “Stabilization Policy and
Lags”. Because these lags exist, and may be long, I believe that policy decisions
145
need to be made earlier than our natural tendencies suggest, which means that it
may occasionally be necessary to reverse a recent decision.
4. Open Issues
I want first to raise the issue of whether the Governor can afford occasionally to be
in the minority in the Monetary Committee. There are two traditions. When Paul
Volcker lost a vote in the Federal Reserve Board, he was weakened. He managed
to reverse the vote on the same day, but he was nonetheless weakened. Further,
Chairmen of the Open Market Committee of the Federal Reserve System do not
lose votes. In the Bank of England, Mervyn King said he wanted sometime to be in
the minority in the Monetary Policy Committee, and he proceeded to lose more
than one vote – in fact, he was in a minority a few times – and he said he was quite
happy to be in the minority. This is a difficult issue. I don’t see how you can
frequently be in the minority on the key decision of the Bank and continue to
represent and recommend the policy of the Bank to the public. I decided that I was
prepared to lose very occasionally, but I didn’t want to make a habit of it. We’ve
had only 17 decisions since the committee was set up, and I haven’t yet been on the
losing side. There was one tie vote where I had the casting vote, and there is one
more coming up on Sunday (June 23, 2013). I don’t know whether to make an
effort to be in the minority, just so that the precedent is there for other people to
feel better about, or not. But I’m sure I’ll vote without worrying about whether to
set a precedent of being on the losing side that could be useful to a future
governor.38
Second, central bank independence: the new law gives the Bank of Israel a
significant degree of independence. But I don’t think that independence is absolute
for any central bank. The Bank of Israel law is not in Israeli terms a basic law – a
law which has quasi-constitutional standing. Rather, it is a regular law, which the
Knesset can change through its normal procedures. As I have frequently told my
colleagues, we are one bad decision away from losing our independence. Well,
maybe one bad decision would be acceptable, a series of bad decisions would not
be. The government would either find a way to fire the Governor, or would change
the law.
In practice, I have not had a problem over the independence of the central bank.
I think I’ve twice received calls in advance advising me what to do on the interest
rate. I said that’s very interesting, thank you for calling, and that was the end of the
pressure. I have had two or three calls telling me I made a bad decision – possibly
that may even have been true.39
38
In the event, I was in the majority in the final vote of my period as Governor of the
Bank of Israel.
39
The Bank of Israel does not have independence in the setting of salaries of its
employees. The system is inflexible and I tried in the negotiations over the law to get more
flexibility into the wage-setting process. The Bank is subject to the decisions of the
146
Third, the financial stability issue. Although the Bank of Israel law includes
supporting financial stability as the third goal of central bank policy, we did not in
2010 work out in detail how the financial stability function should be dealt with by
the Bank. We are fortunate that bank supervision is in the central bank, and
therefore when the Bank Supervisor is concerned about the stability of the banking
system, which is one of the goals set out in the law governing his office, he can
take action. Those who have been following closely the Bank of Israel’s measures
directed at strengthening financial stability know that everything we have done in
the way of macroprudential supervision has been done by the Bank Supervisor.
That is a power we have in the central bank, but there are other supervisors over
other parts of the financial system, and Israel has not yet succeeded in setting up a
system to coordinate their actions. The country needs to do a better job of
coordinating regulation and supervision among the three authorities who operate in
this area – the Supervisor of Banks (Bank of Israel), the Head of the Capital
Markets, Insurance and Savings Department (Ministry of Finance), and the
Chairman of the Israel Securities Authority.
There have been many different attempts around the world to figure out the best
organizational structure for dealing with financial stability and its coordination
among regulators. The most radical approach is that of the United Kingdom, which
has set up a Financial Policy Committee (FPC) in the Bank of England, chaired by
the Governor, but with a membership that is not identical to that of the Monetary
Policy Committee. The FPC can instruct the regulators on the actions they are to
take. The external membership of the two committees differ, and in addition, the
Treasury has a non-voting representative on the Financial Policy Committee. In the
United States, the FSOC (Financial Stability Oversight Council) has a coordinating
role, but it cannot instruct a regulatory authority on actions it is required to take –
for the regulators are formally independent institutions.
I’d like to add one more thing on macroprudential. I don’t think we should
continue to use the term “macroprudential”, because the word covers up a host of
sins. In the 1960s and 1970s central banks used to intervene in particular markets,
sometimes with different interest rates for credit provided to one industry rather
than another, and they had a host of regulations applied to different forms of credit
– for instance in the United States, Reg Q, Reg W, and other Regs. Gradually those
sectoral rules and regulations dropped away until only the short-term interest rate
was left. In part, the recently introduced measures in Israel and elsewhere that have
been called “macroprudential” – such as maximum loan-to-value ratios, changes in
the capital requirements against mortgages, constraints on the share of a mortgage
that can be indexed to very short-term interest rates – are a return to the past.
government wage supervisor, a Treasury employee. I did not think that was a good
arrangement for two agencies which are in Israel, as in many other countries, sometimes in
conflict. I believe the Bank needs more flexibility in this area than it currently has – but that
is a major topic, not a subject for a speech like this one.
147
We’ve introduced measures that deal with some unwanted consequences of
