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Summary of address by the Governor of the Bank of Israel today at the Israel Economic Association annual conference
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Below is a summary of the address by the Governor of the Bank of Israel at the Israel Economic Association annual conference today.
I would like to focus at the beginning of my remarks on the lessons that the previous crisis taught us about monetary policy. Further on, I will expand the discussion to lessons for fiscal policy.
One of the lessons that we learned from the recent crisis regarding monetary policy is that in contrast to what is written in textbooks, including ones on which I collaborated, reaching an interest rate of zero is not the end of expansionary monetary policy, for beyond that lies quantitative and credit easing, Operation Twist, foreign currency purchases, and more.
We learned of another role of the central bank. In addition to being the lender of last resort, the central bank also serves as the market maker of last resort. The Fed, for example, intervened in financial market segments that it saw were not operating properly, and served there as a market maker until those markets were functioning again.
We learned again of the additional roles of the central bank, as they are recorded, for example, in the Bank of Israel Lawsupport for the government's policy objectives, growth and employment, and financial stability.
We learned from the book by Reinhart and Rogoff about the dynamics of debt crises, and the great importance in preventing financial crises. We are currently learning again about the dynamic between monetary and fiscal policy, and apparently we will continue to learn about the growing importance of macroprudential policies.
I would like to now focus primarily on the lessons for fiscal policy that we learned from the crisis. My remarks are based on a lecture I gave recently at the annual IMF Fiscal Foruma lecture which can be found in its entirety on the Bank of Israel website.
During the course of the 1970s, it appeared that the literature afforded a shrinking role to fiscal policy as a policy tool for macroeconomic stability. However, in recent years, it appears that the literature has come to emphasize the stabilizing role of fiscal policy. The literature mentions the term "expansionary fiscal contraction", in connection with countries which carried out contractionary fiscal policies which in the end succeeded in leading to growth and not to contraction, through reduction in interest rates and devaluation. When the government is in a problematic fiscal situation, fiscal contraction can lead to significant reduction in yields, and together with the devaluation, the cumulative effect of fiscal contraction can in fact be expansionary. This effect can be significant precisely for countries which are members of a monetary union and cannot conduct independent monetary policy, although they have the ability to reduce the risk premium that markets ascribe to the government. An important lesson that we learned again is that large deficits, which lead to a high debt burden, are not sustainable and are not good. Primarily, they have a negative impact on the government's flexibility to conduct fiscal policy as a stabilizing tool for the short term.
It could have been expected that the increase in budget deficits and in debt ratios of the large advanced economiesthe US, UK, and Japanwould lead to higher government bond yields to an extent that would make it difficult for the governments to raise debt. This has not happened to date, and we should ask ourselves why. There are several possible explanations:
A. Growth is still slow, so that there is no concern of inflation.
B. Central banks are purchasing government bonds all along the yield curve. For example, in the UK, the Bank of England has bought nearly half of the total new issues of government bonds.
C. Those governments, and their intentions to stabilize the fiscal situation in the future, continue to maintain credibility, apparently, in the markets.
D. The United State benefits from the fact that its currency remains the world's primary reserve currency, which allows it to continue to issue debt without suffering an increase in yields.
As far as the continuing crisis in the eurozone, many people claim that the main problem is that the Europeans do not have a growth strategy. I do not ignore the severe social distress which some European countries are facing, and thus we should try to find the most effective and least hurtful solution possible. In my opinion, the strategy needs to be based on the following:
A. Fiscal tightening does not need to start immediatelyit can wait for one or two years, in accordance with the ability to continue raising resources from the IMF and other institutions, while fostering longer term growth in the various countries.
B. Some economies need structural reforms, which will allow them to reduce the cost of hiring workers and to increase the flexibility of labor markets. Policy measures that increase labor market participation are also required.
C. Product market and financial sector reforms are necessary, and it is particularly important to strengthen the banking system. Reinhart and Rogoff showed that a banking system crisis leads to a long and deep recession, and so it is important to take rapid steps in order to stabilize the system. This is liable to entail high costs, but there have been instances in the past in which stabilizing the banking system ended up profitable.
D. It is very important to improve the business environmentone useful guide in this area is the World Bank's annual Doing Business report. In Israel, by the way, the problems in this area are primarily the bureaucracy around the real estate industry, and it is very important that we improve in this area, in which we are ranked very low compared with other countries.
E. The ECB is facing a dilemmais the money supply already sufficiently large, or can it support growth by purchasing government bonds? We don't know the answer, but it is clear that the ECB is aware of the importance of this question.
F. Eurozone countries cannot nominally devalue their currency vis-?-vis each other, but they can carry out internal devaluation, by reducing prices in various markets. For example, reducing direct taxes, which will reduce the cost of employment, will help improve the competitiveness of the countries in crisis. In extreme cases, such as Israel after the Economic Stabilization Plan, prices can even be supervised for some period of time. I doubt if this can be done in modern Europe, but at least they can avoid acting in the opposite direction, that is, avoid raising prices of products for which the government is responsible for prices.
G. There is an additional aspect, through which it may be possible to support growth in Europecountries with enough fiscal space can implement fiscal expansion, and the increased demand which would flow from that will eventually trickle down to other markets. With that, it is certainly possible that not all economies with the ability will want to increase expenses in this manner.
If these steps are not successful, it is likely that we will see one or more countries exiting the euro bloc. It should be emphasized that is not an easy step at all. In particular, someone who imagines a switch one day from the euro to the drachma, and the next day a devaluation, and the return of the economy to growth, is making a mistake. This is a very complicated and intricate step, as it involves transferring the entire financial and contractual systems from one currency to another, and it will be a very difficult period from a social perspective, not to mention the technical one.
All that is left is for us to wish our European neighbors luck in the battle they are facing, and to continue to closely monitor developments, which will no doubt affect us as well.