monetary policy via regulation and supervision and called them “macroprudential”.
I believe we should call these measures “financial stability” measures, because our
concern is with stability of the financial system, whose importance has once again
been driven home to us as a result of what happened with Lehman Brothers.
It is sometimes said that the consequences of the failure of Lehman Brothers are
unprecedented. However, accounts of the financial crisis associated with the Great
Depression often begin “The bank, Creditanstalt, failed in Austria, …” As a student
I asked myself, how does the failure of a medium size bank in a small country lead
to a global financial crisis. Well, now you can ask how does the failure of a
medium size bank in a large country lead to a global recession. The questions are
the same. While we may not have the precise mechanisms worked out, we do know
that the loss of confidence in financial institutions can be contagious, and
devastating. That is something every central banker has to remember, especially
when the good times begin to roll again.
Fourth, the role of the Governor as the economic advisor to the government: I
was concerned before coming to Israel that the Governor’s role as economic
adviser to the government could create a conflict of interest – possibly that in
seeking to get close to the Prime Minister, the governor might open a path for too
much government influence on monetary policy. I discussed this problem with a
few friends in different countries and one of them said to me, “Stop being a purist.
The question is will it be useful – will you be helping the country if you and future
governors are defined as the economic advisor to the government?” He thought it
would be useful, and on the whole, I thought he was right.
Another argument in favor of keeping the governor-as-economic-adviser role
came from a committee we set up to examine the Research Department of the
Bank. The committee was headed by Larry Meyer, with Marty Eichenbaum,
Elhanan Helpman and Philip Lane of Trinity College, Dublin as the other
members. They came here opposed to the economic advisor role. They ended up
supporting it for a reason I hadn’t thought about at all. They said they were
surprised by how this particular role motivated the Research Department; they said
that researchers felt their work was more important and more worth doing because
it was part of the public discourse on economic policy. The committee said that this
didn’t cause any difficulty and was a good motivator of the Research Department
and of the Bank of Israel. I don’t know whether this function will survive forever,
but it certainly has outlived my expectations, and I guess it will continue to be part
of the law of the Bank of Israel.
Finally: do we have a reasonable central bank law? What changes would we
make if we could completely rewrite the law?40 Fundamentally, the law of the
40
As is inevitable with any law, some details of the law need changing after we have seen
how they have worked in practice. I am not here discussing those technical and relatively
small changes, rather I am talking about the general approach of the new law.
148
Bank of Israel provides a framework for a sensible flexible inflation targeting
approach to monetary policy. The flexible part is essential, for I do not believe that
any central bank ever was a pure inflation targeter – and I include the Bundesbank
in that. I do not think any central bank ever believed that it doesn’t matter to me
what happens to the level of output, so long as inflation stays on target. Nor did
they behave that way. That issue was formally addressed by the invention of
flexible inflation targeting.
I think the framework we have is a reasonable one, I’m not sure whether
lexicographic preferences will survive but I think they should, provided you
understand that you may want to be away from the inflation target for some time.
Our law says two years, but I’m sure a succession of negative disturbances to
output would justify more than two years. I believe flexible inflation targeting will
survive, but there is no question that it is among the issues that we are going to
have to contend with in the years ahead. We also have to work on getting the right
organizational framework for dealing with financial stability. We have to
understand systemic interactions among financial institutions, and among the
different classes of financial institutions, and that is work which my successor
certainly is going to have to take on.
5. Farewell
I don’t want to conclude by saying goodbye to everybody right now. I do want to
conclude by saying again that it was a privilege to be given this job, an unexpected
privilege. There was no point in my adult life when I expected I would be
Governor of the Bank of Israel. Then one day the offer came up, when, on a quiet
Caribbean evening, I received a phone call from the then finance minister, the
current Prime Minister, Benjamin Netanyahu.
Rhoda and I had always wanted to do something positive for Israel, and this
unique opportunity was offered to us. I knew it was unique: finance ministers don’t
call you every day to suggest becoming the Governor of their central bank. So we
said yes, opening the way to a wonderful experience.
I said at the beginning that I could not thank everyone by name and so would
not start doing that. But I do want to thank those members of management and staff
with whom I worked most closely over the last few years: Karnit Flug, Deputy
Governor, quiet, intellectually tough, never afraid to state her views, always willing
to take on critical tasks; Hezi Kalo, the Director General, a man whom I and
everyone trusts, a prodigious worker, whose work and presence have stabilized the
Bank; Eddy Azoulay, my Chief of Staff, who is a miracle of quiet efficiency and
effectiveness; and the office team, Ronit Cohen, Sharona Cooperman, and Metzada
Shamir, with whom it has been a pleasure to work. Every one of these people
works with remarkable efficiency and remarkable pleasantness. To them, to my
other colleagues in management, to everyone with whom we worked: thank you for
everything you have done for your colleagues and for the Bank of Israel.
149
Finally, I want to thank Rhoda, without whose steadfast support I would not
have been able to do this job. This was sometimes not easy for her, but like me, she
would not have missed this experience for the world. Thank you for everything you
have done, and for everything we mean to each other.
Thank you all.

THE NEW BANK OF ISRAEL

Transcription

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